Why climate change makes GDP unsuitable for measuring economic churn

GDP does not capture issues like welfare, inequality and human development. Nor does GDP capture the damage to the environment caused by economic activity, writes T N Ninan

The modern concept of gross domestic product (GDP) dates back about nine decades. It was formally adopted as the primary economic measure in 1944 at the Bretton Woods conference, resulting in the creation of the International Monetary Fund and World Bank. Critics decry the primacy that it has attained since then, because it does not capture issues like welfare, inequality, and human development. Nor does GDP capture the damage to the environment caused by economic activity, and the various effects on people confronting climate change. The ironic fact is that the work of cutting down trees adds to GDP, as does subsequent work on reforestation.

For that very reason, GDP may lose some of its present salience. Consider the growing efforts to control carbon emissions and prevent climate change. Massive investments are going into setting up renewable energy capacity, the production of electric vehicles, and the associated re-invention of many industries. Coal-fired power stations are being shut down in some countries as renewables-based electricity now accounts for all, or almost all, additional power capacity. The sales of cars fuelled by petrol and diesel have peaked in parts of the world. They will soon decline in absolute numbers, making way for electric vehicles. The phasing out of many large, traditional industries will accelerate in the coming decade.

GDP could be misleading during such disruptive churn. It is only NDP (net domestic product, which is GDP minus depreciation) that will capture the churn by tallying also the accelerated depreciation or wholesale discarding of existing assets. If a coal-fired power station is replaced by a solar array or a wind farm, the net addition to economic activity as measured by NDP will factor in the junking of the coal-fired unit, whereas GDP would mislead by recording only the production of the solar array or wind farm.

Depreciation has already gained in importance as the economy’s productive assets have grown. In the third quarter of the last century, the gap between India’s GDP and NDP (i.e. depreciation) was a little over 6 per cent. It is now twice that, at 12 per cent. The drive to control if not reduce carbon emissions should further increase the gap between the two measures during the transition period, as carbon-intensive production facilities give way to cleaner substitutes well before the former’s useful life is over. The railways, for instance, is still adding new diesel engines to its locomotive stock; many of them will have to be shunted to sidings (or hopefully exported) before too long, as the railways electrifies all haulage.

Recording these and other similar changes will still not capture the full extent of the depreciation required because the usual macro-economic numbers, even when they recognise the depreciation of constructed capital, ignore nature’s capital: Water resources, forest wealth, clean air, etc. India’s groundwater table has been falling for decades, and is causing a crisis in granary states. Air pollution is affecting people’s health. Rising temperatures across the Gangetic plain will affect working hours. The dams being constructed in the Himalayas are causing environmental harm; ask the residents of Joshimath. The dams themselves can get damaged: Two under construction were swept away or hit by a rush of water in 2021.

The all-in cost of the change required to deal with all this, and of industrial transformation across the board, cannot but go up. One consequence would be to raise the capital-output ratio, or the number of units of capital required to generate a unit of output. A higher capital-output ratio automatically means slower growth. GDP becomes less reliable in such a scenario as the primary measure of economic activity.

Tracking NDP more closely would also not be enough. The country must additionally track the yearly changes in the economy’s balance sheet of assets and liabilities, including natural and human assets. GDP and NDP must be viewed alongside such a balance sheet, just as a company’s shareholders look at income and expenditure statements along with its balance sheet of assets and liabilities. Often, the balance sheet is the more important document. As climate change forces economies to adapt, the salience of economic measures too will change.