Accounting for externalities in cross-sectional economic models of climate change impacts

Environmental effects and natural resources depletion associated with agriculture production affect the agriculture response to climate change. Traditional cross-sectional climate response models ignore this requirement. This research estimates the impact of climate on European agriculture using a continental scale Ricardian analysis. We correct farm income by accounting for resources (energy, fertilisers, pesticides, and water) use intensity and calculate the sustainable value for a sample of 9497 specialized field crop farms. Compared with the traditional Ricardian method, the marginal effects of temperature remain positive (but less positive) in Northern countries, while it leads to less damages in Southern countries when net revenue and farms' sustainable values are used as dependent variables. Accounting for the environmental effects and depletion of natural capital improves the ability of the Ricardian method to estimate agriculture climate response functions in the long run.