The Understand the Economics of the Social Cost of Carbon

We're all told that CO2 emissions are bad and that we have to act now to avoid disaster in the future. Here is a primer on the economics or financial calculations behind some of those policy recommendations.

Understanding the Social Cost of Carbon

One key consideration in the Climate Change debate is how much damage will occur, when it will occur, and how to quantify the results. If we could come up with a number, then we would be able to judge cost-benefit of various policies today, such as cap-and-trade or taxes directly on
CO2 emissions. One might think that this is an area where economics can be applied to give us clear answers. Well, let's see how that hypothesis works.

Assumptions:

1. This is an economic discussion. It is based on accepting that the IPCC or "consensus" views of CO2 emissions are reasonably correct.  (a dubious assumption, but a topic for a different day)
2. It looks closely at the "discount rate" and the economic models that try to calculate the cost or benefit of CO2 emissions
3. It considers why the EPA ignores guidance from the OMB when calculating the Social Cost of Carbon (SCC)

Understanding the Discount Rate

The first thing to understand is that the models used by economists to determine the SCC are complex, include many different assumptions - such as population growth, technology growth, GDP growth, future emissions (which depend on GDP growth), etc. and then try to factor in how climate change might affect these trends. If it is 4 degrees hotter 75 years from now and we have more drought or extreme weather, what is the cost of that damage? And since it occurs so far in the future, how can we scale that value back to today and compare it to an investment to avoid that occurrence at some point far in the future. The method used to calculate the "present value" of a future event involves a discounted cash flow calculation using the Discount Rate. If you're not familiar with that concept, click here. Or, basically, this is like the inverse of the interest rate you pay on your house. You know that that if you take out a loan for $200K at 5% for 30 years, your total payments are going to be: $386,640.  So... that's the expected value of your house then... or discounting it to today, we end up with $200K.  Obviously, the interest rate makes a huge difference, and unlike the housing market, the interest rates / discount rates chosen for the SCC are not determined by market forces.  They're set by theory and government bureaucrats.

What Does the Literature Say?

While many claim that there is a "consensus" view of climate change itself, the result in the economic literature are mixed:

In the economics of climate change academic literature, there are disputes over the proper discount rate, with some economists arguing that very low rates should be used in order to place future generations on a nearly equal footing with the present generation in policy analysis.  - Robert Murphy

In the IPCC's AR3 report, Stern used a very low discount rate and came up with a very high estimate for SCC.  This was roundly criticized, and not just by the climate skeptics.  William Nordhaus is a very respected economist on the warmist side, and here Murphy quoting what he said about the Stern report:

William Nordhaus has shown that the Stern Review's extreme penalties on emissions are due to the choice of discount rate. Using Stern's parameters for his model's utility function, Nordhaus explains the following apparent absurdity: 

"Suppose that scientists discover a wrinkle in the climate system that will cause damages equal to 0.1 percent of net consumption starting in 2200 and continuing at that rate forever after. How large a one-time investment would be justified today to remove the wrinkle that starts only after two centuries? Using the methodology of the [Stern] Review, the answer is that we should pay up to 56 percent of one year's world consumption today to remove the wrinkle. In other words, it is worth a one-time consumption hit of approximately $30,000 billion today to fix a tiny problem that begins in 2200."

If we go forward to AR4 things improved somewhat, but we still have many of the same issues as Murphy explains.

Even if policymakers took the AR4 results as gospel, some of the popular policy recommendations, such as those being proposed by key Congressmen, are difficult to justify. - Robert Murphy

The Impact of the Discount Rate

Why is that?  Well here's Murphy again from his testimony:

My point in this discussion is not to argue for or against a particular discount rate.
Rather, I am demonstrating how crucial this apparently innocuous modeling choice is. 

Or, graphically, we can see

1.  As the discount rate increases, the SCC drops
2.  Why the EPA ignored charting the 7% rate specified by the OMB (it would have been negative)

Again Murphy:

If the choice of discount rate means the difference between a SCC of $50/ton versus zero, this is clearly a matter that should not be left to a handful of regulators to decide. It
underscores my claim that the “social cost of carbon” is not an objective empirical feature of the world, but is rather a very malleable figure dependent on subjective modeling assumptions, and can be made large, small, or even negative depending on parameter choices.

The Consensus?

We hear much about the 97% or other fictions of the climate change debate.  Above, we can clearly see that the debate is wide from an economic standpoint.  But, is that just because Murphy is an Austrian economist?  NO!

Here's a CAGW economist saying much the same thing.  Robert Pindyck of MIT.

CLIMATE CHANGE POLICY: WHAT DO THE MODELS TELL US?

So how large is the SCC? Here there is plenty of disagreement. Some argue that climate change will be moderate, will occur in the distant future, and will have only a small impact on the economies of most countries. This would imply that the SCC is small, perhaps only around $10 per ton of CO2. Others argue that without an immediate and stringent GHG abatement policy, there is a reasonable chance of substantial temperature increases that might have a catastrophic economic impact. If so, it would suggest that the SCC is large, perhaps as high as $200 per ton of CO2.

And (my bold)

What have these IAMs (and related models) told us? I will argue that the answer is very little. As I discuss below, the models are so deeply flawed as to be close to useless as tools for policy analysis. Worse yet, their use suggests a level of knowledge and precision that is simply illusory, and can be highly misleading.

Here he is on Econtalk as well:

Pindyck argues that while there is little doubt about the existence of human-caused global warming via carbon emissions, there is a great deal of doubt about the size of the effects on temperature and the size of the economic impact of warmer climate. This leads to a dilemma for policy-makers over how to proceed.

What is the Cost to the US vs. the Global Cost

One other point that Murphy raises in his Senate testimony is that the EPA has also deviated from guidance in that it used the global cost of carbon ($33/ton) instead of the cost based on the impact to the United States (somewhere between $2 and $8/ton).  Why might the EPA choose the higher cost?  What would the cost be if a higher discount rate was used?  Would the average American care if the cost of carbon was $0.25 per ton?

And, for another interesting discussion on this topic, listen to this Econtalk with Martin Weitzman.  One "cute" point that is made is that the carbon taxes are "internal" to a country, and therefore might displace other taxes.  In other words, if we have an SCC of $8, but charge $33, then there is a differential of taxes on carbon that could be used to take away other sources of taxes.  Both Weitzman and Russ Roberts laugh about the likelihood that the government would try to do that.

Martin Weitzman of Harvard University and co-author of Climate Shock talks with EconTalk host Russ Roberts about the risks of climate change.

Weitzman argues that climate change is a fat-tailed phenomenon--there is a non-trivial risk of a catastrophe.

Summary

The SCC is based on economic models and predictions that vary quite widely.  If the OMB specified discount of 7% was used, we might have a policy of encouraging the use of coal fired power plants to enhance the benefits.  If we use very low discount rates, then the SCC is very high, but is that a realistic value?   If we use Weitzman's model, does that really help?  What sort of fund would the government set up?  Could we use the carbon tax to fund Social Security?

Hope you learned something about the discount rate and SCC....