The “Social Cost of Carbon” and Climate Change Policy

Economist Frank Ackerman has called the “social cost of carbon” the most important number you never heard of. What is the social cost of carbon, where do the numbers come from, and why should policymakers take care when using them?

The Obama Administration (and the Bush Administration before it) uses the SCC to assess the benefits of regulations that would limit emissions of carbon dioxide (CO2). The SCC estimates the benefit society will gain, expressed in monetary value, by avoiding the damage caused by each additional metric ton (tonne) of carbon dioxide (CO2) released into the atmosphere. It is part of a larger exercise required by long-standing Executive Order of agencies of the Executive Branch of U.S. Government, including the Environmental Protection Agency. When agencies prepare to issue regulations implementing the laws enacted by Congress, they must justify proposed regulations by assessing their costs and benefits. The SCC is used as the benefits part of the cost-benefit analysis. For a regulation that decreases emissions, the SCC represents the damage avoided or the benefit of the regulation, on a dollar per-ton basis.

When government decisionmakers or the public see SCC analysis, the results are presented as a single monetary value (for example the Obama administration arrived at a “central value” of$21 per metric ton of CO2) or range of numbers that tries to capture some of the uncertainties in the estimates (for the Obama administration, $5 to $65 per metric ton of CO2). These estimates are derived from complex computer modeling. However, even a seemingly rigorous SCC estimate masks a series of choices and value judgments made by the economists who run the computer models, and a simplified assessment of climate science.

The Role of SCC and Cost Benefit Analysis in Climate Change Policy

Cost-benefit analysis can be an important and useful tool in government decision making. However, thorny issues arise when applying cost-benefit analysis to climate change. While monetizing environmental costs and benefits is always a challenge when conducting cost-benefit analysis, the analysis central to estimating SCC requires that the modelers make assumptions that go well beyond the usual boundaries of science or economics. The exercise involves many judgment calls that are largely hidden in complex economic models and that may be invisible to policymakers and stakeholders.

When these judgments are embedded in economic models, policymakers and stakeholders do not have the opportunity to discuss and directly debate the underlying complex value choices. In some instances, decisionmakers may not realize that choice of models and factors contain essentially ethical and other considerations. In addition, the process of making calculations often omits essential information, such as the possibility of a very severe outcome.

A debate currently taking place within parts of the economics community asks whether climate policy is a special case for which standard tools of the economic profession such as cost-benefit and SCC analysis are not adequate to assess policy options. Until this debate is resolved, no single value should be accepted by policy makers unless all the assumptions and choices that underpin the calculation are transparent and well understood.

Below are some frequently asked questions about the social cost of carbon and how it is estimated.

How does the government use the social cost of carbon?

The White House’s Office of Management and Budget (OMB) reviews all regulations prior to their being proposed and prior to adoption.¹ OMB has authority to send a regulation back to the agency for revisions or reconsideration when the regulation is deemed not to “comport with the Executive Order’s principles and the President’s priorities.”² The question they ask in the context of SCC is: if, for example, greenhouse emission standards for cars might cost $10 per ton of reduced emissions, will they bring about benefits from reduced emissions that are worth that cost or more? In 2009, an interagency team of U. S. government specialists tasked to estimate the SCC reported a range of values from $5 to $65 per metric ton of carbon dioxide, with a “central value” of $21. At $5 a metric ton, government could do very little to regulate CO2; at $65, it could do more. Higher SCC numbers, such as the UK’s range of $41 – $124 per ton of CO2 with a central value of $83, would justify, from an economics perspective, even more rigorous regulation.

How does the government derive the social cost of carbon?

Economists use complex economic models that seek to mimic or approximate the real-world factors that impose both costs and benefits on society. By doing so, they aim to examine the economic processes at play. The models used for SCC are called “integrated assessment models” (IAMs) because they attempt to incorporate knowledge from a number of fields of study, such as engineering, technology, behavior, and climate science, with the purpose of deciding whether particular climate change policies are economically efficient. The IAM uses mathematical formulas to simulate the relationships between economic activity and measures to control emissions and the desired environmental outcomes. Judgments are distilled into equations in order to compare one against another³ and to capture interactions between different component parts.

One challenge is estimating future damages that might be avoided by acting now and translating these values into monetary damage.⁴ The damages are culled from a vast literature of climate science. Some of the anticipated damages are relatively obvious, such as increasingly more intense floods and droughts. But, since there have always been floods and droughts, the challenge is to estimate which of these can be connected to a changing climate. Where the modeler’s task gets even harder is to identify and monetize the potential consequences of extreme weather events ranging from property damage through famine, dislocation, mass migrations, civil instability, potential conflicts and wars.

Economists estimating these numbers, by necessity, simplify how they represent impacts. Often, they use a proxy, which may not adequately represent the real harms being inflicted. For example, it is easier to assume that temperature rises equally around the globe, even though there will be geographic differences. Even if a model is able to represent differences in temperature increases regionally, it is much harder to integrate into their model that “the rise in average temperatures is not as important as the number of days above a temperature threshold, 32oC (90oF) or less for some major crops.”⁵

Other types of simplifying assumptions are used to capture relevant factors, such as the severity of the damages from changing weather, details of the dynamic earth system, and distortions of carbon cycle feedbacks by anthropogenic GHG emissions. The models cannot accommodate the level of detail that would be needed to try to represent every detail of expected change in the climate system and the consequences of those changes. A few examples of factors the models have particular difficulty with include:

• the impacts of increased temperature that result from rising greenhouse gases altering the balance of incoming and outgoing energy in the Earth-atmosphere system (“radiative forcing”);

• regional temperature effects (since different parts of the earth will react in different ways);

• changes in the climate system that occur in “non-linear” ways (such as feedback cycles, tipping points and cascading effects that are irreversible, as opposed to a smooth and steadily warming world); and

• possible economic, environmental and social impacts such as whether changing weather will lower economic growth (GDP) and human well-being in the future, or whether extreme weather changes will provoke social conflict due to human migrations from less habitable to more habitable parts of the earth.

Surprises and how they interact with other factors are particularly difficult to capture in modeling (whether science or economics). Climate science indicates the potential for unexpected events in the earth system (the cascading effects, feedback loops, tipping points noted above) that are unpredictable in terms of their timing and severity based on current knowledge. Likewise, human behavior is dynamic. Equations are not flexible enough to capture these events accurately, even though understanding the climate system and the possible impacts that changes to that system could have on human life is essential to estimating the SCC. Critics of economic modeling, such as scientists MacCracken & Richardson, question whether an IAM can capture problems “inherent to the complexity of the Earth system.”⁶

How transparent are the assumptions contained in the models?

Some authors of models make their component parts publicly accessible, as well as the tools to run the model. Some models are proprietary and therefore inaccessible by anyone but the author.

Still other models are essentially black boxes because of their complexity and the programming language used. An example of the latter is the FUND model, one of the three used by the U.S. Government in its estimation of SCC. When researchers “looked under the hood” in March 2011, they learned that FUND assumes that agriculture can tolerate huge temperature changes -- an astonishingly wide swing of 17oC above and below historical levels (17 degrees Centigrade is equivalent to 30.6 degrees Fahrenheit). FUND values cumulative damages including sea-level rise, storm damages, droughts and floods, human deaths and diseases, extinction of species, and forced migration of huge numbers of climate refugees at $4 per ton of CO2, with water supply problems and extinction of species accounting for $2 per ton of CO2. It excludes catastrophes (possible collapse of major ice sheets, accelerated methane releases from melting permafrost, collapse of rainforests, and drastic changes in ocean currents).

Reasonable people can and do disagree with these choices. Thus, when policy-makers rely on a model or any of its outputs including the SCC, it is as important that they understand the assumptions behind a model before they apply its final results.

What is the discount rate and why is it so important?

A key variable in calculating the social cost of carbon is the “discount rate.” The discount rate reflects the challenge of capturing the time factor in climate policy. It contains three assumptions. These are that humans prefer to receive benefits in the present rather than the future, that future generations will be richer and a dollar worth less to them as a result, and the opportunity cost of capital (that there are a variety of investment options for any given sum).

In the calculation of cost-benefit and SCC, the choice of discount rate influences whether economists recommend investing in greenhouse gas reductions today or much later. From this perspective, the higher the discount rate, the less significant future costs become. The choice of discount rate for investments in managing greenhouse gas emissions, especially as this issue was handled in the Stern Review, ignited intense debates in the economics profession.⁷ Stern used a low discount rate, approximately 1.4%, compared to William Nordhaus, a professor at Yale University, who currently uses a discount rate of about 3%. Three percent values an environmental cost or benefit occurring 25 years in the future at about half as much as the same benefit today.⁸ As explained by economists Burtraw and Sterner:

At a discount rate of one percent, the discounted value of $1 million 300 years [from today] is around $50,000 today. But if the discount rate is five percent, the [current]…value is less than a mere 50 cents.⁹

This range of discount rates, which span those commonly used in calculating the SCC, lead to differences in net present value after three hundred years that vary by a factor of one hundred thousand.