On the US Governments Estimation of the Social Cost of Carbon

Prepared for Fall Meeting of the ABA Section on the Environment, Energy, and Resources Oct 13, 2011, Indianapolis Daniel H. Cole Professor of Law and of Public and Environmental Affairs Indiana University, Bloomington Outline of Presentation Bottom line of this presentation Establishing a social cost of carbon (SCC) is the most significant step the US government has yet taken toward establishing a national climate policy. But thats not saying much. What is the SCC? Technically, the social cost of carbon is the sum of the private cost of carbon production and consumption plus the externalized costs associated with carbon production and consumption activities. Many of those externalized costs are not priced in markets. As a matter of practical politics, the SCC constitutes the price society should be willing to spend to mitigate greenhouse gas emissions. More expensive policies would constitute inefficient over-regulation; less expensive policies would constitute inefficient under-regulation. In determining the efficient price for carbon emissions, the SCC tells us the efficient Pigovian tax rate.1 Why do we need to price carbon in the first place?

S1 (priva te and s ocial costs)

S 2 (priva te co sts o nly)

p1 p2

D q1
1

q2

In fact, a Coasean tax would be more socially efficient than a Pigovian tax. The difference is that a Coasean tax would not seek to internalize all externalities but only inefficient externalities (those for which the social benefits of internalization would exceed the social costs).

Climate change is a classic externality (or, from another point of view, public good) problem, symptomatic of market failure. The market price of goods and services produced from carbon fails to account for some of the costs of carbon-based production and consumption. Those costs are externalized from the market, but ultimately are borne by people somewhere. Thus, the classic externality graph (above), which describes all conventional pollution problems, equally applies to the problem of climate change. How is the SCC established? Economists determine the damage function from different levels of carbon emissions and/or ambient concentration levels. The physical consequences of climate change entail socio-economic consequences, not all of which are priced in markets. For non-market harms (and benefits) economists must use second-best proxies, such as contingent valuation, to estimate values. Once all of the external costs (and benefits) from carbon emissions have been estimated, economists calculate net costs (or benefits). Virtually all economic models have found net social costs. Those net social costs are added to the private-market costs associated with carbon emissions to derive the SCC. Different economic models and interpretations of those models, in the peerreviewed literature, have yielded different values for the SCC, ranging from less than $10 per ton of carbon dioxide equivalent to more than $300 per ton.2 In 2010, the US governments Federal Interagency Working Group (hereinafter working Group) derived a central estimate of the social cost of carbon (for 2010) of $21.40 per ton of carbon dioxide equivalent. 3

See Richard S.J. Tol, The Social Cost of Carbon: Trends, Outliers, and Catastrophes, Economics Discussion Papers 2008-25 Table A-1 (Sept. 19, 2007). Tols meta-analysis quite properly does not consider estimates outside of the peer-reviewed literature, some of which estimate far higher values of the SCC. Other estimates, from the non-peer-reviewed literature, derive values for the SCC exceeding $1000/ton. See, e.g., Frank Ackerman and Elizabeth A. Stanton, The Social Cost of Carbon: A Report for the Economics for Equity and the Environment Network (April 1, 2010) <http://www.e3network.org/papers/SocialCostOfCarbon_SEI-20100410.pdf>. 3 Federal Interagency Working Group, Appendix 15A, Social Cost of Carbon, Social Cost of Carbon for Regulatory Impact Analysis under Executive Order 12866 (2010). <http://www1.eere.energy.gov/buildings/ appliance_standards/commercial/pdfs/ mhlf_preanalysis_appendix15a.pdf>.

Source: Federal Interagency Working Group, Appendix 15A. Social Cost of Carbon for Regulatory Impact Analysis under Executive Order 12866 (2010).

As the table above indicates, the Working Group set the SCC using a base social discount rate of 3%, along with sensitivity analyses using alternative 5% and 2.5% rates. A 3% discount rate is approximately two times higher than the discount rate employed in the UK Treasurys Review of the Economics of Climate Change,4 (The Stern Review, 2006), which many economists criticized for being too low. On the other hand, the Working Groups 3% discount rate is well below the base rate of 7% required by Executive Order for all federal regulatory impact analyses. In that respect, at least, the Working Groups choice of a central rate of 3% is marginally proenvironmental, but defensible even based on OMBs own guidelines (from Circular A-4).5 It is important to note that discounting for intergenerational problems and policies is a controversial exercise and no single social discount rate is objectively right or wrong; arguments can be made favoring lower or higher discount rates, which is why the Working Group sensibly crunched the numbers using a variety of discount rates (although one can quibble about whether the range of rates they used was sufficiently broad). In all columns of the table above, except the far right-hand column, the Working Group takes the aggregate mean estimate of damage functions from the three most prominent integrated assessment models (IAMs) of climate change, known respectively as DICE, FUND and PAGE. An IAM is an elaborate benefit-cost analysis that derives economic costs and benefits from scientific data. Like all benefit-cost analyses, they include inherently subjective elements, including valuations of non-market goods
4 5

THE STERN REVIEW OF THE ECONOMICS OF CLIMATE CHANGE (2007). A clear majority of economists seem to believe that the OMBs base rate of 7% is too high for regulations with intergenerational effects. See Martin Weitzman, Gamma Discounting, 91 AMER. ECON. REV. 260 (2001).

and bads, as well as discount rates. In addition to the aggregate mean estimates of damage functions, the Working Group also used a high-harm scenario from the PAGE2002 IAM, which was the model used in The Stern Review. The table also indicates that the federal governments SCC is not a static number but increases over time, reflecting the accrual of greater damages over time from climate change. Thus, the SCC rises from $21/ton in 2010 to $45/ton by the middle of this century (using a central estimate based on a 3% discount rate). Is the US governments SCC too low? Critics, including several climate scientists and a few economists, have complained that the federal SCC is too low.6 They believe (among other things) that the economic models, upon which the Working Group relied, generally underestimate the harm from climate change.7 Some critics also believe the Working Groups discount rates are too high.8 The Working Groups SCC valuations are close to the median valuations Richard S.J. Tol derived in his 2008 meta-analysis of more than 200 published estimates of the SCC.9 However, Tols meta-analysis, like the Working Groups assessment, was based on models that (aside from PAGE2002) arguably do not account adequately for the low (but not negligible)probability, high-harm scenarios that reside in the tails of the probability density functions of the damage estimates. According to one recent working paper, a better accounting for uncertainty and high-harm scenarios, as the prominent economist Martin Weitzman has been urging,10 would yield SCC estimates potentially more than twice as high as the Working Groups estimate.11 Instead of $21.40 in 2010, the SCC for that year could be somewhere between $49 and $57.12 However, another recent study that starts with a conventional model (DICE) and incorporates more uncertainty
6

See, e.g., Tiffany Stecker, Administration Grossly Underestimate Carbon Cost, Says Study, New York Times, July 14, 2011 < http://www.nytimes.com/cwire/2011/07/14/14climatewireadministration-grossly-underestimated-carbon-69396.html>. 7 See, e.g., Simon Dietz, The Treatment of Risk and Uncertainty in the US Social Cost of Carbon for Regulatory Impact Analysis, Economics Discussion Papers, No. 2011-30 (2011), <http://www.economics-ejournal.org/economics/discussion papers/2011-30>; Alex L. Marten, Transient Temperature Response Modeling in IAMs: The Effects of Over Simplification on the SCC, Economics Discussion Paper, No. 2011-11 (2011) <http://www.economics-ejournal.org/economics/discussionpapers/2011-11>. 8 See, e.g., Ackerman and Stanton, supra note 2, at 1. 9 Tol, supra note 2, at 6. 10 See Martin Weitzman, On modeling and interpreting the economics of catastrophic climate change, 91 REV. ECON. & STAT. 1 (2009); Martin Weitzman, Fat-Tailed Uncertainty in the Economics of Catastrophic Climate Change. __ REV. ENVTL. & ECON. POLICY __ (2011/12) 11 Jonathan Pycroft et al., A Tail of Tails: Uncertainty and the Social Cost of Carbon, Economics Discussion Paper, No. 2011-36 (2011), <http://www.economicsejournal.org/economics/discussionpapers/2011-36>. 12 Id. at 10, Table 1.

and higher-harm scenarios, yields only a marginal increase in the SCC on the order of $5-$10 per ton (central estimates).13 Still, the Working Groups SCC for the US is consistent with observed market prices for carbon on trading markets for the European Unions Emissions Trading Scheme (EU ETS), which is the worlds largest carbon market in both value and volume of trading (see the chart below).

However, market prices for European Union emission allowances (EUAs) on the ETS market arguably have been lower than they arguably should have been because of softness in national emission caps and structural flaws in the trading system. In other words, the way the ETS is organized may prevent carbon prices from rising to social-cost levels. Ultimately, we cannot know for certain whether the Working Groups SCC is too low, too high, or (what is far less likely) just right. All we really know at present is that the SCC substantially exceeds the current market price of carbon, which is approximately zero, resulting in socio-economic damages that are severe enough to warrant significant and immediate control efforts. Any point-estimate for the SCC inevitably is based on too many uncertain assumptions (including about different countries emissions rates, the choice of a climate stabilization target, and marginal abatement costs) to be reliably accurate. For that reason (among others), the UK Treasury stopped using the SCC as a metric for setting climate policy in December 2007, switching instead to the Shadow Price of Carbon.14 In any case, whether the Working
13

Robert E. Kopp et al., The Influence of the Specification of Climate Change Damages on the Social Cost of Carbon, Economics Discussion Paper, No. 2011-22 (2011) <http://www.economics-ejournal.org/economics/discussionpapers/2011-22>. 14 <http://www.decc.gov.uk/en/content/cms/emissions/valuation/shadow_cost/shadow_cost.a spx>. See also Richard Price, Simeon Thornton, and Stephen Nelson, The Social Cost Of Carbon And The Shadow Price Of Carbon: What They Are, And How To Use Them In

Groups SCC is too low, too high, or just right has little relevance for any plausible US climate policy likely to be adopted in the next 10-20 years. What does the US SCC actually accomplish? As a practical matter, all executive-branch agencies of the federal government must incorporate the SCC into their regulatory impact analyses (RIAs), which are required for all major regulatory initiatives pursuant to a series of presidential Executive Orders. That is certainly the most important (perhaps the only important) aspect of the SCC for the environmental/regulatory lawyers in the room. So far, at least, there is little indication that incorporation of the SCC into agency RIAs has led to any significant changes in regulatory decisions.15 Of course, the SCC would more likely affect the outcome of agency RIAs if its value were higher. From a political perspective, even if the SCC does not affect regulatory outcomes, its adoption could marginally increase the pressure on Congress to adopt mitigation policies that would reduce social costs associated with destabilization of the climate system. But Congress has not yet reacted in any way to the Working Groups SCC. One other possibility is that the SCC was intended, at least in part, to provide warrant and political cover for EPA regulation of GHGs. If so, the fact that the agency has been forced to delay the implementation of its various rules regulating GHGs under the Clean Air Act, in the face of strong political opposition, suggests that the Working Groups SCC has not been particularly helpful as a political lever. So, how important, finally, is the establishment of an SCC? Not very. Under present circumstances, when current federal mitigation policies impose an implicit carbon price of zero, introducing a dubious price ceiling for mitigating regulations seems premature to say the least. The short-to-mid-term risk of federal policies exceeding the SCC is negligible, whether the SCC is $100 per ton, $50 per ton, or $21 per ton. Far more important than establishing a SCC is to get the ball rolling in the right direction on actually reducing GHG emissions. An analogy to the history of conventional air pollution control is instructive. When Congress enacted the Clean Air Act in 1970, no one knew the social cost of sulfur dioxide or any of the other conventional air pollutants. Near consensus that there was too
Economic Appraisal In The UK, Economics Group, Defra (Dec. 2007) <http://www.decc.gov.uk/assets/decc/what%20we%20do/a%20low%20carbon%20uk/carbon %20valuation/shadow_price/background.pdf>. 15 See the discussion of practical application of SCC to Energy Department regulations in Robert E. Kopp and Bryan K. Mignone, The U.S. Governments Social Cost of Carbon Estimates after their First Year: Pathways for Improvement, Economics Discussion Paper, No. 2011-16 (2011) <http://www.economics-ejournal.org/economics/discussionpapers/201116>.

much of the stuff in the atmosphere, causing harm to public health and the environment, was enough to move Congress to start regulating those conventional pollutants. Only later (much later), after emissions of conventional pollutants had fallen substantially, did the federal government reasonably become concerned to avoid over-regulation by assessing the economic costs and benefits of regulation under the Clean Air Act.16 It is unclear why GHGs need to be treated differently. Why should a ceiling price for mitigating carbon emissions be established before Congress controls the very first unit of greenhouse gas? The graph below illustrates that initial reductions of GHG emissions can be had at very low (even negative) cost. According to the McKinsey & Co. report which contained the graph, US GHG emissions could be reduced by up to 2.2 gigatons (billions of tons) of carbon dioxide equivalentenough to offset nearly the entire 35 percent expected increase in national emissions (mainly due to economic and population growth) between 2005 and 2030 for less than $30 per ton (real 2005 dollars), which is below the Working Groups central estimate of SCC for 2030. In the circumstances, it seems, establishing an SCC prior to mitigating even the first unit of carbon emissions is putting the cart before the horse.

16

See United States, Environmental Protection Agency, Office of Air and Radiation, The Benefits and Costs of the Clean Air Act, 1970-1990 (Oct. 1997).