Pricing carbon, mispricing climate?

In the previous article, we discussed the importance of the Social Discount Rate (SDR) in guiding various policies to address the challenges of climate change. Closely related to the SDR is the concept of Social Cost of Carbon (SCC), which is basically putting a number to the damage caused by increased carbon in the air. The SCC is important because it has been used by policymakers to evaluate projects and take mitigation and adaptation measures to address climate change. Let us discuss SCC in more detail.

What is SCC?

The SCC is a marginal cost concept and is basically the damage caused by the emission of one ton of carbon dioxide in one year. The SCC is therefore an important component of any cost-benefit analysis of carbon emissions.

While the idea of social costs and externalities has been around in Public and Welfare economics for a long time, the social cost of carbon entered the Economists’ lexicon with the work of William Nordhaus. More specifically, the social cost of carbon was the cost incurred as a result of one ton of carbon dioxide. This SCC was typically an output from the various Integrated Assessment Models (IAMs), which are nothing but macroeconomic models, incorporating greenhouse gas emissions and their impact.

The first DICE was pioneered by William Nordhaus in 1992, which included a global social welfare function (which required maximisation of utility/consumption), a neoclassical Ramsey production function where climate investments were taken as capital investments, emissions reduction, marginal costs of damages and mitigation, and a climate/geophysical module, which included radiative forcing and climate change. The later DICE models were based on these broad principles. In 2015, the Interagency Working Group of the US asked the National Academies to come up with a SCC. The IWG used three IAMs: various models of Nordhaus (his DICE and RICE models), the Policy Analysis of the Greenhouse Effect (PAGE) and Climate Framework for Uncertainty, Negotiation, and Distribution (FUND) models. All the IAMs have the same objective: to calculate the Net Present Value of the Future economic consequences of Climate Change, using a social discount factor (which can be the market rate or the bond rate or another rate, depending on how one values the future). The IWG did come with a SCC that varied between USD 10 and USD 100.

The Stern Review also used an IAM and came up with a SCC, but the UK government preferred to use emissions reduction targets as a policy tool.

Critique of the SCC

Local Air pollution caused by local emissions of air pollutants is reversed as soon as the emissions cease. However, this is not the case with emissions of carbon dioxide, which linger in the atmosphere for hundreds of years and their effects are felt over decades and centuries: damages are not on the margins. Hence, marginal analysis should not be used to calculate damages and costs of emissions, as is the case with SCC.

Another problem with the SCC is that its value can be anything that the modeller wants it to be: just varying the discount rate and the year of emissions can lead to different SCCs. For example, the IWG got a SCC of USD 36 per ton of carbon dioxide in 2015 and USD 69 per ton in 2050, for a discount rate of 3 per cent. These numbers changed to USD 56 and 95 at a discount rate of 2.5 per cent. This unreliability of SCC was also highlighted by the MIT economist Robert Pindyck in 2014.

A further problem with SCC is that it reduces net damages to a dollar value, without fairly accounting for the varying effects of climate change across geographies, ecosystems and socio-economic contexts. For example, the value of an endangered species to an ecosystem, or the importance of electrification in a rural hamlet in Africa, would perhaps be as important as dealing with flooding or forest fires in the USA.

Conclusion

The SCC was touted as a useful policy tool in evaluating many climate-related investments in the US. However, it has only limited use since marginal analysis should not be applied to non-marginal and non-linear events such as Climate Change. Consequently, SCC should not be used to make decisions on the marginal costs and benefits of abatement and mitigation. As the UK and Europe have done, it is better to set emission targets and impose carbon taxes (which can be calculated in a more straightforward manner than the SCC). There is a lot of work being done on developing IAMs by addressing equity issues, geographical diversity and socio-economic inequality, which may lead to better and more acceptable SCCs. Even so, simple targets such as emissions reductions and carbon taxes would perhaps always be preferred.