As an environmental economist, I work on issues that may be very important –like the fate of the entire planet -- but are also inherently technical and hard to explain. Take the Social Cost of Carbon (SCC) and the Social Discount Rate (SDR). Neither would make a great ice-breaker at a cocktail party, but they are critical for how the world deals with climate change.
One of the first things you do when faced with a new problem is to try to judge how big or serious it is. The SCC is one way of expressing this – as the estimated cost to society of each ton of carbon emitted. This cost, in the abstract world of textbook economics, would be the price that everyone paid when emitting a ton of carbon dioxide into the atmosphere. The trouble, of course, is that the world doesn’t work this way. Everyone doesn’t pay the SCC price, or any price, when they, say, switch on a lamp or drive to work.
There are two ways to bring reality into line with economic theory: either a cap and trade system for carbon (and other greenhouse gases) or a carbon tax. Both make the world pay for carbon emissions, which will drive those emissions downward. But even without those tools in place, it still makes sense for policymakers to make large, long run decisions in a sustainable manner that correctly takes into account the real costs of climate damage. That is why a number of countries, and even some large companies, use a SCC in the cost benefit analyses that inform public policy. In the U.S., the official government value for the SCC is just over $40, in today's dollars, per metric ton of carbon dioxide emitted.
Recently the social cost of carbon has even become a topic of dispute in the U.S. Congress. The House last week passed an amendment that is intended to prevent the Environmental Protection Agency from using the SCC in its rulemakings. (The measure has little chance of being adopted by the Senate.)
What is the Social Cost of Carbon
The SCC is a valuable tool for policymakers in evaluating the benefits and costs of regulations. It improves decision making which would otherwise assume that the price is zero. But of course there are many layers of uncertainty in determining the size of the SCC. First comes the uncertainty concerning how much the planet’s temperature will increase as a result of carbon emissions. This is a complex problem that includes variables from the effects of thawing tundra to the reflectivity of changing cloud patterns and the amount of heat reflected by Earth as it changes “color” due to the Albedo effect. Next, there is the uncertainty of what the effects of changing temperature will be. How fast will glaciers melt? What will happen to the flow of major rivers? How fast and far will sea levels rise? What will happen to plant ecosystems and what, ultimately will all this cost humanity in lost crops, increased costs of transport, economic disruption and social unrest.
Then you have to analyze the feedback effects of our socioeconomic system – that is, how well will humanity handle the changes and costs imposed by global warming. Will we be able to deal with them efficiently or not – or will the world fall into widespread dispute and conflict – dramatically raising the social cost of carbon, not to mention the amount of human suffering in the world.
Finally, even if we were able to correctly estimate all these costs, we would see that they would hit different people in different countries and at different points in time.
How is the poor economist, faced with all these variables, to aggregate them into one single number that accurately expresses the Social Cost of Carbon? To begin to answer that question, we have to bring in the Social Discount Rate (SDR), mentioned above.
The real value of money is variable. The cost of $100 to a poor person in a low income country is not the same as it is to a middle class person in the U.S. Similarly, a dollar in 50 years is not the same as a dollar today.
In many large scale studies like the Stern Review, the latter issue – the changing value of money, or discounting -- has actually been the biggest uncertainty of all! Discounting is a way of establishing equivalency over time. For example, suppose you have a debt of $100 to a bank with a 5% interest rate. The debt will grow to $105 in a year’s time and with compound interest it will grow to $208 in 15 years’ time. In this sense we say that a cost of $208 in 15 years’ time is equivalent to a cost of $100 today or the discounted value of $208 in 15 years is $100.
In the long run, discounting has very large effects. For example, a cost of $1 million in 200 years would be valued at not much more than $50 with a discount rate of 5%, and around than $1 with a discount rate of 7%. This example shows that being affected by a cost of $1 million in 200 years (in the year 2213) is “equivalent” to a cost of $50 – or just $1 – today. Both numbers are very small – and furthermore, a small difference in the discount rate makes a big difference to the value. Discounting with a constant and high discount rate is equivalent to saying that we do not value costs two centuries away at all. But this runs contrary to what many people feel is reasonable – which is why we need to think through this carefully and – in our opinion - revise it.
The Social Discount Rate
The correct value of the social discount rate (SDR) is the subject of a whole literature – it is almost a mini-field of its own. It’s a critically important area because it asks the fundamental question of what we are willing to pay – today – toward the welfare of our children and grandchildren. The SDR is as close as you can get to a “price on the future.” It tries to estimate how much society should pay now for its carbon emissions in order to limit the damage (and cost) of those emissions to future generations.
Last Friday a number of coauthors and I published an article in the journal Science that is a contribution to this debate. The article entitled “Determining Benefits and Costs for Future Generations,” shows that the SDR should fall over time – and that the United States should use a declining discount rate like the ones already used by the governments of Britain and France.
The discount rate is tied to the growth rate of the economy. One of the main reasons for discounting is that we expect to be so much richer in the future and for rich people money is relatively speaking less important. The SDR might fall for several reasons. One of the conceptually simplest is if we believe in “limits to growth.” If the economy cannot grow forever then, by definition, the growth rate will slow down and the SDR will fall over time. Our article in Science focuses on another reason discount rates should fall: uncertainty over future growth rates.
The article illustrates this with a simple numerical example. The discounted value of $1000 at 4% in 100 years is $18.32. But suppose we do not know the discount rate and it might be either 1% or 7%. The discounted value with 1% is $368 and with 7% it is just 91 cents. If it could be either 1% or 7% with 50% probability each, then the expected value (the average of the results discounted at 1% and 7%) would be $184, which is much more than the discounted value with a certain discount rate of 4%. So uncertainty actually gives you a result that is equivalent to using a much lower discount rate.
Our Science article shows that this effect increases over time. So costs far into the future should be assigned a lower discount rate than costs in the more immediate future. What all this economic theory means in terms of caring about our children is that we should care particularly about our grandchildren and even more about our great grandchildren!
We know that the worst effects of climate change will come in the distant future, so with a discount rate that falls over time, the SCC should be higher now. This will make fossil fuels less profitable and renewables more profitable, and future generations will reap the benefits of having to deal with less global warming.
The world of the future, the place where our grandkids and great grandkids will be grappling with the climate change issues we leave behind us, is the reason figuring out the correct SCC and SDR is so important.