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June 20, 2013

What’s Missing From the OMB’s New Social Cost of Carbon? Risk Aversion.

Climatographer Team

The social cost of carbon (SCC) has been referred to as “most important number that you’ve never heard of.”  The SCC is intended to monetize the net impacts/costs of each ton of CO2 emitted.  In principle, if one set a price on carbon using the SCC, everyone would make societally appropriate decisions, and dangerous climate change would be avoided.  Of course, it’s not quite that simple, especially when it comes to how the SCC incorporates risk.

The recent announcement that the Office of Management and Budget (OMB) has released new guidance regarding the SCC for use in federal regulatory proceedings has received  attention from the environmental press, including at Climate Progress and Grist, as has the fact that the revised SCC has already shown up in a new rulemaking on microwave oven standby power.  The new OMB guidance didn’t come out of thin air.  Rather, it is the result of the Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis published in May 2013 by the multi-agency Interagency Working Group on Social Cost of Carbon.  The Working Group’s original SCC analysis appeared in 2009.

Source: Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis
Source: Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis

The new SCC numbers (shown in the above table) are about 50% higher than the prior SCC estimates.  It’s a big change, said to be based on improvements in the models being used to calculate the SCC.  As the table shows, there is no single SCC estimate, both because several variables influence the SCC, and because the SCC should be expressed as a probability distribution.  What’s particularly important:

  • The discount rate applied to the analysis.  The higher the discount rate, the lower the estimated SCC.  This reflects our “time value of money.”
  • The year in which the carbon is emitted.  The SCC rises over time because as the concentration of CO2 in the atmosphere rises, since the damage of an incremental ton is assumed to grow.
  • How worried you are about being wrong.  There are many uncertainties involved, so any SCC estimate will be uncertain.  As the table shows, the “average” of SCC estimates for emissions in 2010 using a 3% discount rate is $33/ton.  But if you want to be 95% sure that your SCC value encompasses the actual SCC, you’d want to use $90/ton.

OBM’s new guidance to federal agencies is to use an SCC figure of approximately $35/ton for current CO2 emissions.  Applied to energy efficiency standards (as in the case of the new microwave standby power standards), the revised SCC can justify higher mandated efficiency levels.

That’s the basics.  But what else should we really know about the whole idea of the social cost of carbon, and how it’s being estimated?  Should environmentalists rejoice over the OMB announcement, and carbon-intensive industries be quaking in their boots?  Is there peril in too actively embracing the new SCC?  How much confidence should we really have in estimates of the SCC?  These are important questions, and too large to answer conclusively here, but we can provide some insights.

What’s the History of the Social Cost of Carbon?  Calculating the future damages of climate change and expressing those damages in terms of each ton of CO2 emissions is not new.  The Minnesota Public Utilities Commission undertook such an analysis as early as 1991, estimating the SCC at between $0.30 and $3.10 per ton.  The Stern Review on the Economics of Climate Change (2006) arrived at a higher figure, about $85/ton.  Other estimates have ranged from 0 (and even negative numbers in the short-term) to thousands of dollars per ton based on avoiding catastrophic climate change.

Why is the SCC Potentially So Significant?  Regulatory agencies like the EPA routinely use cost-benefit analysis of the kind underlying the SCC estimates to justify health and other regulations.  An SCC of $35/ton, escalating each year, could significantly affect decision-making in some sectors, most particularly the electricity sector.  Note that a $35/ton SCC is roughly equivalent to 3.5 cents per kWh for coal-fired electricity, and about half that for natural gas.

Are There Philosophical Objections to the SCC?  Some observers argue that conventional cost-benefit analysis is simply not appropriate for climate change decision-making, given the irreversible and inter-generational attributes of the problem.  Economists (and ethicists) have been debating the right discount rates for public policy decisions for decades, especially when long-term decisions are involved.  At the 3% discount rate OMB is using, for example, $100 of damages incurred 100 years from now is only worth $5 in today’s terms.  One way to interpret this figure is to argue that we’re discounting the interests of our grandchildren in 2113 by 95%.  Is that the right thing to do?

How Much Confidence Should We Have in SCC Estimates?  When you think about it, we’re asking A LOT when it comes to quantifying the social cost of carbon.  We first have to forecast global climate change, which is by definition an uncertain process because we just don’t for sure what the climate change damage function really looks like (the damage function relates greenhouse gas concentrations in the atmosphere to climate impacts).  Then we have to translate estimated global changes into localized impacts.  Then those localized impacts have to be monetized.  This sounds exceedingly complicated, and it would be, which is why the Integrated Assessment Models used for estimating the SCC boil all of this complexity down into a relatively small number of variables and equations.  Given the substantial uncertainties buried in these equations, it should not be surprising that relatively modest changes to key variables can dramatically affect SCC estimates.  SCC estimates also have to be expressed probabilistically to reflect the many underlying uncertainties. 

How Comprehensive Are the Models in Looking at the Impacts of Climate Change?  This is where things get even trickier.  First, there’s the argument that the models underestimate the damages they do include.  Then there’s the question of what impacts (and costs) are missing.  There are big questions that we know  the models do not adequately reflect, including the possibility of rapid sea level rise, ocean acidification, potentially massive methane emissions from melting permafrost, potential shifts in major ocean currents — to list just a few.  In principle, all of these issues should show up somewhere in an SCC probability distribution, but they rarely do. I was in an SCC briefing some years ago, and asked how the models had incorporated the costs of ocean acidification (one of the biggest climate change wildcards).  The answer was: “we don’t know enough about ocean acidification to include it in the SCC estimate.”  I asked how the models had incorporated the risk of major conflicts breaking out over water shortages in the Middle East in the face of climate change.  The answer was that “we don’t know the probability of that, so we didn’t include it.”    

What’s the Right Confidence Interval to Use for SCC Estimates?  The topic of risk is critical, and this is where inconsistencies in how we think about SCC risk and other risks become most obvious.  Offshore oil platforms in the North Atlantic are NOT designed to have a 50% chance of withstanding ocean conditions for the next 100 years; instead, they are designed to withstand one-in-10,000 year events.  At a more personal level, virtually all of us buy fire insurance for our homes.  On average, however, very few of our houses will burn down (the probability is so low as to be roundable to zero).  So when we think about risk we’re not thinking about “averages.”  When the OMB uses an “average” SCC value of $35/ton, it’s being risk-neutral, not risk-averse.  If we want to address climate change, wouldn’t we want to implement an SCC value that would have more than a 50% chance of getting it right?  Based on the OMB’s own updated SCC estimates, selecting an SCC with a 95% change of getting it right would mean a $90 SCC today, growing to more than $200 in 2050.  That’s a game changer by anyone’s measure, and many observers would argue even that figure is too low due to inadequately quantified climate risks.

What does this all suggest?  The social cost of carbon is clearly one element of the public policy toolbox for addressing climate change.  Indeed, almost any real effort to address climate change will have to somehow internalize the economic externality that currently causes greenhouse gas emissions to be higher than is societally desirable.  And it’s hard to internalize an externality if you don’t quantify it by one means or another (although some observers would argue that doing it through the SCC is not the right approach).

So, the OMB has issued updated SCC guidance.  Generally speaking, environmentalists will be happy with the new numbers, since they’re much higher than zero.  But that shouldn’t prevent us from asking whether the results properly reflect the real risks of climate change, and society’s degree of aversion to those risks.  There are several reasons to suggest that the OMB’s current SCC guidance falls short when it comes to managing climate risks:

  • The $35/ton SCC figure doesn’t include all of the potentially high-risk outcomes of climate change.
  • The $35/ton SCC figure substantially discounts the damages that will occur in the lifetimes of many of our children, and certainly our grandchildren.
  • The $35/ton SCC figure stands close to a 50% chance of being too low (even aside from the first two bullet points), and therefore could fall well short of the mark when it comes to adequately managing climate change risks.

Given these factors, caution is warranted all around when it comes to embracing the OMB’s SCC values.  First, will they even be deployed in a meaningful way?  After all, how likely is it that aggressive SCC values will succeed where all prior efforts at climate policy have failed?  Second, if the SCC values don’t adequately reflect climate risks, are they the right tool for climate risk management?  Finally, while the OMB’s new SCC numbers might seem manageable from a business perspective, what if those SCC values are adjusted over time to be more risk-averse?  That would be a much bigger game-changer than what OMB has done so far.  

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Climatographer Team

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