Houston, We Could Have a (Carbon Pricing) Problem!

With the election of Donald Trump, what will happen to carbon prices (or, more accurately, what will happen to the prospect of robust carbon pricing?) Expectations of future carbon prices are potentially important to all sorts of energy (and other) decision-making, which explains why so many decision-makers are interested in carbon price forecasts. Many electric utilities, for example, explicitly build carbon price forecasts into the planning processes that underpin new power plant commitments, energy efficiency investments, and other economic decisions.

Synapse Economics is a consulting firm that issues an annual carbon price forecast. Its 2016 forecast is shown below, illustrating Low, Mid, and High cases. The forecasts basically assume no carbon price for the next several years. That’s because the Clean Power Plan wasn’t scheduled to be implemented in a major way for a while yet. After that, the Synapse forecasts diverge significantly out to 2050. The Low forecast never gets above $40 (all 2015 dollars), the Mid forecast reaches $81, and the High forecast tops off at $110.

It’s worth noting that the Synapse report also shows that electric utilities are incorporating carbon price forecasts into their Integrated Resource Planning (IRP) processes. Those forecasts are almost universally lower than the Synapse Low case.

Carbon prices are usually set legislatively. A carbon tax, for example, would be implemented through statute. Prices can also reflect supply and demand in carbon markets. Carbon price forecasts thus are extremely sensitive to assumptions about future policy trends and mandates. They are also sensitive to political decisions about the structure of carbon markets (e.g., the ability to use offsets and other cost-reducing measures). The recent election will change carbon pricing discussions; a key question is will near-term carbon price forecasts drop to zero, especially if new Administration abandons or scales back the Clean Power Plan.

That’s what makes the Social Cost of Carbon (SCC) potentially more important than ever. The SCC is entirely different from “normal” carbon pricing since it seeks to quantify the economic damage done by each individual ton of emitted CO₂. The SCC is based on complicated yet highly simplified economic models called Integrated Assessment Models, and estimates of the Social Cost of Carbon vary widely — literally from less than $0 to hundreds of $/ton.

Economists have debated SCC values for decades. It was only recently, however, that the U.S. government specified an SCC value for federal regulatory rule-making purposes. The National Environmental Policy Act requires that climate change be incorporated into federal decision-making; coming up with a federal SCC was seen as a way to standardize and simplify how climate change could be handled going forward in regulatory proceedings. Following the work of an Interagency Task Force, the Office of Management and Budget in 2015 approved a specific SCC that currently is set at $41/ton. The price escalates every year going forward, based on the assumption that the amount of damage being done by each ton goes up as the concentration of CO₂ in the atmosphere increases.

The Synapse Economics report includes a chart of the federal SCC. The federal SCC is the purple line in the figure below; it is based on using a 3% discount rate to value future damages. The other lines reflect SCC calculations based on different assumptions and risk adversity, assumptions that were not used in arriving at the official federal SCC. You can see that the official SCC goes from today’s value of about $41 to more than $50 by 2035 and to $71 by 2050.

So what happens with the SCC under a Trump Administration? What if the federal SCC is formally rescinded? Does it disappear, or does it take on a life of its own? Efforts to transition the SCC beyond federal rule-making cost-benefit analysis have been underway for some time:

• There have been efforts (unsuccessful to date) to force inclusion of the SCC into federal coal leasing cost-benefit analysis, which would likely shut those leases down.

• In April 2016, an administrative law judge in Minnesota ruled that the federal SCC was an appropriate externality value to use for Minnesota’s electric utility planning. The ruling was in response to an effort by utilities and coal companies to get the SCC-based externality value reversed. Using the SCC as an externality value for utility planning would appear to be a logical application of the SCC concept. It’s a significant departure, however, from the role for which the federal SCC was developed and approved.

• In August 2016, the Public Services Commission of NY approved an SCC-based price floor for electricity coming from the state’s nuclear power plants. The idea behind this action is that it makes little sense to allow natural gas to displace nuclear power unless you have taken into account the economics of the CO₂ damages associated with natural gas power. Again, this seems to be a logical way to use the SCC — but it’s a huge departure from the SCC’s federal rulemaking roots.

The question of whether the federal SCC would stand up to a court challenge has hung over these and other initiatives. That situation has changed. On August 8th, 2016, a federal court of appeals upheld federal energy efficiency standards that included reliance on the federal SCC value. The court found that the Department of Energy’s use of the SCC was not arbitrary and capricious and was within the agency’s authority. This is the first time that the SCC has been challenged and upheld in the courts. The outcome was by no means guaranteed, given the complexity of SCC methodologies, and it’s not the last time we’ll see the SCC in court!

So within the space of just a few months, the SCC has been upheld in court, and its role has been extended to very different energy decision-making purposes at the state level. The federal SCC is increasingly being seen and deployed as a defensible representation of the economic damages being done by CO₂ emissions.

This is a big issue for carbon pricing for two reasons. The first relates to the fact that many economists believe that the way the federal SCC was calculated leads to too low a value. In practical terms, for example, an SCC of $41/ton will not have much impact on transportation sector decision-making — a sector in which gasoline prices routinely fluctuate by the equivalent of a $100/ton SCC (e.g. $1/gallon).

To understand the second reason, go back and take a look at the two figures introduced earlier. Note that all the carbon price forecasts fall substantially below the SCC for at least the next couple of decades. Synapse Economics’ Low price forecast never even gets close to the SCC value — which means that utility price forecasts don’t get close either.

So what happens under a Trump Administration? If states and the courts start to argue that the SCC is the right proxy for the economic damages being done by each and every ton of CO₂ emitted — which is the unavoidable implication as the SCC extends into state-level decision-making — can the Trump Administration put the genie back in the bottle?

Politically and economically, it’s not beyond the pale to see the SCC becoming a floor price for carbon in state-based market mechanisms. It’s even possible it might become an across-the-board emissions fee for CO₂ emitters. The electricity sector implications would be dramatic, to say the least. It certainly seems true that at least for the next four years, the entire carbon pricing conversation will likely be challenged in a variety of ways. This does raise a “Houston We Have a Problem” kind of situation that the various groups involved will need to figure out.

Earlier versions of this post appeared in August 2016 on LinkedIn and CarbonPulse.