The Social Cost of Carbon – Going Nowhere But Up

In his first few months in office, President Biden has rejoined the Paris Agreement and jump-started a whole-of-government approach to addressing climate change. Included in the President’s early moves is one easy-to-overlook yet critically important action: adjusting the social cost of carbon.

The social cost of carbon (SCC) translates the future harm inflicted by the release of one additional ton of carbon dioxide into a present monetary value (e.g., $50 per ton of carbon dioxide emissions). It answers the questions: How much damage will a ton of carbon dioxide emissions released today cause in the future? And how can those damages be weighed against the costs and benefits of actions taken today?

At federal agencies like the EPA, the SCC is used in cost-benefit analyses because the presence of carbon dioxide in the atmosphere is the primary driver of climate change. The number is important: for example, the Trump administration used a lower SCC to defend less stringent fuel economy standards. The SCC can also influence other government decision-making such as to justify the purchase of cleaner products or to clearly communicate the benefits of decarbonization.

On his first day in office, President Biden relaunched the Interagency Working Group (IWG) on the Social Cost of Greenhouse Gases. The IWG has two main goals: 1) establishing interim social costs of carbon dioxide, methane, and nitrous oxide; and 2) establishing its “final numbers” for the social costs of these gases by January 2022 (this blog focuses on carbon dioxide). To meet these goals, the White House released an interim SCC of $51 per ton on February 26th, a significant increase from $1-7 during the Trump Administration. The IWG is now undertaking an extensive review process to establish its final SCC. Despite significant uncertainty about what the final SCC will be, one thing is clear—it’s going nowhere but up.

A few leading thinkers have outlined some of the factors the IWG should consider in its review (see here and here). However, the White House has already hinted at some of its priorities – in a blog announcing the interim SCC, Heather Boushey, a member of the Council of Economic Advisors, said the administration would work to “ensure that the social cost of greenhouse gases consider climate risk, environmental justice, and intergenerational equity.” If sufficiently incorporated by the IWG, each of these factors would significantly increase the interim SCC.

First, the SCC must value uncertainty to properly account for climate risk. The interim SCC doesn’t incorporate these uncertainties, but it’s likely people would pay more today to avoid the most devastating impacts of climate change (although, as we know, the effects of climate change are already occurring so this would be increased assurance in avoiding the most catastrophic scenarios). People are willing to pay a little extra to avoid extreme costs: Americans buy home insurance to prevent financial ruin in event of a catastrophic fire, even if the risk of such a fire is small. Given the significant uncertainty in the SCC’s calculation—could additional emissions have a larger impact than predicted? Are there unknown extreme risks?—valuing uncertainty in the next SCC will increase its price, perhaps significantly.

Second, the SCC must incorporate equity to ensure environmental justice. Equity considerations aren’t currently included in SCC calculations for a few reasons. However, just as $1,000 is more valuable to a low-income family than a billionaire, the SCC should consider how future climate damages will impact some people more than others, such as by giving greater weight to damages that occur in poorer communities or nations. A focus on environmental justice would demand consideration of disproportionate impacts in the SCC, and, if put into effect, would raise the SCC, possibly by a factor of 2.5 or more.

Third, the SCC must value future generations to ensure intergenerational equity. This is directly related to the role of “discounting” in the calculation of the final SCC. The basic idea is that, for a variety of reasons, future damages and benefits are valued less today (e.g., people would prefer $10 today than 50 years from now). Since the SCC must be useful for today’s decision-making, all future damages caused by the release of one additional ton of carbon dioxide needs to translated into a present value. In addition to calculating what this damage is, policymakers use a “discount rate” to determine how much this future damage is reduced in a present value. The chosen discount rate can dramatically affect the SCC.

Currently, the government uses discount rates of 3 percent and 7 percent for cost-benefit analysis (based on observed market rates of return). However, there has been a healthy discussion about the poor justification for a discount rate of 3 percent or higher for the SCC from both a financial and ethical point of view. As a result, many influential thought leaders are calling on the IWG to use a discount rate of 2 percent or lower, which could have a considerable effect on the SCC (keeping all things equal, a 2 percent discount would change the current interim SCC of $51 per ton to $125 per ton). A focus on intergenerational equity would necessitate a lower discount rate. As Lord Nicolas Stern and Nobel Laureate Joseph Stiglitz recently argued, “there is no ethical justification for giving so little weight to future generations’ welfare.”

The IWG’s task is an important one. The SCC may seem unreasonable to some because it’s difficult to appreciate today the costs that climate change will bring tomorrow and for generations to come. But an accurate, science-based SCC that properly accounts for climate risk and equity (among other factors not covered in this blog) will make clear what Lord Nicholas Stern concluded in The Stern Review over a decade ago: the costs of acting today are far cheaper than the costs of catastrophic climate change.

For all these reasons and more, the takeaway is simple: the social cost of carbon is going nowhere but up.