The number we all should be more familiar with

In all the discussions about climate change and the policies needed (or not) to estimate the cost of climate change mitigation and adaptation, there is one number that hardly features in newspapers and the public discourse even though it is the one key determinant of policy action. I am, of course, talking about the social cost of carbon. 

The social cost of carbon is the price we should be willing to pay for every extra ton of CO2 emitted. It is an economist’s and scientist’s way to tally all the benefits and costs of additional CO2 emissions. Models for the social cost of carbon try to estimate the present value of all future CO2 emissions by weighing their benefits in terms of economic growth and its costs in terms of economic costs (e.g. lost future economic growth due to an increased number of people suffering from droughts, floods, etc) and social costs (e.g. increased number of people with health issues or displaced people).

The key variable in estimating the social cost of carbon is the discount rate used to discount future carbon emissions. Under the Obama administration, the United States used a discount rate of 2%, which is typically also used by other countries like the UK and most European countries. Using this discount rate, the Obama administration used a social cost of carbon of $52 per ton CO2. That means that if we trade CO2 in an emissions trading scheme like the one used in the EU and soon to be rolled out all over China, the cost of emitting one ton of CO2 for a power plant should be $52. If the power plant can sell its electricity profitably while covering this cost of carbon, it should continue to operate. If it can’t sell electricity at a price that covers this cost, it should stop producing electricity from fossil fuels and switch to renewable energy like solar or wind.

There are different studies on what the social cost of carbon should be. The UK government’s Climate Change Committee estimated that in 2020 the social cost of carbon should be at least $37/tCO2e, rising to $95/tCO2e in 2030. And the High-level Commission on Carbon Prices estimated that in 2020, the social cost of carbon should be between $40/tCO2e and $80/tCO2e rising to $50-$100/tCO2e in 2030. Unfortunately, carbon emission certificates are auctioned off at much lower prices today and carbon taxes are also typically much lower than these numbers. In the EU emissions trading scheme, the price for a ton of CO2 emissions auctioned off in 2020 was $30/tCO2e and the UK’s carbon price floor in 2020 was $23.2/tCO2e, at least a third less than what the governments experts recommend.

Of course, that means that businesses have much less incentive to reduce carbon emissions because many projects that would not be economically viable under a cost of carbon around $50 keep running and emitting greenhouse gases.

But none of that is as egregious as the current practice in the United States introduced under the Trump administration. All the “experts” did in the Trump administration was to increase the discount rate for the social cost of carbon to about 3%. That doesn’t sound too bad compared to the 2% maximum discount rate used by experts and governments outside the United States. But it reduced the social cost of carbon to $7/tCO2e or less from the $52/tCO2e the Obama administration used and that has recently been reinstated bu the Boden administration. The chart below shows how the discount rate influences the social cost of carbon. Note that most economists and scientists agree that the discount rate should be somewhere between 1% and 2%.

Social cost of carbon under different discount rates

Source: Tol (2018).

Making such an innocent looking change as increasing the discount rate and reducing the social cost of carbon from $52 to $7 Dollars can then be used to justify policy measures. Tamma Carleton and Michael Greenstone from the University of Chicago have shown nicely how this change leads to vastly different policy recommendations. 

In its last days in office, the Trump administration rolled back fuel efficiency standards for cars in the United States introduced for model years 2021-2026. To justify this policy, the administration needed to publish a cost-benefit analysis. The benefits of lower fuel economy standards are easy to calculate since they reduce the costs of building a car and increase car sales and sales of petrol (or gas for my American readers). These benefits amount to $207bn. The fixed costs of abolishing the standards are roughly $178bn for research development work that has already been done and changes in the administrative process of approving and building cars with different fuel standards. On top of that comes the social cost of carbon from additional exhaust pipe emissions of cars built between 2021 and 2026. In the Obama administration and now again in the Biden administration, using the social cost of carbon of $52/tCO2e the total costs of abolishing the higher fuel standards amount to $222bn, so that the net benefits to society would be -$15bn. In other words, abolishing the higher fuel standards for cars makes no sense because it costs the US $15bn in national income over time. But using the Trump administration's number of $7/tCO2e the total costs of abolishing the higher fuel standards are a mere $190bn and thus abolishing these fuel standards would lead to a net benefit for the economy of +$17bn.

All of a sudden, building gas-guzzling cars for five more years makes economic sense and all because someone decided to discount future costs of carbon emissions by 3% per year instead of 2% per year, reducing the social cost of carbon by 86%.

PS: If you want to know more about the social cost of carbon and why it is so important for investors, read chapter 9 of my book on geopolitics, where I look into the political and economic impact of climate change.