Pricing carbon at its social cost
Pricing carbon at its social cost
Carbon markets will increasingly be influenced by the social cost of carbon
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$1,065 per tonne of CO2!
This summer, Adrien Bilal and Diego Känzig, economists at Harvard and Northwestern University respectively, published a new estimate of the global macroeconomic impact of climate change.
The Social Cost of Carbon (SCC) as it’s known is an estimate of the net economic damage resulting from an incremental tonne of carbon dioxide (CO2) released into the atmosphere. This was the first time that the global SCC has been estimated to be over $1,000 per tonne. Bilal and Känzig’s work naturally caught many peoples attention.1
Employing long-term data on global economic growth and average annual temperature, they find that an additional 1°C of warming will lead to a 12% fall in global GDP. The main divergence in this latest measure of SCC versus previous estimates (by Nordhaus, Burke, Nath, and so on) is its use of global mean temperatures variations.
Global temperature shocks predict a larger and more persistent rise in the frequency of extreme climatic events compared with local temperature shocks. Previous work focused on country-level local temperature variation and typically found that a 1°C temperature shock reduces global GDP by at most 1-3% in the medium term. By contrast, Bilal and Känzig estimate the GDP impact to be around six times larger.
One of the most contentious issues with estimating the SCC is the discount factor. There are a number of different approaches including the time preference that society places on the future benefit of climate mitigation, and the opportunity cost of investing in mitigating climate change, with the discount rate reflecting the long-term risk free real interest rate. For their analysis Bilal and Känzig assume a 2% discount rate, consistent with the secular decline in interest rates.
Another approach to discounting is centred on ethics and assumes that the value placed on people alive today is broadly equivalent to future generations. Calls for a low or even negative discount rate reflect the fact that the worst impacts of climate change are likely to borne by future generations. If they had chosen to take a more ethical approach, perhaps plugging in a discount rate of less than 1%, then by their own estimations the SCC would balloon to over $3,000 per tonne!
The SCC is one of many inputs policymakers use to determine whether a given investment to reduce climate change is worthwhile. The United States government first introduced a consistent SCC to inform its decision making under the Obama administration, estimating it to be $43 per tonne.
The Trump administration estimated the SCC to be between $3 and $5 per tonne, although they only considered the domestic impact of climate change, ignoring any spill-over effects. Most recently, the Biden administration used $51 per tonne in its policy modelling. However, in 2022 the Environmental Protection Agency (EPA) proposed hiking the SCC almost fourfold to $190 per tonne (see The burning question: What climate legacy will Trump 2.0 leave in his wake?).
So what about the $1,065 per tonne? What does that mean for investment in climate mitigation by the US government? Well, first the global SCC needs to be converted to a domestic cost of carbon (DCC), and here the two economists estimate the US DCC to be much lower, albeit still higher than that used by the government in the past:
“The DCC is always lower than the SCC because damages to a single country are lower than at a global scale. Under conventional estimates, the DCC of the United States is $45 per ton, making unilateral emissions reduction prohibitively expensive. Under our new estimates, the DCC of the United States becomes $213 per ton.”
The SCC is, at its heart, a political decision. As we’ve seen, the discount rate is particularly contentious, and one that should in theory reflect the time preference views of the electorate of the day. But it’s clear that the calculation can be sliced and diced in all manner of ways, whether that is accounting for local or global temperature trends to determine future damages, or more surreptitiously, only considering the domestic impact of climate change, and ignoring broader interactions beyond the immediate borders (see It's the climate, stupid!).
The economist Arthur C. Pigou argued that a carbon price should be set at the SCC as it internalises the net economic damage resulting from CO2 emissions. In reality that’s not what happens with the carbon price determined by the marginal abatement cost (MAC) of decarbonisation, and the demand and supply of emission allowances.
The MAC refers to the cost of abating the last tonne of CO2 required to meet an emission reduction target. Sloping upwards from left to right, the MAC curve gradually steepens as additional tonnes of carbon emissions get increasingly more difficult, and hence more costly, to abate. The marginal cost is dynamic, and one of the main factors that influences it is technological progress. However, innovation does not simply occur, by itself, in a vacuum. It needs the right incentives and economic conditions such that the innovation can exploited.
The price of emission allowances, e.g., EUAs in Europe or CCAs in California, are determined by the relative cost of abating emissions (e.g., fuel switching from coal-fired generation to gas and renewables), the relative scarcity of allowances (or at least its perception), hedging behaviour among market participants, and trust in the governments (or other institutions) commitment to its climate targets (see The Currency of Decarbonization: An in-depth convo with Peter Sainsbury (Carbon Risk) about commodity markets, carbon pricing, and the power of incentives).
Each of them - the SCC, the MAC, and the price of emission allowances - are influenced by separate but inter-related factors, while at the same time they each exert a gravitational pull on the other.
Developments in the MAC and the price of emission allowances will play a major role in determining the future economic damage from climate change. The ongoing deployment of renewable energy and other low carbon power generation, and accelerating the decarbonisation of industry both rely on the right economic incentives being in place. Any delays will mean more emissions, higher temperatures, and increased economic damages resulting from climate change.
It’s clear that the SCC is very sensitive to the assumptions used, and these are in turn highly dependent on political decisions. Despite Pigou’s best intentions, and what many investors believe, the SCC should not be taken as the correct price for an emission allowance. There are clearly other more important factors at work.
However, it’s reasonable to conclude that the SCC could become a more powerful driver in the future, especially as the economic damage inflicted by climate change become clearer and more acute. As different regions are hit by extreme weather - hurricanes in Florida, flooding in the Sahara, or heatwaves in southeast Europe - voters may begin to pressure their governments into bringing forward action to mitigate climate change. That means a lowering in the discount rate and hence an increase in the SCC. By extension it is also likely to result in pressure for governments to place more of the cost burden squarely on those responsible for emissions.
There are already some signs that the SCC could start to influence the price of emission allowances. A recent notice by the California Air Resources Board (CARB) informs market participants in the Californian cap-and-trade market of several amendments to the regulations.
One of the amendments refers to a “one-time increase in the prices of the cost-containment provisions to better align with the most-recent federal assessment of the social cost of carbon.” The APCR as its known is currently set at $56.21 and $72.21 per tonne and rises by 5% plus CPI each year, but even in 2030 or 2035 this would still be significantly below the EPA’s SCC of $190 per tonne.2
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https://www.nber.org/system/files/working_papers/w32450/w32450.pdf
https://ww2.arb.ca.gov/sites/default/files/cap-and-trade/nc-CT_Notice_Oct_2024.pdf