SustainaWeekly- How useful is the ‘most important number you’ve never heard of’?
In this edition of the SustainaWeekly, we first take a closer look at the concept of the social cost of carbon (SCC), which is the net dollar cost to society of one additional ton of CO2 emissions. It is important because the SCC summarises in a single number the costs and the benefits of emissions and as a result it can be thought of as a metric of the size of intervention that is required to maximum welfare. Estimates of the SCC are highly dispersed and contentious. In spite of that, the SCC is actively used in the US for policy cost-benefit analysis. We then go on to assess the expected final version of the EU Green Bond Standard (EU GBS) Regulation and the impact for the market. Finally, we go on to update previous analysis on how the industrial sector has been dealing with relatively high gas prices against the background of the need to make the transition to net zero emissions.
Economist: The Social Cost of Carbon (SCC) is an estimate of the cost to society of one additional ton of carbon dioxide emission. Estimates of the SCC are highly contentious but it is actively used in the US for policy cost-benefit analysis. The US revised higher its estimate of the SCC from USD 51 to USD 191 last November. This most recent SCC estimate suggests that the President Biden is 3 times more worried about climate change that President Obama and 40 times more worried than President Trump.
Policy & Regulation: We assess the expected final version of the EU Green Bond Standard (EU GBS) Regulation and the impact for the market. In the short-term, we should expect bonds that comply with the EU GBS to attract a good demand, resulting in a higher greenium. However, in the near- to long-term, the appeal of EU GBS aligned bonds will likely reduce, as green bonds start covering similar transparency requirements, while having lower costs for issuers.
Sector: Relatively high gas prices are a strong incentive for many companies in industry to rapidly reduce their gas consumption. Indeed, many companies in industry have rationalised their gas consumption in the past year or were forced to discontinue or stop production lines altogether. Lower gas consumption in industrial sectors has only partially contributed to industry's greenhouse gas reduction during 2022.
How useful is the ‘most important number you’ve never heard of’?
A passenger flying from Amsterdam to Mexico City and back accounts for around 1 ton of CO2 emissions. The trip will deliver some benefit (leisure or business) to the passenger in the short term, but the CO2 that is emitted from this trip will linger on and the cost to society of that emission will mount over time through rising temperatures, higher sea levels and more severe and frequent weather events. The social cost of carbon (SCC) is the net dollar cost to society of one additional ton of CO2 emissions. More specifically, it is the present value of the stream of costs and benefits of emitting one ton of carbon dioxide or its equivalent today.
Economic theory establishes a strong link between the SCC and the carbon price. The SCC is also a key ingredient in cost-benefit analysis. In the United States, the SCC is actively used by the federal government to, for example, set emission standards for power plants, set vehicle fuel economy standards and for setting tax credits for carbon capture and storage. The Inflation Reduction Act, for example, offers a subsidy of USD 180 for capturing one ton of CO2 emissions.
The SCC has been called the ‘most important number you’ve never heard of’ () or ‘the most important single economic concept in the economics of climate change’ . Important because the SCC summarises in a single number the costs and the benefits of emissions and as a result it can be thought of as a metric of the size of intervention that is required to maximum welfare.
We know what it is, but how big is it?
There have been more than 5,000 estimates of the SCC since Bill Nordhaus’ pioneering work with Integrated Assessment Models (IAM) in the early-1990s. The SCC is generated from IAM and as such the estimate depends heavily on the myriad of assumptions that are embedded in these models. The estimates very unhelpfully range from $0 to hundreds of dollars, and around a-third of these estimates are less than USD 200 per ton of CO2 emissions and two-thirds are in excess of that value. Arguably, the most contentious judgement in these exercises is the discount factor that is applied to future costs. A higher discount rate signals that we care less about the future. The sensitivity of the SCC to the discount rate can be seen in the table below.
The table shows that the average estimate of the SCC stands at USD 43 at a 3% discount rate and nearly 9 times bigger at USD 407 at a 0% discount rate. The dispersion or the uncertainty around this estimate, as measured by the standard deviation, widens as the discount rate falls. Intuitively that reflects the fact that we know the future less well than the present and that a lower discount rate places a greater weight on future values.
Beyond academia, the SCC has been something of a political football in the United States over the past few years. The SCC is, after all, a measure of the ambition of policy makers to combat greenhouse gas emissions. It should, therefore, come as no surprise that the estimate of the SCC reflects that preference. For example, the Obama administration estimated a global SCC at USD 42. The Trump administration discarded that estimate and instead used a much lower estimate of USD 3-5 which was based on an estimate that restricted damages to the United States only. That changed quickly with President Biden. In fact, on his very first day in office, President Biden signed an order to reinstate the Interagency Working Group (IWG) and ordered a revised estimate of the SCC. The IWG was responsible for the SCC estimate until President Trump had it disbanded.
The US is currently using USD 51 which is essentially an inflation adjusted estimate of the SCC from the Obama administration. This estimate is based on a discount rate of 3%. The US Environment Protection Agency (EPA) published a revised estimate of the SCC which is dramatically higher. The new estimate, which is still in proposal stage, is centred at USD 190 at a discount rate of 2%. As before, the estimate is highly sensitive to the discount rate that is assumed in the calculations (see table below).
If the SCC serves as a metric of climate change worry of different US presidents, the Biden administration is more than 3 times more ambitious that the Obama administration and close to 40 times more ambitious than President Trump.
Are you asking the wrong question?
The discussion so far is largely focussed on the US and there is a good reason for that. The US is the only major economy that uses estimates of the SCC for policy analysis in spite of very large uncertainties and disagreements. Canada and Israel also use SCC but they rely on the IWG estimates and Mexico benchmarks against the IWG and the Canadian estimates.
Germany publishes its own estimate of the SCC, but the country does not use the SCC for policy analysis. It’s most recent estimate stood at EUR 180 at 2016 prices and a 1% discount rate and EUR 640 at a 0% discount rate – again demonstrating the sensitivity of the SCC to the discount rate.
These deep disagreements have led many countries to conclude that the SCC has ‘little to no value’ for climate policies. To be clear, that is not to say that the effort or ambition to combat climate change needs to be diminished as a result. If anything, more needs to be done. For example, the High Level Commission on Carbon Prices in the UK concluded that:
‘many of the impact functions used in modelling exercises to calculate the social costs of carbon are biased downward because they fail to consider many vitally important risks and costs associated with climate change—particularly the widespread biodiversity losses, long-term impacts on labor productivity and economic growth, impacts on the poorest and most vulnerable, rising political instability and the spread of violent conflicts, ocean acidification, large migration movements, as well as the possibility of extreme and irreversible changes… for these reasons, many past modeling exercises to calculate the global social costs of carbon have produced numbers that probably underestimate these costs by very large margins.’
As a result, the UK, most explicitly, and other countries, implicitly, have rejected the SCC approach because of the uncertainty and divergence of views and deeper flaws that Stiglitz and Stern have identified in IAMs . For them, the effort required to combat climate change should not be based on a cost-benefit welfare analysis from an IAM, but instead, it should be based on achieving the temperature targets set in Paris in 2015.
The target-based approach and the related ambition to achieve the stretched 1.5 degree target is also highly contentious. Bill Nordhaus, the pioneer of integrated assessment models and a Nobel prize recipient, for example, concludes from an updated exercise on his DICE model…
‘that the 1.5 °C scenario is “infeasible” within the constraints of realism and the model. …. In an unconstrained situation, the 1.5 °C limit was met, but it required an increase in the harmonized global carbon price from USD 6/tCO2 in 2020 to USD 400 in 2040. The present value economic cost was almost USD 1 quadrillion. While the likelihood of this target can be debated for a few more years, the debate will soon end as the target is likely to be passed before the end of this decade.’
More specifically, they estimate the SCC at USD 3,538 for 2020 to achieve 1.5 degrees centigrade. This compares to the current level of global carbon price which stands at USD 6/tCO2.