What is the social cost of carbon?
Written and accurate as at: Jun 10, 2021 Current Stats & Facts
According to legal scholar and Harvard University professor Cass Sunstein, the social cost of carbon (SCC) is “the most important number you’ve never heard of.”1 The SCC is a dollar figure that estimates the present value of potential future damages caused by an additional ton of CO2 emissions. It allows us to compare the expected costs and benefits from policies targeting lower carbon emissions in order to assess their cost-effectiveness. US federal and state governments have been using the SCC to quantify the environmental impact of proposed regulations since 2010, and different SCC values have been used over the last decade.2 Given its importance and complexity, the SCC’s value has been the subject of lively discussion among economists and policymakers, a discussion that got even livelier in the last 30 days while awaiting the new administration’s estimate of the SCC.3
In a recent Dimensional paper, “The Economics of Climate Change,” we explore the SCC in-depth and explain how it links to climate policy. The SCC has a prominent place in the assessment of climate policy because it allows us to measure the externality associated with greenhouse gas (GHG) emissions. GHG emissions represent a negative externality because firms and consumers do not pay for the full environmental costs of their emissions. Externalities include financial losses due to climate change, but also broader impacts such as negative effects on human health and biodiversity. The SCC estimates these environmental costs, present and future, and expresses their current value as a dollar amount. Thus, the SCC is an important reference point for carbon taxation. It also determines which mitigation projects are cost-effective. For instance, if the SCC is $50 per ton, paying $40 to avoid one additional ton of CO2 emissions is socially beneficial, but paying $60 is not.
SCC estimates are typically derived from joint models of the climate and the economy,4 which make assumptions about the costs and benefits of cutting emissions. These models can help find the optimal carbon tax policy and the associated trajectory for future GHG emissions. The SCC is a byproduct of optimisation: it is the carbon tax that causes firms and consumers to cut their emissions by the optimal amount. Importantly, the models can be used in reverse as well: given a policy goal (“limit warming to 1.0°C” or “cut emissions by 30%”), they can tell us the carbon tax that corresponds to the targeted reduction in emissions.
Estimates of the SCC in the academic literature vary widely, from $30 per ton of CO2 equivalent to $300 at the very high end. This variation is unsurprising: the SCC must encompass all future damages due to GHG emissions, including damages whose exact value is unknown (e.g., expected damages from rising sea levels) and damages inherently hard to quantify (e.g., loss of biodiversity). More importantly, all these damages must be discounted to a single present value. Since climate damages unfold over decades, the SCC is very sensitive to the choice of a discount rate. For instance, Nobel laureate William Nordhaus finds a value of $30–$40 in recent work, using a discount rate of around 4%. However, when he uses a discount rate of 1.4%, the rate used in a well-known study commissioned by the UK government (The Stern Review), he finds values above $200.5
On February 19, the administration published a notice in the Federal Register updating its guidance on how the SCC should be used in rulemaking.6 Although the newest US federal guidance does not provide a specific SCC number, it does refer to the SCC used during the Obama administration, which was $50 per ton.7 The number is consistent with academic estimates of the SCC, especially those that use higher discount rates. However, Nobel laureate Joseph Stiglitz and Nicholas Stern have urged the new administration to adopt an SCC closer to $100.8 Again, the difference comes down to discount rates. As argued by Stern and Stiglitz, low discount rates could be justified on risk management grounds because future damages from climate change are highly uncertain and might be irreversible.
The debate about the correct value of the SCC shows no sign of abating. The discussion is not confined to the US, as several countries compute their own value of the SCC for regulatory purposes.9 The research we summarize in our recent paper provides a framework for anyone interested in better understanding the different viewpoints in this important debate.
DISCLOSURES
The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.