What methodological choices went into the IWG numbers?
Economists estimate the SCC by linking together a global climate model and a global economic model. The resulting models are called Integrated Assessment Models, or IAMs. This integration helps economists take a unit of carbon emissions and translate that into an estimate of the cost of the impact that emissions have on our health, well-being, and quality of life in terms of dollars. The models are based on the best available science and economics from peer-reviewed publications.
The IWG uses the three most–cited models, which are William Nordhaus’ DICE model (Yale University), Richard Tol’s FUND model (Sussex University), and Chris Hope’s PAGE model (Cambridge University).
The IWG produced four different SCC estimates by using different discount rates. According to the IWG’s 2010 Technical Support Document, the 3-percent discount rate estimate is considered the central estimate because it uses the central (i.e., middle) discount rate and is based on an average or mean, rather than worse-than-expected, climate outcome. The use of this “central” discount rate is supported by surveys of experts. 1 The IWG further argues that the 3% is consistent with OMB’s Circular A-4 guidance, corresponds to the correct discounting concept (i.e., the consumption rate of interest) when damages are measured in consumption-equivalent units, and roughly corresponds to the after-tax riskless interest rate.
The central estimate is an “average” or mean estimate in the sense that the IWG ran its models thousands of times using slightly varying assumptions to reflect uncertainty, and equally weighted the results to produce a mean average. It is important to note that the SCC is an average estimate of marginal damages, and not an average estimate of average damages. In other words, the SCC is the average estimate of the marginal impacts caused by an additional unit of greenhouse gases. It is not appropriate to interpret the SCC as an estimate of the average damages of all greenhouse gases ever emitted. It is how much the next unit of emissions will cost us..
First, what is a discount rate?
It is easiest to explain the idea of discount rates with a simple example: If offered $1 now or $1 in a year, almost everyone would choose to receive the $1 now. Most individuals would only wait until next year if they were offered more money in the future. The discount rate is how much more you would have to receive to wait until next year. Similarly, if individuals were asked to pay $1 now or $1 next year, most individuals would choose to pay $1 later. Most individuals would only pay now if they were asked to pay more money in the future. The discount rate is how much more you would have to pay in the future to be willing to pay $1 in the present.
Why is the discount rate important?
The discount rate is one of the most important inputs in models of climate damages, with plausible assumptions easily leading to differences of an order of magnitude in the SCC. The climate impacts of present emissions will unfold over hundreds of years. When used over very long periods of time, discounting penalizes future generations heavily due to compounding effects. For example, at a rate of 1 percent, $1 million 300 years hence equals over $50,000 today; at 5 percent it equals less than 50 cents. 2 The discount rate changed by a factor of five, whereas the discounted value changed by more than five orders of magnitude. Depending on the link between climate risk and economic growth risk, even a rate of 1 percent may be too high. 3 Uncertainty around the correct discount rate pushes the rate lower still. 4
Why is the IWG correct to exclude a 7% discount rate?
The IWG correctly excluded a 7-percent discount rate, a typical private sector rate of return on capital, for several reasons. First, typical financial decisions, such as how much to save in a bank account or invest in stocks, focus on private decisions and use private rates of return. However, here we are concerned with social discount rates because emissions mitigation is a public good, where individual emissions choices affect public well-being broadly. Rather than evaluating an optimal outcome from the narrow perspective of investors alone, economic theory would require that we make the optimal choices based on societal preferences (and social discount rates). Second, climate change is expected to affect primarily consumption, not traditional capital investments. 5 Guidelines of the federal Office of Management and Budget note that in this circumstance, consumption discount rates are appropriate. 6 Third, 7 percent is considered much too high for reasons of discount rate uncertainty and intergenerational concerns (further discussed below). Fourth, interest rates are at historic lows, with no indication of increasing, so traditional rates of return used to guide discount rate selection are too high at the present time. 7
What is a declining discount rate?
The IWG chose as one of its discount rates an estimate based upon declining discount rates. The 2.5-percent discount rate was included by IWG as a constant approximation of a declining discount rate. 8 Since the IWG undertook its initial analysis, a consensus has emerged among leading climate economists that a declining discount rate should be used for climate damages to reflect long-term uncertainty in interest rates. 9 Arrow et al (2013) presents several arguments that strongly support the use of declining discount rates for long-term benefit-cost analysis.
But perhaps the best reason is the simple fact that there is considerable uncertainty around which interest rate to use: uncertainty in the rate points directly to the need to use a declining rate, as the impact of the uncertainty grows exponentially over time. 10 The uncertainty about future discount rates could stem from a number of reasons particularly salient to climate damages, including uncertainties in future economic growth, consumption, and the interest rate used by consumers.
Why should the central IWG estimate be interpreted as a lower bound?
A number of factors might result in using a SCC value that is higher than the estimate based on a 3-percent discount rate. Recent research has shown that the appropriate discount rate for intergenerational analysis may be even lower than that reflected in the SCC analysis, which would result in a higher SCC. 11 A jurisdiction might decide that the uncertainty associated with climate damages warrants using a discount rate that declines over time, leading to a higher SCC. 12 A consensus has emerged among leading climate economists that a declining discount rate should be used for climate damages to reflect long-term uncertainty in interest rates and the NAS January 2017 recommendations to the IWG support this approach. 13 Furthermore, a number of types of damage from climate change are missing or poorly quantified in the federal SCC estimates, meaning that the federal SCC estimate associated with a 3-percent discount rate should be interpreted as a lower bound on the central estimate. 14
As we discussed above, Washington State agencies have begun following the recommendation of the state’s energy office and using a 2.5-percent discount rate for their economic analyses involving greenhouse gas emissions, for a number of reasons, including that the damages omitted from the IWG estimates and the uncertainty surrounding climate consequences warrant more dramatic action. 15
In 2017, NAS issued a report stressing the importance of a longer time horizon for calculating the social cost of greenhouse gases, the rationale for which is also included in the 2016 IWG Technical Support Document. The report states that, “[ i ]n the context of the socioeconomic damage, and discounting assumptions, the time horizon needs to be long enough to capture the vast majority of the present value of damages.” 16 The report goes on to note that the length of the time horizon is dependent “on the rate at which undiscounted damages grow over time and on the rate at which they are discounted. Longer time horizons allow for representation and evaluation of longer-run geophysical system dynamics, such as sea level change and the carbon cycle.” 17 In other words, after selecting the appropriate discount rate based on theory and data (in this case, 3 percent or below), analysts should determine the time horizon necessary to capture all costs and benefits that will have important net present values at the discount rate. Therefore, a 3 percent or lower discount rate for climate change implies the need for a 300-year horizon to capture all significant values. NAS reviewed the best available, peer-reviewed scientific literature and concluded that the effects of greenhouse gas emissions over a 300-year period are sufficiently well established and reliable as to merit consideration in estimates of the social cost of greenhouse gases. 18
The best available science and economics thus supports a 300-year time horizon for climate effects. We note that, so far one state, Minnesota, has chosen a different time horizon. For the reasons above, this should not be considered a best practice. 19
As we discussed above, the IWG recommends using a global estimate for a number of reasons. Generally, a global number is appropriate because climate change is a global phenomenon and emissions that occur in one part of the world affect other parts of the world. The same is true for avoided emissions. Simply, if all countries set their greenhouse emission levels based on only domestic costs and benefits, ignoring the large global externalities, the aggregate result would be substantially sub-optimal climate protections and economically inefficient policies.
Why did the IWG develop separate numbers for methane and nitrous oxide, rather than just adjusting by their global warming potential?
The IWG has also developed robust federal estimates of the social cost of methane (SCM) and social cost of nitrous oxide (SCN2O). Methane and nitrous oxide are two important, and potent, greenhouse gases. Prior to the IWG’s work on social costs for the emission of these pollutants, the SCC was multiplied by the Global Warming Potential (GWP) of each gas. 20 But, according to the IWG:
“While GWPs allow for some useful comparisons across gases on a physical basis, using the [SCC]…to value the damages associated with changes in CO2-equivalent emissions is not optimal…because non-CO2 GHGs differ not just in their potential to absorb infrared radiation over a given time frame, but also in the temporal pathway of their impact on radiative forcing, which is relevant for estimating their social cost but not reflected in the GWP.” 21
In other words, because the GWP of each GHG changes over the lifetime of the gas, multiplying the SCC by the GWP in any particular year is inaccurate. The SCM and SCN2O methodologies build directly on the IWG’s SCC methodology, and replace the less accurate methodology of multiplying the SCC by these gases’ relative global warming potential. The same rigorous, consensus-based, transparent process used for the federal SCC has shaped the federal SCM and federal SCN2O estimates. Just as the federal SCC likely underestimates the true social cost of carbon, the federal SCM and SCN2O are likely to underestimate the true social cost of these other greenhouse gases due to omitted damages and uncertainties regarding the scope of the effects in the underlying models. 22 Nonetheless, the 2016 IWG SCM and SCN2O are the best available estimates of the social costs associated with the emission of those greenhouse gases.
Table 3: Social Cost of Methane Estimates (in 2017 dollars per metric ton) 23
|Year of Emission||Average estimate at 5% discount rate||Average estimate at 3% discount rate—IWG’s Central Estimate||2.5% Average||High Impact Estimate: (95th percentile estimate at 3% discount rate)|
Table 4: Social Cost of Nitrous Oxide Estimates (in 2007 dollars per metric ton) 24
|Year of Emission||Average estimate at 5% discount rate||Average estimate at 3% discount rate—IWG’s Central Estimate||Average estimate At 2.5% discount rate||95th percentile estimate at 3% discount rate|
The SCM and SCN2O were developed more recently, so have a shorter history of being used by federal—or state—agencies, but the figures were approved by the IWG and appear in an addendum to the group’s 2016 Technical Support Document. They were also peer-reviewed by the EPA and by academic journals. 25 For other greenhouse gases beyond methane and nitrous oxide, adjusting the SCC with the gases global warming potential is fine. In fact, for now, it is the best option for state decisionmakers.
- Peter Howard & Derek Sylvan, Expert Consensus on the Economics of Climate Change, Institute for Policy Integrity Report (2015).; M.A. Drupp, et al., Discounting Disentangled: An Expert Survey on the Determinants of the Long-Term Social Discount Rate (London Sch. of Econ. and Political Sci., Working Paper, 2015) (finding consensus on social discount rates between 1-3%). ↩︎
- Dallas Burtraw & Thomas Sterner, Climate Change Abatement: Not “Stern” Enough? (Resources for the Future Policy Commentary Series, Apr. 4, 2009), available here. ↩︎
- “If climate risk dominates economic growth risk because there are enough potential scenarios with catastrophic damages, then the appropriate discount rate for emissions investments is lower tha[n] the risk-free rate and the current price of carbon dioxide emissions should be higher. In those scenarios, the “beta” of climate risk is a large negative value and emissions mitigation investments provide insurance benefits. If, on the other hand, growth risk is always dominant because catastrophic damages are essentially impossible and minor climate damages are more likely to occur when growth is strong, times are good, and marginal utility is low, then the “beta” of climate risk is positive, the discount rate should be higher than the risk-free rate, and the price of carbon dioxide emissions should be lower.” Robert B. Litterman, What Is the Right Price for Carbon Emissions?, Regulation, Summer (2013) 38-43, at 41, available here. ↩︎
- See “Isn’t there too much uncertainty around the SCC to use it?” on page 23. ↩︎
- “There are two rationales for discounting future benefits—one based on consumption and the other on investment. The consumption rate of discount reflects the rate at which society is willing to trade consumption in the future for consumption today. Basically, we discount the consumption of future generations because we assume future generations will be wealthier than we are and that the utility people receive from consumption declines as their level of consumption increases . . . . The investment approach says that, as long as the rate of return to investment is positive, we need to invest less than a dollar today to obtain a dollar of benefits in the future. Under the investment approach, the discount rate is the rate of return on investment. If there were no distortions or inefficiencies in markets, the consumption rate of discount would equal the rate of return on investment. There are, however, many reasons why the two may differ. As a result, using a consumption rather than investment approach will often lead to very different discount rates.” Maureen Cropper, How Should Benefits and Costs Be Discounted in an Intergenerational Context?, 183 Resources 30, at 33 (2013). ↩︎
- See Office of Mgmt. & Budget, Circular A-4, Nat’l Archives (Sept. 17, 2003), available here [https://perma.cc/GSV8-TAUR], at 33. ↩︎
- Council of Econ. Advisers, Discounting for Public Policy: Theory and Recent Evidence on the Merits of Updating the Discount Rate, 1 (2017) [hereinafter “CEA Brief”], available here. ↩︎
- TSD 2010, supra note 3, “The low value, 2.5 percent, is included to incorporate the concern that interest rates are highly uncertain over time. It represents the average certainty-equivalent rate using the mean-reverting and random walk approaches from Newell and Pizer (2003) starting at a discount rate of 3 percent. Using this approach, the certainty equivalent is about 2.2 percent using the random walk model and 2.8 percent using the mean reverting approach. Without giving preference to a particular model, the average of the two rates is 2.5 percent. Further, a rate below the riskless rate would be justified if climate investments are negatively correlated with the overall market rate of return. Use of this lower value also responds to certain judgments using the prescriptive or normative approach and to ethical objections that have been raised about rates of 3 percent or higher.") ↩︎
- The arguments here are primarily based on: Kenneth J. Arrow, et al., Determining Benefits and Costs for Future Generations, 341 Science 349 (2013); Kenneth J. Arrow et al., Should Governments Use a Declining Discount Rate in Project Analysis?, Rev. Envntl. Econ. Pol’y 8 (2014); Richard G. Newell & William A. Pizer, Discounting the Distant Future: How Much Do Uncertain Rates Increase Valuations?, 46 J. Envtl. Econ. & Mgmt. 52 (2003); Maureen L. Cropper et al., Declining Discount Rates, American Economic Review: Papers and Proceedings (2014); S.K. Rose et al., Understanding the Social Cost of Carbon: A Technical Assessment, EPRI Report #3002004657 (2014). ↩︎
- Martin L. Weitzman, Gamma Discounting, 91 Am. Econ. Rev. 260, 270 (2001) [hereinafter “Weitzman 2001”]. ↩︎
- Proceeding on Motion of the Commission in Regard to Reforming the Energy Vision, New York Public Service Commission Case No. 14‐M‐0101, Institute for Policy Integrity Comments on Staff White Paper on Benefit‐Cost Analysis in the Reforming Energy Vision Proceeding, Filing No. 447, at 8 (Aug. 21, 2015); CEA Brief, supra note 87. ↩︎
- See Weitzman 2001, supra note 90; Kenneth J. Arrow et al., Determining Benefits and Costs for Future Generations, 341 Science 349 (2013); Kenneth J. Arrow et al., Should Governments Use a Declining Discount Rate in Project Analysis?, 8 Rev Envtl. Econ. & Policy 1 (2014); Maureen L. Cropper et al., Declining Discount Rates, 104 Am. Econ. Rev. 538 (2014); Christian Gollier & Martin L. Weitzman, How Should the Distant Future Be Discounted When Discount Rates Are Uncertain? 107 Economics Letters 3 (2010). Policy Integrity further explores the use of declining discount rates in its recent comments to the National Academies of Sciences, see Policy Integrity NAS comments, supra note 76. ↩︎
- NAS Second Report, supra note 76. ↩︎
- See Omitted Damages, supra note 6; Revesz et al. 2014, supra note 74. ↩︎
- See, e.g., State of Washington, Department of Ecology, Preliminary Cost-Benefit and Least-Burdensome Alternative Analysis: Chapter 173-442 WAC Clean Air Rule & Chapter 173-441 WAC Reporting of Emissions of Greenhouse Gases 38 (2016), available here. ↩︎
- NAS Second Report, supra note 76, at 77. ↩︎
- Id. ↩︎
- NAS First Report, supra note 66, at 32 ↩︎
- See for more information, “Isn’t there too much uncertainty around the SCC to use it?” on page 23. ↩︎
- TSD 2016 Addendum, supra note 67, at 2 (“The potential of these gases to change the Earth’s climate relative to CO2 is commonly represented by their 100-year global warming potential (GWP). GWPs measure the contribution to warming of the Earth’s atmosphere resulting from emissions of a given gas (i.e., radiative forcing per unit of mass) over a particular timeframe relative to CO2. As such, GWPs are often used to convert emissions of non-CO2 GHGs to CO2-equivalents to facilitate comparison of policies and inventories involving different GHGs.”) ↩︎
- TSD 2016 Addendum, supra note 67, at 2 ↩︎
- Alex L. Marten et al., Incremental CH4 and N2 O Mitigation Benefits Consistent with the U.S. Government’s SC-CO2 Estimates. 15 Climate Policy 272 (2015). 15(2): 272-298 (2015, published online, 2014) [hereinafter “Marten et al.”]; Environmental Defense Fund, Institute for Policy Integrity, Natural Resources Defense Council, & Union of Concerned Scientists, Comments on EERE-2015-BT-STD-0016, Energy Conservation Standards for WICF Refrigeration System and EERE-2014-BT-STD-0031, Energy Conservation Standards for Residential Furnaces (Nov. 7, 2016). ↩︎
- TSD 2016 Addendum, supra note 67, at 7 ↩︎
- Id. ↩︎
- Marten et al., supra note 102. ↩︎