What methodological choices went into the IWG numbers?
Economists estimate the SC-GHG 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 available at the time of their initial 2010 estimates, which were 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 SC-GHG estimates by using different discount rates. In the IWG’s 2010 through 2016 estimates, it used 3 percent as its central discount rate estimate. However, in its 2021 update, the IWG dropped the use of the term “central estimate” for the 3-percent rate. Recognizing the evolving economics on this issue, the IWG recognized that discount rates of 2 percent or lower may be appropriate for discounting climate damages.
In the EPA’s draft SC-GHG update, the agency adopts a 2 percent near-term discount rate as its central rate, which declines over time.
First, what is a discount rate?
In economics, a discount rate translates impacts that occur at different times into a common present value. Because individuals have a positive time preference—meaning we value present welfare over future welfare—a discount rate reduces the value of future impacts.
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.
The higher the discount rate, the lower the value placed on effects in the long-term future. Accordingly, the use of lower discount rates produces higher SC-GHG estimates.
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 SC-GHG. 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 in the future equals over $50,000 today; at 5 percent it equals less than 50 cents. 2 Depending on the link between climate risk and economic growth risk, even a rate of 1 percent may be too high for the SC-GHG. 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, we should make choices from the broad perspective of society. 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).
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 Moreover, as noted above, EPA’s 2022 draft update also applies a declining discount rate.
The use of these declining discount rates reflecting the economic consensus that a declining discount rate should be used for climate damages. This reflects 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.
Why should the IWG estimates be interpreted as lower bounds?
Although the IWG numbers were based on the best science and economics available at the time of their initial development in 2010, they are now widely regarded to underestimate the true cost of climate change for numerous reasons.
A key reason is the discount rate. Whereas the IWG initially adopted a central discount rate of 3 percent, climate economists now widely believe that discount rates of 2 percent or lower are appropriate for climate effects. As noted above, EPA’s 2022 draft updates applied a near-term discount rate of 2 percent that declines over time. Similarly, the Office of Management and Budget recently proposed the use of a 1.7 percent social discount rate throughout federal benefit-cost analysis.
Several states have lowered the IWG’s discount rates consistent with the best available economics. For instance, Washington State agencies use the IWG’s valuations using a 2.5 percent discount rate. New York State uses a central discount rate of 2 percent.
Greenhouse gases can remain in the atmosphere—and heat the climate—for centuries. The use of a 300-year time horizon ensures that these long-term impacts are captured in the climate-damage estimates.
In 2017, the National Academies of Sciences issued a report stressing the importance of a long time horizon that captures all important impacts of climate change. 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 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 IWG uses 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 However, the GWP changes over the lifetime of each greenhouse gases. Accordingly, multiplying the SCC by the GWP in any particular year does not produce the best estimate.
The SCM and SCN2O methodologies build directly on the IWG’s SCC methodology. The same rigorous, consensus-based, transparent process used for the federal SCC has shaped the federal SCM and federal SCN2O estimates. However, just as the IWG’s SCC underestimates the true social cost of carbon, the federal SCM and SCN2O underestimate the true social cost of these other greenhouse gases. 22 In its 2022 draft update, EPA included draft estimated values for the SCM and the SCN2O.