Scientific Method / Science & Exploration

Have the feds put the right price on carbon?

An economic analysis suggests that the US government's estimate is way too low.

Aurich Lawson / Thinkstock

When the US government formulates a new environmental regulation, it typically performs a cost-benefit analysis of the expected impact of the changes. These calculations can be rather complex, as things like regulating pollution exact a cost on the polluters, but may save money for society as a whole. In 2007, a court ruled that the government needed to establish a price for carbon emissions (technically, the National Highway Transportation Traffic Safety Administration was ordered to do so when formulating new fuel efficiency standards). By 2009, the Obama administration had convened a multi-agency panel to come up with a standard value to be used by all federal agencies. The group produced a range of values, but came up with a central figure that it recommended all agencies use: $21 per metric ton of CO2.

A new, open access publication has now taken that estimate to task, with its authors complaining that the feds were far too simplistic about setting a price on carbon. Their analysis suggests that the cost of carbon should be at least twice that, and possibly over 12 times higher.

The study's two authors are based at the National Resource Defense Council and Cambridge University. And, even if you don't agree with their analysis, the study remains an interesting read because it does a good job of describing why putting a price on carbon is a real challenge. As expected, the results naturally depend strongly on the assumptions that you make, showing that small differences in assumptions could have a huge impact on policy.

The initial process of setting a price on carbon isn't very different from that of projecting climate change itself. Emissions scenarios (continued emissions, stabilization by 2050, etc.) get plugged into a climate model, which can project what the world will look like at various dates. The economic costs to humans, in terms of things like impacts on health, loss of infrastructure, changing agricultural zones, etc. can then be calculated using an economic model. All of these processes involve uncertainties, so the models are run thousands of times with slightly different values to get a range of uncertainties.

These models have a number of weaknesses. For example, they can't consider unforeseen technological innovations, such as an efficient means of carbon capture and storage. At the same time, there are things are already causing problems—ocean acidification being one of them—that aren't factored in at all. On the whole, the authors say, the process is widely viewed as underestimating the costs of current emissions.

In any case, this process can provide an estimate of the costs that can be avoided by preventing emissions now, putting a price on carbon. But then the fun starts: these costs are borne now, while the benefits will be received in the future. Adjusting for this requires calculating what's called a "discount rate," which reflects the fact that the money spent on controlling emissions could have been put to other uses, even if it's only earning interest.

This is where some of the simplicity of the US government analysis comes into play. Rather than trying to figure out what discount rate is likely, it simply picked a set of potential returns: 2.5, three, and five percent. It was the middle of these that put the $21/metric ton price on carbon.

One obvious problem with this that is pointed out by the new paper is that current rates of return appear higher than they should be because many externalities aren't priced into economic growth. But that's not the only problem with the government's approach—it also ignores other work in this field.

Economists have already developed a formula for calculating discount rates. It includes a factor that compensates for the fact that, as incomes grow over time, the savings experienced in the future will have less value, since they'll be a smaller fraction of the total income. But it also includes one that adjusts for the fact that most people will probably be willing to bear some costs now in order to keep from eliminating resources needed by future generations. As the authors note, the only reasons for ignoring this factor that's been proposed is "the unlikely possibility that the human race becomes extinct in the future (for a reason unrelated to climate change)."

Another complicating factor that's not considered by the government is that the impacts of climate change will frequently be most severe on the poor, both in terms of nations and individuals. Given that, even smaller costs will have an oversized impact on basic living conditions.

In general, the authors clearly feel that the middle-of-the-road three percent value used by the US government is too high, and largely based on the rate of return from risk-free bonds, rather than a careful analysis. They also point out that the EPA (which was involved in setting this value) had surveyed rates used by other organizations and countries, and found that three percent was the highest typically used (many values, in fact, were less than half that). Dropping to a rate of two percent would more than double the price of carbon (to $62/metric ton), while a value of 1.5 percent would raise it to $122. Using the more sophisticated method of calculating the discount rate could, depending on assumptions, produce a value over 12 times the $21 figure recommended by the US.

What are the consequences of these higher values? It would only take a price on carbon of $52/metric ton to make photovoltaic power economically competitive with coal, something that is only currently true for natural gas and wind (based on Department of Energy figures that don't include a price on carbon). If the cost went up to $74, then wind would be competitive with natural gas, too.

Clearly, this is a case where there is no one right answer, and even the best estimate will involve a number of assumptions. But the authors of the paper have made a compelling case that the US government could have been a lot more sophisticated in its analysis, and that small changes in the approach used could have a very large effect on policy.

Journal of Environmental Studies and Sciences, 2012. DOI: 10.1007/s13412-012-0087-7  (About DOIs).

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