When the Price Is Right

Carbon pricing: Across (and sometimes even within) academic disciplines, no topic under the broad umbrella of climate economics tolerates quite so large a gap between facts and dogma, and between the power of a seemingly simple idea on the one hand and raw political power on the other.

What’s in a Name?

There is the name itself. The term “carbon pricing” is much more than that. For one thing, it’s not just about carbon or, more accurately, carbon dioxide (CO2). Any climate solution must include containment of other, in some ways more potent, greenhouse gases like methane and nitrous oxides. Carbon in this context is just a stand-in.

“Pricing,” too, is a stand-in. A carbon tax is a direct price exacted per ton of CO2 (and other greenhouse gases) emitted. It’s the preferred classroom example of carbon pricing because it is conceptually simple and fits into broader discussions of market externalities. But confusingly, “carbon tax” can also serve as shorthand for many other policy instruments, notably emissions trading.

Emissions trading establishes a price for carbon, but it does so indirectly. The government sets a cap on total emissions, and then lets regulated emitters like refineries trade allowances (rights to emit) among themselves or with anyone else wanting to invest in carbon reductions. Some analysts strongly prefer the simplicity of the direct carbon tax to a cap-and-trade system. But either approach results in a price for each emitted ton of CO2.

The next step is a litmus test of sorts, and where the real divisions among climate analysts emerge. To some, “pricing carbon” ends with a carbon tax or an emissions trading system, or at best a hybrid. For example, a tax that adjusts automatically to meet an emissions containment goal, or a cap that tightens when prices are too low to have any impact on behavior or relaxes when carbon prices spike. Environmentalists like emissions certainty (think cap and trade), the argument goes, whereas businesses prefer price certainty (carbon taxes).

Either way, pricing carbon ends there for purists. It is, after all, what the founding fathers for emissions trading – British economist Arthur Pigou for the tax, and Canadian economist John Dales, invoking Nobel Laureate Ronald Coase – would have wanted.

Or perhaps not. Disciples often are inclined to overstate the case made by their intellectual forbearers. Take John Stuart Mill, one of the founding fathers of market liberalism and free trade. He made a compelling case for tariffs to protect “infant” industries, a thorn in the eye of many a self-declared libertarian. With carbon pricing, too, dogmatic purity all but commands fealty to the mantra of “price carbon, and get out of the way.” Everything else, the purist view goes, would be undue meddling in private markets.

You Say Potato…

In its simplest form, the argument for carbon pricing hews closely to one of the most fundamental of economic principles: People respond to incentives. That principle, though, says little to nothing about how the incentives should be created in the first place. A carbon tax is one; cap and trade is another. But all too often lost in the debate is the reality that more direct regulations can also set a price and create very real incentives.

King Edward I attempted to ban “sea coal” – bituminous soft coal that generates a lot of soot in burning – in the year 1306 and threatened repeat offenders with death. That was an incentive if there ever was one. It’s easy to agree that outright bans, enforced by a barbaric system of justice, are not what economists, or anyone else, have in mind when arguing for a carbon price. But it’s hard to disagree with the notion that bans buttressed by capital punishment create incentives, and rather strong ones at that. An infinite price – death – is still a price. The underlying economic principle at work is exactly the same.

Economists might decry bans as unduly costly, unworkable or worse. Nobody has successfully banned fossil fuels altogether since the British crown tried and failed in the early 14th century – at least not in any comprehensive way amounting to more than “banning” a particular coal plant through local zoning regulations. That does not mean, however, that there is no place for more direct regulations up to, and including, targeted bans.

Here’s one. Setting an energy-efficiency standard for lighting that’s tough enough to effectively ban incandescent lightbulbs – as the EU and the United States have done – passes conventional benefit-cost tests. That is, the societal benefits outweigh the costs of the loss of one form of lighting. The United States did so with the Energy Independence and Security Act of 2007, signed into law by President George W. Bush. By the time President Trump took up the cause, moving to scrap the efficiency standards in 2019, the economics were so far in favor of phasing out incandescent bulbs that the EPA had to ignore the environmental benefits of lower energy use to make the math work – and even then it failed to do so. The Biden administration has since reinstated the standards, and then some, aiming to make the LED bulbs that replaced incandescent lighting even more efficient.

Is setting an energy-efficiency standard for lightbulbs the same as setting a carbon price? Not in the literal sense, nor in the sense of establishing property rights for emissions in the form of a cap-and-trade system. But yes, it creates incentives to use less polluting light- bulbs by regulating more polluting ones out of the market.

For some, “regulation” is code for dreaded government intervention. It might thus be something to trade away for a lower carbon price. But that is exactly the point. Why else would Exxon be in favor of a “simple” $50 per ton carbon tax, were it not for the fact that it hoped to remove regulations that come with a higher carbon price?

There is, indeed, a long tradition in economics of drawing a distinction between direct regulation, sometimes called “command-and-control” instruments, and “market-based” instruments like taxes and cap and trade. As every intro econ student knows, the latter are more flexible and, thus, more cost-effective in achieving a particular target. But there is no denying that any form of regulation follows the same basic principle of increasing the price of what is being regulated while lowering the relative price of the alternative.

Take clean energy standards for the nation’s electricity grid. Well over half of U.S. states now have them, deployed with various degrees of ambition. Some include natural gas as part of the “clean” energy mix; others include nuclear, while many focus exclusively on renewable energy sources, with names like “renewable energy” or “renewable portfolio” standards. Regardless of their name though, there is no denying their impact. By some accounts, they are responsible for around half of the total growth of renewable electricity generation in the past two decades.

The mechanism? States set standards, mandating that utilities and other entities obtain renewable energy credits or certificates, commonly known as “RECs.” These RECs can either be created in-house by actually generating renewable energy, or they can be purchased from others. The principle is the same as the one that underlies cap-and-trade systems. The policy might have the word “standard” in the name, something often associated with political progressives who are opposed to “market” solutions. But energy standards also establish a price, via a market, making them a “market-based,” solution – something espoused (at least in theory) by political conservatives.

To be clear, clean energy standards do not establish an economy-wide carbon price. They only operate in the power sector, at once the most important single sector and often the cheapest to decarbonize. Cheap does not mean costless or ineffective, though. The most comprehensive analysis out there says that state-level clean energy standards cut U.S. CO2 emissions by between 10 and 25 percent while raising electricity rates by around 10 percent. Expressed in dollars per ton of CO2 avoided – an equivalent carbon price – values range from around $60 to $300. Whether these carbon prices are worth the costs depends crucially on another metric: the social cost of carbon (SCC).

Distinction With a Difference

The first thing to know about the social cost of carbon is what it is not. It is not a carbon price in the narrow sense of the term, implying a price embodied in a tax or discoverable through market activity in a cap-and-trade system. Economists do themselves no favor when they conflate the process of calculating the SCC with prescribing a particular policy.

Confusingly, there are two ways of calculating the SCC. One is by tallying the damage to the climate caused by emitting CO2 translated into a common metric, typically U.S. dollars per ton. This is the way the U.S. government defines its social cost of carbon, in part for legal reasons. The resulting measure serves as an input on the benefit side of regulatory benefit-cost analyses. Figuring out whether lightbulb standards provide net benefits to society means tallying their benefits, including the SCC, and comparing them to the costs. (Spoiler alert: LED bulbs are so cheap and use so little electricity that it’s not even a close call.)

The second way to calculate what often also goes under the heading of the SCC is as the product of one of the world’s most ambitious benefit-cost analyses, comparing both the benefits and costs of cutting CO2 emissions around the globe. Economists typically call that number the “optimal carbon price.” That is an important metric to know as a broad guide for climate policy. However, it is not a reasonable policy prescription to argue to just set the global carbon price at that level, tomorrow. The world is too complicated a place – and, frankly, too little is known – to bet on one-size-fits-all in terms of policy planning.

To add to the confusion, even the U.S. SCC calculations got their start in global benefit-cost analysis, with Nobel economist Bill Nordhaus’ pioneering “dynamic integrated climate-economy” (DICE) model, which was first published in 1992. Later versions of DICE figured into the U.S. government’s SCC calculations until the Biden administration restored Obama-era calculations as its “interim” social cost of carbon soon after taking office in 2021. That calculation turns off the cost side of the model to avoid calculating the “optimal” price and instead just tallies the climate damages associated with one additional ton of CO2 emitted.

The second thing to know about the SCC is that there is no single right number. Climate damages are too uncertain to allow for that. There are large ranges that are sensitive to crucial inputs, like people’s inherent aversion to risk, and most important, how one sets the discount rate used to translate expected future climate damages into today’s dollars.

The Obama administration offered a “central” SCC value of around $50 per ton of CO2 emitted right now, a value that corresponds to its assumption of a 3 percent discount rate to measure the future costs created by today’s emissions. The Biden administration, to its credit, did away with the misleading “central” label when it restored the Obama-era SCC calculations after the Trump years. It instead presented a range from around $15 to over $150 per ton of CO2.

The $15 lower bound corresponded to a calculation with a 5 percent discount rate for future climate damage. The higher the rate, the less value is placed on future damages, de-pressing the SCC. The lowest discount rate used at the time, 2.5 percent, corresponded to a $75 per ton social cost of carbon. The analysts essentially left the choice among those discount rates to the policymaker applying the SCC.

Sky’s the Limit

Then there is the $150 per ton upper bound. That figure corresponds to the 95th percentile of the distribution as a stand-in for a high-risk scenario in which more-terrible-than-expected things happen because of carbon pollution. The difference between $50 and $150 is stark, as the comparison with the imputed costs of state-level clean electricity standards makes clear. With an SCC of $50, all the state standards fail a narrow benefit-cost test focused on climate alone. With an SCC of $150, many standards are immediately in the money.

Importantly, the “interim” SCC range from $15 to $150 is far from the last word. The Biden administration has since spearheaded an ambitious process to revise the Obama-era numbers underlying the calculation.

An initial report of the revised SCC from the EPA was published in May 2022. The new equivalent to the Obama $50? Closer to $200, almost four times higher. The lowest number in the corresponding range is now $120, up from $15! And the highest number presented upfront? A stiff $340. Importantly, that $340 does not yet even correspond to the 95th percentile probability range, but merely represents the median value associated with the lowest discount rate, now 1.5 percent instead of the prior 2.5 percent.

Unearthing the 95th percentile figure takes a bit of work. It doesn’t appear in black and white until one gets to a figure on page 69 of the EPA document. In fact, there are three versions of it, corresponding to three different modeling approaches, which alone shows how difficult it is to define a single “correct” approach. But the message is clear: while the median SCC estimates hover between $190 and $200 per ton, the 95th-percentile upper bound (of the distribution presented) ranges from a bit over $500 to well over $750 per ton of CO2 emitted today!

Those Devilish Details

Why those large increases in the SCC? There are lots of technical reasons. (Full disclosure: I was one of seven formal external peer reviewers for the report.) But in the end, it boils down to two factors: estimating damages and choosing the discount rate.

Tallying climate damages is a major undertaking. The first efforts used in DICE and models like it were anchored by some rather heroic assumptions, with lots of room for improvement. Hence the founding of the Climate Impact Lab, a research collective explicitly formed to improve the quantification of such damages. Some of these refinements might lead to small decreases in estimated damages, but most have led to increases – and often large ones at that.

All told, improved damage estimates alone have increased the Obama-era $50 figure to around $80 per ton. By itself, that is a significant increase, especially since it is still only a partial estimate of actual damages. The two main climate damage sectors figuring in the calculation are agriculture and human mortality: losses of crops – and people.

There are plenty of missing climate damages and quantifications still to do, from health impacts to labor productivity on the one hand and military conflict to migration on the other. The latest research frontier is the effort to assay damages due to extreme heat and other weather events rather than just changes in the mean. Plenty of studies point to the fact that heat alone is deadly.

Then there are major climatic tipping points – for example, ice sheet disintegration, thawing Arctic permafrost that releases methane, and radical weather changes linked to atmospheric circulation – which go well beyond local effects. Quantifying them increases the SCC by somewhere between 25 and 50 percent by our own estimates. We calculate a 10 percent probability that tipping points alone could more than double the SCC. None of these calculations are yet included in the esti- mates that have already quadrupled the prior $50 number to around $200.

So if damages alone increase the number from $50 to $80, what accounts for the difference from $80 to around $200? Discounting.

It might be easy to dismiss that increase as a purely ethical choice. If you place more value on the quality of the environment to be enjoyed by future generations, lower the discount rate accordingly and watch the SCC go up. Choosing among plausible discount rates opens up plenty of heady academic debates – there are lots of complex factors at work. The SCC update makes some significant strides on the discounting front to integrate some of the latest economics. Ultimately, though, the decision to declare 2 percent the new 3 percent was almost entirely mechanistic. Using the identical logic established in the Bush administration’s Office of Management and Budget guidance from the year 2003 directly leads to the 2 percent figure. And there is ample further evidence to justify this move.

Improvements to the SCC ought not end there, and they would only increase the number further. For example, by one estimate, explicitly modeling society’s aversion to risk increases the SCC by between 20 and 25 percent. Representing equity considerations – more heavily weighting the happiness or health of low-income households – doubles or even triples the social cost of carbon. I can see why the Biden administration might be hesitant to arrive at “central” SCC estimates of well beyond $200, but political reticence should not be influencing the calculation of this crucial number.

Many countries look to the U.S. social cost of carbon for guidance. Others, such as Ger- many, have made their own calculations.

Derived at a time when the U.S. “central” number was still $50, Germany’s value is over $225 per ton of CO2, with a second value of over $800 as a “recommended” estimate that emphasizes equity across generations. Ger- many, too, is now revising its prior estimates, and the number will presumably rise as a result. All that would point to ambitious German solar feed-in tariffs and other policies as even more of a necessity than they already are. Any U.S. clean energy standard, too, would pass muster with these numbers.

That is the key bit: no SCC calculation, however high the number, would “solve” climate change by itself. It stills takes actually pricing carbon, whichever form that might take. State-level clean energy standards are one such policy. An explicit federal carbon price would be another, and in many ways superior, instrument – though even an ambitious federal carbon tax would not be a replacement for clean-energy standards that push renewables onto the electricity grid by fiat. Nor would it be a replacement for the myriad policies needed to help decarbonize buildings, transport and any number of industrial sectors.

The highest direct carbon tax paid anywhere is about $125 per ton of CO2 – in Sweden, covering around 40 percent of the country’s emissions. The European Union’s cap-and- trade carbon market, where price is determined by market purchases of emissions allowances, is running close, at around $110 a ton. Significant changes to the EU system that are in the works promise still higher prices to come.

Most other carbon taxes and cap-and-trade systems at best play a supporting role in curbing emissions. California’s system, which dates from 2013, caps 85 percent of all of the state’s greenhouse gases, in contrast with the EU’s, which only covers around half of the block’s CO2 emissions. But California’s market price for carbon remained below $20 through 2021 and now hovers around $30 per ton. Even a low price helps cut emissions, but the $30 is an order of magnitude below the SCC.

The overriding point remains that effective climate policy, whatever its name, goes back to the most fundamental of economic principles: everyone involved – from corporations to households – responds to incentives. True decarbonization, of course, rests on the details. Simply shouting “price carbon!” all day is not going to make it so. That goes for any kind of climate policy. Change is hard. Change in the face of vested interests comfortable with obscuring the truth and delay- ing rational climate policy for as long as possible is harder.

There is solid evidence to suggest that imposing a serious carbon price reduces emissions. Sweden’s $125 per ton of CO2 cut the country’s transportation emissions by over 10 percent. And after three decades of experience in over three dozen countries, there is ample evidence that existing carbon prices, imposed through taxes or through cap-and-trade systems, work to cut emissions without materially undermining aggregate employment or economic growth. It’s similarly plain that the resulting emissions cuts alone are not enough to get where we must go. A tell-tale sign? Most prices paid per ton of CO2 are not anywhere close to SCCs of $200 or more.

Thesis, Antithesis, Synthesis

The one climate policy that cannot be mistaken for carbon pricing of any kind is its polar opposite: subsidies for clean alternative sources of energy. They, too, stand on solid economic footing, akin to John Stuart Mill’s case for protecting “infant” industries against competition until they learn to be more competitive. Research, development and deployment of new technologies does not happen in a vacuum, and there is every reason to believe that subsidies can make a huge difference. Much like CO2 is a negative “externality” in need of a price to define its place in the economy, positive learning-by-doing externalities all but demand subsidies.

Comprehensive climate policy must take both pricing carbon and subsidizing the alternatives seriously. Much as there is no single, correct SCC or carbon price, there is no one-size-fits-all recipe for making climate policy work. Policy sequencing, experimentation and the deliberate building of coalitions, at home and abroad, are all essential components of such a broad climate policy push.

The U.S. Inflation Reduction Act of 2022, the bipartisan infrastructure law, and the CHIPS and Science Act play a major role in this push. None of these price carbon directly (even though the IRA does have a little-known but crucial provision that puts a direct price on climate-warming methane leakages from wells).

That is just as well. The goal, after all, is to get emissions down, not to get energy prices up. The best outcome in the end: zero carbon emissions, and a zero carbon price – an economy in which nobody demands carbon and nobody supplies it. The world will have moved on from the carbon age, and it will be better for it.

Gernot Wagner is a climate economist at the Columbia University Business School. His most recent book is Geoengineering: the Gamble (Polity Press).

This essay was first published by the Milken Institute Review under the title “Taming Carbon” (23 October 2023). It is the first in a mini-series; the second essay is titled “Tipping Carbon” (24 July 2024).

Citation:
Wagner, Gernot. “Taming Carbon.” Milken Review, 23 October 2023.

Tagged: Perspective, SCC, Washington