The social cost of carbon as a marker for price floors

Estimates of the social cost of carbon can help set floor prices in emissions trading schemes.  Estimates are likely to suggest a floor price for the EUETS of around €20-30/tCO2, rising over time. 

(Note: for a discussion on the social cost of carbon itself see the page on this issue under carbon pricing).

 

Those arguing against any price management in the EUETS sometimes suggest that, first, there is nothing wrong with the currently low level of prices, as it simply means that targets have been met at low cost, and, second, that there is no objective basis for setting the level of a floor price.

However neither of these propositions is valid.  We can be fairly sure that current prices in the EUETS are too low because prices are below the bottom end of the range of estimates for the damage caused by emissions – the social cost of carbon (SCC) – and so violate the principle that the externality of environmental damage should be fully included in the marginal price of emissions.  The emissions reduction target to 2020, an inevitable trade-off between costs and benefits, was, with hindsight, insufficiently ambitious[1].  And the SCC provides an objective, non-arbitrary method for setting a price floor, although inevitably the quantification is subject to uncertainties.

Estimating the SCC involves many uncertainties about the nature, extent and cost of damages, and the value that should be placed on non-market effects, including many changes to ecosystems.  These uncertainties are compounded by the damage being determined by the stock not the flow of GHGs, and even by the cumulative effect of the stock over time, with effects depending on how long a given concentration of GHGs is present in the atmosphere.  Furthermore the effects of changing the stock are likely to be highly non-linear effects.  There is also considerable uncertainty about the discount rate that should be used in weighting current and future costs, and the adjustments necessary to account for effects across people at very different levels of income (equity weighting).  These uncertainties lead to a wide range estimates of the SCC.

The US Environmental Protection Agency (EPA) has recently published new estimates of the SCC.  These are intended for use is assessing the cost effectiveness of policies such as fuel efficiency standards for vehicles.  Because many damages are large but occur in the distant future the choice of discount rate has a particularly large effect on the results, so the results are presented for a range of discount rates.  Values in $2011 range from $12 to $117/tCO2 in 2015 (around 2013€9.50- €92/tCO2) rising over time by roughly 2% p.a. in real terms.  This range, covering an order of magnitude, is fairly typical of surveys of the SCC, though some have argued for much higher values, and a few for lower values[2].

Social Cost of CO2, 2015-2050 a (in 2011 Dollars)

Discount Rate and Statistic

Year

5% Average

3% Average

2.5% Average

3% 95thpercentile

2015

$12

$40

$62

$117

2020

$13

$46

$69

$137

2025

$15

$51

$75

$154

2030

$17

$56

$81

$170

2035

$20

$61

$87

$187

2040

$23

$66

$93

$205

2045

$25

$71

$99

$220

2050

$28

$76

$105

$236

a The SCC values are dollar-year and emissions-year specific.  Source: USA Environmental Protection Agency[3]

There are some who have argued that the uncertainties are so great that such analysis is all but useless for policy making[4].  However this seems to go too far.  Although wide, this range is a useful guide for decision making because it gives guidance for appropriate minimum levels for the carbon price, demonstrating clearly that the current EUETS price is almost certainly below the cost of the damage caused by emissions of greenhouse gases.  These estimates can thus act as useful markers for the level of floor price that should prevail under the EUETS.  Indeed at a 3% discount rate the SCC estimate for 2020 of $46/tCO2 is quite close to the target UK carbon price floor of £30/tCO2.

Many of the limitations of the modelling suggest that there are good reasons to suppose that any floor price should be higher than the bottom end of the range of estimates[5].

First, such a low estimate follows from the application of a constant, continuously compounded discount rate of 5%.  It is likely to be more appropriate to use a discount rate that falls over time, which would reduce the effect of discounting and so increase the estimated SCC towards the higher values in the table.  A workshop held by the EPA acknowledges this as a consensus view, and that this approach is the adopted by the UK and France[6].

Second, the lower estimates of the SCC also exclude some effects, and fail to take adequate account of some high impact events (upper tail of the distribution).  Even the higher estimates will often exclude material damages [7].  Inclusion of these would lead to higher damage estimates.  Indeed, the discontinuities raise fundamental challenges to the concept of marginal damage from a tonne of emissions.  Furthermore, even for those damages that are included models used to estimate the costs of damages may not yet include the latest evidence on impacts, which in many cases suggests higher levels of damage.  Underestimates of damages are likely to be especially large at high temperature changes.

On balance it thus seems likely that an optimal floor price is above the bottom of the range shown by the EPA, perhaps around the value for a 3% discount rate of around $40/tCO2 (€30/tCO2), although a case for higher numbers can readily be made.  However corresponding EU analysis would be likely to be required in practice to underlie the setting of any floor price level, and pragmatic considerations may lead to the choice of a value below this, perhaps in the range €20-30/tCO2.  It may be desirable to converge to this level over a few years in practice to prevent significant price discontinuities.  This would of course need to be accompanied by adequate shielding for sectors at risk of carbon leakage.

If the price of EUAs were to rise towards the top of the range of estimates for the SCC then it may imply that some abatement would be more expensive than the damage caused by the emissions, and so would not be warranted on grounds of economic efficiency.  This may suggest the need for a price ceiling at around this level.  However, the case for this is much less clear-cut than for the lower bound, due to the possible presence of the discontinuities, high impact events, and non-market costs already alluded to.  This may imply that only a higher ceiling price, or even no ceiling price at all, is appropriate if this takes the form of unlimited additional allowances being made available (fuller discussion of this point, including how it relates to abatement efforts elsewhere as well as the political economy dimension, will need to await another post).  However the upper end of the range of SCC estimates may at least form a marker for an appropriate price at which to release allowances held in a price containment reserve of allowances taken from within the cap, such as that found in California, providing a “soft” ceiling until the reserve is exhausted.

The California and Quebec schemes have floor prices approximately consistent with the range of SCCs, with price floors at $10/ tCO2.  Although a little below the estimates shown in the table this is indexed at 5% real p.a., and so will quickly converge with the levels shown if this indexation is retained.  However RGGI has a price floor (around $2/short ton) that looks much too low by this metric, with a strong case for a substantial increase.

Estimates of the SCC may be uncertain, but they nevertheless represent a useful way of putting at least a lower bound on the price in an ETS.  The use of uncertain estimates is better than allowing the price to fall to close to zero, a price which is surely wrong.  And it is likely that estimates of the SCC in a European context would imply a floor prices well above current EUETS prices.

Adam Whitmore – 11th September 2013 (with a minor update 2nd April 2014)


[1] The marginal price signal is at too low a level, so some economically efficient abatement is not being signalled.  It is possible that an inefficient mix of abatement is being purchased, even though the level of abatement is efficient.  This could be the case if, for example, there was too much expensive abatement through renewables programmes.  In this case the appropriate response would be to reduce the expensive abatement under other programmes, in which case the price floor in the ETS would still be appropriate but might not bind.  Alternatively, renewables programmes may recognise the presence of other market failures, notably those associated with failure to recognise spill-over effects from innovation, and the policies in place are appropriate.  In this case the cap is too loose.  Some mix of these explanations is of course possible, although the latter seems the more plausible.  In either case a floor to maintain an efficient marginal price signal remains appropriate.

[2] Comparing estimates of the SCC from different sources presents a number of difficulties, including the currency and year in which the estimates are quoted (US$ 2011 here), the date of the estimates and the assumptions made, all of which are sometimes unclear.  However, most estimates seem to imply values roughly within the US EPA range.  For a discussion of a variety of issues see: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/42502/sei-scc-report.pdf.  Also see: L. Johnson and C. Hope, “The social cost of carbon in U.S. regulatory impact analyses: an introduction and critique” Journal of Environmental Studies and Sciences.  September 2012, Volume 2, Issue 3, pp 205-221.  More recent work by C. Hope and M. Hope (“The Social cost of CO2 in a low growth world” Nature Climate Change, August 2013) points out that with lower growth estimates of the SCC rise as future generations are correspondingly poorer (essentially this is an aspect of the discount rate issue).  A few calculations by others in the past have produced very low and even occasionally negative values for SCC (implying GHG emissions are beneficial), due, for example, to increased agricultural productivity, but these do not seem a plausible reflection of current circumstances and understanding.

[4] See http://web.mit.edu/rpindyck/www/Papers/Climate-Change-Policy-What-Do-the-Models-Tell-Us.pdf  The author argues that the assumptions, especially on the damage function, cannot be sufficiently robust to base conclusions on.  However he acknowledges the pragmatic value of such results as a possible marker for a carbon price.

[5] For estimates giving higher values see: http://www.e3network.org/papers/Climate_Risks_and_Carbon_Prices_executive-summary_full-report_comments.pdf, which explicitly critiques the US EPA analysis.

[6] http://www.rff.org/Publications/Resources/Pages/183-Benefits-and-Costs-in-Intergenerational-Context.aspx

[7]  A good survey of omissions from calculations of the SCC is given by a recent report co-sponsored by the US NGOs the Environmental Defense Fund and National Resources Defence Council

http://costofcarbon.org/blog/entry/missing-pieces

One thought on “The social cost of carbon as a marker for price floors

  1. Pingback: Are Emissions Trading Schemes working? | smallgreensunshinemachines

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