Tag Archives: social cost of carbon

Can emissions trading produce adequate carbon prices?

Prices under emissions trading schemes have been low to date.  Sometimes this may be because systems are new, but the EUETS is long established and needs to demonstrate that it can now produce adequate prices. 

Prices under emissions trading systems around the world have so far remained low.  The chart below shows carbon pricing systems arranged in order in increasing price, with prices on the vertical axis shown against the cumulative volume covered on the horizontal axis.  Carbon taxes are shown in purple, emissions trading systems in green.  It is striking that all of the higher prices are from carbon taxes, rather than emissions trading systems.

Prices under Emissions Trading Systems and Carbon taxes in 2016

capture

Source:  World Banks State and Trends of carbon pricing report[1].  Prices are from mid-2016.

Prices in the largest emissions trading system, the EUETS have been around $5-6/tonne, and prices in the Chinese pilot schemes have been similar and in some cases even lower, although with little trading.  The price under the California and Quebec scheme (soon to be joined by Ontario) is somewhat higher.  However, this is supported by a floor set in advance and implemented by an auction reserve price.  If this price floor were not present a surplus of allowances would very likely have led to lower prices.  The Korea scheme has had very low trading volumes, so does not provide the same sort of market signal found under more liquid schemes.

In contrast, a wide range of carbon taxes are already at higher levels and in some cases are due to increase further.  The French carbon tax, which covers sectors of the economy falling outside the EUETS, is planned to reach €56/tCO2 (US$62/tCO2) in 2020 and €100/tCO2 (US$111/tCO2) in 2030[2].  In Canada a national lower limit on carbon prices for provinces with an explicit price-based system (not shown on the chart) is due to reach $50 per tonne in 2022[3]. The UK carbon price floor, which covers power sector emissions, was due to rise to substantially above current levels, but is currently being kept constant by the Government, mainly because the price under the EUETS is so low.

Increases such as those due in France and Canada will bring some carbon taxes more in line with the cost of damages, and thus to economically efficient prices.  The cost of damages is conservatively estimated at around $50/tonne[4], rising over time (see here for a discussion of the social cost of carbon and associated issues).  The increases will also bring prices more into line with the range widely considered to be necessary to stimulate adequate low carbon investment[5].

Low prices under emissions trading systems have been attributed to a range of factors, including slower than expected economic growth and falling costs of renewables[6].  However these factors do not explain the consistent pattern of low prices across a variety of systems over different times[7].

While it is difficult to derive firm evidence on why this pattern should be present, two factors seem plausible.  The first is systematic bias in estimates – industry and governments will expect more growth that actually occurs, costs will be overestimated, and these tendencies will be reflected in early price modelling, which can often overstate likely prices.

But the second, more powerful, tendency appears, based on anecdotal evidence, to be that there is an asymmetry of political risk.  The political costs of unexpectedly low prices are usually perceived as much less than those of unexpectedly high prices, and so there will always be tendency toward caution, which prevents tight caps, and so leads to prices being too low.

This tendency is difficult to counteract, and has several implications for future policy.

First, it further emphasises the value of price floors within emissions trading systems.  Traditional environmental economics emphasises the importance of uncertainty around an expected level of abatement costs or damages.  If decision makers are not in fact targeting expected average levels, but choosing projections of allowance demand above central expectations then the probability of very low prices is increased, and the case for the benefits of a price floor is stronger.

Second, it implies that it is even less appropriate than would anyway be the case to expect the carbon price alone to drive the transition to a low carbon economy.  Measures so support low carbon investment, which would in any case be desirable, are all the more important if the carbon price is weak (see here for a fuller discussion of the value of a range of policy measures).   While additional measures do risk further weakening the carbon price, they should also enable reduced emissions and tighter caps in future.

Third, it requires governments to learn over time.  Some low prices may reflect the early stage of development of systems, starting slowly with the intention of generating higher prices over time.  However this does require higher prices to eventually be realised.

The EUETS has by some distance the longest-established system, having begun eleven years ago and with legislation now underway for the cap to 2030, by which time the system will be 25 years old.  The EU should be showing how schemes can be tightened over time to generate higher prices.  However it now looks as though the Phase 4 cap will be undemanding compared with expectations (see previous posts).  The recent vote by the European Parliament’s ENVI committee failed to adopt measure that are adequate to redressing the supply demand balance, with tweaks to the market stability reserve unlikely to be enough.  This undermines the credibility of cap-and-trade systems more generally, rather than setting the example that it should.  Further reform is needed, including further adjustments to supply and preferably auction reserve prices.

The advantages of cap-and trade systems remain.  Quantity limits are in line with the international architecture set by the Paris Agreement.  They also provide a clear strategic signal that emissions need to be reduced over time.

However there is little evidence to date that emissions trading systems can produce adequate prices. The EU, with by far the most experience of running an ETS, should be taking the lead in substantially strengthening its system.  At the moment this leadership is lacking.  Wider efforts to tackle climate change are suffering as a result.

Adam Whitmore – 23rd January 2017

[1] https://openknowledge.worldbank.org/handle/10986/25160

[2] World Bank State and Trends in Carbon Pricing 2016.  See link in reference 1.

[3] http://news.gc.ca/web/article-en.do?nid=1132169  Canadian provinces with volume based schemes such as Quebec with its ETS must achieve emissions reductions equivalent to these prices.

[4] $40/tonne in $2007, see https://www.epa.gov/climatechange/social-cost-carbon, escalated to about $50 today’s dollars.

[5] See this recent discussion: https://www.weforum.org/events/world-economic-forum-annual-meeting-2017/sessions/the-return-of-carbon-markets

[6] Ref: Tvinnereim (2014) http://link.springer.com/article/10.1007%2Fs10584-014-1282-1#page-1

 

[7] The South Korea ETS may be a partial exception to the pattern.  However it is unclear due to the lack of liquidity in the market.

The EUETS and the need for price floors (and maybe soft ceilings)

Standard objections to introducing price containment mechanisms into the EUETS carry little weight.  It’s time to give price containment more serious consideration.

With the price of allowances in the EUETS currently down at around €4/tCO2 the question of whether direct price containment (price floors and ceilings) should be introduced has naturally been the subject of renewed debate, especially in the light of the French proposal earlier this year to introduce a price corridor.

The debate tends always to feature a standard set of objections to price containment.  Most of these lack validity when applied to well-designed mechanisms.  Here I take a look at why this is so, in the hope that the debate can become more realistic and constructive, focusing on the benefits and design challenges around price containment.

The broad themes underpinning the rationale for price containment are as follows:

  1. All emissions of GHGs are damaging, not just those above the cap. Reducing emissions below the cap and further tightening the cap thus have benefits.
  2. The financial cost of damages emissions (the social cost of carbon – SCC), although uncertain, is well above current prices[1]. This implies that further emissions reductions with a cost between the current price and the cost of damages have a net benefit.  However these are not currently being incentivised by the carbon price.  This is one reason why a floor prices is beneficial.
  3. The market structure and parameters are set by regulatory decisions. These decisions are inevitably taken under uncertainty, and market design is about optimising outcomes under uncertainty.  Design is more robust to uncertainty with both price and quantity targets than with either alone.
  4. Supply adjusting in response to price makes the EUETS more like a normal market.
  5. It is essential for reasons of international obligations and environmental integrity that the cap is maintained[2], so moving to a pure carbon tax is not a good idea.

Based on these premises the following responses to standard objections to price management can be made.

“Price management is interfering in the market”

The form of the market is a politically determined construct. Modifications to this construct are appropriate to correct shortcomings in the current design, where supply is too rigid to accommodate uncertainties. The cap does succeed in limiting the total emissions but fails to produce adequate signals for additional abatement.   Modification is required to reduce supply of allowances if prices become too low, in order to retain efficient price signals.

Allowing the supply of allowances to respond to price is not interfering with the day-to-day operation of the market. On the contrary, it is designing it to function more like a normal market.  In most markets supply varies with price (elasticity of supply is not zero in most markets[3]).

 “There is no environmental benefit to a floor price because the cap does not change” or “it does nothing to reduce supply or increase ambition towards targets in the Paris Agreement”

The critical question here is what happens to unsold allowances. There are many possibilities for dealing with unsold allowances, including cancelling them at the end of a phase, cancelling a proportion at the end of a phase, or cancelling them on a rolling basis.

Provided that there are appropriate provisions for cancelling unsold allowances, total emissions over time can be reduced, and so there is a clear environmental benefit.  Even if this is not the case, allowances may simply stay in the reserve, or caps may be tighter in future due to emissions reductions achieved, also creating an environmental benefit.

“If the EU is meeting its target at low cost the price should be correspondingly low”

No it should not.  The low price signals that the target is not stringent enough to adequately reflect damages.  All emissions are damaging, even those within the cap, and if more abatement can be achieved at lower cost than the damage caused this is what should happen.

Measures which further decrease emissions in response to lower cost of abatement also help reinforce the EU’s international leadership position on climate change.

“It goes against the quantity based nature of the EUETS” or “it’s introducing a carbon tax”

Prices can managed by automatically adjusting supply in response to price, for example by putting a reserve price in auctions.  This is entirely consistent with the quantity based nature of the EUETS, in that it works by adjusting quantity.  Indeed, as noted, it makes the EUETS more like almost all other markets where the quantity of supply varies in response to market prices.

It is possible to use tax-based measures to impose a floor, as the UK does and France will do from January 2017, but it is not necessary to do so.

Characterising price floors  as a tax appears often to be used as a way of creating political momentum against the idea.  An EU tax requires unanimity among Members States and attempts to introduce a carbon and energy tax in the 1990s were notably unsuccessful, and similar efforts would doubtless prove challenging.  Characterising floors as a tax may also help develop political opposition to a floor.  Branding the Australian ETS as a tax (which it was not) was successful in helping build opposition there, with eventual repeal of the scheme.  Price management through adjusting quantities should not be misrepresented in this way to artificially discredit it.

“It reduces market efficiency”

This confuses efficiency of trading with efficiency of the price signal.  If you were never to change the number of allowances, trading alone might indeed remain the most efficient way of meeting the cap.  However this has created prices which failed to adequately signal efficient abatement (in effect the market is telling you that the current cap is too loose).  There is thus a misallocation of resources towards to many emissions and too little abatement.

“The price may be set at the wrong level”

Having both price and quantity limits increases robustness to the unexpected.  If the cap has been set at appropriate levels then prices will anyway lie within the range of any  price containment, and price limits will not bind.  However the existing EUETS cap has been set at a sub-optimal level –too many allowances have been issued and the price is too low.

Limiting the price simply recognises that future demand for allowances may be mis-estimated, or the level of the cap may be subject to biases, for example due to asymmetries of political risk from setting the cap too high or too low.

 “It will never be possible to agree a price”

Price will doubtless be contentious but there are several reference points, notably the following:

  • estimates of the SCC, which represents the financial cost of damages, although calcualtions typically exclude important costs of damage. The SCC is highly uncertain, but well above the €4/tonne currently prevailing in the EUETS under almost any reasonable set of assumptions.
  • prices under other schemes, especially those with price management;
  • prices consistent with those needed to signal abatement sufficient to reach climate targets.

This gives a framework of negotiation.  The level of the cap, which is always set with a view to abatement costs and prices, is anyway contentious.

There are many difficult issues to resolve in designing appropriate price containment mechanisms for the EUETS and setting price boundaries at appropriate levels.  Spurious objections such as the ones discussed here should not be allowed to form an obstacle to much-needed debate about the best way forward.

Adam Whitmore – 14th September 2016

Note:  The advantages of hybrid price quantity instruments have been extensively reviewed in the environmental economics literature, going back to the original paper on the subject by Roberts and Spence Effluent Charges and Licenses Under Uncertainty (1976).  Understanding the need for prices to fully reflect the cost of environmental damages goes back further, to Pigou “The economics of welfare” (1920).  See standard texts on environmental economics for a fuller treatment.  These conclusions are not uncontentious, in particular because some observers continuing to favour a carbon tax.  My own view remains that including a cap on emissions is preferable, and that many of the advantages of a carbon tax can be realised by a well-designed floor price.

[1] Furthermore there are other non-priced damages which imply the benefit of abatement is greater than implied by the SCC.

[2] Also, any ceiling should be soft to allow prices to rise above the ceiling rather than allowing emission to go above the cap, for example with allowances in price containment reserve taken from within the cap.

[3] Almost the only markets with completely fixed supply are the markets for tickets to major sporting events and for authentic works by dead artists.  For example the number of tickets to the men’s final at the Wimbledon tennis championships is limited by the number of seats, and the number of authentic Picasso’s cannot now increase with price (although the number of fakes can).

 

Carbon prices around the world are consistently too low

Carbon pricing is spreading rapidly around the world [i].  However prices almost everywhere are far too low at the moment to price emissions efficiently.  The chart below summarises carbon prices in those jurisdictions with pricing.  The horizontal axis shows volumes, the vertical axis shows prices, as in a conventional commodity supply curve.  The vast majority of priced emissions – about 90% of the total – are priced below $14/tCO2.  Higher carbon prices are invariably for small volumes, and are found only in Europe and British Columbia.  They include prices under the French carbon tax, which covers sectors outside the EUETS, the UK carbon price floor, where the EUA price is topped up, and longstanding carbon taxes in Scandinavia.

The chart also shows the social cost of carbon – which represents the cost of the environmental damage caused by emissions – as estimated the US EPA.  This is almost certainly an underestimate[ii] of the true cost, and the concept has other limitations that imply it is no more than a lower bound to what it is worth paying to avoid emissions.  Carbon prices are thus too low even compared with a likely underestimate of the cost of emissions.  Taxes are too low and caps are too loose to price carbon adequately.  Consequently efficient abatement is not happening[iii].

Prices and volumes of carbon pricing around the world

Carbon supply curve

Price data is from May 2015.  I have excluded the Mexican carbon tax on the grounds that it does not apply to natural gas and so does not fully tax carbon.  The Chilean carbon tax is included although it does not come into force until 2018.  The South African carbon tax is scheduled to be introduced next year, but may be postponed, or may not be introduced at all.  The EUETS price would be somewhat higher but for the weakness of the Euro against the dollar at the moment.   The Social Cost of Carbon is the US EPA estimate at a 3% discount rate and converted to $2015 – see reference 2.

Prices may increase in future.  However this process looks likely to be too slow in most cases.  For example, under the California and Quebec scheme prices are currently at the floor set by the auction reserve.  This escalates at 5% p.a. real terms.  However at the present rate this will take until around 2050 to catch up even with the EPA’s estimate of the social cost of carbon[iv], which also shows increases in real terms over time.  Prices elsewhere in North America are mostly lower still.  In the EU there is little evidence from forward markets that allowances will reach significantly closer to the social cost of carbon over the next few years, and it seems unlikely that China will seek to price emissions at much above levels that prevail in the EU and North America.  It therefore seems likely on present trends to be a long time before prices in major jurisdictions reach levels that reflect the cost of damage from climate change, or are sufficient to limit temperature rises to two degrees.

This implies that further action is needed to make higher prices more politically acceptable.  Doing this will be a huge challenge, but two strands of any solution appear clear.  Ensuring that industry that is genuinely vulnerable to carbon leakage is appropriately safeguarded from competitive distortions will help mitigate political obstacles to higher pricing.  And efficient carbon pricing may further be helped by more explicit recycling of revenue to citizens, including ideas such as cap-and-dividend, in which the proceeds of sale of allowances under a cap-and-trade scheme are returned directly to citizens.  This in effect defines citizens as owners of the right to emit and so gives everyone a stake in higher prices (more on this in a future post).  Elements of such an approach are evident in British Columbia and were part of the former Australian scheme.

Measures other than carbon pricing are in any case necessary to bring about the required transformation of the energy sector[v].  And while carbon prices remain too low there will be an even greater need for such approaches, even if these may sometimes themselves help keep the carbon price low.  Funds to subsidise deployment of low carbon technologies may come from the proceeds of carbon pricing, especially in jurisdictions such as North America where earmarking of revenues is common.

The spread of carbon pricing is a success story, but a limited one in view of the prices prevailing to date.  Efforts both to strengthen the carbon price and enhance complementary policy approaches are needed if climate change is to be limited to acceptable levels.

Adam Whitmore – 2nd June 2015

 

Notes

[i] See  here

[ii] See  here

[iii] 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.  However for a number of reasons this does not seem plausible.  For example, abatement is currently insufficient to meet the agreed 2 degree target, and support for renewables globally is clearly not excessive in view of their present share of generation and the required speed of reduction (although it may well be desirable for more of the support to be in the form of a higher carbon price on fossil fuel use).

 

[iv] Escalating the current carbon price at 5% real terms to 2050 gives a price of about $74/tCO2, roughly in line with the EPA’s central estimate of the Social Cost of Carbon at that date of 2011$76/tCO2.

[v] See here

Making climate change policies fit their own domain

A new framework acts as a sound guide for policy formation.

There is a widely held narrative for climate policy that runs something like this.  The costs of damage due to greenhouse gas emissions are not reflected in economic decisions.  This needs to be corrected by imposing a price on carbon, using the power of markets to incentivise efficient emissions reduction across diverse sources.  Carbon pricing needs to be complemented by measures to address other market failures, such as under-provision of R&D and lack of information.  Correcting such market failures can help carbon markets function more efficiently over time.  However further interventions, especially attempts by governments to pick winners or impose regulations mandating specific solutions, are likely to waste money.  This narrative, even if I have caricatured it a little, grants markets a central role with other policies in a supporting role.  Its application is evident, for example, amongst those in Europe who stress and exclusive or central role for the EUETS.

While this narrative rightly recognises the important role that markets can play in efficient abatement, it is incomplete to the point that it is likely to be misleading as a guide to policy.  A better approach has recently been characterised in a new book by Professor Michael Grubb and co-authors.  He divides policy into three pillars which conform to three different domains of economic behaviour.  Action to address all three domains is essential if efforts to reduce emissions to the extent necessary to avoid dangerous climate change are to succeed.  These domains and the corresponding policy pillars are illustrated in the chart below.

Three domains of economic behaviour correspond to three policy pillars …

Domains and pillars diagram

In the first domain people seek to satisfy their needs, but once this is done they don’t necessarily go further to achieve an optimum.  Although such behaviour is often characterised by economists as potentially optimal subject to implicit transaction costs this is not a very useful framework.  Much better is to design policy drawing on disciplines such as psychology, the study of social interactions, and behavioural economics.  This domain of behaviour relates particularly to individuals’ energy use, and the corresponding policy pillar includes instruments such as energy efficiency standards and information campaigns.

The second domain looks optimising behaviour, where companies and individuals will devote significant effort to seeking the best financial outcome.  This is the domain where market instruments such as emissions trading have the most power.  Policy making here can draw strongly on neoclassical economics.

The third domain is system transformation, and requires a more active role from governments and other agencies to drive non-incremental change.  The policy pillar addressing this domain of behaviour includes instruments for technology development, the provision of networks, energy market design, and design and enforcement of rules to monitor and govern land use changes such as deforestation.  Markets may have a part to play but the role of governments and other bodies is central here.  The diversity of policies addressing this domain means that it draws on a wide range of disciplines, including the study of governance, technology and industrial policy, institutional economics and evolutionary economics.

As one moves from the first to the third domain there is increasing typical scale of action, from individuals through companies to whole societies, and time horizons typically lengthen.

This framework has a number of strengths.  It is both simple in outline and immensely rich is its potential detail.  Each domain has sound theoretical underpinnings from relevant academic disciplines.  It acknowledges the power of markets without giving them an exclusive or predominant role – they become one of three policy pillars.  It implies that the vocabulary of market failures becomes unhelpful, as I’ve previously argued.  Instead policy is framed as a wide ranging endeavour where the use of markets fits together with a range of other approaches.  While this may seem obvious to many, the advocacy of markets as a solution to policy problems has become so pervasive, especially in Anglo-Saxon economies, that this broader approach stands as a very useful corrective to an excessively market-centric approach.

The framework is high level, and specific policy guidance needs to draw on more detailed analysis.  The authors have managed to write 500 pages of not the largest print without exhausting the subject.  However, the essential framework is admirable in its simplicity, compelling in its logic, and helpful even at a high level.  For example it suggest that EU policy is right to include energy efficiency, emissions trading and renewables – broadly first, second and third domain policies respectively – as well as to be active in third domain measures such as improving interconnection, rather than relying exclusively on emissions trading (although as the EUETS covers larger emitters, so first domain effects are less relevant for the covered sector).

The framework in itself does not tell you what needs to be done.  In particular the challenges of the third domain are formidable.  But it provides a perspective which deserves to become a standard structure for high level guidance on policy development.

Adam Whitmore – 31st October 2014

Costing damages from climate change offers only a partial guide to choice of policy

Estimates of the cost of damages from greenhouse gas emissions are more use for ruling in policy measures than ruling them out.

Estimates of the cost of the damages caused by greenhouse gas emissions (often referred to as the social cost of carbon) are widely used to assess the cost effectiveness of policies to reduce emissions.  Broadly speaking, emissions reductions that are cheaper than the cost of damages are judged cost-effective, while emissions reductions more expensive than the cost of damages risk being deemed not cost effective.  For example, the US EPA uses an estimate for the social cost of carbon of $39/tonne of CO2 (in 2015 at a 3% discount rate) as its benchmark, with policy measures leading to emissions reductions at a cost lower than this being considered cost effective.  Such estimates also act as a benchmark for carbon prices, on the grounds that an economically efficient carbon price should equal the expected cost of damages [1].

Detailed modelling is used to estimate the additional costs of damage per tonne of additional emissions (see notes at the end of this post for a short summary of this process).  The modelling is often thorough and elaborate, and attempts to be comprehensive.  However there are several factors which tend to lead to estimates of the cost of damages being below what it is really worth paying to avoid emissions.

Omitted costs

Many of the costs of climate change are omitted from models, essentially assuming that they are zero.  For example, knock-on effects, such as conflict from migration, are often not modelled, but may be among the largest costs of climate change.  Other costs are dealt with only partially, because they are difficult to estimate reliably [3], or difficult to measure as a financial loss.  For example, it is difficult, and in many ways impossible, to develop adequate costings for the loss of major ecosystems.

Difficulties in estimating the effects of large temperature changes

Models designed to estimate the cost of damages for a temperature change of one or two degrees may be become highly misleading if used to estimates the costs of larger temperature changes.  Damages may increase only quite slowly with small temperature changes, but are likely to increase quite rapidly thereafter, and perhaps catastrophically when certain thresholds are reached [4].  This is often not represented adequately in models.  For example, the widely used DICE model shows GDP only approximately halving with a temperature rise of 19 degrees centigrade.  This is unlikely to be realistic, and indeed the model’s author has cautioned against its use for temperature changes above around 3 degrees.  But temperature changes above 3 degrees would be very likely under a business as usual emissions scenario, and the effects of such large temperature changes are a major cause for concern.

Treating GDP growth as exogenous

Most models assume that the drivers of GDP growth are largely unaffected by even very severe climate change.  Over a century, even slow growth (anything above 0.7% p.a.) more than doubles GDP, and so more than offsets the costs of warming even if GDP is assumed to halve from the level it would otherwise reach.  Even with a temperature rise of 19 degrees over a century people appear, on average, better off than today, because the benefits of growth (more than doubling GDP) outweigh the costs of climate change (halving GDP).  Calling this result counterintuitive is something of an understatement.

Role of risks

Analysis often excludes some risks which are difficult to model, for example some types of climate feedbacks.  This effectively assumes that they won’t happen and so won’t cause any damage, ignoring the risks.  Indeed, even attempting to set a single average cost of damages fails to address the question of willingness to tolerate the chance of a cost much larger than the estimated average (due to low probability high impact events).  The EPA does estimate of the cost in the upper tail of the damage distribution, and some other modelling explicitly includes a range of sensitivities.  However these approaches, at best, go only part way towards addressing the problem of the risk of catastrophe outcomes, especially in view of the other limitations I’ve outlined.

Finally, the process of assessing policy measures needs to take account of all costs and benefits.  Measures to reduce emissions often have valuable co-benefits for health which need to be factored in to decision making.  And analysis needs to take account of future benefits for emissions reduction, for example in promoting early stage technologies.

Estimates of the cost of damage from greenhouse gas emissions remain useful inputs into decision making.  They can be useful in ruling policy measures in – if a policy measure has a cost per tonne below even a cautious estimate of the cost of damages then it is very likely cost-effective.  But they are much less useful for ruling measures out.  It is probably worth paying a good deal more to reduce the risks of large changes to the climate than the conventional estimates of damage costs suggest.  And in any case judging which risks are acceptable will always be a matter of political and ethical debate, rather than a simple matter of costings.

Adam Whitmore – 13th October 2014

Notes

[1] This principle that pricing of pollutants should reflect the cost of damages is commonly discussed in terms of Pigovian taxes or the Polluter Pays Principle.  

[2] The cost of damages, commonly referred to as the social cost of carbon (SCC), is usually estimated by modelling the cost of damages from additional emissions.  A base case emissions track is specified.  The changes to the climate and the resulting impacts associated with this base case emissions track are modelled.  The financial costs of the damages resulting from the impacts, for example due to rising sea levels, are estimated.  This process is repeated, adding an additional (say) billion tonnes of extra emissions, and calculating the costs of the additional damages that result.  The (discounted) additional cost of damages per tonne of additional emissions is derived from this.  These calculations are usually done using elaborate models known as Integrated Assessment Models (IAMs).  Estimates of the Social Cost of Carbon such as those used by the US EPA can refer to estimates from several different IAMs.  The uncertainties involved in the modelling lead to a wide range of estimates for the SCC. 

[3] 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

[4] A good review of the limits of modelling can be found in Nicholas Stern, The Structure of Economic Modelling of the Potential Impacts of Climate Change, Journal of Economic Literature 2013.  This includes the reference to damages at very large temperature changes, quoting work by Ackerman, Stanton and Bueno: Fat tail, Exponents, Extreme Uncertainty: Simulating Catastrophe in DICE, Ecological Economics 69, 2010