Contributed by Robert Lyman ©2019
Robert Lyman is an Ottawa energy policy consultant. His bio can be read here.
The CO2 Coalition is a non-profit conservative think tank based in Arlington, Virginia. Its mission is “to promote broader understanding of the beneficial effects of more carbon dioxide in the atmosphere around the world”. It aims to “foster informed public debate on the scientific evidence”. In July, 2019 the coalition published a paper written mainly by Bruce Everett, Ph.D., a man with 45 years of experience in international energy. The paper, entitled The Social Cost of Carbon and Carbon Taxes, analyzed how the United States and other countries calculate the social cost of carbon, as one element in the cost-benefit analysis of regulatory measures intended to reduce greenhouse gas emissions. The paper can be downloaded here:
The purpose of this note is to summarize the highlights of that paper, and to draw some conclusions relevant to Canada.
The first thing to understand, especially for non-economists, is what cost-benefit analysis is, and what it is used for. To quote Wikipedia, cost-benefit analysis is “a systematic approach to estimating the strengths and weaknesses of alternatives used to determine options that provide the best approach to achieving benefits while preserving savings.” A cost-benefit analysis may be used to compare potential courses of action or to calculate the value against the cost of a decision, project, policy or regulatory measure.
As both the costs and benefits of a project or policy may extend over many years, those who conduct cost-benefit analysis seek to translate the projected flow of future costs and benefits into equivalent present value terms. They do this by using a parameter called the “discount rate”, defined as the difference between the value of a dollar tomorrow and a dollar today. For example, if the discount rate is three per cent, , the value of a dollar one year from now is 1/1.03 or about 97 per cent. The value of a dollar two years from now is 1/(103) squared, or 94 per cent, and so on. The basic idea is that money has a time value and that a dollar today is worth much more to a person, company or country than a dollar ten years from now.
It should be acknowledged that there are limitations on the usefulness of cost-benefit analysis. Its value depends on the accuracy of the individual costs and benefits estimates and of the acceptability to the decision makers of the implicit value judgments that are embedded in the choice of discount rates and the period of time over which the flow of costs and benefits are projected. Still, without analytical tools like cost-benefit analysis, decision makers are sometimes left with arguments about competing values that are completely unquantified, and perhaps more important, hidden rather than explicit. Cost-benefit analysis brings a higher degree of transparency and discipline to the comparison of advantages and disadvantages; it should not be the only test used for decision-making, but it can make a valuable contribution to the quality of the decision.
What is Being Measured?
Carbon dioxide is a benign gas, a non-pollutant essential to all life, and a by-product of the conversion of fossil fuels into energy. It is claimed by some, however, that the increasing concentration of carbon dioxide and equivalent “greenhouse gases” (GHGs) in the atmosphere is leading to potentially catastrophic global warming and other climate changes. The challenge, therefore, is to estimate the potential range of climatic changes over time (assuming that adverse effects will occur), to translate these into economic impacts, and to compare the future costs of these impacts to the present value of the costs of the mitigation measures being proposed. The most appropriate use of cost-benefit analysis in this context is in comparing one mitigation option versus another.
Under the Obama Administration, an Interagency Working Group (IAG) was tasked with estimating the “social cost of carbon” (SCC), or, more precisely, an estimate of the monetized damages associated with an incremental increase in carbon dioxide emissions in a given year. The SCC was supposed to tell us the cost to the global economy, under certain assumptions, of increasing carbon dioxide emissions by one metric tonne. A metric tonne is roughly what a car emits every 2,500 miles.
The IAG used integrated assessment models (IAMs) to calculate the SCC. An IAM is two connected models: a climate model that calculates global average temperatures from carbon dioxide emissions and a “damage function” that estimates economic costs and benefits as a function of the expected temperature increase in the models. The IAG used three IAMs and five scenarios in its analysis and ran about 150,000 simulations with slight variations in the key assumptions.
Like cost-benefit analysis, economic models have their advantages and disadvantage. They require the analyst to be explicit in terms of the assumptions that are included. Ultimately, however, they are based on thousands of mathematical equations that represent either the best estimation of relationships or the best guesses available. Only those who design the models fully know how they work and how much guesswork is involved. The media rarely, if ever, has the expertise to question the accuracy of model outputs.
The Calculation of the SCC
An essential but often ignored background factor in the analysis of future costs, especially at the global level, is the income that future generations are likely to have at their disposal to pay for those costs. According to the International Monetary Fund, global per capita income is U.S. $11,673 at present. Due to economic growth, average income is projected to increase between nine and 31 times by 2300. The loss of a few percentages of GDP based on future temperature changes may have only very modest impacts of future economic wellbeing.
Why 2300? Because that is the year that the IAG used to test the probable damages due to climate change. It assumed that the long-term temperature increase resulting from a doubling of carbon dioxide concentration would be 3.5 degrees Celsius. This assumption is especially controversial among scientists skeptical about future warming, who argue from empirical data that the result of CO2 doubling would be closer to one degree C.
So, three assumptions drive the official U.S. estimate of the value of the SCC: (a) the discount rate is 3 per cent, (b) the year 2300 is the time horizon, and (c) climate sensitivity has a mean value of 3.5.
The Discount Rate
How do we value the present versus the future? Economists generally use an approach based on the actual interest rates, but there are few examples of interest rates that have applied over very long periods of time. Environmentalists sometimes challenge the use of financial markets as a standard, and argue for a “normative” approach. A normative approach would be based on the view that the discount rate is a measure of intergenerational equity and that the use of higher discount rates inherently disadvantage our grandchildren and great grandchildren. The famous Stern Report in the U.K. urged the use of a 1.4 per cent discount rate; others have gone so far as to suggest a negative rate.
The U.S. Office of Management and Budget (and the Canadian Treasury Board) specifies that departments should use discount rates of thee per cent and seven per cent in policy evaluation.
The choice of discount rates makes a great difference to the estimated value of the SCC. At three per cent, the SCC in 2019 is U.S. $57.50 per tonne. At one per cent, it is U.S. $581.60 per tonne, and at seven per cent it is U.S. $8.90 per tonne.
The Time Horizon
The IAG’s choice of 2300 is economically questionable but politically understandable, according to Bruce Everett. By this, he means that the IAMS used by the U.S. government show little damage from climate change in the short term.
Using a three per cent discount rate and an end-year of 2100, for example, the SCC estimates per tonne under the Merge IAM ranged from U.S. minus $10.50 (i.e. a net benefit) to U.S. $26.60 (high end) with a medium value of U.S. $15.40.
Using a five per cent discount rate and an end-year of 2100, the SCC estimates per tonne using the Merge IAM ranged from U.S. minus $8.50 to U.S. $12.60, with a medium value of U.S. $7.20.
At the seven per cent discount rate recommended by the Office of Management and Budget and the Canadian Treasury Board and at a time horizon ending in 2100, the SCC is almost eliminated, falling to U.S. $1.30 per tonne.
In short, by reasonable variations in the key assumptions, one can generate virtually any SCC one wants without changing the economic scenarios or the damage functions. In addition, this wide range of outcomes does not even consider the key questions of climate dynamics. If one were to reduce the assumed climate sensitivity from 3.5 to 1.0, the average SCC would be negative (i.e. a net benefit).
Implications for Canada
The same underlying assumptions that underpin the calculation of the SCC are sometimes applied to the calculation of the appropriate level of the carbon taxes imposed by governments. In fact, as explained previously, this is a misuse of concepts adopted for inclusion in cost-benefit analysis, intended primarily to compare the advantages and disadvantage of alternative measures, not the ideal rates of tax measures.
The present rates of carbon dioxide pricing in Canada (i.e. Cdn $20 per tonne scheduled to rise to Cdn $50 per tonne by 2022) are lower than the U.S. IAG estimate of the value of the SCC in 2019, which tends to give them more credibility, especially in the media. In fact, the CO2 Coalition’s paper shows how weak is the analysis that underlies such a judgment.
The Stakes are Too High to be Tricked by the Numbers
The Parliamentary Budget Office (PBO) published a report in which it estimated that, in order for Canada to reach its self-imposed target of a 30% reduction in greenhouse gas emissions by 2030, the carbon tax rate would have to increase from $50 per tonne in 2022 to $102 per tonne in 2030…. In fact, Canada’s economy is uniquely vulnerable to the adverse effects of emission-reduction measures that raise costs. Here, where 48 per cent of the GHG emissions occur in two provinces (Alberta and Saskatchewan), where much of the economic activity is in energy-intensive resource-based industries, and where climate and geography give rise to higher energy demands than in most other countries, an all-out effort to reduce fossil fuel emissions will be especially detrimental, both in economic and political terms.