March 2010


Those following U.S. climate policy will have run into talk of the “discount rate” this week. A discount rate, for those not in the know, is the flip side of an interest rate. Where an interest rate allows us to calculate how much something we have today (like money in the bank) will be worth in the future, a discount rate tells us how much something we will have in the future is worth to us today.  The idea is that we prefer pleasure now to pleasure later (and pain later to pain now). Imagine, for example, that someone owed you $100 in a year. What’s the least you would accept now rather than wait a year for the $100? Supposing it is $90, then we say that your discount rate is 10 percent.

Many environmental economists, including me, are troubled by the use of almost any discount rate greater than zero to calculate the current worth of values (future benefits and harms) that will occur more than a generation from now – an issue of especially importance in climate economics. Here’s what all the kerfuffle is about: When used in long-term analyses of environmental impacts – climate change, the storage of nuclear waste, etc. – the discount rate quantifies our ethical judgment regarding the importance of the welfare of future generations (compared with our own). When we say that the discount rate is zero, we mean that we consider the health and well-being of future generations to be just as important as our own health and well-being. The larger the discount rate, the more we value our own lives and livelihoods over those of our grandchildren.

The current conventional wisdom calls for discount rate that is something like the short-term  “risk-free” interest rate (3 to 5 percent) for calculating the worth today of values that will exist at sometime within the next 20 or 30 years, and slightly lower discount rates for values that will exist in the more distant future. The idea is that the interest rate on the safest investments is what people require to compensate them for waiting (getting their payment later, rather than now).

But people routinely put savings away at very low interest rates. To my mind, this strongly suggests that, even within a single generation, the discount rate can be very low. We save money because it will have a value to us in the future. That we’re willing to put it in savings accounts that often have a less than 1 percent annual interest rate after adjusting for inflation means that it’s worth it to us to put $100 away today to secure about $100 in the future. It would surprise us to hear that our neighbors – unable to find an investment with a 10 or 20 percent rate of return – chose to spend all their money today. We put money away because the future (our own, and that of our families) is important to us. That we can earn some interest on that money is just a side benefit.

Reasonable people can and do disagree about the most appropriate discount rate to apply to long-term problems, although the use of discount rates above 5 percent has become much more unusual in recent years, and a discount rate over 3 percent on values that will occur in 2050 or later certainly would raise the eyebrows of many (most?) climate economists.

That’s why reports last week – now said to be erroneous – that the Office of Management and Budget (OMB) was recommending discount rates of 25 or even 50 percent for use in environmental analyses got a lot of people in a lather (these outrageous rate recommendations are now said to have originated with a staffer in another agency and were posted online, but not advocated, by OMB).

Similarly, the Obama administration’s recommendation of a social cost of carbon based on a 3 to 5 percent discount rate, for an analysis that stretches hundreds of years into the future, puts a surprisingly low value on the next generations’ welfare. Here’s an example: An event with the magnitude of material damages of Katrina (which some estimates put at $300 billion) occurring 500 years from now would be worth just $110,000 today at a 3 percent discount rate, or $8 at a 5 percent discount rate. Personally, I think the future is worth more than that.

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It’s nice to win, now and then, in the battle against really bad economics.

Back in 2006, California adopted an ambitious state climate policy, known as AB 32. It will require higher fuel efficiency standards for cars and trucks, better insulation and energy efficiency in homes, and more vigorous promotion of renewable energy. Careful analysis by the state’s Air Resources Board and analysts at the University of California-Berkeley showed that AB 32 will have neutral to slightly positive effects on California jobs and incomes – a conclusion that was unacceptable to some of the bill’s opponents.

Last year, two reports trashing AB 32, and state regulation in general, were released by Sacramento State College business professors Sanjay Varshney and Dennis Tootelian (click here for the first, here for the second).  They projected that AB 32 would reduce the state’s overall income by 10 percent, and that regulation in general would shrink California’s output by one-third. Released with great fanfare, these super-sized critiques started showing up in media discussion of AB 32.

I did a report called “Daydreams of Disaster” for the California Attorney General’s office, evaluating the Varshney-Tootelian (V&T) studies. V&T assumed that all benefits of AB 32 were too speculative to include; in effect, they estimated benefits at exactly zero. The costs caused by AB 32, on the other hand, are treated with expansive generosity. Housing costs surge upward, based on the cost of converting homes to zero net energy consumption (but with no resulting savings on utility bills). The projected fuel savings from new, high-mpg cars are treated as a cost imposed on owners of older cars (but not a savings to new car owners). Food cost increases are estimated in an entirely data-free manner. V&T then multiply everything by 2.8 to account for indirect costs.

Even worse is the V&T critique of regulation in general. They estimate a single equation explaining state GDP, across the 50 states, based on six different rankings of state business climates from Forbes. Those rankings give every state a number from 1 (best) to 50 (worst); in the V&T equation, every one-point increase (worsening) in the “regulatory climate” ranking decreases state GDP by a bit more than $4 billion. California comes in at number 40 in the Forbes scorecard for regulatory climate, so V&T project losses to the state of more than $160 billion. And don’t forget to multiply the result by 2.8!

The worst mistake here, although not the only one, is this: State-by-state differences in the size of the economy are – surprise! – primarily determined by the population of the state, a factor left out by V&T. (Why does California have a bigger economy than Rhode Island? Because California is a bigger state with more people, not because of either state’s business climate or rankings in Forbes.) When I reran V&T’s analysis taking state population into consideration, the Forbes rankings had no correlation with the size of the state economy per capita.

My report was one of three independent evaluations of the V&T work, all reaching entirely negative conclusions. The word is starting to get around: the Legislative Analyst’s Office of the California legislature released its own analysis of the shoddy quality of the V&T reports; the head of Small Business California asked that the studies be removed from public websites, due to “deeply flawed methodologies and useless conclusions”; the story even made the San Francisco Chronicle last Friday, which quoted my summary remarks: “The losses they [V&T] project would be serious economic impacts – if they were real. They are, however, entirely unreal; they should be viewed merely as daydreams of disaster.”

There’s plenty more bad economics out there to do battle with. But it’s gratifying to see that there are some limits to what you can get away with in public debate.

Wait a second, the free carbon permits aren’t going to be given away on an equal per capita basis? Let me get this straight: The plan is to give free permits to pollute to the largest historical polluters? Why? Because otherwise, these most polluting industries will fight to block the climate legislation. Is this how all policy is made? We can’t pass a health bill that doesn’t include a giveaway to insurers? Would an anti-smoking measure have a little something in it for tobacco companies? A gun law with a present for the gun manufacturers? Well, probably this is how all policy is made.

Still, the purpose of climate legislation isn’t to make power companies happy, nor is it to guarantee them a continued stream of profits. Capitalism creates and destroys: There’s no guarantee that what made a profit today will make a profit tomorrow, and there is no obligation on the part of the voting public to shore up business models that are damaging to the public good. The purpose of climate legislation should be twofold, 1) to reduce greenhouse gas emissions, and 2) to do so in a way that promotes equity.

Yes, assuming a particular overall cap on carbon, giving the permits away instead of selling them should end up with the same reduction in emissions. (To get this result, the permits would have to be fungible – that is, after they are given away or bought from the government, they can then be sold again to the highest bidder; this leads to the efficient market solution that neo-classical economists are always yammering about. The companies that can reduce their carbon emissions most cheaply will do so and sell the permits they do not need to companies for whom it would cost more to reduce emissions.)

But here’s what would be different: If the government sells the permits, that revenue can go to reduce taxes, or support green jobs, or send a dividend check to every citizen. If the government gives away the permits to private companies, the value of the right to pollute the atmosphere (which, as I’ve mentioned, belongs to every global citizen on an equal per capita basis) ends up going to the same malefactors that have been getting this windfall for decades.

Personally, I don’t think that having made a profit in the past gives you some sort of “God-given” right to make a profit in the future, whether the public likes your product (or your way of doing business) or not. And I don’t think that U.S. environmental regulations need to be business-friendly in order to be the right thing for our society to do.

The value of a clean, low-carbon-dioxide atmosphere is enormous, and it belongs to all of us, equally. I’d like to think that my Senators (this means you, John Kerry and Scott Brown) won’t be intimidated into giving it away.

This is very exciting news: The Senate’s new climate bill calls for the allocation of free carbon permits!

Now I realize this is controversial, but, personally, I can’t wait to receive mine. I couldn’t be more thrilled to have – in such a tangible form – control over my per capita right to pollute or not to pollute the atmosphere. I know it won’t be much – just one 300 millionth of the U.S. cap on emissions, but it still means a lot to me.

I’ll have to think carefully about how to use it. Naturally, I have a strong inclination to retire the permit (take it out of circulation); maybe I could make it into a nice papier maché art object to hand down to my grandchildren and great-grandchildren. A small souvenir of a good and important choice. I can only imagine that they’ll be grateful.

I suppose that power companies and other big greenhouse gas polluters will soon be knocking on my door wanting to buy my permit. Well, they better be willing to pay top dollar, because it’s going to take a lot (the true social cost of carbon?) to get me to part with it.

* Warning: This blog posting contains sarcasm. The Senate’s free carbon permits are not really for you and me; they’re for power companies. Stay tuned for more on this topic.

The public debate over the possible economic implications of addressing climate change has generated a lot of heat, but not much light. One area of confusion is the difference between the price of a tradable permit under a cap-and-trade system and the overall economic impact of the program. It is true that a cap-and-trade program is one way to put a price on greenhouse gas emissions (call these carbon emissions for shorthand); a carbon tax would be a different approach to achieve the same objective. However, most would agree that ending free pollution by pricing carbon is a necessary part of a comprehensive climate and energy program. Let’s dig into the issue of compliance costs and overall societal costs and benefits.

There are two main aspects of compliance cost under cap-and-trade: the cost of reducing emissions, and the cost of acquiring tradable permits (typically called allowances). To simplify, we’ll leave aside the cost of offsets, another option under cap-and-trade. Also to simplify, assume all allowances are auctioned.

Even if they are working to reduce emissions, most businesses are likely to continue to produce emissions and need allowances to cover them for many years. But the cost of acquiring allowances isn’t a real economic cost; the money spent to pay for them does not disappear. It accumulates as government revenue. The question is what to do with that revenue: It could be returned to regulated firms, but one of the principal insights in climate policy in recent years is that regulated businesses will be able to pass along much of these costs to consumers. For this reason, there is significant momentum to return the revenue from allowances to the people or to make investments that speed and smooth the transition to a low-carbon economy.

If the emissions market is functioning, the price of an allowance should be roughly equal to the cost of the most expensive ton reduced. That’s because if every ton of carbon has a cost, firms are likely to keep paying to reduce emissions, using every option open to them, until the options are so expensive that it is cheaper to buy allowances. But again, businesses will be able to pass along a large share of these costs. And many of the investments needed to reduce emissions will produce important benefits.

Greater reliance on clean, free domestic energy sources such as wind and solar power will mean greater energy security. Less fossil-fuel combustion will mean cleaner air, improved public health, lower health care costs, and improved worker productivity and performance by students in schools. A price on carbon will contribute to progress in clean technology by providing greater incentives for those who innovate, and this in turn will boost the prospects for American business in this rapidly growing global market. And of course, there is the enormous benefit of avoiding the damages, biophysical and economic, that would result from unabated planetary overheating.

Carbon prices do not reflect these broader socioeconomic effects, and they are almost invariably left out of economic modeling of climate policy that forecast future impacts, too. For more on that topic, see my report on economic modeling of California’s global warming law.

Chris Busch, Ph.D., is policy director of the Center for Resource Solutions, a nonprofit in San Francisco that creates policy and market solutions to advance sustainable energy.

A new study on the economic impacts of Cantwell-Collins’ proposed “CLEAR Act” – the cap-and-dividend climate regulation that I wrote about a few weeks ago – shows that, in every state, the average household will come out ahead. Their extra costs in energy bills will be more than made up for by an annual dividend check. Some states, however, would have a greater net benefit than others: Oregon and Vermont would receive the biggest net benefits; Indiana and Delaware, the smallest.

This is one of the key obstacles to making a cap-and-dividend bill palatable to majorities in Congress. Somehow it’s not enough that working- and middle-class families stand to benefit from this climate policy – the idea that some states would benefit more could turn out to be a deal breaker.

Authors Jim Boyce and Matt Riddle present an innovative solution to this disparity: state-specific dividends calculated to give the median household in each state the same net benefit. Under this plan, the per capita annual dividend check would be $262 in Oregon and $352 in Indiana, but the net benefit to the median household in each would be $65, due to differences in energy consumption between the two states. With any luck, that could be just enough sugar (for Congress) to make the medicine go down.

A policy of tailoring dividends to energy consumption, however, should probably stop there, or it risks sliding down a slippery slope. Some readers may wonder, why not a specific dividend for every income class in every state? How about for every household (so nobody loses out due to the new policy)? Making a dividend check that matches each household’s cost from climate legislation would entirely negate its effectiveness. The idea is supposed to be that households will choose to use less fuel and buy less energy-intensive products because these things will cost more under a carbon tax or tradable permit system. But if each household were given a check for exactly its added costs, nobody’s purchasing behavior would change at all.

In order for a “market-based” climate policy to work, we all have to respond to price signals that tell us it’s worthwhile to conserve energy. Too much tailoring of any climate regulation could weaken those signals.

I understand that UN Secretary General Ban Ki-moon is having some trouble finding appropriately illustrious women to sit on the newly formed High-Level Advisory Group on Mobilizing Climate Change Resources. (Here’s an open letter from 138 women’s organizations asking the Secretary General to reconsider his appointment of a panel consisting of 19 men and no women; since then, France has replaced its appointee with a woman, French Economy Minister Christine Lagarde).

Since the panel is drawn primarily from current and former heads of state (four members) and high-level economic policy-makers in national governments or international institutions (10 members), I thought I would help the Secretary General out by identifying their female counterparts. A very small amount of Googling on my part turned up nine current female heads of state and more than 50 current female finance ministers, as well as a host of other current and former high-level female dignitaries.

Here are a few suggestions of other women (looking a little further than government officials) who would be assets to the new climate-change finance group:

Sunita Narain is the director of the India-based Centre for Science and Environment. Her research and writing on climate change have found a wide international audience and made a major impact on the way that climate equity issues are framed. Her work with Anil Agarwal on an equal per capita right to the atmosphere for every global citizen is essential reading for policymakers and climate economics students alike.

Dessima Williams is Grenada’s ambassador to the United Nations and the chair of the Alliance of Small Island States. AOSIS has helped to bring to the public view the disproportionate burden faced by small low-lying countries, where climate change-related sea-level rise is already causing enormous damage.

Elinor Ostrom is a Nobel laureate in economics, best known for her work on the institutions that guide the use and misuse of common resources, including our shared atmosphere.

Any other suggestions? I’d love to hear them (you can post a comment using the link above), and I’m sure the Secretary General would, too.

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