My colleague (and blog contributor) Frank Ackerman has a new article on Grist that explains why the United States can’t afford to settle for the “social cost of carbon” estimate used in the fuel-efficiency and tailpipe emissions standards unveiled April 1.

As we outlined in our recent white paper, “The Social Cost of Carbon” (available on the E3 Network website), the $21-per-ton figure being used by the government as a “central estimate” of the damages caused by carbon dioxide emissions is based on flawed economics and questionable value judgments.

Frank’s article describes how the government came up with that number, and why the SCC is so important: It’s like a “volume dial” that determines how strict environmental standards should be. Even worse, as Congress considers a climate bill, the $21 SCC could be taken as the recommended level for a carbon tax or permit price:

If that happens, there is no way the United States could reach the widely discussed, science-based goal of cutting emissions by 80 percent by 2050, which would require a much higher price on carbon. Given how cost-benefit analyses dominate U.S. policymaking, a $21 SCC could have a devastating impact on environmental legislation.

It’s easy to think of the fuel-efficiency standards as yesterday’s news, and not discuss the SCC again until it comes up in Congress. But in fact, now is the time to do our homework and figure out what the true price of carbon should be – before that, too, is a done deal.

An Obama administration task force has recently proposed that $21 per ton is an appropriate “social cost of carbon.” (The social cost of carbon, or SCC, is an estimate of the damage caused – both today and in the future – by the release of an additional ton of carbon dioxide into the atmosphere; it’s a topic that I’ve discussed frequently in this blog (see here, here, and here). A bigger SCC means that the federal government is willing to do more to more to slow greenhouse gas emissions; conversely, a smaller SCC means that fewer emissions abatement measures will be considered “economical.”) In an Economics for Equity & Environment white paper, released today, Frank Ackerman and I discuss the very serious errors and omissions that have led to EPA, OMB and other agencies’ promotion of what is a very low SCC.

As our paper demonstrates, the calculation of the SCC is less science than alchemy. It is also – like much of cost-benefit analysis – a very strange way of making decisions. Cost-benefit analysis sounds like common sense: weigh the costs of an action against the benefits. A good policy will have net benefits; a bad policy, net costs. Simple.

Well, actually, no, not so simple. There are (at least) three big problems:

Problem #1: When it comes to the greenhouse gas emissions (and many other environmental issues) we can’t measure the costs and benefits with any accuracy. We’ve never filled the atmosphere with CO2 before. We’ve never tried to remove large quantities of CO2 from the atmosphere before. Some of the important consequences of climate change, such as the loss of human lives and risks of extinction of endangered species, simply don’t have meaningful prices (although economists have at times made up dollar values for them). And many of the costs of halting emissions and benefits of averting damages will occur well into the future. That’s a lot of uncertainty, which doesn’t tend to increase the accuracy of economic predictions.

Problem #2: Many of the costs and benefits will affect not us, but our great-grandchildren, and there is a fair amount of disagreement (a least among economists) about how to weigh these future impacts in the decisions we make today. Some (like me) say we should weigh all damages equally regardless of whether it is us or our descendants that suffer the costs. Others feel that future costs (and benefits) are worth far less than those that take place today.

Problem #3: While climate policy will benefit humanity as a whole, the costs of reducing emissions and the benefits of avoiding a climate catastrophe will impact different people differently. Most people will be net gainers from climate policy (more benefits than costs), but some will be net losers (more costs than benefits). This is true both across generations – future generations are the biggest net gainers from climate policy – and among the Earth’s population today. As a broad generalization, poorer people have more to gain from climate policy. The more one weighs the interests of the net losers compared with the net gainers, then, the less one will conclude that we should do to avert climate change.

In short, cost-benefit analysis is complicated, and its results are open to a lot of interpretation. Regrettably, that is how the U.S. government makes decisions about environmental issues. In a cost-benefit analysis of emission reducing policies, the social cost of carbon is the benefit from each one-ton reduction in carbon emissions (it’s the damage that doesn’t happen, and thus, a benefit). A bigger SCC means a bigger benefit from reducing emissions, making it more likely that any particular carbon reduction policy will pass muster as delivering greater benefits than costs.

There is no way to truly measure the SCC. (Seriously, all climate damages throughout time reduced to one figure in today’s dollars? If you really have faith in such a figure, I have a bridge in Brooklyn that I’d like to sell you.) The Obama administration should consider looking at the problem of emissions abatement from an entirely different angle: For example, by how much do we need or want to reduce U.S. emissions, and what’s the cheapest way to do that? Alternatively, how much can we afford to devote to insuring ourselves against the danger of catastrophic climate change? Decisions made from starting points like these are far more likely than cost-benefit analysis to result in a climate policy that is both effective and economical.

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.

In response to my recent post about the EPA’s little-known social cost of carbon (SCC) value and its importance in setting the stringency of U.S. emission reductions measures, one reader posted this comment:

… It seems to me that the social cost of carbon is whatever it is. The issue is how close EPA gets their estimate to the true value…

Perhaps, but the EPA’s current efforts at calculating the SCC – with its strong bias towards the lower end of estimations from the climate economics literature – is unlikely to arrive at that putative “true value.”

Here’s another way to calculate the SCC: We could ask ourselves, in general terms, what payment would we accept in exchange for our permission to allow greenhouse gas emissions to continue to grow, and to accept a drastically changed climate and all the social and economic damages that would come with it?

Before you answer, here’s something to consider: If we allow emissions to continue, we know that the climatic changes will be profound and the damages serious, but we don’t really know how profound and how serious.

This is what climate scientists and economists call the “problem of uncertainty.” We have a good idea of what the most likely damages will be, and even a good idea about their lower bound (best case). But the upper bound (worst case) is almost impossible to imagine, let alone quantify, with any confidence. In other words, it’s a big gamble: What would you accept in exchange for my assurance that the damages probably will be difficult but not devastating?

If your answer is some variation on “not for all the money in the world!” then for you (and for me) the SCC is infinite.

The SCC answers the question: What’s the damage done by one more ton of CO2 emitted into the atmosphere? Or, what benefit would make it worth it to you to allow the damage caused by that one additional ton? An infinite SCC tells us that future damages are so great that any additional emissions are simply unacceptable.

For anyone out there who likes to think graphically: The idea presented here is that part of the SCC curve is vertical. For a somewhat technical discussion of these issues see my critique of the now-defunct British method of calculating the SCC.

Just about every climate policy has something to do with the price of carbon dioxide emissions. A carbon tax is just a price the emitter pays for each ton of carbon dioxide released into the atmosphere. Under cap-and-trade or cap-and-dividend allowance systems, a limit is placed on carbon emissions, and a market forms to buy and sell the right to emit; this market sets a price on carbon. Similarly, the EPA’s regulation of greenhouse gases under the Clean Air Act rests on a type of carbon price known as the social cost of carbon (SCC).

It sounds obscure and technical, I know, but with climate legislation stalled in Congress, the EPA regulatory actions could be the only U.S. climate policy that we see for a long time. So it’s worth a little of our time and brain cells to figure out just what the SCC means and why we should care.

The dollar figure put on the SCC will determine just how much regulation actually takes place. The EPA will look, in traditional cost-benefit-analysis style, at the cost of complying with a regulation in comparison to the SCC. If complying with the regulation costs more per ton than the SCC, the EPA won’t require it. If it costs less, it will. A high SCC means lots of regulations to reduce carbon dioxide emissions (think: higher fuel-efficiency requirements on cars, tighter emissions requirements for power plants). A low SCC means little or no regulation.

The EPA’s method of calculating the SCC is troubling and, perhaps, the subject of another blog posting. Suffice it to say, the figure is fairly arbitrary, based on a bunch of value judgments that need a lot closer examination by a wider public. The first EPA regulations that will depend on the SCC are part of a “rulemaking” regarding cars and light trucks – a process that has been more or less invisible to the general public. Once an SCC becomes part of an established regulation, it will become that much easier for the value set to be propagated to further regulations, citing precedent.

The EPA has the power to greatly reduce greenhouse gas emissions, and I’m hoping that they’ll use this power for good by setting a high SCC. Unfortunately, their proposed rulemaking does not support this hope – its SCC is small, and the justification given for this value is weak.

If you’re interested in the more technical details, check out Frank Ackerman of SEI-U.S.’s critique of the EPA rulemaking.