Nobel Prize Laureate and environmental economist William Nordhaus calls the social cost of carbon (SCC) “the most important single economic concept in the economics of climate change” and it’s a requirement for all US federal environmental regulation analysis.1 So, what is the SCC and how does it work?
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What is the social cost of carbon?
Human activity, a major driver of climate change, is also affected by climate change, and these impacts are already being experienced today.2
Physical climate change impacts, such as rising sea levels, increasing frequency of extreme weather events, and warmer temperatures, flow through to economic impacts, changing the value of our assets, how healthy and productive we are, how much we work, and how much we earn. We group these impacts together under the term “economic damages.”
The social cost of carbon estimates the economic damages that result from an additional tonne of carbon dioxide (CO2) emitted.3 There are four steps involved:
- estimate the relationship between CO2 emissions and ambient CO2 concentrations;
- estimate the relationship between ambient CO2 concentrations and temperature;
- estimate the causal effects of rising average temperature on measures of economic activity;4 and
- apply a discounting method to estimate the current-dollar value of future damages from emissions.5
Each estimation involves complex models, sensitivity analysis and a range of different parameters that apply the question: “What if this happened?”
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How might we use the SCC?
Usually when we want to decide if something is worth doing or not, we weigh up the costs and the benefits. The SCC is the economic cost of continuing to emit GHGs. So as an economy, we could choose to spend up to the SCC in mitigation efforts in order to avoid this cost and feel confident the world is getting value for money. Domestically, we would pay for any reductions in climate damage, but the value of avoided climate damages would be distributed globally and over time. This is where it becomes useful to consider the additional domestic value from any reductions we were able to achieve as well as the incentive it would create for other countries to respond in kind.
In this context, the SCC can offer a reference point for a carbon price via an emissions trading system or carbon tax. Why would we want to price emissions to reflect the cost of their climate damages? Simple: in economics, this is a classic case of an “externality.” These emissions are causing damage somewhere and this damage isn’t paid for by the person doing the emitting. This represents a loss of both social justice and economic incentive to stop emitting. So to “internalise” the externality and incentivise behaviour change, one solution is to price this damage and charge those that do the damaging. Determining those that do the damaging can be a much bigger issue for another article. Instead, check out this talon-ted bird.
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Note: wherever possible I have referenced the source of information and added further reading. This topic is complex and detailed and I encourage those interested to look further into the fantastic analysis and research done by some of the world’s leading environmental scientists and economists. These sources can be found in the reference list below.
1. Nordhaus here and Resources for the Future Social Cost of Carbon here
2. For more information, see the IPCC Special Report on the Impacts of Global Warming of 1.5°C (https://www.ipcc.ch/sr15/ and IPCC Fifth Assessment Report https://www.ipcc.ch/assessment-report/ar5/.
3. The social cost of carbon typically focuses on emissions of CO2 only, rather than emissions of all greenhouse gases expressed on a CO2-equivalent basis.
4. Kahn, Mohaddes, Ng, Pesaran, Raissi and Yang, 2019. Long-term macroeconomic effects of climate change: a cross-country analysis. NBER working paper here
5. Resources for the Future. Social Cost of Carbon here
The next blog in this series can be found here.