Low-Energy Fridays: “Babe wake up, new social cost of carbon just dropped.”

The Biden administration ended last year with a Christmas present in the form of updated “social cost of greenhouse gases” estimates. As The New York Times points out, the new value of $190 per ton is significantly higher than the $42 per ton estimated under the Obama administration, so, at a glance, it seems that the benefit from climate regulation has increased. But what is often distilled down into a single number belies an underlying rulemaking complexity, and it’s important to keep in mind that the latest social cost of carbon (SCC) estimate is sure to inflame a debate on regulatory benefits that has been going on for years because the value of the SCC is more a product of regulator choice than quality analysis.

When regulators propose rules, they try to estimate the “net present value” of future damage. For example, suppose a fertilizer used on farms is expected to cause $1,000 of damage per ton—but 100 years in the future. The present value of that $1,000 in the future depends on how quickly the economy grows and the relative wealth between the current generation and a future generation. The SCC works similarly and is an estimation of climate damage 300 years in the future, discounted to a present value so that regulators can compare the future benefit of avoiding climate change with the costs of new regulation today.

Returning to the farming example, the present value of that future $1,000 can be very high or very low because the further out the benefit is, the more sensitive the present value is to the “discount rate.” Just like saving for retirement in which one has a future target and must estimate how much to invest today based on the expected rate of return and how many years they have to save, we discount future regulatory benefits to account for the economic growth that happens between when the burden is incurred and when the benefit is attained.

Suppose it costs $10 in today’s money to avoid the $1,000 of future pollution in our farming example, and the farming industry has an annual rate of return of 5 percent. After 100 years, that $10 would be $1,315, so the regulation would shrink the economy. But if the rate of return is only 3 percent, then the future value of that $10 would only be $192, so the regulation would carry more benefit than cost.

In regulator parlance, at a 5 percent discount rate, the net present value of the future $1,000 would be $7.60, which is less than $10, so the regulation would not be net beneficial. At a 3 percent discount rate, it would be $52.03, which is larger than $10, so the regulation would be net beneficial (and I promise, analysts struggle with this too).

Regulators must determine what discount rate is appropriate to use, and, as shown in our example, the further out the benefit is, the more sensitive the “social cost” of a pollutant is to the discount rate. The difference between the old and new SCC is mostly explained by a change in the discount rate. The $42 per ton figure was in 2007 dollars and used a 3 percent discount rate, and the $190 per ton uses 2020 dollars and a 2 percent discount rate. Adjusting for inflation and discount rate would make the new SCC 46 percent higher than the old value, rather than 350 percent higher.

That remaining 46 percent increase is explained by the regulators changing the methodology for calculating the SCC, in which they created a new model and relied on more recent research to estimate future global climate damages. Needless to say, it is also challenging to get those damage estimates correct—but that’s a topic for another day.

The important thing to keep in mind is that most of the difference between the old and new SCC is explained by the change in discount rate, and this is somewhat controversial. Traditionally, regulatory benefits are supposed to be calculated with discount rates between 3 and 7 percent, as these should reflect the rate of return on the regulated industry. Recall from our farming example that if the expected rate of return is high, then the regulation is less likely to be net beneficial. Conventional guidance directs regulators to use discount rates that align with the rates of return on capital, and the Obama administration took considerable flak for bucking this trend with its SCC that did not include a 7 percent discount rate estimate.

The Biden administration’s decision to use a 2 percent discount rate is one that is sure to reopen the debate about what discount rate is appropriate. But it certainly does not bolster confidence in regulators’ claim of benefits if, instead of arguing that they’ve discovered new benefits, they claim that past administrations simply used an incorrect discount rate. The defense of a lower discount rate relies on the claim that climate change is an intergenerational problem, but, importantly, economists don’t agree on what that discount rate should be.

Another critical part of this is that the SCC’s benefits are global benefits, not domestic benefits, as is the norm. This has also been a source of controversy for the SCC, as more than 80 percent of the estimated benefits do not accrue to the economy that faces the regulatory burden.

To put this in perspective, with the Obama administration’s preferred 3 percent discount rate and global benefits, the old SCC was approximately $50 per ton—but under more conventional guidelines of a 7 percent discount rate and looking at only domestic benefits, the SCC would have been just $1 per ton. The new SCC will face similar scrutiny, as its values would be far lower if they were only estimated as domestic benefits and did so within a standard discount range.

Essentially, we are seeing that the estimated SCC is not an exact science at all, and whether the value is tiny or massive depends almost entirely on regulators’ preferences for discount rates, domestic versus global benefits, and the research referenced when estimating damages. The new SCC largely reflects regulators using even lower discount rates and finding more global benefits to include rather than a major step forward in analytical quality.

At the end of the day, getting the SCC values and its discount rate correct is essential for determining whether regulation carries net benefits or net costs to the public, and it isn’t clear yet whether the regulators got it right this time or need to go back to the drawing board. The one thing that is certain, though, is that the new SCC is going to spark a lot of debate and invite skepticism, given that it defies even more conventional guidelines than the old SCC did.