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The Inexact (But Crucial!) Science of Climate Economics

Even the best economic climate models differ wildly. Here’s why we need them anyway.
Climate Economics

(Photo: Calin Tatu/Shutterstock)

In climate justice circles, there are few policy proposals dreamier than a universal carbon tax—a fee on polluters that would encourage corporations and consumers to reduce their carbon footprint, while making green-energy sources less expensive relative to dirty fuels like coal and natural gas.

The carbon tax is in a pickle, though, and not just because of climate change skeptics in Congress. The problem: In order to set an efficient market price on carbon emissions, it’s helpful to know the social cost of those emissions (i.e. the scale of the externality being priced). But climate economists don’t agree on that cost. In fact, they’re not even close.

In 2013, for example, an interagency working group formed by the Obama administration estimated that the social cost of carbon is $37 per ton. But a Stanford University study only two years later placed the cost at $220 per ton—a difference of nearly 500 percent.

This inconsistency has serious implications. For one, under an executive order signed by President Clinton, federal agencies aren’t allowed to impose regulations on industry unless they determine that “the benefits of the intended regulation justify its costs.” Because the social cost of carbon is a cost of inaction, agencies can chalk it up as a benefit of environmental regulations, such as those on industrial pollution and fuel efficiency.

That’s why the exact cost-of-carbon figure is such a big deal: A higher number means greater perceived benefit for environmental regulations, while a lower number means less perceived benefit—a margin that can make the difference between green policies and dirty ones.

So what really is the social cost of carbon? And why can’t economists agree? For starters, Kristen Sheeran, the Oregon director of Climate Solutions, says climate models aren’t as far apart as they might seem. Yes, the gap between $37 and $220 is a big one, but both figures dwarf the estimate of $0, which is how policymakers implicitly valued carbon costs before economists entered the fray.*

As climate action debates heat up, Sheeran says economic models are bringing the big picture into focus, even if they still disagree on the finer details. “The assumptions and approaches sometimes differ, but reputable economists at national and international bodies and universities are reaching basically the same conclusion,” she explains. “And it’s that the economic damages of not acting immediately and aggressively on climate change far outweigh the expenses of shifting away from fossil fuels.”

Sheeran also notes that the discrepancies between economic climate models can be largely explained by two major variables: the discount rate, and the age-old problem of uncertainty.

In classical economics, the discount rate reflects the principle that a dollar received today is more valuable than a dollar promised in the future. And that makes sense: Given a dollar today, you could choose to spend it and enjoy it right away. Or you could choose to invest that dollar, in anticipation that it’ll be worth even more next month, and even more in 10 years.

Regardless, the discount rate reflects reality in personal finance decisions. But Sheeran says it represents a fallacy in climate economics. For one, it assumes a consistent rate-of-return for future investments—and considering the scale of the climate problem and the disruption it’s likely to cause, that’s a risky bet. But the discount rate also poses a moral problem. In effect, it carries the implicit assumption that, as a society, we’d prefer to deal with disruption in the future than deal with it today. This assumption is consistent with economic rational-actor theory (because hey, I’ll probably be dead in 50 years anyway), but Sheeran says that it will be a tough argument to explain to our grandkids. “When you’re talking about climate change and the impacts on human beings and social systems over generations, you can’t discount the future,” she says. “It’s ethically wrong.”

While the discount rate discussion might get wonky fast, it’s a debate that matters. With no discount rate, the dollar that climate action saves 50 years from now is valued exactly the same as the dollar our economy loses today by transitioning away from fossil fuels (a good thing, environmentalists say). But with a high discount rate, the dollar saved in the future is worth significantly less. Multiply that difference by billions of dollars in projected economic damages, and the gap between $37 per ton and $220 per ton begins to make a lot more sense.

The federal working group and the researchers at Stanford did, in fact, use different discount rates, but that difference alone doesn’t entirely explain their separation. Another big factor: uncertainty. As the Stanford study explains, economic models must cope with uncertainty about how climate change will impact poor countries versus rich ones, uncertainty about how economic impacts will compound themselves year after year, and uncertainty about how the value of ecosystem services will change as they become more scarce. When you’re projecting decades into the future, marginally different assumptions about these variables can lead to wildly different calculations of economic cost.

According to Sheeran, this uncertainty problem is especially pronounced for so-called “black swan” events—climate outcomes that are highly unlikely, but that would be catastrophic if they do occur. For example, consider this quandary: If there’s only a five-percent chance that rising global temperatures will plunge the southwest U.S. into a crippling agricultural famine within this century, should economic models account for the potential losses? And if so, how? For economists, there’s no easy answer. “If agricultural production decreases slightly year after year as temperatures rise little by little, that’s easier for our models to predict,” Sheeran says. “But if we reach one of those critical thresholds where climate systems totally go awry and the changes become precipitous rather than marginal, that’s where it becomes difficult.”

The uncertainty about long-term climate outcomes—and about human adaptations to them—has raised questions about the utility of economic modeling in policy discussions. Meanwhile, other critics have argued that distilling ecological processes into economic figures is a fundamentally flawed practice, one that effectively “evaluates” something that should be priceless.

But while Sheeran acknowledges the limitations of her discipline (“Even the best economic models,” she says, “will imperfectly capture what’s truly at stake with climate change”), she also argues that economics can’t be ignored—especially if the goal is political action.

Sheeran points out that moral arguments for action have historically failed to convince policymakers who prefer to focus on dollars and cents. Those officials once used economics as their justification for inaction; now, Sheeran says, economics is helping turn the tide. “If one insists on looking at this from a purely economic perspective, there’s overwhelming evidence that the damages from climate change far outweigh the short-term transition costs,” she explains. “That’s a very powerful message, and one that I think is beginning to permeate the body politic.”


"Catastrophic Consequences of Climate Change" is Pacific Standard's year-long investigation into the devastating effects of climate change—and how scholars, legislators, and citizen-activists can help stave off its most dire consequences.


*Update — January 29, 2016: This article has been updated to better reflect Kristen Sheeran's current job title.