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Discount Rates Matter – Why discount rates matter to evaluate the cost of carbon

Placing a price on the cost of greenhouse gas emissions is crucial to properly account for the external costs and implications of greenhouse gas emissions into the total economic cost involved, and can aid us in evaluating whether policies to reduce emissions are properly justified.


The cost of GHG emissions is calculated via a Social Cost of Carbon (SCC), which is an estimate for the marginal cost of impacts caused by emitting one tonne of greenhouse gases (in $/tonne of carbon dioxide equivalent) at any point in time and is inclusive of non-market environmental and social impacts of emissions. The SCC’s intent is to correct the failure to incorporate the external costs of GHG emissions into the total cost of production and shift the burden of emissions to those who are responsible for emitting them, rather than those who suffer from its impacts.

Calculating an estimate for the social cost of carbon requires knowing how long carbon dioxide resides in the atmosphere and estimating the impacts of a tonne of carbon dioxide on society - which is no easy task; requiring estimates of the total damage and costs of climate change effects on a range of factors, and then estimating the equivalent impacts of an additional (marginal) tonne of emitted GHGs in the atmosphere.


Because the effects and costs of carbon emissions occur over time, a comparison of impacts over time is needed using what is referred to as a Discount Rate - which determines the weight placed on impacts occurring at different times in the future. Discount rates define the value of future costs and damages relative to the present, and are used in SCC estimates to value the cost of emitting or mitigating emissions in the present compared to the future.


Discount rates work in an opposite way to an interest rate. Whereas interest adds value to current investments in the future, discount rates mean an investment made now is worthless in the future relative to the present. Depending on the discount rate, future costs and returns on emissions reductions can vary considerably, affecting how we choose to mitigate emissions now and in the future. A high discount rate means that future costs from GHG emissions matter less to the present as damages occur predominantly in the future and an investment in mitigating emissions is best left for the future – resulting in a low $/tCO2 SCC value. A low discount rate means that investments in reducing emissions now will lose less value in the future (i.e., be as valuable in the future as now) and is, therefore, a more worthwhile investment to take now – resulting in a high $/tCO2 value.

Best estimates of SCCs are produced via Integrated Assessment Models (IAM) which predict the effects of climate change under various scenarios and allow for the calculation of monetized damages. Different IAMs consider various factors of climate impacts and varying degrees of impact severities and often produce vastly different SCC values depending on what factors are considered and their predicted degree of severity.


One point of contention that can vary between IAMs and results in vastly different SCC estimates is the discount rate. What discount rate to use is contentious because it is an inherently ethical and political judgment, but highly consequential as it defines the relative value of present costs and future damages. Some have argued for a high discount rate (>5%), arguing that SCC estimates in the range of hundreds of $/tCO2 in present value are grossly high and that economic development now should be prioritized so that future generations will be better equipped to tackle the issue when the costs of emissions reductions (in their reasoning) will be lower. Others however promote a lower discount rate (<3%), citing that uncertainty in climate predictions in the future, the ethical burden of allowing future generations to deal with issues caused in the present, and a risk-averse approach to climate-induced damages justify a low discount rate to generate a high SCC value to incentivize investments in emissions reductions now.


Choosing what discount rate to use therefore affects what SCC estimates are derived from IAM models and what $/tCO2 value should be used to properly incorporate the external cost of emissions into market prices - for example, to set a carbon tax rate equal to the social cost of carbon, and what level of investment should be taken to mitigate emissions in the present and how many emissions can be reduced via market-driven mechanisms and policies.

 

Iwan Pritchard