Tuesday, June 25, 2013

Setting a Carbon Price: What's Known, What's Not

A number of scientists believe that rising levels of carbon dioxide are likely to lead to climate change. Maybe they are incorrect! But prudence suggests that when enough warning sirens are going off, you should at least start looking at options. In that spirit, I found it useful to consider Robert S. Pindyck essay on "Pricing Carbon When We Don’t Know the Right Price," in the Summer 2013 issue of Regulation magazine. The issue also includes four other articles on carbon tax issues. Pindyck sets the stage in this way:

"There is almost no disagreement among economists that the true cost to society of burning a ton of carbon is greater than its private cost. ... This external cost is referred to as the social cost of carbon (SCC) and is the basis for the idea of imposing a tax on carbon emissions or adopting a similar policy such as a cap-and-trade system. However, agreeing that the SCC is greater than zero isn’t really agreeing on very much. Some would argue that any increases in global temperatures will be moderate, will occur in the far distant future, and will have only a small impact on the economies of most countries. If that’s all true, it would imply that the SCC is small, perhaps only around $10 per ton of CO2, which would justify a very small (almost negligible) tax on carbon emissions, e.g., something like 10 cents per gallon of gasoline. Others would argue that without an immediate and stringent GHG abatement policy, there is a reasonable possibility that substantial temperature increases will occur and might have a catastrophic effect. That would suggest the SCC is large, perhaps $100 or $200 per ton of CO2, which would imply a substantial tax on carbon, e.g., as much as $2 per gallon of gas. So who is right, and why is there such wide disagreement?"
Pindyck acknowledges the uncertainty over how the atmospheric science of climate change, but as befits an economist, his main focus is on the economic issues. He points to the often cited study by Michael Greenstone, Elizabeth Kopits and Ann Wolverton, who published a 2011 paper on "Estimating the Social Cost of Carbon for Use in U.S. Federal Rulemakings: A Summary and Interpretation." They estimated a "central value" for the social cost of carbon of $21 per ton of carbon dioxide emissions. But as Pindyck points out, this central value is of uncertain value for three reasons. First, the link from climate change to an effect on economic output " is completely ad hoc and of almost no predictive value. The typical IAM ["integrated assessment model"] has a loss function that relates temperature increases to reductions in GDP. But there is no economic theory behind the loss function; it is simply made up. Nor are there data on which to base the parameters of the function; instead the parameters are simply chosen to yield moderate losses that seem “reasonable” (e.g., 1 or 2 percent of GDP) from moderate temperature increases (e.g., 2° or 3°C). Furthermore, once we consider larger increases in temperatures (e.g., 5°C or higher), determining the economic loss becomes pure guesswork. One can plug high temperatures into IAM loss functions, but the results are just extrapolations with no empirical or theoretical grounding."

A second problem is that the "central value" doesn't reveal anything about the potential risk of catastrophe--and by the time one has combined the uncertainties of how well climate science can predict catastrophic weather changes that are 50 or 100 years away, combined with uncertainties over the economic costs of those weather changes, this problem is severe.

The third problem is choosing a "discount rate"--that is, how should we best compare the costs of acting in the near-term to reduce carbon emissions with the benefits that would be received in 50 or 100 years? Presumably, a substantial share of the benefits will go to people who do not yet exist, and who, presuming that economic growth continues over time, will on average have considerably higher incomes than we do today.  Placing a high value on those future benefits means that we should be willing to sacrifice a great deal in the present; placing a lower value on those future benefits means a smaller willingness to incur costs in the present. But deciding how much to discount the future is an unsettled question in both economic and philosophy.

Pindyck's policy proposal is to set a low carbon tax now. He argues: "Because it is essential to establish that there is a social cost of carbon, and that social cost must be internalized in the prices that consumers and firms actually see and pay. Later, as we learn more about the true size of
the SCC, the carbon tax can be increased or decreased accordingly." My own views on this subject favor a "Drill-Baby Carbon Tax."

But I'd take a moment here to note that the temptation to argue based on the low-probability chance of catastrophe needs to be handled with care. After all, there are lots of possible sequences of events that are low-probability, but potentially catastrophic. Those who want to limit use of fossil fuels call up  certain climate change scenarios. Those who are anti-science point to the possibility that scientists working with genetics or nanotechnology over the next century will create a doomsday plague. Those who favor huge spending on defense and espionage point to the possibility that a rogue government or a group of terrorists will be able to arm themselves with weapons of mass destruction. Those who favor aggressive space exploration talk about the possibility of the earth suffering a devastating strike from an asteroid in the next century or two. Write your own additional political, economic, and science fiction disaster scenarios here! My point is that being able to name a catastrophe with a low but unquantifiable probability is a fairly cheap tool of argumentation.