Economics of Emissions Reductions

We have alluded to some of the economic considerations in climate change mitigation elsewhere in this course; now we are going to jump into it with both feet. To some extent, the economics of climate change is a matter of cost-benefit analysis. Alternatively, we can view this as balancing dueling costs. There is, of course, the cost of action. Some mitigation schemes actually cost nothing, and, in fact, they might even save us money—these are called no regrets strategies. They are the things we ought to do anyway: recycle, reuse, reduce our use of energy, etc., whether or not they make a difference for climate change—we will have more to say about these later in the lesson when we discuss reducing individual carbon footprints. However, other mitigation schemes, like carbon sequestration or use of energy sources that are more expensive than relatively cheap fossil fuels, cost money. On the other hand, there is the cost of inaction. We have seen those costs — we know that there is potential harm that could be done across all sectors of society by climate change impacts.

One complication is taking into account so-called externalities — hidden costs that are not, by default, taken into account in the economic decision-making process. What is the value of a coral reef? What is the value of a functioning ecosystem? What is the value of a species? What is the value of human life and does this differ among nations, between rich and poor? Quickly, as you may gather, discussing the economics leads us into a discussion of matters that are no longer simply economic in nature, but, indeed, raise fundamental ethical questions as well. We will discuss these ethical considerations later in the lesson.

But, for the time being, let us return to the economic framing of the problem. To do so, we need to introduce a quantity known as the social cost of carbon (SCC). This is the cost to society of emitting a (metric) ton of carbon. As noted above, precisely evaluating the true cost to society becomes very difficult. Economists typically resolve this difficulty by simply ignoring those costs that are not easily quantified (i.e., ignoring the externalities), and focusing purely on the more straightforward economic costs.

There is quite a bit of debate among economists regarding the true value of the SCC. In part, the divergence of opinion relates to different assumptions regarding the appropriate level of what is known as discounting. Discounting, in economics, relates to the fact that a dollar a year from now is worth less to you than a dollar today, because of the lost opportunity of not having the dollar today. In typical financial markets, this discount rate is somewhere in the range of 6%. One can argue that there is a similar discounting phenomenon that applies to climate change mitigation. The argument is that money that might be spent on climate change mitigation today could be spent on other investments, and perhaps because of improvements in, e.g., energy or in emissions mitigation technology that will arise in the future, it will actually be cheaper to decrease our emissions by the same amount a year from now.

What is unclear, however, is whether or not it is appropriate to apply similar discount rates to those used in financial markets to climate change mitigation. For one thing, the costs and benefits are not borne by the same individuals. The carbon we are emitting today will most likely incur the greatest costs for our children, or even our grandchildren's generation. Is it appropriate to place less value on their quality of life than we place on our own? Once again, we see that deep ethical considerations are easily hidden in the sorts of assumptions that might superficially seem to be objective economic considerations. While some economists like William Nordhaus of Yale University have argued for discount rates as high as 6% (though in recent years he has lowered his estimate of the appropriate discount rate to 3%), others such as Sir Nicholas Stern of the UK, in his well known review of the economics of climate change, argues, for ethical reasons, that the appropriate discount rate should be far lower (Stern favors a 1.4% discount rate). There is a direct relationship between the discount rate and SCC. A 6% discount rate amounts to an SCC of roughly $20/ton, while a 3% discount rate translates to $60/ton, and a 1.4% discount rate translates to an SCC of roughly $160/ton.  The U.S. under the Obama administration used a value of $36/ton despite the uncertainties.  The Trump administration wanted to reduce this to $1 to $6/ton , even though there are indications that even the Obama-era number could be a substantial underestimate (at nature.com and scientificamerican.com).  As of March 2021, the Biden administration has the SCC set at $51/ton.  More on the SCC and how we arrive at these numbers can be found in the article: "The Social Cost of Carbon".

Another complication is the possibility of tipping points. Most economic cost-benefit analyses assume that climate changes smoothly with increasing greenhouse gas concentrations. However, if there is a possibility of abrupt, large, and dangerous changes in the climate—e.g., the sudden collapse of ecosystems, melting of the major ice sheets, etc.—and the threshold for their occurrence is not precisely known, then any amount of future climate change could be perilous, with costs that cannot be anticipated in advance. This is one potentially crucial flaw in standard cost-benefit analysis approaches and part of the reason for the so-called precautionary principle, which advises erring on the side of caution (i.e., on the side of dramatic emissions reductions) when the potential threat—great harm to civilization and our environment in this case—is unacceptably costly.

Mitigation efforts, nonetheless, will only proceed if they pass the cost-benefit analysis, and to do so, the estimated SCC must be greater than the cost of emissions reductions. One way to make emissions reductions cost less is to make the emissions themselves cost more, i.e., to put incentives on the reductions. Any serious effort to mitigate carbon emissions must internalize the cost of the damage to our environment that they cause. There have been fierce arguments among economists and policy experts about how best to accomplish this.

The two widely considered approaches are the so-called carbon tax — a surcharge on carbon emissions at the point of origin, e.g., automobiles and trucks, coal-fired power plants, etc., and the so-called cap and trade — a system of tradable emissions permits aimed instead at end use, e.g., the automobile or airline industries, the energy industry, etc. In such a system, a limit is placed on the total allowable emissions; this is the cap for a particular industry, and the emissions rights can be traded in an open market.

Advocates of a carbon tax often see it as a market-based mechanism that is relatively free of bureaucracy, can be used to raise revenue, or can be made revenue-neutral though offsetting reductions in other taxes. Proponents of cap and trade, by contrast, might point out that it is a more effective approach for insuring that emissions remain below some specified level—something that could be particularly important when dangerous tipping points loom. The cap and trade approach, moreover, has been tested and shown viable in other contexts, such as the mandated reduction of sulfate aerosols with the clean air acts of the 1970s to combat the acid rain problem. A limited tradable system for carbon emissions has shown success in the European Union.

We have already seen that, depending on discount rates and other assumptions, one can come up with vastly different estimates of the SCC. But there seems to be some consensus that a reasonable estimate lies somewhere within the range of $20 to $100. As a point of reference, a 9 cents per gallon gasoline tax would amount to roughly 30$/year for the average American who drives roughly 10,000 miles a year, thus emitting a metric ton of carbon.

So, what sorts of emissions reductions might be expected at varying levels of assumed SCC? This is shown in Figure 12.4 below.

Figure 12.4: Reduction Potential at 3 Different Carbon Costs (U.S. $ Per Metric Mon)

Credit: Mann & Kump, Dire Predictions: Understanding Climate Change, 2^nd Edition
© 2015 Pearson Education, Inc.

It is evident that if we adopt a very low (e.g., $20/ton) value for the SCC, then emissions reductions will be quite modest, while at $100/ton the reductions are considerably more substantial. We saw earlier in the course that carbon emissions, at least approximately a decade ago, were roughly 8.5 gigatons of carbon per year; in the most recent years they are near 10 gigatons per year. In terms of CO₂ equivalent that amounts to 37 gigatons/year. [To convert from carbon to CO₂ equivalents, we need to consider the following: 1 mole of CO₂ contains one mole of carbon; molar weight of carbon is 12 g/mole; molar weight of oxygen is 16 g/mole; molar weight of CO₂ is 12+2*16 = 44 g/mol. Therefore, to convert from units of carbon to CO2 equivalents, units of carbon must be multiplied by 44/12 conversion factor.] To bring emissions to zero, we would need to reduce these emissions by 37 gigatons per year. At a $20/ton cost, we see that the reductions over all 7 sectors (energy supply, transport, buildings, industry, agriculture, forestry, and waste removal) add up to about 13 gigatons/year, a small portion of that 31 gigatons/year. On the other hand, at $100/ton, the reductions add up to almost 24 gigatons/year, making a quite serious dent in the 37/year that constitutes current emissions, reducing carbon emissions to 13 gigatons CO₂ equivalent/year.

Let us try to place this discussion in the context of what strategies might need to be implemented to avoid dangerous anthropogenic interference (DAI) with the climate system. We saw earlier (in Lesson #6) that to stabilize below 450 ppm, CO₂ levels must be brought to a peak within the next decade, and ramped down to 80% below 1990 levels by mid-century. Emissions in 1990 were about 6.5 gigatons carbon per year.

So, doing the calculations, 80% below 1990 levels yields about 5 gigatons CO₂ equivalent per year, about 40% of the 13 gigatons we estimated would result from an SCC of $100/ton. So, let us estimate that reducing emissions to 5 gigatons CO₂ equivalent would require a SCC on the order of $180/ton.

We can use the Kaya Identity approach to interpret what improvements in carbon efficiency such an SCC would translate too. Since the Kaya identity evaluates emissions in terms of gigatons carbon, let us convert the 5 gigatons CO₂ equivalent back to carbon emissions: just under 1.5 gigatons carbon/year, as it turns out.

So, the bottom line is that if you place a large enough cost on emitting carbon, it is possible to achieve the necessary reductions to stabilize CO₂ concentrations at non-dangerous levels. Stabilizing CO₂ concentrations at 450 ppm would appear to require an SCC roughly in the range of $180/ton carbon emitted, which, in turn, would amount to a roughly 4% per year improvement in carbon efficiency. How that improvement will come about, necessarily, will be dictated by governmental policies. Only by internalizing the true costs of carbon-based energy and fundamentally revising government incentives for developing non-carbon (or carbon neutral) based energy sources, such as wind, solar, hydro-power, bio-fuels, and potentially—albeit with certain important caveats—nuclear, will market mechanisms operate under rules that will increase the SCC to the necessary levels.

Now, let us take a more detailed look at the opportunities for reductions in the various sectors of our economy and society.