What Is the Right Price for Carbon Emissions? the Unknown Potential for Devastating Effects from Climate Change Complicates Pricing

By Litterman, Bob | Regulation, Summer 2013 | Go to article overview

What Is the Right Price for Carbon Emissions? the Unknown Potential for Devastating Effects from Climate Change Complicates Pricing


Litterman, Bob, Regulation


As concern over climate change grows, policymakers face a difficult question: How much should society spend today to protect future generations against the unknown risks emissions create? Two issues make determining the appropriate price of carbon emissions a particularly difficult question for economists. First, the unusually long time before environmental damages are expected to be realized makes them difficult to value today. Second, the potential for a low-probability, high-damage scenario to occur is fundamentally uncertain.

There is no disagreement among economists on the benefits of pricing carbon emissions. Prices create the appropriate incentives for producers and consumers to reduce emissions and shift them to higher-value uses. They do this by internalizing the externality of future damages created by economic activities that produce emissions. Relying on prices to allocate scarce resources is vastly superior to the command-and-control approaches of current policies, which rely on public subsidies and mandates to use particular alternatives to fossil fuels.

What is the correct tax on emissions? The views range from $5 per ton of carbon dioxide at the low end (around 4 cents per gallon of gas) to over $100 per ton (as much as $1 per gallon). The current consensus of economists is at the low end of this wide range. Frustrating that effort is the fact that, on average across the world, the net subsidies to fossil fuel consumption (primarily in developing countries) are on the order of $16 per ton of carbon emissions created, according to the International Energy Agency. The European Commission Emission Database for Global Atmospheric Research estimates that carbon dioxide emissions for 2011 totaled 33.376 gigatons, and were boosted by subsidies of $523 billion.

Is Climate Change a Hedge or a Risk?

Because of the long time horizon until damages are expected to occur, the present value of the expected climate damages is distressingly sensitive to alternative discount rates that are not observable in the market and thus difficult to justify. Interestingly, however, the valuation of these expected damages is the less controversial part of the debate. There is a general consensus among economists that future generations will be able to deal with the average impacts of climate change relatively uneventfully. The present value of damages is generally thought to be in a range of $5 to $35 per ton of carbon dioxide. The U.S. government recently estimated this present value to be $20 per ton, and the International Monetary Fund has suggested using a value of $25 per ton.

The more controversial issue is how to deal with uncertainty. In fact, economists do not even agree on the direction of this effect. A sensible argument can be made that the risk embedded in emissions actually lowers the appropriate price of carbon dioxide emissions relative to the price that correctly reflects expected damages. Another sensible argument can be made that the risk created by emissions increases the appropriate price. Economists generally assume that global real per-capita income growth will be around 2 percent per year, meaning that people will be much better off in the distant future. Given even a very pessimistic assumption about real income growth of, say, 1 percent per year without factoring in climate damages, people will have 64 percent higher income in 50 years. At 2 percent per year of economic growth, the average per-capita income will be 169 percent higher. In recent decades, despite the recent recession in developed economies, the global per-capita income growth has been much higher than those values, averaging 2.8 percent over the past 50 years and 3.8 percent over the past 10 years, according to the World Bank. At 2.8 percent growth per year, people in S0 years will have four times as much income as today, and in 100 years they will have 16 times.

How does climate change affect those economic growth possibilities? …

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