In Praise of Judith Curry’s Week in Review–and the Social Cost of Carbon

As someone who tries to keep up with stories related to energy and climate change, I know how hard it is to keep your finger on the pulse. I used to do a weekly review here at TLW and it was actually very close to work (shudder).

Judith Curry at Climate Etc. has done a remarkable job following the various segments relevant to the climate debate. This week’s post on energy and policy is no exception. I want to explore one of the stories she linked to in a little more depth.

If you think that the climate change debate is all about temperatures and models, her link to a discussion of the social cost of carbon should wake you up to the fact that it’s all about the money. And I’m not talking about contributions from the Koch brothers or subsidizing solar power.

When companies pollute the water or air and they don’t have to pay for the damages that pollution causes, it’s called a negative externality. Now that CO2 is classed in the U.S. (wrongly, IMO) as a pollutant, there are efforts to quantify the damages and to create a metric known as the Social Cost of Carbon (SCC).

This is done by estimating the price in today’s dollars to repair the damage a unit of CO2 (or equivalent) will cause in the future.

I think it’s a legitimate exercise in theory, but I don’t place much stock in early efforts. One of the reasons why it’s difficult is that people on different sides of the climate debate cannot agree on what is called the ‘discount rate’.

One of the stories Judith Curry linked to shows just how contentious this can be. It has a point of view–heck, it’s titled ‘OMB Whitewash on the Social Cost of Carbon‘–but whatever your stance on the impacts of climate change, there is good information here.

That includes a good plain-language explanation of discounting:

“Present dollars are more important than future dollars. If you have to suffer damage worth (say) $10,000, you will be relieved to learn that it will hit you in 20 years, rather than tomorrow. This preference isn’t simply a psychological one of wanting to defer pain. No: Because market interest rates are positive, it is cheaperfor you to deal with a $10,000 damage that won’t hit for 20 years. That’s because you can set aside a smaller sum today and invest it (perhaps in safe bonds), so that the value of your side fund will grow to $10,000 in 20 years’ time.

In this framework, it is easy to see how crucial the interest rate is, on those safe bonds. If your side fund grows at 7% per year, then you need to set aside about $2,584 today in order to have $10,000 in 20 years. But if the interest rate is only 3%, then you need to put aside $5,537 today in order to have $10,000 to pay for the damage in 20 years.

An equivalent way of stating these facts is to say that the present-discounted value of the looming $10,000 in damages (which won’t hit for 20 years) is $2,584 using a 7% discount rate, but $5,537 using a 3% discount rate. The underlying assumption about the size and timing of the damage is the same—the only thing we changed is the discount rate used in our assessment of it.”

tom-cheney-first-rule-what-happens-in-accounting-stays-in-accounting-new-yorker-cartoon

Faithful readers of this space will know that much of the criticism of Nicholas Stern’s massive report on the costs of climate change and efforts to combat it were centered on his choice of a very low discount rate, which greatly colored his conclusions.

It’s an important issue. CAGW alarmists and Konsensus Kooks prattle on about the end of the world, saying we are heading for an environment that looks like a Mad Max movie or worse. However, in actual fact even Stern only predicts economic losses of between 1% and 5% of global GDP as a result of climate change. (And to arrive at that figure he not only used a low discount rate, but also over-estimated population rise and the rise in CO2 concentrations.)

But it’s a confusing issue as well. Those who most want action on climate change are also the ones urging a small discount rate, which pushes up the cost of fighting climate change, often to the point where the struggle seems impossible. I imagine they feel that if the cost is too low nobody will take it seriously. And just perhaps they hope that the fight against climate change will get more funding if the cost is higher.

My point is that most of the time we are focused on small ball. Temperature adjustments, solar variation, foolish pronouncements by people who would be better off keeping silent–all of that can be reduced to trivia by a simple accountant’s decision.

More importantly, a lot of these decisions are being made now–and made perhaps in too much haste. We may indeed be headed for a long term future of low interest rates that justify the EPA’s choice of a low discount rate. We’ve already had a long period of almost zero interest rates and Japan’s example shows that such periods can last longer than anyone expects.

However, at some point inflation will return and interest rates will rise. This can confound estimates of the Social Cost of Carbon.

6 responses to “In Praise of Judith Curry’s Week in Review–and the Social Cost of Carbon

  1. I’m all for considering the Social Cost of Carbon (SCC).

    Provided they begin with the realisation that for those doing the sums, it’s called “Life”.

  2. I want you to breathe deeply, relax, take a glass of cold water and read the following with an open mind:

    The economic return of a very long term investment should be estimated using TWO discount rates used in SERIES. The first, higher rate should be the long term cost of capital, which for the USA can be said to be around 5%. This rate should be applied until the investment reaches discounted payout. Afterwards, the discount rate should be the long term inflation rate.

    Breathe deeply. Don’t spit on your screen. Read on:

    I’ve modeled this for over 20 years and it works. i arrived at it by looking at the problem backwards, putting myself in the shoes of a person sitting in the future and pondering what should have been done in the past.

    • I’m so relaxed I’m barely conscious!

      Your suggestion seems sound. It’s not much different from the OBM guidelines of doing it twice at 3% and 7%. I like your idea better.

  3. I think it’s quite different. Prepare a spreadsheet like this:

    Top row years 0 to 200
    Row 2..the investment (for example you could say it’s $100 billion in solar and wind power generation and associated grid and storage).
    Row 3. The operating cost of the investment (my rough guess is $5 billion dollars per year). A row 3prime can have the income benefits from having the equipment built and maintained.
    Row 4 the net co2 emissions saved over the next 30 years by installing the equipment and running it for its 30 year lifespan.
    Row 5 The change in CO2 atmospheric concentration due to the row 3 emissions saved.
    Row 6 The change in the climate parameters (this could have sub rows for sea level change, temperature, drought, etc)
    Row 7 The estimated yearly benefits from the positive climate outcomes listed in row 5.

    You can skip rows 5,6, and 7 if you wish.

    Now all you do is add up the investment (negative), the operating costs (negative) and row 7 (the benefits or income). This is going in row 8.

    Such a sum will be negative for the first years because the climate impact on income (Row 7) would take over a decade to make a difference.

    Now discount the sum row 8 at 5 % per year.

    Next, do a cumulative of the discounted stream at 5%. If global warming is indeed harmful the stream is negative for a while but eventually it turns positive. This is the discounted payout year at 5 %. Call it Year PO.

    Once you have this year pegged, discount the original row 8 sum at 3 %.

    Splice the discounted values at 3 % after year PO.

    Now you have a single row of discounted numbers, the discount rate until Year PO is 5 %, the discount rate after YEAR PO is 3 %. Sum the total in that row for 200 years. That sum is the total discounted value of the investment.

    Now take the total tons of CO2 that weren’t emitted thanks to this renewables project (call it CO2 saved). Divide the total discounted value of the investment by the tons of co2 saved. That’s the income generated for 200 years, on a per ton CO2 basis, for not emitting a ton of co2 as a result of investing the $100 billion.

    Note that I included the cost of the hypothetical renewables project. But one could do the same exercise excluding the investment and the Opex and just using the presumed benefits stream. But in this case there’s no way to create a payout year, because there’s no investment. The method I propose shows the cost of carbon as a benefit when it’s not emitted. It’s a different way to look at this problem. I think it’s much better.

  4. There no 200 year investments I am aware of. There are very few bonds that go past 50 and those are really rare and seldom work out. Most 30 year instruments either default or are paid off/refinanced before the 30 year mark. *Nothing* is predictable much past 30 years in terms of finance or economics.
    Five years is challenge enough.
    The climate obsessed have demonstrated basically zero understanding of economics, which is not surprising since they also ignore history, reality, science, and basic math and statistics as well.

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