Module 11: Social Cost of Carbon

Economists use a theoretical construct called “efficient markets” in which marginal costs and benefits are balanced to set prices and quantities of goods. Climate change is external to energy markets, so energy prices and production are severely distorted and catastrophic costs are incurred to society. This is called a market failure. Market theory prescribes that these external social costs be added to the marginal costs of carbon emissions to correct the failure. 

The social cost of carbon includes all damages of carbon emissions: disease, hunger, death, ecosystem losses, rising sea levels, disasters, fires, migration, war, and so forth integrated over all future time. These future costs are exponentially discounted using a formula that captures the value of money over time. Climate economists disagree vehemently about the proper discounting formula, leading to extremely divergent estimates of the social cost of carbon (more than a factor of 20). Nevertheless, virtually all economists agree that internalizing these unknown costs using carbon taxes is the best possible climate policy.

The inability of economists to define and defend the value of the discount rate, which is the master variable that determines the social cost of carbon, is a severe weakness of this metric. Other important critiques of climate economics include:

• Damages are badly underestimated and may exceed the value of the global economy
• Analyses are naive with respect to emerging energy and mitigation technologies
• Rates derived from short-term finance are used for intergenerational discounting over centuries
• Failure to consider low-probability outcomes with catastrophic consequences (tail risk)
• Use of marginal analysis to model wholesale transformation of the global economy
• Radical assertion of ethical judgement thinly disguised as calculations

Upon completion of this module you should be able to: 

1. Explain how efficient markets balance marginal costs and benefits to set prices and production levels.
2. Describe how external costs lead to market failure and social problems.
3. Enumerate categories and costs of climate damages that are external to energy markets.
4. Explain how economic discounting is used to calculate the present value of future costs.
5. Outline the procedure used by economists to estimate the social cost of carbon.
6. Describe some of the critiques of climate economics.

• Module 11: Social Cost of Carbon [PDF]
• Climate Economics. [Schmittner OER Chapter 9]
• Nordhaus, W. D. (2016). Revisiting the social cost of carbon.  . PNAS, Vol. 114, No. 7. 
• Hampshire-Waugh, M. (2021). Damage Assessment – Quantifying the Social and Economic Costs of Climate Change (Chapter 5). 
• The Stern Review: Stern, N. The Economics of Climate Change. Cambridge University Press. 2006

• Video 11.1: Efficient Markets
• Video 11.2: Market Externalities
• Video 11.3: Climate Damages
• Video 11.4: Discounting the Future
• Video 11.5: Social Cost of Carbon
• Video 11.6: Critiques of Climate Economics

Module 11: Social Cost of Carbon

1. In the economic theory of efficient markets, how is the allocation of resources optimized to set both prices and production of goods and services? In what sense is this allocation considered “optimal?”
2. What is mean by the term “market externality?” How do economists recommend that externalities be mitigated? Give an example of a market externality and a policy response that reduces its harmful impact.
3. Why do some prominent economists consider climate change to be “the greatest market failure in history?” Why is this failure especially hard to remedy?
4. What algebraic form do economists often use to predict climate damages? How is the climate damage function specified/quantified?
5. Besides causing global warming, describe how burning fossil fuels damages today’s economy. How many premature deaths does carbon combustion cause each year worldwide?
6. When economists perform “cost-benefit analysis” of climate change policy, what do they usually consider “costs” and what do they consider “benefits?”
7. How do economists use the concept of discounting to weigh the costs and benefits of climate change policy? How do they choose a numerical value for the discount rate and how does that affect their policy recommendations?
8. Economic cost-benefit analyses of climate change requires tracing the links between avoided emissions and corresponding reductions in current and future damages. Outline the methods and models used by economists to perform these calculations. 
9. Describe the range of estimates of the social cost of carbon produced by mainstream economists. Why is it so large?
10. Explain some critiques of economists’ cost-benefit analyses of climate change policy.