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