The Rising Cost of Climate Change: Evidence from the Bond Market

Social discount rates (SDRs) are crucial for evaluating the costs of climate change. We show that the fundamental anchor for market-based SDRs is the equilibrium or steady-state real interest rate. Empirical interest rate models that allow for shifts in this equilibrium real rate find that it has declined notably since the 1990s, and this decline implies that the entire term structure of SDRs has shifted lower as well. Accounting for this new normal of persistently lower interest rates substantially boosts estimates of the social cost of carbon and supports a climate policy with stronger carbon mitigation strategies.

The Risk-Adjusted Carbon Price

The social cost of carbon is the expected present value of damages from emitting one ton of carbon today. We use perturbation theory to derive an approximate tractable expression for this cost adjusted for climatic and economic risk. We allow for different aversion to risk and intertemporal fluctuations, skewness and dynamics in the risk distributions of climate sensitivity and the damage ratio, and correlated shocks. We identify prudence, insurance, and exposure effects, reproduce earlier analytical results, and offer analytical insights into numerical results on the effects of economic and damage ratio uncertainty and convex damages on the optimal carbon price. (JEL E12, G22, H23, O44, Q35, Q51, Q54)

Carbon Taxes

Economists argue that carbon taxation (and more generally carbon pricing) is the single most powerful way to combat climate change. Since this is so controversial, we need to explain it better, and to be precise, the efficiency gains are largest when the costs of abatement are strongly heterogeneous. This is often—but not always—the case. When it is not, standards can fill much the same role. To internalize the climate externality, economic efficiency calls for a global carbon tax (or price) that is equal to the global damage or the so-called social cost of carbon. However, equity considerations as well as existing geographical and sectoral differences in the effectiveness of carbon taxation at reducing emissions, suggest earlier implementation of relatively high taxation levels in some sectors or countries—for instance, among richer economies followed by a more gradual phase-in among low-income countries. The number of national and subnational carbon pricing policies that have been implemented around the world during the first years following the Paris Agreement of 2015 is significant. By 2020, these programs covered 22% of global emissions with an average carbon price (weighted by the share of emissions covered) of USD15/tCO2 and a maximum price of USD120/tCO2. The share of emissions covered by carbon pricing as well as carbon prices themselves are expected to consistently rise throughout the decade 2021–2030 and beyond. Many experts agree that the social cost of carbon is in the range USD40–100/tCO2. Anti-climate lobbying, public opposition, and lack of understanding of the instrument are among the key challenges faced by carbon taxation. Opportunities for further expansion of carbon taxation lie in increased climate awareness, the communicative resources governments have to help citizens understand the logic behind carbon taxation, and earmarking of carbon tax revenues to address issues that are important to the public such as fairness.

The Social Cost of Carbon

The past few decades have seen an expansion in the use of cost-benefit analysis as a tool for policy evaluation in the public sector. This slow, steady creep has been a source of consternation to many philosophers and political theorists, who are inclined to view cost-benefit analysis as simply a variant of utilitarianism, and consider utilitarianism to be completely unacceptable as a public philosophy. This chapter attempts to show that this impression is misleading. Despite the fact that when construed narrowly, cost-benefit analysis does look a lot like utilitarianism, when seen in its broader context, in the way that it is applied, and the type of problems to which it is applied, it is better understood as an attempt by the state to avoid taking sides with respect to various controversial conceptions of the good.