The “social cost of carbon” (SCC) is a key feature in the debate over climate change as well as the principal justification for costly regulations by the federal government. We here at IER and other critics have raised serious objections to the procedure by which the Obama Administration has produced estimates of the SCC.
There are several key points on which the Administration is obfuscating, but in this post I’ll focus just on the choice of discount rates. This one variable alone is sufficient to completely neuter the case for regulating carbon dioxide emissions using the social cost of carbon, so it is crucial to understand the controversy.
The “social cost of carbon” is already being used in federal regulatory analysis and will be the centerpiece of agitation for a U.S. carbon tax. The SCC is defined as the present-discounted value (in dollar terms) of the flow of net damages from climate change due to the emission of an additional unit of carbon dioxide. (Other greenhouse gases—except water vapor—can also be included in a regulatory / tax framework, by conversion to their equivalent in carbon dioxide.)
The Obama Administration formed an Interagency Working Group (IWG) on the Social Cost of Carbon that first released estimates of the SCC back in February 2010 and then provided a major update in May 2013 (and most recently revised them in July 2015). Groups such as IER submitted formal Comments in early 2014 upon the procedures by which the IWG generated its estimates of the SCC. Upon this last revision in July, the Office of Management and Budget responded to the battery of complaints.
Unfortunately, there were several damning objections that we at IER leveled in our formal Comment, to which the OMB has given a very inadequate response. (Marlo Lewis had a similar reaction.) I will do a series of posts here at IER to walk through some of the main problems, starting with the choice of discount rate.
Why Do We Discount Future Damages?
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 cheaper for 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.
Discount Rates in Climate Policy
Generally speaking, the climate damages that occur in computer simulations don’t begin to significantly affect human welfare in the aggregate until the second half of the 21st century. In other words, the computer-simulated damages need to be discounted over the course of decades and even centuries. (The Obama Administration Working Group used three computer models to calculate damages through the year 2300.) Thus we can see why the choice of discount rate is so crucial.
In its latest revision, the Working Group estimated that for an additional ton of carbon dioxide emitted in the year 2015, the present-value of future net damages would be $11 using a 5% discount rate, $36 using a 3% rate, and $56 using a 2.5% rate (see table on page 3 here). Yet when the media refer to these numbers as “the social cost of carbon,” it obscures how arbitrary the figures are. They can range from $11/ton to $56/ton just by adjusting the discount rate in a narrow band from 5% to 2.5%.
Violating OMB’s Clear Guidance
Fortunately, OMB provides explicit guidance (in the form of “OMB Circulars”) to federal agencies on how to select discount rates. Specifically, as we carefully explain on pages 12-17 of IER’s formal Comment, OMB Circular A-4 (relying in turn on Circular A-94) states that “a real discount rate of 7 percent should be used as a base-case for regulatory analysis,” as this is the average before-tax rate of return to private capital investment.
Now it’s true, Circular A-4 goes on to acknowledges that in some cases, the displacement of consumption is more relevant to assess the impact of the policy under consideration, in which case a real discount rate of 3 percent should be used. Thus it states: “For regulatory analysis, you should provide estimates of net benefits using both 3 percent and 7 percent” (bold added).
Notice what Circular A-4 does NOT say. It does NOT say that if a particular regulation primarily impacts consumption, that then only a 3 percent discount rate should be used. No, it says that a 3 percent and a 7 percent rate should be used, in all cases, in order to handle the fact that some regulations will primarily affect industry/capital while others will affect consumption.
It is also true, as many people have pointed out, that in the climate change policy debate, the costs and benefits must be reckoned for generations into the future, and perhaps this means we should be using a lower discount rate. The White House issued a subsequent primer on Circular A-4, which (among other topics) dealt with just this issue. Here is what they concluded:
If the regulatory action will have important intergenerational benefits or costs, the agency might consider a sensitivity analysis using a lower but positive discount rate, ranging from 1 to 3 percent, in addition to calculating net benefits using discount rates of 3 percent and 7 percent. [“Regulatory Impact Analysis: A Primer,” p. 12, bold added.]
There is no ambiguity or wiggle-room in the above. The OMB was not telling federal agencies that they could pick and choose the appropriate discount rate, based on the context. No, they said you always should include the standard 3 and 7 percent rates, and if you want, you can include analyses based on lower rates.
Well, the Obama Administration Interagency Working Group only reported the “social cost of carbon” using the 2.5%, 3%, and 5% rates that we mentioned earlier. They simply did not report what the “social cost of carbon” would be, using a 7% rate. They just ignored OMB’s rules, the goals of which are stated clearly in Circular A-4:
Benefit-cost analysis is a primary tool used for regulatory analysis.2 Where all benefits and costs can be quantified and expressed in monetary units, benefit-cost analysis provides decision makers with a clear indication of the most efficient alternative, that is, the alternative that generates the largest net benefits to society (ignoring distributional effects). This is useful information for decision makers and the public to receive, even when economic efficiency is not the only or the overriding public policy objective.
It is pretty obvious why the Working Group ignored the obvious OMB guideline. At a 7% rate, the SCC in 2015 is slightly negative in one of the three climate/economic models used by the Working Group, and it’s about $5/ton in the other two computer models. Thus on balance, the official White House estimate for the SCC would be a blend of these numbers and itself be close to $0/ton. (We explain the details at our formal Comment, again on pages 12-17.)
You can’t very well have the Obama Administration release a formal report showing that with a standard discount rate used in regulatory analysis, carbon dioxide has virtually no negative impact on humanity. So the Working Group simply ignored the clear OMB guidelines.
OMB Punts, Hopes People Are Busy With Fireworks
There’s no way around what the OMB’s Circular says, and how the Working Group flat-out ignored it. There’s also no way around the magnitude of this omission. Imagine if the public realized that at a standard OMB-required discount rate, one of the computer models chosen by the Obama team showed net benefits from carbon dioxide emissions through the year 2030. Better just to not publish such results, rather than trying to explain them away as inappropriate in this context.
In case you’re curious, in the 44-page document released right before the July 4th weekend, here’s how the OMB handled the fact that the Working Group ignored its rules. After spending several pages (correctly) reviewing OMB’s guidelines on discount rates, on page 22 the document claims:
As explained in the 2010 TSD, after a thorough review of the discounting literature, the IWG chose to use three discount rates to span a plausible range of constant discount rates: 2.5, 3, and 5 percent per year. The central value, 3 percent, is consistent with estimates provided in the economics literature and OMB’s Circular A-4 guidance for the consumption rate of interest. [Bold added.]
The part I have put in bold is incredibly misleading. It would be like someone robbing a bank and then arguing, “My actions were consistent with the bank’s published policies, because a sign said, ‘Have a nice day!’”
Yes, as we quoted from three separate places above, the OMB guidelines explained where the 3 percent number came from, but it always said to include a 7 percent figure as well.
Part of OMB’s original rationale for insisting on both rates in all regulatory cost/benefit analyses presumably was to avoid giving discretion to individual analysts. By telling every report to include both rates, the OMB would err on the side of more information and this procedure would allow for apples-to-apples comparisons among reports. After all, in practice every proposed federal policy has impacts on both industry and household consumption, and so the rationale for one discount rate versus the other could be applied in just about any case. Analysts who wanted to ding or approve a particular regulation could always make a subjective case for one discount rate versus the other, and so by having all analyses include both the 3 and 7 percent rates, outsiders could knowledgeably review the full picture and understand how significant a particular judgment call would be.
Rather than erring on the side of full disclosure, and letting the public see just how crucial this seemingly arcane debate over interest rates really is, the Working Group decided to ignore the clear OMB guidelines. And apparently, the OMB is just fine with an agency ignoring its own promulgated rules. Its Director, Shaun Donovan, may have even ordered his employees to get the right answer, judging from some of his comments concerning climate change: “Donovan stated that the OMB staff, under his direction, are seeking to get the cost-benefit analysis correct when they review government policies, regulations, and programs. To insure ‘that we are appropriately pricing in climate change in all that we do.’” The Daily Kos writer who penned the above quotation is very happy to see that Donovan is doing his part to facilitate more aggressive federal intervention in this arena.
It is troubling that the analysis necessary to make valid decisions for government actions affecting the American public appear to have been politicized, and there is no one watching the watchman. In fact, it appears that the watchman may be overseeing the crime.
Unfortunately, the problems with the Working Group’s estimates of the “social cost of carbon” aren’t limited to a suppression of discount rate reports. There are several other major problems, which the recent OMB document does not solve. We will report on these other issues in future posts.