Arman Rahman
October 7, 2014
15.411
Case Study 1
i. Determining Benefits and Costs for Future Generations, Science on July 26, 2013 ii. Improve economic models of climate change, Nature on April 4, 2014
To Whom It May Concern: The Office of Management and Budget of the United States needs to reevaluate the Social Cost of Carbon and loss of Gross Domestic Product due to climate change with recent scientific developments and a declining discount rate to form a more appropriate response to the issue. Many of the current estimates use methods and models from the 90’s due to lack of funding. The Social Cost of Carbon (SCC) is a prediction of the cost of future damages due to the emission of one ton of carbon dioxide. Alternatively this is the money saved due to preventing the emission of one ton of carbon dioxide. These predictions are used by governments and companies to decide how much to invest in reducing carbon emissions. They form the basis of many environmental laws and financial decisions. As such they are important in both political and economic terms. Critics say that the Social Cost of Carbon is an inaccurate and shouldn’t be used, however they can still be useful indicators and all the leading models point in the same direction. The inaccuracy of estimates should provide impetus to spend more money revising estimates, not abandon them. The Social Cost of Carbon is computed using population and economic growth estimates to predict resulting changes in greenhouse emissions and global temperature. These changes are then used in “damage functions” which predict the economic costs of damages caused by the changes in emissions and temperature. These future costs are then translated into present value using a discount rate.
Past studies have used a constant discount rate to calculate the Social Cost of Carbon, but this can cause problems since the SCC is an intra-generational cost. Future discount rates are uncertain because it’s hard to predict the rates of growth in consumption and return of investment. They have to be predicted using empirical models and the judgment of the researcher. Models estimated using historical data imply that the discount rate declines over time. Thus a more accurate to predict the cost of long term projects is a declining discount rate (DDR) which is similar to a regular discount rate in that all the benefits and costs in a given year are discounted at the same rate, however for a DDR the rate used declines over time. In using an uncertain future discount rate it is important to update the DDR as new information is revealed.
Using a declining discount rate in computing the Social Cost of Carbon can dramatically change the prediction. Since present value is inversely proportional to the discount rate used the decreasing discount rate used in a DDR will raise the present value. In one example a SCC of $10.70 computed using a constant discount rate increased to $19.50, $26.10, and $27.00 using three different DDR’s. Not only does using a DDR in computing the SCC increase the accuracy of the computation, but also it presents a more dire and pressing SCC, suggesting the need for an equally pressing political and economic response.
We can compare the difference between a declining discount rate and a constant rate in terms of the present value, as a percentage of global GDP, of the