As I explained when the May update came out, the Obama Administration’s “working group” on the “social cost of carbon” reports figures that vary crucially depending on the discount rate we choose. According to the updated document, the negative externality associated with one ton of carbon dioxide emissions in the year 2010 was:
==> $11/ton at a 5% discount rate,
==> $33/ton at a 3% discount rate,
==> $52/ton at a 2.5% discount rate.
You can see how much the discount rate matters on this issue. (The reason is that the computer-simulated damages don’t really start accruing until several decades in the future.)
Now this raises the interesting question of, “Which discount rate should the government use?” Oh if only there were some guidance!
Fortunately, the Office of Management and Budget (OMB) provided the following guidance in its 2003 update to Circular A-94:
2. Real Discount Rates of 3 Percent and 7 Percent
As a default position, OMB Circular A-94 states that a real discount rate of 7 percent
should be used as a base-case for regulatory analysis. The 7 percent rate is an estimate of the
average before-tax rate of return to private capital in the U.S. economy. It is a broad measure
that reflects the returns to real estate and small business capital as well as corporate capital.
The effects of regulation do not always fall exclusively or primarily on the allocation of
capital. When regulation primarily and directly affects private consumption (e.g., through higher
consumer prices for goods and services), a lower discount rate is appropriate. The alternative
most often used is sometimes called the social rate of time preference. This simply means the
rate at which “society” discounts future consumption flows to their present value. If we take the
rate that the average saver uses to discount future consumption as our measure of the social rate
of time preference, then the real rate of return on long-term government debt may provide a fair
approximation. Over the last thirty years, this rate has averaged around 3 percent in real terms on
a pre-tax basis. For example, the yield on 10-year Treasury notes has averaged 8.1 percent since
1973 while the average annual rate of change in the CPI over this period has been 5.0 percent,
implying a real 10-year rate of 3.1 percent.
For regulatory analysis, you should provide estimates of net benefits using both 3 percent
and 7 percent. An example of this approach is EPA’s analysis of its 1998 rule setting both
effluent limits for wastewater discharges and air toxic emission limits for pulp and paper mills.
In this analysis, EPA developed its present-value estimates using real discount rates of 3 and 7
percent applied to benefit and cost streams that extended forward for 30 years. You should
present a similar analysis in your own work.
I have been in close contact with various people who go through all these releases with a fine-tooth comb, and none of us has yet found an estimate of what the SCC would be, at a 7 percent discount rate, even though that is part of the default regulatory requirement.
Also, if you want to argue that we should use Treasury yields, OK–tell me what the yield is on a (hypothetical) 75-year Treasury bond, because that’s (at least) the time horizon involved in climate change regulations and taxes. If we interpolate from the existing Treasury yield curve, it’s not obvious what the yield should be, but one could argue it’s more than 3 percent–especially if we think we’ll get out of the second Great Depression by 2050.
UPDATE: The last time I posted on this, somebody in the comments said the SCC couldn’t possibly be negative, regardless of the discount rate. Well, look at this figure from page 14 of the May 2013 update to the White House Working Group’s estimate:
At just a 5% discount rate, the “average” SCC is reported as $12/ton. (And that’s for a ton of emissions in 2020, when the SCC will be higher than it is right now.) But if you look at those blue bars, you’ll see that this is because around 20% or so of the computer runs (at this discount rate) yield a SCC that is nonpositive, but which is counterbalanced by the 80% or so runs that have a positive SCC.
As you can see from the distribution of the green and red bars, throwing in a 7% discount rate would result in even more probability weight falling on the $0 or negative scenarios. Would the overall result be negative? I don’t know for sure without seeing the actual annual numbers, but the OMB default rule means that the Working Group should have reported that figure.