Determining the Discount Rate for the Social Cost of Carbon

Yesterday, Minnesota Public Radio reported that Administrative Law Judge LauraSue Schlatter determined that the federal government’s social cost of carbon estimations should be used to inform the Minnesota Public Utilities Commission’s decision making on sources of electricity generation. The federal estimations are about ten times the current valuation of the costs of future damages from CO2 and air pollutant climate change. The article states a “range of valuations,” between $11 and $57 dollars, and that a figure would be decided on later this year. So….how are these numbers determined, who determined them, and what would be the most reasonable to use?

Below, I’ve pasted in some passages from the technical documentation from the EPA for determining these estimates. In a nutshell, there are multiple agencies using multiple and various models that model the future value of damages. These are then aggregated, and then a discount rate is applied. The discount rates vary based on different theories and estimations of future scenarios.

For our clients, Ecotone has been using these federal rates, as well as the current value of carbon credits on the California market. The safest of the rates we will be using going forward will be the Federal rate for the current year, at the 3 percent discount rate.

From the EPA technical documentation:

The Discount Rates Selected for Estimating SCC

In light of disagreement in the literature on the appropriate market interest rate to use in this context and uncertainty about how interest rates may change over time, we use three discount rates to span a plausible range of certainty-equivalent constant discount rates: 2.5, 3, and 5 percent per year. Based on the review in the previous sections, the interagency workgroup determined that these three rates reflect reasonable judgments under both descriptive and prescriptive approaches.

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. As previously mentioned, the consumption rate of interest is the correct discounting concept to use when future damages from elevated temperatures are estimated in consumption-equivalent units. Further, 3 percent roughly corresponds to the after-tax riskless interest rate. The upper value of 5 percent is included to represent the possibility that climate damages are positively correlated with market returns. Additionally, this discount rate may be justified by the high interest rates that many consumers use to smooth consumption across periods.

The low value, 2.5 percent, is included to incorporate the concern that interest rates are highly uncertain over time. It represents the average certainty-equivalent rate using the mean-reverting and random walk approaches from Newell and Pizer (2003) starting at a discount rate of 3 percent. Using this approach, the certainty equivalent is about 2.2 percent using the random walk model and 2.8 percent using the mean reverting approach.26 Without giving preference to a particular model, the average of the two rates is 2.5 percent. Further, a rate below the riskless rate would be justified if climate investments are negatively correlated with the overall market rate of return. Use of this lower value also responds to certain judgments using the prescriptive or normative approach and to ethical objections that have been raised about rates of 3 percent or higher.

Technical Doc:

https://www3.epa.gov/otaq/climate/regulations/scc-tsd.pdf

December 2015 update, with the values for the SC-CO2:

https://www3.epa.gov/climatechange/Downloads/EPAactivities/social-cost-carbon.pdf

 

 

 

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