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:

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




Ecotone Partners Mentioned in Oliver Russell White Paper

Oliver Russell & Associates, a purpose-driven brand consultancy and Certified B-Corp out of Boise, ID, has released its second white paper in a series on building purpose-driven companies. The paper, titled “Prove It! discusses the credibility of purpose-driven brands, and the importance of third-party verification of outcomes. Ecotone Partners GBC, INC. from Minneapolis is mentioned as an exemplar of social and environmental impact accounting for Small and Medium-sized Enterprises:

The consulting world is adapting to provide solutions for social entrepreneurs. One example is Ecotone Partners, a specialized firm in Minneapolis that helps companies measure, manage, and communicate their social, environmental, and business impacts.

Big accounting and professional service firms such as Deloitte, Ernst & Young, Grant Thornton, PricewaterhouseCoopers, and McKinsey & Company, among others, are moving into the social impact auditing space. These programs are likely aimed toward larger, more established corporations that are coming to understand that the market is taking social impact seriously.

“There is definitely a trend for social impact reporting to become closer and closer to accounting,” Jeremy Nicholls, CEO of the Social Return on Investment Network, told The Guardian. “One of the things that is now increasingly being looked at is the inter-relationship between financial reporting and social or environmental impact—or natural capital.”

The first white paper in the series was released on October 7th, 2015, entitled “Create It!,” and the third will be released later in Q4 2015, called “Share It!”

Download “Prove It!” here, after an e-mail sign up: