You are here

POLICY BRIEF: Calibrating the Price of Climate Risk

May 9, 2018

KEY POLICY INSIGHT: Science reveals that doing nothing about fossil fuel emissions is leading to shattering changes in the earth’s climate. But how do we measure the cost of doing nothing today? A novel economic model puts a price on inaction, revealing that billions quickly turn into trillions in foregone consumption tied to climate change. It’s a mathematical argument for moving quickly to adopting a carbon tax in order to avert the unimaginable costs of delay.

The Price of Inaction

Forecasters find reason for gloom with President Trump’s decision to withdraw the United States from the Paris Climate Accord and undermine Environmental Protection Act enforcement. Minnesota and other states, rather than the federal government, may be challenged to take the vanguard in curbing carbon emissions. The latest cost/benefit study suggests they’d better hurry.

Economic equations can be a blizzard of bewildering elements, a jumble of exponents, coefficients, and derivatives. But the financial calculus for climate change can be simply put: inaction + time = calamity.

Bob Litterman, founding partner in Kepos Capital, makes the case that economists can put a price on risk, a price on uncertainty, and a price on delay. He’s recently coauthored a working paper for the National Bureau of Economic Research with Kent Daniel, at Columbia University, and Gernot Wagner, at Harvard University.  

“It’s huge. It’s growing. It’s preventable,” he said. Every year that passes without action imposes economic costs that are far higher than the year before. The accumulation of damage is stunningly rapid and staggeringly high.”

With his research collaborators, Litterman estimates that delay of a single year costs society $900 billion, corresponding to a 2 percent hit to global consumption.

Each and every year, the cost of inaction rises, but not in a steady curve. More like the trajectory of a rocket. Five years of delay represents a striking loss in consumption – on the order of $24 trillion. That’s the equivalent of a worldwide recession.

How do economists know they’re estimates are plausible? They’ve had plenty of practice.
 

Exhibit 1
Exhibit 1: Decomposition of the Social Cost of Carbon (SCC) into risk aversion and expected damage portions. As the level of risk aversion is raised from a very low level to a level consistent with the historically observed equity-risk premium, the optimal carbon price increases from $38 to over $55 per ton.(1)

Applying Asset Pricing Theory to Climate Risk

Markets, one way or another, price risk all the time. Bonds traded across the globe bear implicit price tags on inflation risk, market risk, interest risk, credit risk. Like those jeopardies, spewing billions of tons of carbon into the atmosphere implies costs that can be measured – at least within a likely range of probabilities.

“The trillions of dollars in damages coming at us are sunk,” Litterman said. “They were stupid. Had we addressed this problem, they wouldn’t be there. But now it’s too late.

“But the additional costs we’re talking about are preventable by appropriately pricing emissions immediately.”

The very industries that, in the past, have resisted government intervention to avert carbon emissions, in some cases, are changing roles – accepting calls for combat against CO2 escaping into the environment. The case for the change of heart, in Litterman’s view, will center on protecting profits in the years ahead.

“Climate change, in itself, could be a great restraint on future growth,” Litterman said. “Think about climate damage when you anticipate growth rates.” Corporate America shows signs of accepting that argument.

Industrial giants, from BP, Shell, and ExxonMobil to General Motors, Procter & Gamble, and PepsiCo, last year created the Climate Leadership Council, a group advocating a carbon tax and other measures aimed at reducing CO2 emissions.

Even airlines, a major contributor to greenhouse gas emissions, have motivation to back pricing carbon.

Litterman’s case: Higher fuel prices would translate to higher ticket prices – bad news for airline revenues today. But reducing emissions, in the long run, would ensure airlines are free to grow and add routes without fear of draconian regulation triggered by a climate crisis.

Lessons from History

Litterman compares the climate threats ahead to the days before the late 19th Century Johnstown Flood.

A reservoir kept filling. A dam, which had held back the water for years, suddenly burst. No one truly knew the capacity of the reservoir until nearly 15 million cubic meters of water roared through a

Pennsylvania valley, killing more than 2,200 people and devastating everything in its path.

The earth’s atmosphere is a kind of reservoir, filling with billions of tons of additional carbon emissions every year. How much can that reservoir hold before a torrent of environmental disasters become inevitable? No one knows for sure.

“We already may be there,” he said.

Where many are pessimistic about quick social action to avert climate tragedy, Litterman is an optimist – both that private industry and government can find motivation to sharply cut carbon emissions and that technology can make alternatives to fossil fuel not only worthwhile but appealing.

The formulas for calculating carbon taxes could be complex but the consequences would be clear, even for consumers who know little about the details. Rising prices would change the inducements for consumers, both in how much they consume and what energy choices they make.

In the past, when the price of gas ballooned temporarily, the public appetite for SUVs, minivans and gas-guzzling muscle cars receded. A dollar-a-gallon gas tax could permanently transform smaller, lighter hybrid and electric cars from marginal options to mainstream choices.

“My dog understands incentives,” Litterman said. “He has no idea what incentives are. But he responds to them.”

Exhibit 2
Exhibit 2: Annual emissions based on a $40/metric ton tax on CO2 and a tax growth rate of 2% above inflation. (2)

Putting a Price on Carbon

Last year, two members of Congress proposed a response to carbon emissions that Litterman endorses: a tax on greenhouse gases, imposed at the level of extraction – from oil and gas wells to coal mines. The tax quickly would be passed along to consumers at the gas pump and in the price of all manner of products tied to fossil fuels.

Litterman and his coauthors estimate that a $1-a-gallon carbon tax on gasoline – the equivalent of a tax of $100-a-ton on carbon emissions, would be the ideal choice to change consumer behavior where enormous amounts of carbon are released, on roads and highways.

Others suggest even smaller carbon tax targets would dramatically alter incentives in consumption and the economics of alternative energy. The public interest group, Resources for the Future, has developed an online calculator that shows how the interplay between varying levels of carbon taxes – and economic growth – reduce greenhouse gas emissions.

The calculator shows the cost of doing nothing. CO2 emissions, in the absence of a carbon tax, continue to rise. Even with other conservation measures, greenhouse gases in 2018 remain at 90 percent what they were in 2005.

But with a carbon tax of $40 per ton, CO2 overall emissions in 2018 fall to 73 percent of 2005 levels. And, assuming the economy grows at a modest 2 percent rate, carbon levels in the atmosphere in 2030 would fall to 63 percent of what they were in 2005.

Meanwhile, the tax would raise $175 billion in revenue in 2018, gradually rising to $192 billion in 2030, under the same assumptions.

The revenue could be used to reduce other taxes or spend on government programs that are habitually delayed, such as repairing highways, roads, and bridges. Alberta, Canada rebates revenue from a carbon tax to taxpayers – a move likely to contribute to the popularity of the levy.

Think Global, Act Local

Last year, nine Northeastern and Mid-Atlantic states agreed to accelerate emission reductions over the next decade. The Regional Greenhouse Gas Initiative is a consortium that will use “cap and trade” – a market solution to pricing carbon emissions – to promote a 30 percent cut in power plant discharges from 2020 to 2030. The states agreeing to the goal include Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island and Vermont.

California initiated a “cap and trade” carbon emissions program in 2013.

Petitioners are gathering voter signatures to impose a carbon emission “fee” on the November ballot in Washington State.

Wind power now produces enough electricity to light nearly a million homes in Minnesota, one of the nation’s leading wind power states. But more could be done.

Litterman sees a precedent in another long-debated social issue: gay marriage. Twenty years ago, most Americans opposed gay marriage. Only a handful of states recognized same-sex unions.

Today, gay marriage is legal in all 50 states, in the wake of a Supreme Court decision and a wave of state initiatives.

A turnaround in combating carbon emissions could arrive suddenly, after years of stalemate.

“Minnesota has an opportunity to lead the way,” Litterman said. “They should price emissions. The first places to make the move will be states."

Footnotes

(1) Daniel, Kent D., Robert B. Litterman, and Gernot Wagner. “Applying Asset Pricing Theory to Calibrate the Price of Climate Risk.” NBER Working Paper No. 22795. Issued in November 2016.

(2) Resources for the Future. E3 Carbon Tax Calculator. http://www.rff.org/blog/2017/introducing-e3-carbon-tax-calculator-estima....

Policy briefs from the Heller-Hurwicz Economics Institute are intended to convey policy relevant research done by researchers associated with the Institute and do not represent the position of the Institute or its funders.