Carbon Costs, Uncertainty and Computer Games

Carbon Costs, Uncertainty and Computer Games: A Few Thoughts

After reading about US government efforts to assign a social cost of carbon (which, by the way, is still underway under the current administration), I wanted to offer some comments on why there is controversy over the assigned amount - and suggest a way around it. I wish I had been aware of the public comment period so that I could have done this officially, but perhaps this post will help anyway.

Assigning costs to environmental impacts is an essential part of integrating sustainability efforts with traditional financial modeling and analysis, and of assessing the relative value of sustainability projects. It’s also something my colleagues and I find extremely interesting (yeah, we’re a little nerdy), which is why EarthShift Global’s team has worked since 2000 on assigning costs to greenhouse gas emissions, acid rain and other impacts. We initially used the Total Cost Assessment methodology, and over the last 5-6 years have delved in more extensively using the more-sophisticated Sustainable Return on Investment (S-ROI).

These costs have three important uncertainties:

• The amount of emissions and the actual damage that they cause;
• The discount rate used (i.e., how much future benefits are worth in today’s dollars
• The value that each of us, with our own priorities and assessments, assigns to the damage.

Bottom line—no single number provides a good metric for these costs. But before drilling down into these uncertainties, let’s talk about uncertainty and our decision-making processes.

The Sources of Uncertainty and Our Decision-making Processes

There is a lot of concern that decision-makers and the public can’t understand uncertainty. But we all work with uncertainty every day. We know how to understand a forecaster’s comment about “a 60% chance of rain” and use it when planning our days. We and our municipal officials know that heating and cooling and snowplowing costs will vary from year to year, and that if we have enough stability, it’s a good idea to have a “rainy day” fund for unexpected expenses. So, it’s not a big leap to understand that emissions impacts are dependent on weather, climate, and a host of other factors, and that damage from them is at least as uncertain as the everyday things we deal with.

With that in mind, let’s get back to the sources of uncertainty. Variability in the emissions themselves is one factor. Greenhouse gas emissions from fossil fuel have relatively low uncertainty – burning a liter of natural gas to cook our dinner releases about the same amount of CO2 as burning a liter of natural gas to generate electricity. But greenhouse gas uptake and emissions from crop growth, use, and composting has a lot of variability. The amount and type of fertilizer added to a field will vary the uptake and emissions and the amount of fertilizer can vary from field to field, year to year.

The impacts of these emissions also change over time. Methane is a potent greenhouse gas, but degrades rapidly, so impacts are much higher in the short term. Do we consider the short-term or the long-term effects when we monetize?

Then there’s the discount rate. It sounds like a cut-and-dried financial metric, but it rightly gets a lot of attention in discussions of social impacts on future generations. Some argue that these impacts do not reduce in value (or cost) the way money does. Others argue that social impacts should use the same cost-of-capital approach as any other investment. Moreover, the actual cost of capital in the future is uncertain; to accommodate this in our models, our Director of R&D Caroline Taylor recently suggested that we use a stochastic discount rate that considers the total variance in cost of capital over a given time horizon. This would go a long way towards alleviating concerns over which rate is used.

The last piece of uncertainty has to do with our values. For some, a reduction in greenhouse gas emissions has no value because they do not see it achieving any goal. It’s analogous to the way some of us see no value in computer games, vitamins, or movie tickets. But other people gladly pay for them, so we all have to admit that there is value there nonetheless.

To set a low end on the social cost of carbon, we can use the appropriate carbon markets. They provide a real, tangible value for carbon that somebody is willing to pay. At the other end of the scale, we can include every bit of quantifiable potential human health and ecosystem damage from climate change using the precautionary principle to guide us. That would generate a value that only a die-hard tree-hugger would consider.

The Results

The result of this spread (which also incorporates uncertainty in the underlying data and impact assessment) is a range of values for climate change that no one can really disagree with. The impacts on the low end are an actual value that someone will pay today, which even skeptics can’t deny, while on the high end, we’re reflecting the value system of the deep ecologist. And the rest of us are likely somewhere in between.

Surprisingly, the resulting ranges are typically not that big when we turn them into dollars. And they usually provide a good foundation for decision-making. In the few cases where the results are ambiguous, it usually means that we’re considering the wrong metric. Does it make sense to compare spinach and an orange based on fat content? What about French fries versus onion rings? In the first instance, neither has much fat at all; in the latter, they both have a whole lot. Wouldn’t we be better off choosing based on some other metric, like vitamin content or fiber? The same is true with ambiguous answers in carbon costs for two different systems. The true differential between systems could be species diversity (think solar versus hydropower), or long-term risk (think solar versus nuclear power).

So, while we encourage the government to come up with and use a social cost of carbon, we suggest that they should consider value ranges that represent the wonderful diversity of thought in our country. And we encourage them to continue the effort to monetize other emissions and resource use so that we have tools to help us decide in situations where carbon isn’t the right metric.

We welcome your thoughts on how to share uncertainty with both policymakers and decision-makers, and how to get the tree-huggers among us to be more inclusive in their consideration of other value systems.

 - Written by Lise Laurin