Paul Watkisspaul_watkiss@btinternet.com

10th April 2006

With contributions from Tom Downing (SEI) and Miche le Pittini (Defra)

The Social Cost of CarbonValuing the Impacts of Climate Change

Presentation Outline

� Background to the SCC in the UK

� SCC focused on marginal social cost (1 t)

� Defra SCC project

� Findings and recommendations

� Defra bottom up analysis

UK Government

� Kyoto - UK = 12.5% reduction agreed

� UK domestic target = 20% reduction in CO2 by 2010 from 1990

� UK Energy White Paper (2003) = UK should put itself on a path to reducing carbon dioxide emissions by some 60% (from 1990 levels) by 2050 (*).

� Progress recently reviewed + new UK Climate Change Programme

http://www.defra.gov.uk/environment/climatechange/uk/ukccp/index.htm

� UK will significantly exceed Kyoto (23-25%), CO2 15-18% below 1990 levels

Costs of Inaction – Social Cost of Carbon

� In 2002, the UK Government Economic Service recommended an illustrative range of SCC estimates (marginal global damage costs)

� Central value of £70/tonne of carbon (tC)… $100/tC or 29 Euro/tCO2

� Within a range of £35 to £140/tC

� All rising at £1/tC/yr

� Based on ExternE (Fund and OF)

� Recommended range used to ‘value’ carbon in project and policy assessment in Government (including Regulatory Impact Assessment).

NB: ER £1 =1.5 Euro: ₤1 =$1.42 = using PPP rates from 2000 (note MER £1 = 1.75$)

Policy Applications – UK Government

� All policies (all departments and Government agencies) have to undergo a regulatory impact assessment RIA = economic appraisal = CBA

� Assess costs and benefits, where benefits include non-market effects

� SCC estimates have been used widely in this context.

� SCC estimates have also used for input to design of economic instruments for environmental regulation

Existing Government Applications SCC

� Used in project appraisal, e.g. transport appraisal

� Used in policy appraisal, e.g. renewables obligation, building regulations

� Used as input to design of taxes and charges, e.g. waste taxes, Road user charging

� Used in recent CCP evaluation and appraisal of revised CC programme, though cost-effectiveness was main criterion used

Social Cost of Carbon

� In 2004 two studies commissioned, looking at modelling and focusing on:

� 1) Uncertainties

� Tom Downing, David Anthoff, Ruth Butterfield, Megan Ceronsky, Michael Grubb, JiehanGuo, Cameron Hepburn, Chris Hope, Alistair Hunt, Ada Li, Anil Markandya, Scott Moss, Anthony Nyong, Richard Tol, Paul Watkiss

� 2) Application in Policy

� Paul Watkiss, David Anthoff, Tom Downing, Cameron Hepburn, Chris Hope, Alistair Hunt, Richard Tol.

� Published by Defra: http://www.defra.gov.uk/environment/climatechange/carboncost/index.htm

Social Cost of Carbon

� 1) Uncertainty/Modelling work on SCC – different lines of evidence

� Literature review, knowledge elicitation, modelling analysis (FUND and PAGE)

� 2) Modelling/Policy work - how SCC been/should be used in policy

� What information needed to implement

� Stakeholder consultation on SCC and on policy applications

� Trend towards lower values in recent years (adaptation, benefits)….BUT

-50

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year of publication

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1. Literature Estimates of the SCC

Source: Richard Tol

Coverage of the Impacts - Risk Matrix

Source: Tom Downing and Paul Watkiss

Market Non Market (Socially Contingent)

Projection(e,g, sea level

Rise)

Bounded Risks

(e.g. droughts, floods, storms)

System change

& surprises(e.g. major

events)

Coastal protection

Loss of dryland

Energy (heating/cooling)

Loss of wetland

Heat stress Regional costs

Investment

Agriculture

Water

Variability

(drought, flood, storms)

Ecosystem change

Biodiversity

Loss of life

Secondary social effects

Comparative

advantage &

market structures

Above, plus

Significant loss of landand resources

Non- marginal effects

Higher order

social effects

Regional collapse

Irreversible losses

Regional collapse

Uncertainty in Valuation

Uncertainty in

PredictingClimateChange

In future, possibly will extend to cover time dimension as well

Market Non-Market

Projection

Boundedrisks

System change/ surprise

Socially contingent

Limited to Nordhaus and Boyer/Hope

Limit of coverage of some studies,

including Mendelsohn

None

Some studies,e.g. Tol

None*

None

None

Models only have partial coverage of impacts

Values in the literature are a sub-total of impactsSource: Tom Downing and Paul Watkiss

2. Knowledge Elicitation

� In the absence of values, fill the matrix by asking experts. 14 Interviews

� William Cline� Tom Downing� Sam Fankhauser� Michael Grubb� Cameron Hepburn� Chris Hope� Alistair Hunt� Alan Ingham� David Maddison� Anil Markandya� David Pearce� Joel Smith� Richard Tol� Paul Watkiss

� Unable to respond to the protocol

� Robert Mendelsohn: uses a different metric� Paul Ekins: not willing to assign numeric values to the social cost of carbon

Results: Min-Avg-Max, £/tC

� Note the confidence in estimates was always low!

3. Modelling Work

� Two leading but very different IAMs: FUND and PAGE

� Discount Rate

� Equity weighting

� Risk aversion, Ambiguity aversion

� Climate Sensitivity

� Surprises /abrupt climate change scenarios

Pattern with Time

2000 2020 2040 2060 2080 2100 2120 2140 2160 2180 2200 2220 2240 2260 2280

Source: FUND, 0% PRTP

-10

0

10

20

30

40

50

60

0% PRTP 1% PRTP 3% PRTP Weitzman Greenbook

£/tC

The Effect of Discounting

Source FUND, year 2000 emission, no equity weights, best guess

UK Government – move towards declining discount rates (Treasury Green Book, 2003)

Period of years 0–30 31–75 76–125 126–200 201–300 301+

Discount rate 3.5% 3.0% 2.5% 2.0% 1.5% 1.0%

The STPR has two main elements:

The rate at which individuals discount future consumption over present consumption, on the assumption of an unchanging level of consumption per capita over time. This is the so-called ‘pure rate of time preference’ (PRTP). The Green Book suggests a PRTP value of around 1.5 per cent a year for the near future.

An additional element, if per capita consumption is expected to grow over time, reflecting the fact that these circumstances imply future consumption will be plentiful relative to the current position and thus have lower marginal utility. This effect is represented by the product of the annual growth in per capita consumption (g) and the elasticity of marginal utility of consumption (µ) with respect to utility. The Green Book indicates the annual rate of g is 2 per cent per year, and the elasticity of the marginal utility of consumption (µ) is around 1.

SRTP is the sum of these two components

SRTP = PRTP + µ*.g

With a pure time preference rate of 1.5%, and values of 2% of g and 1 for µ, the resulting recommended discount rate is 3.5%.

IMPACTS VS ADAPTIVE CAPACITY

MOST VULNERABLE

RESIDUAL RISKS

Vulnerability/Equity – Distributional Effects

• Poorer countries likely to be net losers, as more vulnerable

If adjust impacts across regions makes big difference to results

Issue of consistency with other policy (UK or EU citizens)

Equity Weighting

-100

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200

300

400

500

600

700

800

0% PRTP 1% PRTP 3% PRTP Greenbook

£/tC

No equity weighting

Equity weighted

Steering group and peer review panel decided probably should equity weight, but

Issue of consistency with other international policy

Source FUND, year 2000 emission, best guess, for EW ε = 1

*Changes withscheme and if

dynamic EQ

In a pure utilitarian framework, equity weighting is based upon the diminishing marginal utility of consumption.

With a utilitarian social welfare function, each person’s utility counts equally. Each additional unit of consumption provides diminishing marginal utility. That is, giving £1 to a rich person produces less utility (welfare or happiness may substitute as rough equivalents) than giving £1 to a poor person. So, utility increases with consumption, but at a decreasing rate. A common way to represent this is when utility, u, of consumption, c, is represented by an isoelasticutility function: u(c) = c(1-ε)/(1-ε), where ε denotes the elasticity of marginal utility.

Evidence on the appropriate value of the elasticity of marginal utility (ε), can be found from a variety of sources. However, no definitive guidance exists on the correct value, which can be regarded as an ethical parameter.

A value of ε = 1 is commonly employed in the literature. Range plausibly 0.5 – 1.2, but aid spending implies lower

higher ε, the more rapidly marginal utility falls with additional wealth. In other words, a high ε implies that there is littleadditional utility gained from additional consumption by people who are already rich.

The impact of different choices for ε can be shown by considering two countries, one rich (R) and one poor (P). Suppose country R has an income ten times that of country P. The table below, adapted from Pearce (2003), shows the value of a marginal pound to R relative to a marginal pound to P. For ε = 0 (no equity weighting), a pound to R is worth the same as a pound to P. For ε = 1.0 (commonly employed in the literature), giving 10 pence to P achieves the same utility increase as giving £1 to R: marginal income to P is valued ten times more highly than to R.

even though a pure utilitarian would not weight utility, a utilitarian would weight consumption flows because of the diminishing marginal utility of consumption. These weights on consumption flows are termed equity weights and the appropriate equity weight for consumption going to country R is (YN/YR)ε, where YN is a benchmark (or numeraire) income level. The equity weight for consumption going to P is equivalently (YN/YP)ε..

Impact of equity weighting when YR = 10YP

ε 0.0 0.5 0.8 1.0 1.2 1..5 2.0 4.0 Loss to R as a fraction of gain to P 1.0 0.31 0.16 0.10 0.06 0.03 0.01 ~0

Climate Sensitivity

� Climate sensitivity –average global temperature - doubling of CO2

� Looked at different climate sensitivities, 4.5, 7.5, 9.3

� At time we thought these were extreme but….

� Oxford University - climateprediction.net

Range of climate sensitivity much greater – up to 11˚C

The Effect of Climate Sensitivity

Probability Distribution Function Best Guess vs. Cl imate Sensitivity Scenarios (Monte Carlo [climate parameters uncertain] 1000 ru ns)

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0.015

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-50 50 150 250 350 450 550

MD $/tC (Green Book discounting)*note: runs with species sector damages >100 or <- 100 $t/C ignored

prob

abili

ty

Best Guess (2.5˚C)

C1 (4.5˚C)

C2 (7.7˚C)

C3 (9.3˚C)

Factors with Large Effects

-1000 0 1000 2000 3000 4000 5000 6000

Discounting, 0-3%

Clima te sensitivity (4.5)

Equity w e ighting/Income+

Equity w e ighting/income

Clima te sensitivity (7.7)

Discounting schemes

Clima te sensitivity (9.3)

Sensitivity on Major Climate Effects

-100 -50 0 50 100 150 200

Adapta tion

Methane (100)

THC + 8kyra cold

THC + Flicke rings

THC Collapse

Risk aversion/Fund

Risk aversion/Page

THC + Younger Dryas

Methane (2680)

Methane (8667)

Equity w e ighting/Losers

-£30-£20-£10

£0£10£20£30£40£50£60

Agr

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PRTP=0%

Green Book, EQ

Source: FUND

-£8

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PRTP=0%

Green Book, EQ

• Regional validation• Balance between sectors• Effect of discounting

Regional and sectoral coverage

Statistical Data and Reporting

– Mean or median values?

– Uncertainty is strongly right-skewed.

– Mean much higher than median,

– PAGE typically quotes mean, FUND typically median

– Literature review - median $14/tC and mean $93/tC (1995$)

– FUND – median $10, 1% trimmed mean $27/tC (GB, no EQ)

– Steering group considered mean most appropriate measure of central tendency – in line with principle of maximising expected utility and at least conveying some of the risk of nasty surprises

What did we learn?

� Understanding of future climate system, impacts, adaptive capacity, and values is improving, but knowledge of social costs of climate change is still poor.

� Lack of adequate sectoral studies and understanding of regional interactions precludes a central estimate of the social cost of carbon with any confidence.

� Estimates of the SCC are particularly sensitive to the choice of discount rates and the temporal profile of net damages, as well as any equity weighting

� Climate uncertainties and the climate sensitivity are key factors in larger estimates of the social cost of carbon.

� Simple choice over measure of central tendency (median vs. mean) can significantly change the results

Defra Uncertainty Study

� Estimates of the social cost of carbon span at least three orders of magnitude, from 0 to over 1000 £/tC

� reflecting uncertainties in climate and impacts, coverage of sectors and extremes, and choices of decision variables.

� A lower benchmark of 35 £/tC ($50/tC; Euro 15/tCO2) is reasonable for a global decision context

� committed to reducing the threat of dangerous climate change and includes a modest level of aversion to extreme risks, relatively low discount rates and equity weighting.

� Note with different assumptions, different estimates

� An upper benchmark of the SCC for global policy contexts is more difficult to deduce from the present state-of-the-art, but the risk of higher values for the social cost of carbon is significant.

• Survey of decision makers and experts (UK focused)

• Best approach for deriving and applying carbon shadow prices

• How to use the model results in policy

• Found very different views on the numbers and applications

• Conflict between theory (experts) and users (policy) on complexity of approach to recognise uncertainty

Defra Policy Study

Making the Numbers Useful

� Models work with 2000 emissions for marginal social costs

� Policy makers need values over time, in future decade, for different gases

� Ideally want change in SCC - different stabilisation / reduction policies

� Need to capture how the values change (total and marginal).

� Given SCC uncertainty, several commentators favoured marginal abatement costs to reach pre-ordained policy targets as shadow prices.

� However, on close examination, uncertainty was almost as large (0 to £600/tC)

Policy Study interpretation - SCC

0

25

50

75

100

125

150

175

200

2000 2010 2020 2030 2040 2050 2060

£/tC

Existing illustrative central SCC

PAGE SCC mean

FUND trimmed mean (1%)

these SCC estimates still do not include consideration of the full risk matrix – they exclude socially contingent effects and major events, and (in particular in the case of FUND) only have a partial coverage of bounded risks and non-market impacts.

Policy Study interpretation - SCC

Year of emission

Central guidance *

Lower central

estimate

Upper central

estimate

Lower bound

Upper bound

2000 55 35 130 10 220

2010 65 40 160 12 260

2020 80 50 205 15 310

2030 100 65 260 20 370

2040 140 90 330 25 450

2050 210 130 420 30 550

these SCC estimates still do not include consideration of the full risk matrix – they exclude socially contingent effects and major events, and (in particular in the case of FUND) only have a partial coverage of bounded risks and non-market impacts.

Recommendations – SCC in major CC policy

� Benefits of climate change policy should be considered when setting long-term targets and goals.

� Some benefits can be directly estimated as monetary values, but a wider framework is needed to take all relevant effects into account. Single monetary estimates of the SCC should be avoided for major policy decisions.

� The framework should include a disaggregated analysis of economic winners and losers by region and sector, and a disaggregated analysis of the impacts of climate change including key indicators such as health and ecosystems.

� The full risk matrix identified in the study (including risk of major change) should be considered, and the analysis should include extensive uncertainty analysis (time).

� Green Book recommendations should be used for assumptions (UK) on discounting for consistency with general Government guidance to CBA, but with sensitivity analysis. The uncertainty analysis should also consider different equity assumptions.

� This is an informed process leading to a long-term goal. Detailed policies follow from, and should be consistent with the long-term goal, once set (suggests primary of cost-effectiveness analysis once there is a pre-ordained policy target)

Research Recommendations

� Disaggregated effects of SCC value, by sector and region and by impact (more regional/sectoral studies will be needed to improve capacity of current models)

� Develop a broader framework to inform long-term policy decisions – Should include estimates of the physical impacts that we cannot monetise.

� More consideration of the alternative approaches for equity weighing and discounting, and the ethical (and political) issues they raise.

� How best to apply declining DR to CC, dynamic equity weighting

� Analysis of SCC value in future years, under different emission and socio-economic scenarios (for different GHGs), under different reduction scenarios

� Scope potential damages from rest of risk matrix with sensitivity

� Major focus on adaptation – looking at cost-benefit analysis to investigate climate proofing vs. living with risk

Quantifying the costs of impacts and adaptation in the UK

� Adds to information on UK climate impacts & adaptation required under the UNFCCC

� Estimates of the UK costs of climate change impacts under different adaptation scenario useful to:

� Comparing costs of adaptation now, versus future damages resulting from inaction.

� Contrasting mitigation costs and damages, with and without adaptation responses.

� Clear gap in regional/sectoral studies conducted to date is lack of robust cost estimates – this study is designed to fill this gap.

Quantifying the costs of impacts and adaptation in the UK

� Broad consortium, led by Metroeconomica

� Focusing on selected sectors & impacts – time horizon to 2100

� Aims at producing aggregated and disaggregated regional & sectoral estimates of future climate change costs in the UK.

� Will also estimate UK costs & benefits of the extreme weather conditions of Summer 2003

� Applying methodology for costing the impacts of climate change developed by Metroeconomica for UKCIP

� Use of climate change and socio-economic scenarios for the UK developed by UKCIP

Quantifying the costs of impacts and adaptation in the UK

� UK-wide studies with regional disaggregation� Tourism

� Health

� Building & cultural heritage

� Flooding & coastal erosion

� Energy

� Manufacturing/Retailing

� Transport

� Regional-based studies, aggregated to UK total (if p ossible)� Water: River Earn, Scotland and Sussex Water Resources Supply Area

(Led by project C)

� Agriculture: Scotland

� Biodiversity: Most sensitive habitats/species

� Cultural heritage: Flooding in Lewes

Quantifying the costs of impacts and adaptation in the UK

Study Boundaries:

� Not undertaking CBA of adaptation options within sectors

� Not quantifying indirect impacts in UK as result of CC impacts elsewhere (except tourism)

� Limit scope to marginal impact analysis, but

� Qualitative description of impacts of rapid or extreme Climate Change scenarios

Conclusions

� The SCC estimates derived depends strongly on key assumptions (mean vs. median, discounting, equity, time-scale, climate sensitivity)

� Values only cover partial set of impacts – when set against risk matrix – major gaps for the impacts that are driving international policy (major events)

� Recommend use of wider framework alongside monetary estimates, particularly if assessing implications of long-term climate change policy strategies

� Defra study recommended mean value as best measure of central tendency, declining discount rate , equity weighting– with these, SCC is important

� Major short-term and longer-term research needs, including more bottom-up/ valuation study (Major UK study currently being undertaken for Defra)