Carbon Dioxide Emissions – How Do We Arrive at a Price Tag

Part 3 in our – Putting a price on carbon series

At the heart of carbon pricing is the idea of using economic reasoning to help the environment. In the third entry of our blog post series, “Putting a price on carbon,” we explain how economics can help us describe and quantify the problems resulting from carbon emissions.

What is the economic take on carbon emissions? Marginal Utility and Marginal Cost.

From an economic perspective, there is an optimal level of carbon emissions. On the one hand, carbon emissions result from activities people undertake because they consider them beneficial: heating one’s home, driving one’s car to work, or eating meat.

On the other hand, these very emissions also have a negative effect on the environment. Consumption only makes sense if the benefits outweigh the costs. The optimal emission level is, therefore, the point where costs and benefits cancel each other out, or – in economic parlance – where the marginal utility to consume (the benefit from one additional quantity of a good) is equal to the marginal costs of consumption (the cost of one additional unit).

How can we get closer to an optimal level of carbon emissions? Changing the Cost-Benefit Equation.

The big problem is that we are currently far off from the optimal level of carbon emissions. From a whole-of-society analysis, the costs that these emissions produce are higher than the benefits. The reason is that actors in the market only do an individual cost-benefit analysis. They only consider, for instance, the retail price of gasoline as a cost when buying it, not the damage caused by the car’s emissions to the environment.

The idea of carbon pricing is to bring these additional costs – which economists call negative externalities or external effects – into the individual cost-benefit equation. Increasing the gasoline price incentivizes actors to consume less. As a result, we can get closer to the optimal level for society as a whole of carbon emissions.

How can we calculate the negative effect of carbon emissions?

Putting a price tag on carbon emissions requires us to quantify the negative effects. This takes at least three steps: First, we need a climate model to calculate the impact of an additional ton of carbon emissions on the greenhouse gas effect.

Second, we must project how this additional greenhouse gas effect damages the environment and society, for instance, by rising oceans, more droughts, or worse water quality. Third, we must quantify the damage in dollars or euros.

The last step is particularly tricky as it is not easy to put a price tag on human health or other goods that are not traded in a marketplace. It is also difficult to estimate the probability of damages, and it is unclear over which time horizon to calculate them.

How high are the economic costs of one ton of carbon emissions? 

As a result of this complexity and uncertainty, there are very different approaches to calculating the costs of carbon emissions – and there are also huge divergences in the results. According to Ricke, Drouet, Caldeira, and Tavoni (2018), the cost estimates for one ton of carbon emissions range from $10 to $1,000 across a number of scientific studies. They themselves put the price at $400.

In Robert Pyndyck’s 2016 survey among economists and climate scientists, the average estimate was about $290 – with a stark difference between the former and the latter. While economists put the price at a relatively modest $174 on average, climate scientists estimated the true costs to be on average at $316.

How will the costs evolve in the future?

While estimates may differ, one thing is clear: The costs of carbon emissions will rise over time. A 2019 study by Björn Bünger and Astrid Matthey, commissioned by the German Environment Agency (Umweltbundesamt), for instance, focuses on the costs that a ton of carbon emitted in Germany produces. The researchers arrived at estimates of €195 for 2020, €215 for 2030, and €250 for 2050.

However, as more and more carbon is emitted into the atmosphere, various feedback loops are triggered, for example, the thawing of permafrost, which releases even more greenhouse gases into the atmosphere. At one point, this process could even become irreversible: Even if we stopped emitting carbon at once, the greenhouse gas effect would continue to increase.

In our next post, we’ll take a closer look at the policy options states have at their disposal to put a price on carbon.

This is the third post in our series, Putting A Price on Carbon. Read our earlier posts:

• Carbon Pricing – 7 questions on an emerging global economic dynamic
• Carbon Emissions – Where’s the problem?

References:

Bünger, B., und A. Matthey (2019). Methodenkonvention 3.0 zur Ermittlung von Umweltkosten – Kostensätze Stand 02/2019. Dessau-Roßlau.

Pindyck, R. S. (2016). “The Social Cost of Carbon Revisited”. NBER Working Paper 22807. Cambridge, MA.

Ricke, K., L. Drouet, K. Caldeira und M. Tavoni (2018). “Country-level social cost of carbon“. Nature Climate Change (8). 895–900.