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Is cost-benefit analysis the right tool for federal climate policy?

Posted on 25 October 2021 by Guest Author

This is a re-post from Yale Climate Connections by Lexi Smith

Cost-benefit analysis (CBA) may sound like the realm of wonky bureaucrats tinkering on the edges of major policy initiatives. But CBA can have enormous consequences, especially in the context of climate change. When calculating climate harms, seemingly small assumptions made by economists can make or break a policy intervention.

Consider how we make decisions about future payoffs: Would you rather have a thousand dollars today or in a year? A rational actor’s decision would be to receive the money now because investing it will yield more money in a year’s time. This notion that the same amount of money is worth more now than in the future is applied in CBA as a “discount rate.” A discount rate is essentially an assumption about future returns to capital. When applied over long timescales in analyzing climate policy, discount rates value future generations at pennies on the dollar.

The federal government suggests using seven and three percent discount rates. With a discount rate of 7%, $5 trillion of damages from climate change in 2100 would be valued at about $24 billion in 2021. A 3% discount rate would yield $484 billion in 2021.  A seemingly small assumption yields wildly different results for how much we should spend to prevent harm to future generations. Furthermore, these rates rest on the assumption that the economy will continue to grow and create stable returns to capital over time. But as climate change worsens, the global economy may stagnate and destabilize, meaning growth assumptions baked into discount rates are no longer accurate. An assumption of economic growth is used to justify further emissions that may themselves destabilize growth.

To offer another example, say that an economist posits that damages from climate change will be linear and extrapolates those damages based on scientists’ predictions of harm for 1 to 3 degrees Celsius of warming. But at higher temperatures, runaway feedback loops could mean that the harms of climate change are far more serious than a linear model would predict. A cost-benefit analysis might find that a solar panel installation in your neighborhood won’t be justified after using its prediction of linear harm. But a more accurate model that accounts for the possibility of catastrophic harm could find that the solar panels are a sound investment.

Role of cost-benefit analysis on climate change

At present, nearly all major federal policies must undergo CBA before they can be implemented by the executive branch. This CBA process originated under the Reagan administration, but every administration since then has kept some form of it in place. President Biden could change this process via executive order if he wanted to pursue more aggressive climate policies. By changing the way that climate policies are evaluated and fixing some of CBA’s biases against climate action, Biden could proceed with more ambitious executive action.

President Biden has already shown some willingness to rethink how costs and benefits of climate change are calculated. In the wake of Trump administration attempts to eliminate the social cost of carbon, Biden, on the day he was sworn into office, convened a task force to reinstate and update this important metric for government-wide emissions reductions. So far, the group has set the cost at roughly the same levels as the Obama administration ($51 per ton of CO2 emitted), but it plans to go further. The task force acknowledged in February that the models “used to produce these interim estimates do not include all of the important physical, ecological, and economic impacts of climate change recognized in the climate change literature.” The group’s technical support documents admit that the models’ quantification of damages from climate change “lags behind the most recent research” and that as a result of this and other shortcomings, the Obama-era figures “likely underestimate societal damages from [greenhouse gas] emissions.”

This move to reevaluate the social cost of carbon is in step with a growing scientific consensus. A wealth of new research suggests that previous analyses have woefully underestimated probable damages arising from climate change. A higher social cost of carbon informed by this new research would better capture both short- and longer-term harms. But refining estimates of that one variable is only part of a bigger, more complicated picture: Prominent economists have begun debating whether CBA is an appropriate approach to climate policy in the first place.

Going beyond a higher social cost of carbon?

Cost-benefit analysis in the context of climate change is vulnerable to seemingly small assumptions creating massively skewed results. While some people think that these problems can be fixed by making more accurate assumptions, others are skeptical of CBA altogether.

MIT economist Robert Pindyck, for instance, has written that CBA climate models “have crucial flaws that make them close to useless as tools for policy analysis:

  • “certain inputs (e.g., the discount rate) are arbitrary, but have huge effects on the SCC estimates the models produce.
  • the models’ descriptions of the impact of climate change are completely ad hoc, with no theoretical or empirical foundation; and the models can tell us nothing about the most important driver of the SCC, the possibility of a catastrophic climate outcome.
  • [These] analyses of climate policy create a perception of knowledge and precision, but that perception is illusory and misleading.”

The assumptions and gaps in these models are not just arbitrary, but also biased. Often the most difficult benefits to quantify are environmental values, like species preservation or open space. While it is easy to calculate how much emissions reductions will cost a coal plant, it can be much harder to measure the broad societal benefits of such a policy.

Temple University legal scholar Amy Sinden studied 45 CBAs conducted by the EPA for major rules between 2002 and 2015. She found that 80 percent “excluded categories of benefits that the agency itself described as either actually or potentially ‘important,’ ‘significant,’ or ‘substantial’ because they were unquantifiable due to data limitations.”

For these scholars and other CBA skeptics, CBA is so assumption-laden and skewed that it likely cannot be saved, at least in the climate change context.

Does cost-benefit analysis have to go?

Earlier this year, Nicholas Stern of the London School of Economics and economics Nobel laureate Joseph Stiglitz of Columbia University published a paper suggesting that President Biden should reform the government’s approach to accounting for climate change in policy decisions. Stern and Stiglitz argue that policymakers should:

  • “first, describe the likely consequences from climate change, under current arrangements;
  • second, examine how the economy and emissions could be managed to give a good chance of stabilizing at different temperatures; and
  • third, combine these two elements into a judgement on an approach to a temperature target.”

This method is known as cost-effectiveness analysis.

Cost-effectiveness analysis deals less than CBA with preserving the economic benefits of emitting greenhouse gases, and more with evaluating lowest-cost pathways toward a more stable climate. Rather than trying to estimate an “efficient” level of greenhouse gas emissions based on shaky assumptions about future harms, Stern and Stiglitz suggest putting the cart behind the horse: starting with the temperature targets elected leaders would like to achieve and then adjusting economic activity and resulting emissions to meet those targets. For instance, climate policy could be built around a specific target that warming does not exceed 1.5 degrees Celsius.

Unsurprisingly, this provocative suggestion has been met with controversy. Joseph Aldy, A.J. Meyer, and James Stock of Harvard and Matthew Kotchen of Yale published a response to Stern and Stiglitz in Science this past August. The clash between Stern and Stiglitz and their respondents seems to boil down to two principal issues. First, are existing climate-economy models accurate enough that they can serve as the basis for setting emissions limits in a situation of significant uncertainty? Stern and Stiglitz think not. Second, would we rather set targets based on those models or through the political process? Stern and Stiglitz favor the latter.

The first question is an empirical one: Some are optimistic about the models’ ability to better incorporate climate science. Others contend that the models are inherently laden with biased assumptions that discourage climate action. The second question raises deeply political questions about the comparative advantages of technocracy, democracy, and markets. Cost-benefit analysis uses observed individual spending patterns as proxies for people’s desires, whereas cost-effectiveness analysis focuses on their collective political preferences. Cost-benefit analysis uses technocratic models to try to determine the most economically efficient result, and then shapes government action to fit that result. Cost-effectiveness analysis, on the other hand, uses economic expertise to figure out how to reach a politically-determined goal.

Reasonable minds can surely differ on both of these questions. But if the Biden administration is serious about moving beyond the limitations of traditional economic cost-benefit analysis and reshaping the dialogue around climate policy, the Stern-Stiglitz thesis may provide an outline for doing just that. Cost-effectiveness analysis would justify more aggressive climate action than CBA.

Part 2 of this series will examine some of the legal and bureaucratic barriers the Biden administration could face if it pushes for CBA reforms.

Lexi Smith is a third-year student at Yale Law School. She studied environmental science and public policy as an undergraduate at Harvard, and she worked as an advisor to the Mayor of Boston on climate policy before enrolling in law school.

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