Pricing Unknowable Risks

In addressing efforts to estimate the benefits of combating climate change, David Simpson’s article asks in its title, “How Do We Price an Unknowable Risk?” (Issues, Winter 2022). To be fair, many dimensions of climate change risks are understood, subject to uncertainty, including economic damages. For example, refer to the Intergovernmental Panel on Climate Change’s recent 3,600+ page report.

The impressive advances in the damages literature over the past decade enable a rigorous updating of the social cost of carbon (SCC)—the monetized damages associated with another ton of carbon dioxide emissions—used to inform assessments of federal regulations. These assessments show whether the benefits of a regulatory action justify their costs. This is analogous to a business deciding whether a new investment will yield returns in excess of its costs, and to a household weighing the lists of pros and cons in making a decision.

Despite a rich understanding of climate impacts, Simpson claims that the “unknown and unknowable risks of climate change argue for caution” as an alternative to SCC-informed policies. But what is “caution”-based policy? The precautionary principle may sound appealing, but that’s because it can have different meanings for different people. Operationalizing the concept quickly becomes ambiguous and political, resulting in different applications and outcomes in different contexts. Under the precautionary principle, an opaque political benefit-cost analysis often substitutes for a transparent regulatory analysis that draws from tools and insights among multiple disciplines’ peer-reviewed literatures.

Another alternative that Simpson discusses—estimating a target-consistent price trajectory that represents the least-cost attainment of a specified long-term emissions target—likewise suffers from political shortcomings. First, it focuses exclusively on costs in how it frames the environmental objective. By making costs so transparent in policy implementation without any accounting or presentation of benefits, this framing could reduce public support for climate policy.

Second, the starting point of this approach is the political decision of an emissions target level and year. Then, this approach requires an assumed set of policies that deliver the carbon price trajectory through its target year. In effect, the target-consistent price relies on political decisions about goals and the means to achieve them, not science. This stands in sharp contrast to the approach of the SCC, that starts by integrating scientific understanding of the impacts of adding more greenhouse gasses to the atmosphere. Indeed, the real-world experience with such a target-consistent price shows how arbitrary political decisions can influence the price path. In 2008, the United Kingdom employed this approach for an 80% reduction target and assumed that the target would be met by purchasing lower-cost emission reductions from other countries.

The decarbonization of the modern global economy will represent one of the most profound transformations of economic activity in history. Policymakers driving such a change will make better decisions (getting the job done through a wise use of resources) and tell a more compelling story (the benefits of these ambitious actions justify their costs) through the use of the social cost of carbon.

Joseph E. Aldy