Why The ‘Social Cost Of Carbon’ Can Not Be Used In Cost-Benefit Analysis

The social cost of carbon (SCC) quantifies the economic damage associated with emitting a ton of carbon dioxide into the atmosphere. Regulatory impact analyses from U.S. federal agencies utilize the SCC to estimate the benefits of regulations related to global warming. These analyses in turn provide justification for regulations that can have costs that extend into the billions of dollars.

SCC estimates are calculated using Integrated Assessment Models (IAMs), economic growth models that incorporate a range of assumptions that carry significant uncertainty. IAM models have been heavily criticized due to their sensitivity to various input parameters. This has led some to consider these models too experimental for practical policy application. Given the costs of climate regulations are real, benefits that stem primarily from hypothetical computer simulations seem ill-suited for comparison.

This article aims to shed light on one additional, often-overlooked problem with the SCC models: namely, their unsuitability for use in cost-benefit analysis. This problem stems from the fact that these models rely on an arbitrary social welfare function methodology instead of calculating the costs and benefits associated with CO₂ emissions exclusively in monetary terms, which is what standard cost-benefit analysis requires.

Efficiency requires equal treatment across generations

If regulations only had intra-generational impacts, meaning they only affected people living right now, then an economic analysis would, in principle, be relatively straightforward to conduct. In theory, an analyst could assess what people today are willing to pay to enjoy the benefits of regulations, what they are willing to bear in the form of costs, and then make an assessment as to whether regulations create more benefits than costs.

A problem that arises is that most regulations have some inter-generational consequences. This is true by virtue of the fact that people are continually being born and dying, that regulations have purported benefits that come in the future (as with climate change regulations), and, because regulations impose costs in the future as well. For example, regulations displace investments and these foregone investments would have produced returns over protracted periods of time.

When regulations have such intergenerational effects, the analyst must come up with some manner of comparing the impacts across generations. One such approach would be to weigh the benefits and costs that fall across generations equally. In other words, a dollar of benefit would be treated as equivalent regardless of which generation receives it. This approach evaluates “economic efficiency.” It assesses the total gains and losses to societal wealth. Efficiency treats generations equitably because it is completely indifferent to how benefits and costs are distributed across or within generations.

“Social welfare” as an alternative to efficiency

An alternative approach—the approach taken in the IAMs used to calculate the SCC—is to employ a mathematical “social welfare function” that purports to measure the total impact policies have on the wellbeing of society. Rather than tally up how many dollars of benefits and costs a policy accrues, the social welfare function instead adds up the total impact on “utility”—something that is not directly observable to the analyst.

There are many such social welfare functions that could be employed for this purpose (and, to be fair, the notion of efficiency also corresponds with a particular social welfare function). One of the most popular—and the one used to calculate the SCC—is to adopt the perspective of an immortal “social planner”: a God-like individual tasked with centrally planning the economy. The social planner method has its roots in an economic growth model called the Ramsey model, where the planner can also be viewed as an aggregation of all the individuals in the currently-living generation.

When climate analysts rely on the Ramsey social welfare function to estimate the SCC, they have implicitly assumed that the way to deal with the issue of differential impacts of climate change regulations across generations is to evaluate impacts from the perspective of the present generation only. The current generation takes into account impacts beyond its members’ lifespans, but the wellbeing of future generations does not enter the social welfare function directly.

The SCC is incompatible with standard cost-benefit analysis

In a 2023 regulatory impact analysis, the Environmental Protection Agency (EPA) estimated the SCC to be around $120/ton in 2020 based on the Ramsey method. However, it is important to note that the outputs of the Ramsey model are not dollars like exist in your wallet. Rather, they are “utility-weighted dollars,” because they incorporate information about the social planner’s/current generation’s utility.

The utility-weighted SCC dollars are incompatible with standard cost-benefit analysis, which measures economic efficiency, and, by extension, where dollars are reported in unweighted form. A key advantage to measuring efficiency is it enables the analyst to focus on objective magnitudes, leaving it up to others to decide whether the distribution of impacts is ethical or not. This approach of tallying costs and benefits as they actually accrue to impacted parties is more scientific than claiming a policy improves or reduces “welfare,” which can’t be confirmed via direct empirical methods, and which may mislead by elevating or downplaying the importance of certain impacts relative to others.

The SCC politicizes cost-benefit analysis

When it comes to moral questions, economists have no particular claim to expertise. Indeed, even professional philosophers struggle to reach consensus as to what counts as “fair” treatment across generations. While few would argue economic efficiency is a flawless measure of human welfare, it is the most objective and scientific measure available to analysts, and it is therefore the one that most avoids the taint of politics.

The IAM models blur the distinction between objective and subjective measures of welfare, and between the positive and the normative aspects of economic analysis. Therefore, they unnecessarily politicize cost-benefit analysis. A truly objective economic analysis would remove any subjectivity or value judgments made by analysts. As such, no objective economic analysis would ever include any estimate of the social cost of carbon as it is presently calculated by the U.S. federal government.