The tragedy of the commons is a term that frequently enters climate change discussions. It symbolises what happens to a common resource when used across multiple users. Because it is shared among many, consumers stop acknowledging the other users, and if you leave the market free for all, the resource vanishes in no time.
Does that mean a solution is not possible? The answer is yes. In the original format, the game is played only once, whereas, in real life, the consumers get several chances course-correct their actions. In the case of climate change, there was a phase that was dominated by the exploitation of resources with no thinking about the consequences (global warming). But once the understanding came, there were plenty of opportunities created by the likes of UNFCC that resulted in a Kyoto protocol or a Paris agreement. In other words, cooperation is possible and can alter some of the eventualities of the tragedy of the commons.
We have seen that the global CO2 emissions in 2021 were about 39.4 gigatonnes. But how do different countries contribute to this? Hsiang and Hsiang report contributions from the top 15 countries in 2014. Here are the top 10 that I picked up.
Country
Emissions (2014) G tonne CO2
Cumulative Emissions (1751–2014) G tonne CO2
Emission per capita (2014) tonnes CO2
China
10.3
174.7
7.5
United States
5.3
375.9
16.2
India
2.2
41.7
1.7
Russia
1.7
151.3
11.9
Japan
1.2
53.5
9.6
Germany
0.7
86.5
8.9
Iran
0.6
14.8
8.3
Saudi Arabia
0.6
12.0
19.5
South Korea
0.6
14.0
11.7
Canada
0.5
29.5
15.1
Notice that these ten already account for 75% of the total 34.1 Gt in 2014! Also to check is the disparity in the per capita contribution and the cumulative contribution that created this monster of climate change in the first place.
Hsiang and Hsiang, Journal of Economic Perspectives, 2018, 32(4), 3–32
The final estimate for the cost of carbon emissions depends on a few more parameters.
The equilibrium climate sensitivity (ECS) is one of them. It is defined as the global average surface temperature change when doubling the CO2 in the atmosphere. After several discussions with the experts, the IWG came out with a distribution of ECS:
median equal to 3 °C
67% probability that ECS is between 2 and 4.5 °C
0% probability that it is less than 0 °C or greater than 10 °C
If you like to know more about the distribution (a right-skewed distribution), read the paper by Roe and Baker (2007) published in science.
Now comes the famous discount rate. We have already discussed how an inappropriate value for the discount rate can throw a technology project out of the window. Government agencies typically use numbers between 3 and 7, whereas most climate literature chooses between 0 and 3. After considering all these, the IWG finalised three values at 2.5%, 3% and 5%.
Another value, and we will see what happens in 2016, is the choice between domestic SCC vs global. The team (2010) considered the US emissions a global externality, and the magnitude will reflect that. It was then reversed to a domestic problem in 2016 by the Trump administration, only to be brought back to “normal” by Biden. As per Wagner et al., a tonne of CO2 emitted in the US causes 85% of the damage abroad!
The results
All these parameters finally lead to a range of cost values for climate damage. Thousands of model runs finally resulted in the following values for the price (USD/ton CO2): 5th, 25th, 50th, 75th, and 95th percentile SCC values of -$9, $4, $14, $28, and $65, respectively.
Four point-estimates are selected for each year in the following manner.
The central value: the average SCC of models at a 3% discount rate.
The 2nd value: is the average SCC of models at a 2.5%
The 3rd value: is the average SCC of models at a 5%
The 4th: the 95th percentile 3%
2010 (USD/ton CO2)
2025 (USD/ton CO2)
Central (3%)
21
30
Second (2.5%)
35
46
Third (5%)
5
10
Fourth (95th percentile of 3%)
65
90
Reference
Greenstone, M., E. Kopits, and A. Wolverton. “Developing a Social Cost of Carbon for US Regulatory Analysis: A Methodology and Interpretation.” Review of Environmental Economics and Policy 7, no. 1 (January 1, 2013): 23–46.
Roe, G. H.; Baker, M. B., Why Is Climate Sensitivity So Unpredictable?, Science, 2007, 318, 629.
Wagner et al., Eight priorities for calculating the social cost of carbon, Nature, 2021, 590, 549
The Social Cost of Carbon (SCC) is the monetised cost of damages of the incremental increase in CO2 emissions. Remember the cost-benefit-risk triangle? Such calculations enable administrations to take a cost-benefit approach in deciding on any investments for emissions reduction. The interagency working group (IWG) provided the required study for the US using what is known as the integrated assessment models (IAM), and we will see how they developed SCC estimation.
To simplify, IAM provides the missing link between the physics and economics of climate change. To further break it down, IAM includes four key relationships, viz. future emissions of greenhouse gases (GHG), the effect of GHG on the climate, the impact of climate changes on the environment and finally, the connection between the environmental hit and economic damages. IWG used three models: the Dynamic Integrated Climate and Economy (DICE), the Policy Analysis of the Greenhouse Effect (PAGE), and the Climate Framework for Uncertainty, Negotiation, and Distribution (FUND).
These are commonly used models by scholars and in the Intergovernmental Panel on Climate Change (IPCC) reports. While they are all different in their details, they model emissions to concentrations, concentrations to temperature changes, and temperature changes to monetary damages. For example, the FUND model evaluates damages to agriculture, forestry, water, energy, sea level, ecosystems, human health, and extreme weather. On the other hand, the DICE model does it for agriculture, coastal areas, energy use, human health, outdoor recreation, and human settlements and ecosystems.
We already know that many of these are not exact physics and economics. And the model output depends on the assumptions used. Therefore, several probabilistic scenarios results from these models and the outcomes require incorporating all of them, thus resulting in a distribution of costs.
IWG estimated the SCC on five trajectories adopted by the Stanford Energy Modeling Forum exercise, EMF-22. The first four are Business-as-usual (BAU) CO2 concentrations (612, 794 and 889 ppm in 2100). The fifth one stabilises at 550 ppm CO2equivalent. More parameters (annual CO2 emissions, per capita GDP, populations) of those scenarios are in the following tables.
EMF-22 Scenario
2000
2050
2100
IMAGE
26.6
45.3
60.1
MERGE
24.6
66.5
117.9
MESSAGE
26.8
43.5
42.7
MiniCAM
26.5
57.8
80.5
550 ppm
26.2
20.0
12.8
Annual emissions (GtCO2/yr)
EMF-22 Scenario
2000
2050
2100
IMAGE
6,328
17,367
43,582
MERGE
6,050
13,633
27,629
MESSAGE
6,246
16,351
32,202
MiniCAM
6,017
14,284
42,471
550 ppm
6,082
15,793
37,132
GDP per capita (2005$)
EMF-22 Scenario
2000
2050
2100
IMAGE
6.1
9.0
9.1
MERGE
6.0
9.0
9.7
MESSAGE
6.1
9.4
10.4
MiniCAM
6.0
8.8
8.7
550 ppm
6.1
8.7
9.1
Global Population (billions)
That leaves two important parameters before reaching a price for today’s carbon – discount rate and domestic contribution (in this case, the US). We will see them next.
Reference
Greenstone, M., E. Kopits, and A. Wolverton. “Developing a Social Cost of Carbon for US Regulatory Analysis: A Methodology and Interpretation.” Review of Environmental Economics and Policy 7, no. 1 (January 1, 2013): 23–46.
We have seen already – the carbon tax sets a price for CO2 release but is uncertain over the total emissions. Cap and trade define total emissions, not the price (the social cost of carbon). Yet, in an ideal market, both yield similar outcomes.
There are differences, though. Tax prevents emissions price volatility. Here is an example of price fluctuations in the market. It may prompt you to argue for a price floor, price ceiling or both.
A common criticism against the cap and trade system notes the requirement of additional administration fees. They argue that the carbon tax scheme applies at the point of origin of carbon (upstream), where the number of players is in the thousands. Whereas the cap and trade method is at the point of burning (downstream) where the numbers are in millions. Experts dismiss this argument and point out the applicability of both schemes on either end. It is, however, a fact that, unlike that in the carbon tax, in cap and trade, the regulator not just watches the emissions but also monitors the transactions of permits between companies.
Another concern that a tax-based system often underestimate is the physics of emissions, i.e. the nonlinearity of climate calamity with CO2 in the atmosphere. A fixed (or even a variable) carbon tax lets the emissions go on a free ride, whereas the cap and trade fix the total emissions, no matter what.
The final difference is how the two schemes sound different. In countries where the word tax is synonym with encroachment on personal freedom, cap and trade is a politically acceptable solution to climate change.
The second method of regulatory intervention is cap and trade. Here, the system sets a maximum value for the emissions; this is the cap. It also provides allowances, in emission permits, to firms to cover each unit of CO2 (or any other pollutant) produced. The company can redeem one for every emission unit or trade it to another party, who can then use it.
As expected, the price will now move up to P*. What is the value of the permit? You will see that in the following.
The value is the green box of the figure, identical to that of the revenues in the carbon tax scheme. But how does that value per unit (the line, ab, joining the supply and demand curve or the) exactly match with the unit tax of the previous scheme? Did the government charge the permit to the firms by that amount? Well, it doesn’t matter – the permits can be free or can come with a price, and yet the eventual price in the market (for trading) reaches that value. It is because, in a trade, each permit comes with an opportunity cost for the selling firm or the maximum price it can afford for the buying firm. Anything beyond that price will make the total cost (marginal cost + permit) cross the willingness to pay of the consumer. Therefore, the final price (set by its supply-demand curves) settles to ab.
Free or fee?
While the offering price doesn’t matter to the outcome (the number of emissions), it differs in the final destination where the money (the green box) ends up. If the regulator charges a price ab to the permit, the entire green box becomes its revenue. If not, it adds to the firm’s bottom line. You then expect companies to pass the benefit to the consumers, but this seldom happens.
We have seen that the free market is at a Pareto efficient state, and therefore, it will not care about shouldering the social cost of carbon. The only way to break this equilibrium is through regulatory intervention. And the two popular mechanisms are carbon tax and cap and trade. The intention is to force firms to alter the production process to reduce emissions per unit of goods sold in the market.
Carbon tax
It works if you know the price of unit emission of CO2 to the atmosphere. In other words, you know the social cost of carbon and set a tax on the difference between the supply marginal cost curve and the social cost curve.
Subsequently, the price moves up to P, and consumers’ willingness to pay moves towards reduced consumption, Q.
In the process, the regulator gets a revenue (green box), the firm’s profit (yellow triangle) reduces a bit, and the consumer ends up paying more!
The regulator will use the money for handing over incentives to reduce CO2; the firms will also find low carbon innovations to bring back their margin and also sell more products to satisfy the needs of the customer.
Economists call the social cost of climate (SCC) an externality. Before establishing any corrective mechanisms, it is vital to quantify SCC. The 2016 paper by Carleton and Hsiang in Science is a good resource for understanding the topic. The article summarises multiple counts of parameters such as changes in GDP, mortality, and social conflicts as a function of average temperature.
In simple terms, one needs to solve three relationships simultaneously to reach a future cost of climate. They are
Finally, you use a discount rate to bring the cost to today.
Establishing the first one, between greenhouse gas (GHG) emissions and temperature, is climate scientists’ job. The second and third are economists’ forte. Uncertainties over the parameters require equations to be solved over a range of inputs, and the simulations (Monte Carlo of hundreds of thousands of realisations) result in distributions. If you are curious about how they look, check out the Interagency Working Group (IWG) on the Social Cost of Greenhouse Gases by the United States Government.
Reference
Carleton and Hsiang, Social and economic impacts of climate: Science
Technical Support Document: Social Cost of Carbon, Methane, and Nitrous Oxide Interim Estimates under Executive Order 13990: Interagency Working Group
You have seen the destroyed value if society lets the market operate at equilibrium (maintaining the status quo). The role of governments is to implement mechanisms to move the balance towards a value that reflects the cost of climate change. It could be efficiency mandates, taxes, incentives etc.
But those are solutions or policy decisions. The question we address today is how to calculate the social cost. An example of a metric is the monetary value of all the future damages incurred globally by one additional tonne of CO2 emitted. Based on this, a price per tonne of CO2 ejected today is established by applying a discount factor.
What is a discounting factor, and how much should it be? We have seen it before: it is a way of assessing the present value of a future amount of money.
Present value = Future Value x (1 + discount rate)number of years.
Ask this simple question: how much are you willing to pay for a $100 benefit 50 years from now? It depends on the discount rate used, and the following table provides how it changes.
Discount rate (%)
Future Benefit ($)
Price to Pay now ($)
7
100
3.4
5
100
8.7
3
100
23
2
100
37
1
100
61
So, at 7%, you are practically willing to pay nothing ($3.4). So you discounted the future so much as the value is so distant for you. At 2% or so, you are getting something that enables you to invest serious money.
Politics of emission
Although climate science and economic models do help the cause, at the end of the day, setting a carbon price is a political decision. An example is how the United States did the cost-benefit analysis and reached a monetary value for CO2 emissions.
In 2010 the Obama administration constituted an Interagency Working Group (IWG) of climate scientists and economists to calculate the social cost of carbon. Through its revisions in 2013 and 2016, the leadership has set a price of about $50/tonne of CO2. The subsequent Trump administration revised the value in 2018 to $7, which later changed back to 50 by Biden!
Trump administration managed a smaller number for the SCC by limiting themselves to the (cost of harm in) US, whereas every US tonne of CO2 costs 85% of damages abroad.
How scientists and economists could create a social cost is up next.
The economics of climate change is simple. Climate change is a cost that the firms and the consumers in the market aren’t willing to pay. Economists call this cost a negative externality.
We know from one of the earlier posts the existing Pareto equilibrium exists in the market. The players we considered, the companies and the buyers, do not like to pay the cost as they think it will make them worse off.
Here is the original Pareto efficient system that (only) takes care of the marginal cost to the company and the customer’s willingness to pay.
But this doesn’t care about the climate cost to society. It is the cost society must pay, but the supplier and the consumer do not. Had you included that, the actual cost curve would have been like this (red line), and consumption would have been lower, at Q* at a higher price, P*.
But that doesn’t happen, and consumption is higher at Q’. The triangle (red), formed below the social marginal cost curve bounded by the actual consumption and what it should have been, is the “destroyed value”.
How can society force the system to pay the price? That is next.
