The Rising Cost of Climate Change: Evidence from the Bond Market

Michael Bauer,Glenn D Rudebusch

doi:10.2139/ssrn.3649958

Michael Bauer, Glenn D Rudebusch

Open Access

https://doi.org/10.2139/ssrn.3649958

Copy DOI

Abstract

The level of the social discount rate (SDR) is a crucial factor for evaluating the costs of climate change. We demonstrate that the equilibrium or steady-state real interest rate is the fundamental anchor for market-based SDRs. Much recent research has pointed to a decrease in the equilibrium real interest rate since the 1990s. Using new estimates of this decline, we document a pronounced downward shift in the entire term structure of SDRs in recent decades. This lower new normal for interest rates and SDRs has substantially boosted the estimated economic loss from climate change and the social cost of carbon.

Highlights

When economic costs and benefits are distributed over time, they must be discounted to produce comparable present values that can be assessed on an equal footing
Our results provide support for lowering the discount rate used in the United States to calculate the social cost of carbon described in Interagency Working Group (IWG)-SCC
This paper has argued that the decline in the equilibrium real interest rate over the past three decades has important consequences for the economics of climate change

Summary

Introduction

When economic costs and benefits are distributed over time, they must be discounted to produce comparable present values that can be assessed on an equal footing. We determine how much the downward shift in the term structure of SDRs increases the social cost of carbon (SCC), which is the present value of all future damages from a marginal increase in carbon emissions.1 For this calculation, we use damage estimates from two new versions of the classic DICE model that was originally developed by William Nordhaus (Nordhaus, 2017). Across various empirical real interest specifications coupled with two alternative climate-economy models that capture the economic damages from greenhouse gas emissions, we estimate that the decline in rt∗ and resulting downward shift in SDRs since the 1990s has caused the SCC to at least double in size. Our empirical results are more closely aligned with previous prescriptive discount rates, as in Stern (2007), which support stronger efforts toward climate change mitigation

The role of the equilibrium real rate in discounting

Estimates of the term structure of SDRs

Findings

Conclusion