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

Michael D. Bauer,Glenn D. Rudebusch

doi:10.1162/rest_a_01109

Abstract

Abstract Social discount rates (SDRs) are crucial for evaluating the costs of climate change. We show that the fundamental anchor for market-based SDRs is the equilibrium or steady-state real interest rate. Empirical interest rate models that allow for shifts in this equilibrium real rate find that it has declined notably since the 1990s, and this decline implies that the entire term structure of SDRs has shifted lower as well. Accounting for this new normal of persistently lower interest rates substantially boosts estimates of the social cost of carbon and supports a climate policy with stronger carbon mitigation strategies.

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