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Option Value and the Social Cost of Carbon

What Are We Waiting For?

Scientists and economists have long recognized that significant uncertainties and irreversibility characterize climate change. And yet, the social cost of carbon (SCC), the preeminent policy tool to address climate change applied by the U.S. government, does not include the option value (OV) that arises due to these characteristics. We demonstrate a simple methodology for approximating the OV underlying the SCC using the Bachelier formula.

Applying this methodology to the official U.S. SCC estimates, we find that these estimates increase by 71% to 81% depending on the discount rate. Conducting a sensitivity analysis, we find that OV increases the more thorough the explicit representation of uncertainty in the underlying climate-economic model. Given the large magnitude of OV, we believe that official U.S. SCC estimates and the next generation of climate-economic models must account for OV. As these newer models promise to more fully represent uncertainty, OV will increase in importance in the future along with its relative value.