The Social Cost of Carbon: Pricing What Matters
When a power plant burns coal, it emits carbon dioxide that will warm the planet for centuries. But the plant operator doesn't pay for that warming—it's absorbed by society. This gap between the private cost (to the operator) and the social cost (to everyone) is the core problem climate economics tries to solve.
The Social Cost of Carbon, or SCC, is an attempt to put a dollar figure on the harm caused by one additional ton of CO2 emitted into the atmosphere today. It's not a market price you'll find on any exchange. Rather, it's an estimate—informed by scientific and economic models—of how much damage that ton will cause over time, discounted back to today's dollars.
The U.S. Environmental Protection Agency currently estimates the SCC at $190 per ton of CO2 (as of 2023, using a 2 percent discount rate). The Resources for the Future, a research organization, estimates roughly $185 per ton. But these aren't final numbers. The EPA projects the SCC will rise to $255 per ton by 2025 and potentially $370 per ton by 2050, reflecting both the accelerating damage from additional warming and our growing scientific understanding of climate risks.
How do economists calculate this? It's a four-step process. First, they use emissions scenarios to project how much CO2 will be in the atmosphere in future years. Second, they feed those emissions into integrated assessment models—academic tools with names like DICE, FUND, and PAGE—that translate atmospheric CO2 into temperature increases. Third, they estimate the economic damage from those temperature increases: lost agricultural productivity, increased flood and hurricane damage, health costs from heat stress, and more. Fourth, they discount all those future damages back to a present-day value, turning a harm in 2050 into a number we can compare against today's economic decisions.
But here's where it gets contentious. The SCC isn't just a scientific number—it's deeply shaped by one crucial choice: the discount rate.
Discount Rates: How We Value the Future
Imagine you're offered $100 today or $105 next year. Most people prefer the $100 today because you could invest it and earn interest. The rate of return you could earn is the "discount rate"—it reflects your preference for money now versus money later.
In climate economics, the discount rate determines how much we care about damages that will happen decades or centuries from now. A higher discount rate means future damages matter less in today's dollars. A lower discount rate means we weigh future harms more heavily.
This is where the Stern Review, published in 2007, and Nobel laureate William Nordhaus's work diverge dramatically. Stern, writing for the UK government, argued that climate damages are fundamentally different from ordinary investment decisions. Future generations can't negotiate with us or bet their money elsewhere. They simply inherit the world we leave them. On ethical grounds, Stern argued, we shouldn't dramatically discount their welfare. He used a discount rate near 1.4 percent, with a near-zero "pure time preference"—the pure assumption that a pound of suffering in 2070 matters almost as much as a pound of suffering today.
Nordhaus, by contrast, relies more heavily on market interest rates. Since real interest rates in the economy hover around 3-4 percent, he uses a discount rate in that range. His logic: if individuals and firms consistently borrow and lend at these rates, it reveals their revealed preferences for present versus future consumption.
The practical consequence is staggering. The 1.4 percentage-point difference between Stern's rate and Nordhaus's results in an SCC that's roughly ten times higher in Stern's framework. When you're analyzing policies that cost billions today but prevent damages in 2060, that difference determines whether the investment looks economical.
There's no purely technical answer here. The choice of discount rate is fundamentally ethical. It encodes a moral claim about how much we owe to future generations. Stern essentially argues we owe them a lot. Nordhaus argues markets have already revealed a lower obligation. Both are reasonable people; they simply disagree about intergenerational justice.
For practitioners, the lesson is clear: whenever you encounter an SCC estimate or a long-term climate cost-benefit analysis, ask about the discount rate. It's often the hidden hinge on which the entire analysis turns.
Externalities and Market Failures: The Price We Don't Pay
An externality occurs when one party's action imposes costs (or benefits) on others who didn't choose to bear those costs and are not compensated for them. Climate change is the externality of externalities: the burning of fossil fuels imposes costs on everyone downwind, everyone in flood zones, everyone whose agriculture depends on stable climate patterns, and everyone alive in future generations.
But climate externalities are just the beginning of the story. When coal plants burn, they release not just CO2 but also sulfur dioxide, nitrogen oxides, and particulates. These air pollutants cause respiratory disease, heart attacks, and premature death. In 2018, air pollution from fossil fuel combustion was linked to approximately 350,000 premature deaths in the United States alone. Conservative estimates put the annual health costs in the range of $886.5 billion—a figure that rivals the GDP of some nations, yet is almost entirely invisible to the investors and operators of fossil fuel infrastructure.
Similarly, between 2016 and 2020, extreme weather events in the United States caused approximately $606.9 billion in direct losses. Hurricanes, floods, droughts, and wildfires destroy homes, disrupt agriculture, disable infrastructure, and claim lives. The victims of these disasters bear the costs. The institutions that benefit from greenhouse gas emissions—power utilities, oil companies, manufacturers—do not. This is the fundamental market failure.
Why does this matter? Because markets work by aligning incentives. When you buy a good, you pay a price that, in a well-functioning market, reflects all the costs of producing it. That incentivizes efficiency. But when a ton of coal is sold at a price that only covers mining, transport, and combustion—while ignoring $190 to $370 in climate damages plus hundreds of dollars in health costs—the market price is divorced from the true economic cost. Too much coal gets burned. Too much carbon gets emitted. Resources get allocated inefficiently.
Solving this requires either putting a price on the externality (via carbon tax or cap-and-trade) or regulating it away entirely. Either way, the goal is the same: make the invisible visible, and force decision-makers to account for the full cost of their choices.
Carbon Pricing: Tax vs. Cap-and-Trade
Once we accept that carbon externalities exist and that markets need a correction, we face a design question: should we use a carbon tax or a cap-and-trade system? Both aim to reduce emissions, but they take different approaches.
A carbon tax is straightforward. Government sets a price per ton of CO2 and charges it whenever carbon-based fuels are extracted, imported, or burned. Firms and individuals face a predictable cost for emitting: $X per ton. They respond by either paying the tax (if emissions are cheap to reduce) or cutting emissions (if reduction is cheaper than the tax). The price is fixed; the quantity of emissions that results is uncertain.
The British Columbia carbon tax offers a real-world example. British Columbia implemented a $15 per ton carbon tax in 2008. Over time, it rose to $80 per ton in 2024. The results: fossil fuel consumption per capita fell 17.4 percent compared to the rest of Canada, while the provincial economy grew faster than the national average. On April 1, 2025, the provincial government eliminated the tax, but its decade-plus run showed that a tax can meaningfully change behavior without economic collapse.
Cap-and-trade works differently. Government sets a maximum quantity of emissions it will allow—the cap. It issues that many allowances (each one equal to one ton of CO2), and firms must hold an allowance for each ton they emit. Firms can trade allowances among themselves. This creates a market price for carbon, but it emerges from supply and demand, not from government decree. The quantity of emissions is fixed (at the cap); the price is uncertain.
The European Union Emissions Trading System, the world's largest carbon market, operates this way. In 2025, allowances were trading at EUR 60-80 per ton, with prices projected to reach EUR 149 per ton by 2030 as the cap tightens. The RGGI, a cap-and-trade system covering ten northeastern U.S. states, set its trigger price at $17.03 per allowance in 2025. Like the EU ETS, RGGI allows firms flexibility in how they achieve emissions reductions, while ensuring the aggregate target is met.
Which is better? It depends on your priorities. A tax is cleaner and more transparent; firms know the cost of their emissions and can plan accordingly. But it doesn't guarantee that a specific emissions target will be hit—if damages turn out worse than expected, you might want to cut deeper, but you'd have to raise the tax, and that takes political will. Cap-and-trade guarantees the quantity of emissions. But the price can spike unexpectedly, hurting firms and drawing political backlash. In practice, many economists favor a tax for its simplicity and certainty, but many policymakers prefer cap-and-trade because it feels less like an additional burden on industry.
What matters most is that one or the other exists. The difference between a $0 price for carbon and a $60-80 price is far larger than the difference between a tax and a cap.
Green Bonds and Blended Finance: Channeling Capital
If carbon pricing and regulation make clean energy economically competitive, who funds the transition? The capital markets have developed new instruments specifically for this purpose.
Green bonds are debt instruments issued by governments, corporations, and development banks to finance environmental projects. Instead of specifying where the money goes, a traditional bond just needs to find buyers willing to lend. A green bond explicitly commits to using proceeds for climate and environmental projects—renewable energy, energy efficiency, green building, ecosystem restoration, and similar. Investors who care about climate outcomes can direct their capital intentionally.
The green bond market has exploded. As of December 2024, cumulative issuance had reached €2.22 trillion, equivalent to approximately $2.6 trillion. In 2024 alone, $1.1 trillion in green bonds were issued, a 5 percent increase from the prior year. Green bonds now represent 60 percent of the entire sustainable bond market.
The market is guided by standards. The International Capital Market Association publishes Green Bond Principles. The Climate Bonds Initiative publishes a standard that helps issuers verify their claims. The European Union's Green Bond Standard ensures consistency and prevents greenwashing—the practice of falsely marketing a product as environmentally friendly.
But green bonds alone won't finance the transition. The clean energy sector in developing countries, for instance, faces high capital costs and political risk that private investors hesitate to bear. This is where blended finance comes in. Blended finance mixes concessional capital (from governments or philanthropies, willing to accept below-market returns or higher risk) with commercial capital (from investors seeking standard market returns). The concessional capital—often a small portion of the total—absorbs the first-loss risk, making the investment palatable to private markets. A solar project in rural Kenya might be financed with a $2 million grant from a development bank, a $5 million concessional loan willing to accept 2 percent returns, and a $10 million commercial loan expecting 8 percent returns. The combination attracts capital that wouldn't otherwise materialize.
For practitioners, the key insight is that capital markets have adapted. Climate projects are no longer exotic. Mainstream investors now have straightforward vehicles for directing capital to clean energy, and development institutions have tools to bring private investment to harder-to-reach markets.
Stranded Assets: The Risk Hiding in Plain Sight
One reason investors and policymakers should take climate economics seriously is this: climate policy, if implemented aggressively, will destroy the value of trillions of dollars in fossil fuel reserves.
Coal, oil, and gas reserves in the ground have value only if they can be extracted and burned. But if climate policy succeeds—if the world rapidly transitions to renewables and enforces a strict carbon budget—much of those reserves will never be burned. They'll become stranded assets, economically worthless.
Research by Carbon Tracker, a financial think tank, estimates that 60-80 percent of carbon reserves held by listed fossil fuel companies could become stranded under climate-aligned policies. The breakdown is stark: roughly 33-35 percent of oil reserves, 49-52 percent of natural gas reserves, and 82-88 percent of coal reserves could be left in the ground. For the oil and gas sector alone, this could strand approximately $1.4 trillion in upstream assets.
Why? The global carbon budget for a 50 percent chance of limiting warming to 1.5 degrees Celsius is approximately 300 billion tons of CO2 equivalent. Current global emissions are roughly 40 billion tons per year. Simple division suggests we can emit at current rates for only about 7-8 years before exhausting that budget. In reality, emissions will probably be higher in coming years, making the budget even tighter. That means fossil fuel infrastructure currently planned—pipelines, refineries, coal plants—will live shorter economic lives than historically expected. Some might be abandoned before they're even built.
For investors holding fossil fuel equities or bonds, this poses a portfolio risk that's quantifiable but often ignored. For fossil fuel companies, it creates pressure to downsize, shrink capital expenditure, or pivot to other energy sources. For banks financing fossil fuel projects, it creates credit risk: will the borrower be able to repay? For policymakers in coal, oil, and gas producing regions, it creates an urgent need to plan for economic transition.
Understanding stranded assets is not about ideology. It's about seeing where value is going in a carbon-constrained world.
Just Transition: Leaving No One Behind
Coal miners in Appalachia, oil workers in the Gulf Coast, auto workers in Detroit—these communities depend economically on fossil fuels. If climate policy shuts down their industries without alternative employment, the immediate human cost is devastating. This is the central challenge of just transition.
Just transition is both an ethical imperative and an economic insight. The ethical imperative is simple: communities shouldn't bear the costs of climate action if the benefits are shared globally. The economic insight is subtler: if workers and communities feel abandoned by climate policy, they'll resist it politically, stalling the transition globally. Justice and effectiveness align.
The International Labour Organization published guidelines for just transition in 2015, emphasizing decent work, social dialogue, and social protection. But what does this look like in practice?
Germany's coal phase-out offers the most developed example. Germany aims to eliminate coal entirely by 2038. The transition directly affects 32,800 workers in coal mining and fossil fuel power plants. To manage this, the government allocated €42.8 billion through 2038 to affected regions in structural support: retraining programs, new business development, infrastructure investment, and direct support for workers facing unemployment. Alongside the phase-out, Germany has aggressively promoted renewable energy, expecting approximately 230,000 new jobs in renewables by 2050, more than offsetting coal losses.
In the United States, the Inflation Reduction Act (2022) includes roughly $370 billion for clean energy transition investments. Critically, it includes prevailing wage requirements—paying workers union-scale wages on clean energy projects—and apprenticeship programs to build skilled workforces. It also grants up to five times the tax credit for qualifying clean energy projects in census tracts with coal plant closures, explicitly directing capital to fossil fuel communities.
The lesson is clear: transition without justice becomes transition that fails. Workers need alternative employment, retraining, and income support during the transition. Communities need economic diversification. If policymakers ignore this, they'll face political backlash that halts progress. If they invest in just transition, they build the political coalition necessary for rapid decarbonization.
Looking Ahead: The Role of Artificial Intelligence
Each of the concepts above—social cost of carbon, discount rates, externalities, carbon pricing, green bonds, stranded assets, and just transition—is being transformed by artificial intelligence.
The integrated assessment models used to calculate the SCC are computationally intensive, expensive to run, and slow to iterate. Machine learning models trained on climate simulations and economic data can approximate SCC estimates far faster and at much lower cost. This makes scenario analysis more feasible: policymakers can easily see how SCC changes with different climate assumptions, different damage functions, different discount rates. Better analysis leads to better policy.
The valuation of renewable energy and clean infrastructure projects requires forecasting long-term electricity prices, technology cost curves, and policy stability. AI models trained on historical data and real-time market signals can improve these forecasts, reducing the perceived riskiness of clean energy investment and lowering the cost of capital.
Carbon accounting is fragmentary and opaque. AI systems can integrate satellite imagery, sensor data, and financial records to create real-time, auditable carbon footprints across supply chains. This makes carbon pricing regimes more effective (by catching evasion) and green bonds more credible (by verifying environmental claims).
Just transition requires matching displaced workers to new opportunities, optimizing retraining investments, and predicting where industries will grow. AI systems can analyze labor market data, skill requirements, and regional economic trends to design more effective transition programs.
Stranded asset risk can be modeled more sophisticatedly by combining climate scenarios, policy trajectories, and financial data in machine learning frameworks. This helps both investors understand their exposure and policymakers anticipate the disruption from rapid transitions.
At Economics & AI for Earth, we believe the intersection of climate economics and AI is where transformative change happens. Better models lead to better prices. Better prices lead to better incentives. Better incentives lead to a sustainable world. Our mission is to help policymakers, investors, and founders understand these relationships and build the institutions needed to steer the economy toward sustainability.
Climate economics is not boring accounting. It's the study of how we value the future, allocate resources across generations, and navigate the largest collective action problem humanity has ever faced. Master these concepts, and you'll understand the economic logic of the transition to come.