Account for the cost of carbon emissions

Washington gridlock may be here to stay. But in a policy area where progress could and should be made–addressing the risks from harmful aviation emissions–our federal representatives are becoming irrelevant, if not outwardly hostile to meaningful solutions.

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Airplanes release carbon dioxide, and these carbon emissions pollute the atmosphere and exacerbate the impacts of climate change, threatening the planet and its majestic natural places.

The consequences of increased carbon pollution also affect our economy. An airplane’s carbon emissions meet the classic definition of an externality–the price that people and companies face for emitting these pollutants is substantially lower than the social cost imposed by the pollution. When this externality is not priced, individuals and companies are induced to pollute freely, forcing the costs of that pollution onto future generations.

We should price the risk created by carbon emissions appropriately, as the European Union proposes for the aviation sector. This can be done inexpensively. The International Air Transportation Association estimates that, on average, an airline ticket would only cost an additional $9-$19.

No one likes higher prices. But, as restaurant patrons expect that their bill will reflect the dining establishment’s food and operating costs, similarly, an airline’s ticket price should incorporate the total costs associated with travel, including the impact of carbon emissions. Quite simply, the impact of our actions on the future of the planet should be priced into the ticket. It creates the right expectations and the right incentives.

Recently, I joined five Nobel Prize winners and many of this country’s leading economists in sending a letter to President Obama to make this point. We have not received a response.

Meanwhile, the U.S. is leading a coalition of the unwilling–countries opposed to the EU plan–in instigating a trade war aimed at forcing the EU to back down, just to avoid accounting for the cost of carbon emissions. This is a mistake.

I’ve spent most of my career assessing and attempting to price risk. The EU proposal makes sense, and should be expanded globally.

The earth’s capacity to safely absorb greenhouse gas emissions is limited. This capacity is a scarce resource and if it is not priced, we will all continue to waste it.

Failing to price the environmental risks is the same kind of short-sighted thinking that got our country into the mortgage crisis – the systematic risk embedded in mortgages was not priced and so financial institutions let the risk pile up. Carbon pollution in the atmosphere is doing the same thing today, piling up because we are not pricing it appropriately.

The U.S. federal government’s Working Group on Social Cost of Carbon estimates that the expected discounted damage–the current value of the expected future impacts of the carbon emissions–is around $21 per ton of carbon dioxide. But these are just the expected damages; the price of carbon emissions should actually reflect a significant risk premium.

Climate change impacts represent a non-diversifiable risk, like nuclear war, global pandemics, and exposure to the equity market. Such risks should not be priced at the expected discounted damages, but rather require an additional risk premium that reflects the entire distribution of outcomes, in particular the unknowable potential for tail events representing extreme impacts on nature and on the livelihoods of future generations.

On average, the world today is actually subsidizing the production and consumption of fossil fuels at the rate of more than $10 per ton of carbon dioxide produced. Yes, governments are taxing us to pay for these subsidies.

The current policy is irrational. It selfishly pushes increased costs onto future generations while at the same time increasing their gamble with the earth’s environment.

We urgently need to institute policies that lead to one appropriate global carbon emissions price in all sectors. A great way to start would be for President Obama to support the EU’s attempt to show leadership in pricing the aviation sector’s greenhouse gas emissions, or at least not get in the way. It is embarrassing that the U.S. is not leading the discussion of global pricing of carbon emissions in the International Civil Aviation Organization, but rather attempting to intimidate the EU.

The aviation sector presents us with a rare opportunity to make global progress now, but, ultimately, the cost of carbon pollution needs to be built into all prices, not just airline prices.

In the meantime, the EU is giving flight to the concept of pricing climate risk appropriately. Instead of trying to tear up the runway, it would be wise for the U.S. to get in the co-pilot seat.

Dr. Litterman, a former assistant professor of economics at MIT, headed Goldman Sachs' risk department. He currently is a partner at Kepos Capital and serves on the board of World Wildlife Fund (WWF).