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The true cost of carbon

A global carbon price may have been more than the Paris Agreement could provide, but the collective commitment to limit planetary warming is generating momentum for unilateral pricing systems. When China launches its national emissions trading scheme (ETS) later this year, 40% of total global emissions will be covered by carbon markets, the European Union ETS having been operational since 2005.

Schemes like those in China and the EU, also known as cap and trade systems, cap the total level of greenhouse gas (GHG) emissions based on an emissions reduction target. The cap is lowered over time and companies are allowed a decreasing number of emissions permits (allowances), with the option to sell extra allowances to larger emitters. This creates supply and demand for allowances, establishing a market price for emissions.

The other main form of carbon pricing is a carbon tax, which had a short-lived trial in Australia between 2012 and 2014. Without a predetermined emissions reduction, a carbon tax sets a direct price on carbon by fixing a tax rate on GHG emissions, or on the carbon content of fossil fuels.
The concept of internal carbon pricing is also gaining traction. Of the more than 5,700 companies who disclosed to the CDP in 2016, one quarter reported that they currently practice pricing of carbon emissions, or will begin doing so in the next two years. This includes multinational giants like Microsoft, the Tata Group and Rio Tinto, and in Australia, Qantas, Origin Energy and Woolworths.

Some companies, like Microsoft, price carbon through an internal carbon fee program, which operates like an ETS for business units. Others, such as Rio Tinto, adopt shadow price assumptions for use in decision-making, in anticipation of explicit or implicit pricing by government.

So far, so good for the low carbon trajectory.

However, while there is international consensus on the importance of carbon pricing for accelerating the shift away from fossil fuels, the cost of carbon is something of a slippery concept.

In the US, for example, internal company prices range from less than USD $1 to as much as $150 per tonne1. Within the EU ETS, the forecasted cost of allowances for 2017 is 5.25 euros (USD $5.75), and the anticipated starting prices of allowances in the Chinese ETS will be 30 yuan (USD $4.34).

So what should the carbon price be?

A central concept in the economics of climate change is the social cost of carbon (SCC), an estimate of the monetised damage caused by a one tonne increase in GHG emissions in a given year.
Finding this number is a complex task, involving an understanding of the effect of emissions on global temperatures, the effect of temperature change on social, economic and environmental factors, and the intergenerational interests at play.

In 2015, the SCC was set by the US Interagency Working Group at a central estimate of $37 in 2007 USD ($40 in today’s value), and projected at around $70 by 2050. US federal agencies were to use the SCC to evaluate the benefits of emissions regulations, efficiency standards, technology subsidies and other mitigation policies.

Critics suggest that the 2015 price should have been closer to $220. The modelling tools that produced the lower price have been criticised for making simplifying assumptions that do not account for the possibility that climate change may affect the basic growth rate of the economy.

This is significant because if climate change affects not only economic output but also growth, as some economists argue, the cumulative effect will lead to a higher SCC. A higher cost carries much greater weight in the argument for mitigation when reduced to a cost/benefit analysis. At the same time, of course, mitigation efforts may also impact economic growth, but the risk of climate change-associated damage looms greater.

In March 2017, US President Donald Trump signed an executive order to disband the Interagency Working Group, sending federal agencies back to 2003 guidance on regulatory impact analysis.

On the other side of the political spectrum, the World Bank’s Carbon Pricing Leadership Coalition, formed in 2014, unites government, the private sector and civil society to promote the pricing of carbon. It’s High-Level Commission on Carbon Prices was established to identify indicative corridors of carbon prices, and consider the social cost of carbon.ety in the project of expanding the use of carbon pricing.

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