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OVERVIEW | The elusive but all-important price of carbon

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The Elusive but All-important Price of Carbon


On 30/11/2015, the 21st session of the Conference of Parties (COP21) of the United Nations Convention to Combat Climate Change (UNFCCC) will begin in Paris with high expectations. Within this context, the financial price assigned to CO2 emissions is of the utmost importance, as it is a determining factor in deciding which mitigation and adaptation measures are worth taking. The article looks at the various approaches for setting a carbon price, its significant variation around the world, and the prospects for a unified framework.


As 30th November looms closer and the world gears up for a seminal meeting of the COP to agree on a universally acceptable plan to address climate change, the fundamental issue of the price of carbon remains unresolved. Uncertainty surrounds not only its numerical value, but also its definition and the methodology used to calculate it. By now there is near-universal acceptance that climate change is anthropogenic in origin, albeit with the ‘extremely likely’ attribution to human influence that is indicated in the Fifth Assessment Report (AR5).


The price of carbon is a direct quantitative means of internalising, in economic terms, the external costs of climate change impacts. How that would be done and who would bear the cost remains to be decided. Given the acceptance of both the causes of climate change and the necessity to mitigate, there is no doubt that existing tools at our disposal, namely the Emissions Trading Schemes (ETS) and carbon taxes, or combinations thereof, will continue to expand both geographically and across sectors.


When discussing the carbon price one should keep in mind that there are at least 5 different definitions, namely:

  1. The price of an allowance in an ETS, such as the European Union Allowances (EUA) in the EU ETS, whereby one EUA represents the right to emit one tonne of CO2.
  2. The amount of the carbon tax.
  3. The so-called effective (or notional) cost of carbon, i.e. the cost to be incurred by an entity in meeting carbon control policies which may include renewable obligations, energy efficiency measures, etc.
  4. The marginal abatement cost of carbon, i.e. the effective cost of the cheapest measure that achieves a given reduction of emissions, usually determined via a ‘cost curve’ of all measures considered. A related but different cost is the average policy cost, which is the cost per unit of all measures needed to reach the specified reduction.
  5. The social cost of carbon, i.e. the marginal cost incurred by society by the emission of an additional tonne of CO2. An estimate of this cost is contained in the internal carbon price published by the US government which has become the object of intense political debate.

An advance press release of the 2015 Carbon Pricing Watch of the World Bank provides a clear picture of the progress in setting a price for carbon. The various ETS and carbon tax regimes worldwide already cover over 11% of global emissions, and represent almost 50 billion USD in value (34 billion USD in ETS allowances and 14 billion USD in carbon taxes) with 42 countries involved, some of which (USA, China, Canada) have multiple schemes. In Europe alone, 11 EU Member States plus Switzerland, Norway and Iceland have both ETS and carbon tax schemes in place.


The price of carbon found in the various ETS and carbon tax regimes varies substantially. This can be explained by the high volatility over time in the EU ETS allowance price (from a peak of around 35 Euros per tonne of CO2 in 2006, to less than 3 Euros in 2013), the spread5 of carbon taxes from less than one US Dollar per tonne of CO2 in Poland to 130 USD in Sweden, and the differences in prices of recently established ETSs. For example, 6 USD per tonne of CO2 in the US RGGI ETS, 8 USD for the Beijing ETS, 9 USD for the Swiss ETS and 13 USD for the California ETS (all prices in late March 2015).


As governments contemplate measures to reduce emissions and adapt to climate impacts, the private sector (which would be called upon to implement these measures) is recognising the importance of the carbon price in the preparation of future business plans. Thus, in recent months, private enterprises have become more vocal in affirming their support for its effectiveness and many have been calling for the establishment, in the forthcoming negotiations, of “clear, stable, long-term, ambitious policy frameworks” to “reduce uncertainty and help stimulate investments in the right low carbon technologies and the right resources at the right pace”. See, for example, the 29th May 2015 letter from 6 CEOs of the largest energy companies to Laurent Fabius, President of the Paris COP and Cristiana Figueres, Executive Secretary of the UNFCCC, as well as the 74 countries and 1000 businesses that signed the “We support putting a price on carbon” statement at the UN Secretary-General’s Climate Summit in 2014. Such a framework would entail the expansion of carbon pricing schemes across the globe, by first establishing such schemes where none exist, and then linking them all together.


It should be pointed out that private enterprises have already taken matters into their own hands and have used ‘corporate’ carbon prices for their own internal purposes, with varying values in view of their sector exposure, ranging from a few US Dollars to over 100 USD per tonne of CO2. This is demonstrated in a December 2013 article in The Economist, titled Some firms are preparing for a carbon price that would make a big difference” based on a Carbon Disclosure Project study.


The Economist: Some firms are preparing for a carbon price that would make a big difference


The linking of the various ETSs is not an easy task. The many difficulties have been analysed in a large number of studies and were also the subject of an inquiry by the UK House of Commons in 2014. Aspects requiring harmonisation include the level of ambition, enforcement rules, cost containment arrangements, methods of allocation, specification of emissions, sector coverage, offset eligibility criteria, absolute vs. intensity allocations, banking rules, and length and timing of trading periods. Competitiveness issues in view of the differences in the economies of countries as well as income distribution issues will also have to be resolved, with national political considerations presenting formidable barriers. Optimistic estimates, such as the one by Promethium Carbon, do not envision the realisation of a global ETS before 2025 at the earliest.


The evolution of the future price of carbon also needs to be discussed if it is to become a truly effective tool to reduce emissions, generate financial resources for mitigation and adaptation actions, and guide the private sector’s efficient planning in view of the long life cycle of many investments that aim towards a low carbon economy. Policy makers will clearly be called to prepare to make adjustments (see for example the recently enacted Market Stability Reserve fix for the EU ETS) taking into account social and economic conditions, technology advances and national circumstances.


It should be noted that the European Commission expects the EU ETS allowances price to reach between 20 and 40 Euros by 2030, in view of its adopted target of a 40% reduction in greenhouse gases. Similarly, the UK Committee on Climate Change estimates that the price should be GBP 20 by 2020, increasing to GBP 70 by 2030 to achieve the UK's emission reduction target. On the other side of the Atlantic some forecasts indicate prices around USD 15-25 in 2020 and USD 25-45 by 2030, with the large variations explained by pending or planned policy implementation. A common feature of all forecasts is that the price will increase, and if intergenerational equality is assumed, the growth rate would be of the order of 3 to 5% in real terms per year.


Much depends on what is decided in Paris in December, in particular regarding the introduction of carbon pricing schemes worldwide, and the creation of a framework for merging existing schemes.


The global warming even exceeds 2 degrees advertised. It is necessary that all states of the world make efforts to reduce CO2 emissions and one of the solutions is to introduce the green background and an international carbon tax.