Explore this article and audio – a glimpse into FORESIGHT's depth

Join our global community of experts, contribute your insights in commentary and debate, and elevate your thought leadership. Get noticed, add value – be part of FORESIGHT's engaging discourse. Join us today.

Not a silver bullet

Carbon prices at sufficiently high levels can push firms to internalise the costs of greenhouse gas emissions while providing a long-term price signal to drive investments needed for decarbonisation. Emission trading systems and carbon taxes feature in a growing number of climate strategies, but even the most well-designed instruments must be accompanied by other policy measures if emissions reductions goals are to be reached

A number of international markets are introducing carbon markets at different price levels to help reduce emissions


PRICE POINT
Many market analysts predict carbon prices of over $100 per tonne across most markets in the near future TOUGH QUESTIONS
Businesses are being asked how they will adapt operations to deal with the growing carbon prices KEY QUOTE
A clear price signal provides companies and investors with greater certainty regarding future price levels for efficient capital allocation


The price for emission allowances on the European Union’s Emission Trading System (ETS) approached €100 per metric tonne of CO2 in both February and August 2022, the highest level since the market’s establishment in 2005 and well above the €8/tonne level they had traded at as 2018 began.

Market gains for the EU ETS over the last four years have accompanied measures to tighten up the rules of the trading platform and more ambitious EU policy measures, notably the 2021 Fit for 55” package aimed at reducing the bloc’s emissions by 55% in 2030 compared to their 1990 level, up from the previous target of a 40% emission cut.

Economists like the idea of putting a price on greenhouse gas emissions, arguing that it is a cost-effective lever for meeting emission reduction goals. The principle is that the polluter pays”, internalising social, environmental and economic costs of global warming that previously were borne by society at large. This in turn should provide an incentive for emissions abatement and investments in lower carbon alternatives.

The EU ETS is a cap-and-trade scheme, where a cap is placed on greenhouse gas emissions of participating sectors that is tightened over time so that total emissions fall.Market participants—which currently include power utilities, industrial facilities and the intra-European flights of airlines—buy or receive allowances. Low emitters can sell their allowances on the market to those who pollute too much, encouraging the most cost-effective decarbonisation to proceed first.

We see the ETS as the cornerstone of EU climate policy and the key tool to reach the emission reduction objectives of 2030 and beyond,” says Marion Labatut of French energy group EDF.

EXPANDING TOOL

While the EU ETS was the first international trading emission scheme and is also the largest in terms of trading volumes, the bloc is far from alone in using carbon pricing.

As of April 2022, there were 68 carbon pricing instruments globally and three more scheduled for implementation, including 37 carbon taxes and 34 emission trading systems, figures from the World Bank show.

Following the establishment of a national ETS covering electricity generators in 2021 in China, the world’s largest emitter, carbon pricing mechanisms now cover about 23% of global emissions. In the United States, the world’s second-largest emitter, plans for carbon pricing at the national level have gone nowhere, but there are state-wide and regional initiatives.

TAXES VS TRADING

ETS mechanisms come with the advantage that a trajectory can be set for emissions reductions although there is more uncertainty on price levels. Carbon taxes have the benefit of price certainty and are more straightforward to implement, but new taxes can be unpopular or difficult to put in place.

In 1991, Sweden became one of the first countries to implement a carbon tax, initially setting a rate of SEK 250 per tonne of CO2 emitted and gradually increasing it to SEK 1200 per tonne in 2022. According to the Swedish government, By increasing the tax level gradually and in a stepwise manner, households and businesses have been given time to adapt, which has improved the political feasibility of tax increases.”

Canada has also taken a stepwise approach to a federal carbon tax, which is set now at C$50/tonne and is scheduled to rise to C$170/tonne in 2030.

Pricey carbon Heavy industries are encouraged to reduce their emissions through the introduction of carbon taxes


THE PRICE OF CARBON

The High-Level Commission on Carbon Prices identified a $50-100/tonne range as the price needed by 2030 to keep global warming below 2°C—the upper end of the limit agreed in the 2015 Paris Agreement on climate change. Yet, the World Bank notes that less than 4% of global emissions in 2022 are covered by a direct carbon price at or above this range.

After years of low prices, emissions allowances on the EU ETS have changed hands at a price over €80/tonne for much of the year, while S&P Global expects allowance prices to exceed €100/tonne from 2025 as the bloc accelerates with its net zero goals.

More ambitious targets may require higher carbon prices. Simon Dietz from the London School of Economics and other researchers found in a 2018 study that limiting the global temperature rise to 1.5°C by 2030 could require a median price of $145/tonne in 2005-dollar prices. That would be equivalent to about $220/tonne today.

Edward Baker of Principles for Responsible Investment (PRI), a United Nations-supported network of financial institutions, points out that the height of carbon prices will also depend on the chosen decarbonisation pathway. If the focus is on renewable energy, prices needed are likely to be a lot lower” but countries looking to maintain a more sizeable role for oil & gas and carbon capture and storage (CCS) could require significantly higher prices, he says.

THE PRICE IS RIGHT

Getting the carbon price right can be complicated. While low prices can reduce the effectiveness of carbon pricing instruments, prices considered excessive are also problematic, particularly at times when households and businesses are already worried about high energy bills.

The Net Zero Asset Owners Alliance (NZAO), composed of 73 institutional investors with combined assets of $10.6 trillion looking to decarbonise their portfolios by 2050, recently laid out a vision for how carbon pricing should be overhauled. Its roadmap includes expanding carbon pricing and raising the long-term price signal on existing markets but also stresses the importance of predictable increases in prices, noting that rapid increases in carbon prices could erode political support.

A clear price signal provides companies and investors with greater certainty regarding future price levels for efficient capital allocation,” the NZAO says. It also creates stable and reliable incentives for investors, companies and consumers to adopt or develop low or zero-emission technologies or practices.”

In emission trading markets, where the intersection of supply and demand sets the price, policymakers can help provide predictability by setting price floors and ceilings that increase gradually over time.

CREDIBILE THREAT

Patrick Bayer from the Centre for Energy Policy at the University of Strathclyde believes that the higher prices now seen on the EU ETS will lead to an increase in sustainable investments, but notes that even low carbon prices can lead to emissions reductions and encourage greener” investments if there is a credible regulatory system in place.

In a 2020 study, Bayer and Michaël Aklin of the University of Pittsburgh foundthat sectors covered by the EU ETS emitted 11.5% fewer emissions between 2008 and 2016 than they would have in a world without ETS, even though prices at the time were low. If you have certainty that carbon pricing will continue then it might make sense to invest today instead of waiting before prices rise €150 a tonne,” adds Bayer.

INVESTMENT DRIVER

Drawing a direct connection between carbon pricing and specific investments can be complicated, although there is some evidence it drives some investment activity.

One 2016 study showed that patents in sectors covered by the EU ETS were up to 10% higher than those in other sectors. A 2018 survey of Chinese businesses showed that 75% expected the ETS would affect investment decisions.

The environmental think tank E3G and the Jacques Delors Institute found that the EU ETS has driven some incremental clean innovation investments that were already close to the market, accelerating a shift away from some technologies in the power sector set into motion by other measures, like support for renewable energy.

THE FRUITS OF CARBON

Carbon taxes and emissions trading are also a source of government revenue, which can be funnelled back into investments in innovation needed for decarbonisation and to address distributional and social issues associated with putting a price on carbon.

Carbon pricing revenues in 2021 rose to $84 billion, about 60% higher than the year earlier, according to the World Bank figures, with revenues from ETS mechanisms surpassing that of carbon taxes for the first time.

An ETS set to be deployed in the state of Washington in the US in 2023 is billing itself as a cap-and-invest” system, as proceeds from emission allowance auctions will be earmarked for investments in climate resiliency programmes, clean transport and addressing health disparities. California claims to invest billions of dollars in emission reduction projects with funds from its ETS.

CARBON CLUBS

Carbon leakage occurs when firms relocate to countries with less strict emissions constraints and lower compliance costs, which could lead to an increase in total emissions.

To address the risk of carbon leakage, the European Commission has provided a higher share of free allowances for companies in high-emission, trade-exposed sectors. This, however, has dampened the price signals on the ETS.

To pave the way for the phase-out of free allowances, avoid carbon leakage and ensure a level playing field for its companies, the EU is planning to put in place a Carbon Border Adjustment Mechanism (CBAM).

Initially, imports into the EU in five sectors—iron and steel, aluminium, fertilisers, cement and electricity—would have to comply with reporting requirements on emissions. Starting in the latter half of the decade, goods imported from countries outside of the EU ETS would have to pay a levy at the border based on embedded emissions. Goods from those countries with their own direct carbon pricing system would receive a rebate equal to the carbon price already paid in the country of origin.

The response of trade partners has been mixed, with Brazil, China, South Africa and India calling it discriminatory and some observers calling for a more collaborative approach. The new mechanism would also need to be compliant with World Trade Organisation (WTO) rules.

Frans Timmermans of the European Commission has expressed confidence that a growing number of countries will take comparable measures to decarbonise their economies, Which would make the introduction of CBAM not necessary, or only in a very limited way.”

Japan and Canada are also considering CBAMs, while California already has an adjustment mechanism for electricity imported into the state. These border adjustment mechanisms flow from the idea that if we have clubs, then everyone else will have no choice but to flock to them,” says Lee Beck of the Clean Air Task Force (CATF), a US-based non-profit. But in reality, decarbonisation is driven by regional and local political economies.”

COSTS AND BENEFITS

Governments are not the only ones seeking to put a price on the cost of greenhouse gas emissions. A growing number of companies and financial institutions are also looking to incorporate carbon costs in investment decisions.

The European Investment Bank (EIB) uses a shadow carbon cost as part of the cost-benefit analysis made when it assesses whether to provide financial support to projects. The EIBs shadow carbon cost now stands at €120/tonne and is seen growing to €250/tonne in 2030 and €800/tonne in 2050.

The figure reflects modelling of the level CO2 prices would need to reach to limit the global temperature rise to 1.5°C if governments gave themselves only one instrument to achieve that, explains Edward Calthrop of the EIB.

Calthrop notes that governments actually pursue a variety of policies. Some countries participating in the EU ETS also apply carbon taxes while there are also costs associated with implementing the EUs Renewable Energy Directive and Energy Efficiency Directive, for instance.

WAKING UP

[Companies] have had to wake up to the long-term trend of carbon pricing,” Calthrop adds, which wasn’t being taken seriously when prices on the EU ETS were hovering below €10/tonne.

Companies are also increasingly being asked by investors to explain how they will continue to do business with a high carbon price. There was a time when there was a very focused discussion around oil and gas majors and coal-fired plants and now this has extended to high-emission industry and the agricultural space,” Calthrop says.

It may be difficult for companies in hard-to-abate sectors like cement or steelmaking to present credible decarbonisation strategies, which depend largely on factors such as technological and process innovation, green hydrogen and carbon capture and storage (CCS), he notes.

CARBON CONTRACTS FOR DIFFERENCE

While prices on the EU ETS have increased significantly over the last few years, they may still not be sufficient to spur sufficient investments in emerging technologies like green hydrogen and CCS.

The European Commission has announced plans for the rollout of carbon contracts for difference using cash from its Innovation Fund to support green hydrogen use in industry, like the contracts for difference successfully used for renewable energy. In this case, if the emission allowance price falls below an agreed strike price, the government would top up the difference. Should it go above the price, the recipient of the contract would have to pay the difference back.

The concept of a carbon contract for difference was applied in the SDE++ auction in the Netherlands in 2021 to the Porthos project to capture CO2 from industries present at the Rotterdam port and transport it via pipeline for storage in empty gas fields. The Dutch government has earmarked €2.2 billion to bridge the gap between ETS costs and the total investment cost for capturing, transporting and sequestering CO2 and expects to be receiving payments when ETS prices increase in the future.

JUST TRANSITION

The EU is looking to extend emission trading to the buildings and transport sectors with the creation of a separate emissions trading system focused on companies that supply heating and road transport fuels.

There are concerns, however, that the extra cost could just be transferred to consumers. Low-income households, which spend a higher percentage of their income on energy and have less money to invest in energy efficiency, would be hurt most.

With carbon pricing, the main element in ensuring equity is to, Make sure revenues are redistributed to the ones that need them the most, the most vulnerable households and enterprises,” says Pauline Mathieu of EDF.

Mindful of the potential social impact of carbon pricing, the European Commission plans to use some of the funds from the new ETS to set up a Social Climate Fund to finance short-term direct support to vulnerable households and investments in road transport and buildings, principally to benefit vulnerable households, micro-enterprises and transport users.

In Canada, most proceeds from the federal carbon tax are returned to families in their tax returns through what are known as Climate Action Incentive payments.

NO SILVER BULLET

Carbon pricing alone won’t get us to where we need to go in some sectors,” notes Labatut of EDF. A case in point is transportation, where a high carbon price is unlikely to lead to the necessary rollout of charging infrastructure for electric vehicles, she says.

The European Alliance to Save Energy, a business-led alliance to promote energy efficiency, has stressed that, Carbon pricing in the building sector can only work effectively and efficiently as part of a well-designed broader policy mix.” Even if a fuel switch is achieved, carbon prices are expected to have a limited impact on renovations, it says.

The World Bank argues that carbon pricing should be implemented as part of a policy toolbox that includes public investments in infrastructure, technology and innovation and regulations like building standards.

According to the High-Level Commission on Carbon Prices, Carbon pricing by itself may not be able to induce a transition at the pace and on the scale required for the Paris target of well below 2°C” without unacceptable costs and distributional impacts. It is theoretically both unsound and impracticable to rely on carbon pricing only.” •


TEXT Heather O’Brian PHOTO Parrish Freeman