Understanding carbon pricing trajectories

Jean-Baptiste Vaujour is a Professor of Practice at emlyon business school where he teaches about consulting and green finance. He is an energy economist and a registered expert at the EU Commission and for the World Energy Council. He has recently published a book on the decarbonisation of the economy.

 

Source: https://tradingeconomics.com/commodity/carbon

Carbon pricing has become a cornerstone of environmental policies around the world. According to the latest World Bank tally, 110 carbon pricing instruments have been implemented, covering 53 countries, either through taxes or carbon markets. According to theory, carbon prices provide a clear price signal to the actors of the economy and informs them of the environmental cost of their pollution. They then have a clear incentive to reduce their emissions if they wish to reduce the associated bottom-line impact. The central question in this framework is to determine what the optimal carbon price should be.

Pricing a commodity that does not exist

Cutting through the controversies, at the end of the day, providing a price to carbon is complex because without direct regulatory intervention, there would be no transaction. Atmospheric pollution is a negative externality of the growth process, i.e. it is not spontaneously reflected in transactions between parties since it is impossible to prevent people from using the atmosphere, which is a public good.

Public authorities have to come up with a system by which the externality will be reintegrated in the normal working of the economy. In a tax system, they will provide a clear price signal and collect direct revenues from all polluting actors. In a cap-and-trade system, polluting rights (“allowances”) will be provided to emitters, and they will be allowed to trade these rights in order to meet quotas that are defined on a case-by-case basis. Taxes allow for a control on the price of CO2, markets allow for a control on the quantities that are actually emitted.

Providing a perspective

Whichever system is chosen, it is however crucial that public authorities form a view on the actual value of carbon. This view is based on the Social Cost of Carbon (SCC) which monitors the cost of climate change for society as a whole. It can be broken down into two broad elements: the cost of climate change, destructions in the future, and the cost of transition, changes to the economic structure today and tomorrow. It therefore relies on hypothesis on technological change and transition pathways that can be followed and has to choose a discount rate. The discount rate is the rate that reflects the fact that economic consequences in the future do not have the same value as economic consequences today. There is a heavy academic debate on how this discount rate should be calculated which we will discuss in a further article.

What matters for our discussion in the present article is that the value of carbon cannot be understood as a static reference, i.e. it will change over time. This is the result of a conjunction of factors, out of which three play a major role :

1.       The technological, social and economic paradigm that prevails at the moment of the computation of the cost of carbon is perpetually changing. For example, a new battery technology might emerge that makes it simpler, more efficient and more affordable to store electricity on an industrial scale. This will provide downward pressure for the cost of carbon emissions as economic actors will rapidly adopt the technology and reduce their emissions, thus reducing the potential cost of environmental destructions.

2.       The cost of inaction. As governments and economies delay action on climate change, the quantity of GHG in the atmosphere increases, as well as the probability of catastrophic, systemic, irreversible damages. The presence of environmental tipping points, situations from which the Earth system cannot recover, induces a non-linear social cost curve: the more we wait, the more expensive mitigation and adaptation become.

3.    The difficulty to abate emissions coming from specific economic sectors has to be reflected in a price trajectory, otherwise they will never have an incentive to reduce their emissions. For example, industrial steel production requires a lot of heat to melt raw minerals and has historically relied on coal furnaces. Replacing these with electric ark furnaces or relying on hydrogen is extremely expensive as it relies on new, only partially tested technologies and requires significant investments to deploy at scale. Only an significantly high carbon price may provide enough economic incentives for steel markers to invest in such technologies. If the price remains at a “reasonable” price that reflects the supply-demand equilibrium for all economic sectors, there will not be enough time for such industries to change their practices. So policy makers have to either steadily increase tax levels or to reduce the amount of allowances they put on the market.

This results in carbon price trajectories that have to increase over time and that will also increase if we compute them at different periods (see table below from Christian Gollier, Du sang, des larmes et de la sueur : Les coûts de la transition énergétique, Collège de France, 2021).