The Price of Carbon

“Carbon pricing is an invaluable tool for redirecting investments and transforming markets to build low-carbon, climate-resilient economies that will drive prosperity, strengthen security and improve the health and well-being of billions of people […]”.

The United Nations Secretary-General Ban Ki-Moon stated the previous sentence on the 21st of April, supporting the action of several national and sub-national leaders, World Bank Group, The International Monetary Fund and the OECD heads, regarding the expansion of carbon pricing policies.

There are a few issues concerning the pricing of carbon that are important to understand, like how it is estimated and implemented and which are the macroeconomic results gained so far. Let’s start with a brief presentation of the more recent events linked to the carbon pricing topics.

On the 30th of November 2015 the United Nations Climate Change Conference, also known as COP 21 (Conference of the Parties), took place in Paris with 195 countries participating in it. The outcome of this conference was a twelve-page text, made up of 29 articles, and its main aim was to limit the arise of temperature to below 2°C. During the COP 21 the Carbon Pricing Leadership Coalition officially started, it is a voluntary partnership of national and sub-national governments, firms and non- profit organizations with the goal of applying a carbon-pricing agenda throughout the global economy. More specifically, the aims of this coalition are to introduce carbon pricing policies in governments which are not still applying them, to strengthen the development of existing carbon pricing policies and to increase cooperation and information sharing. More recently, on the 21st of April in a press conference the main leaders of the Carbon Pricing Panel, a narrower group inside the CP Leadership Coalition, made up of governments, private and institutional leaders, challenged the world to expand carbon pricing policies and to cover the 25% of global emissions with them by 2020, and the 50% by 2030.

Plainly speaking, carbon pricing policies can be summarised by the sentence “put a price on carbon”. But how is it possible to estimate a price for carbon emissions? Clearly, it is not that easy.

The first step that governments have to undertake is to capture the amount of what are known as the external costs of carbon emissions. These are costs that people living in a country pay in an indirect way, as negative externalities. However, this task is probably the hardest one, mainly because of two issues. First, the features of climate change, namely both its forward dynamics and its human and natural components, are complex to understand and consequently to estimate. Second, any evaluation regarding climate change requires value judgments about temporal and spatial impacts. Despite the difficulties, the Social Cost of Carbon (SCC) has been estimated by economists through Integrated Assessment Models. These models enables to estimate the cost of the impact that carbon emissions have on the quality of life in terms of dollars, using the best available science and economic knowledge. The most used models are the DICE model by William Nordhaus, the FUND model by Richard Tol and the PAGE model by Chris Hope.

The graph above shows an increasing relationship, which is slightly different among the three models, between the rising of temperatures and the variable “Loss”, intended as the ratio between global damages on the quality of life and the global level of GDP. It’s worth to note that both in 2010 and in 2013 the Obama administration created the Interagency Working Group (IWG) on the SCC. In order to estimate SCC in the US, the IWG used DICE, FUND and PAGE models and it computed a central estimate, around 40$ for a unit of emissions in 2015 with a 3% discount rate, a minimum estimate, around 11$ for one unit with a 5% discount rate, and a maximum estimate, around 57$ for one unit with a 2,5% discount rate. However, the last evaluation of the Intergovernmental Panel on Climate Change noticed that the current estimate for the SCC may omit several impacts that would probably increase the damage level (i.e. intensify the increasing relationship shown above).

Once a government has obtained an estimate, the second step of carbon pricing policies is to apply it to its economy. The main forms of carbon pricing are two: emissions trading systems (ETS) and carbon taxes. ETS assign a specific amount of greenhouse gas emissions to industries in a specific sector, binding them not to go above their assigned level. However, it is possible for industries to sell unused amounts to other industries willing to pay, creating a true demand and supply mechanism. The first and the biggest ETS implemented so far is the one of the EU, introduced back in 2005. It covers more than 11000 power stations and industries in the EU countries. A peculiar feature of this ETS is that the level assigned to companies and factories decreases over time, in order to reduce the total amount of emissions. In 2009 an important revision of the EU’s ETS has occurred, regarding changes such as applying a single EU-wide level, instead of national levels, including more sectors and gases and using auctioning as method for assigning limits, that substitute free allocation. Alternatively, a carbon tax is a more direct instrument, which assignes a tax rate on greenhouse gas emissions. These methods of pricing carbon are not unique. For example, removing subsidies for using fossil fuels and introducing regulation policies that take into account the SCC may be accurate as well. Still, the ETS and carbon taxes are more efficient and more direct in facing the issue.

Finally, what is the current situation of carbon pricing policies? Are there any benefits in applying them?

The graph above summarizes the implemented and the scheduled carbon pricing policies (with carbon taxes and ETS). It regards 40 national and 20 sub-national governments. Let’s consider several examples. China started ETS in seven provinces in 2013/2014 and plans to extend them to a national level in 2016. Mexico started a carbon tax in 2014 and has a voluntary carbon market. South Korea launched an ETS in 2015, one of the biggest of the world. California and Quebec both started an ETS in 2013 and linked their systems in 2014. Two among the several cases of carbon pricing policies’ benefits are worth to speak of. The Canadian province of British Columbia has been using a carbon tax, 30$ a ton, for seven years so far, covering 72% of carbon emissions. The revenues of the carbon tax, around 6 billion$, have been invested in tax cuts or subsidies for low-income households and small businesses, which produced a strong increase in the job occupation rate of the province and the possibility of free tax situation for citizens belonging to the lowest tier in the income chart. However, the most interesting case regarding carbon pricing is the one of Sweden. The North-European country introduced the first carbon tax in the 1991. It has increased from 29€ to 125€ nowadays and it is coordinated with the EU ETS. As stated by Magdalena Andersson, the current Minister of Finance, and Isabella Lövin, Minister for International Development Cooperation, “With the highest level of CO2 tax worldwide, Sweden provides strong evidence that decoupling GDP growth from CO2 emissions is possible […]. Noteworthy is also that this decoupling has been absolute, i.e. the emissions have decreased in absolute terms at the same time as GDP has increased […].”. The outstanding results of this carbon pricing policy are shown in the graph below.

The trend of the global economy towards carbon pricing policies seems clear, with a constant increase in their implementation and development, with national, sub-national and international institutions coordinating and helping each other. It appears that in the next few years we will assign a precise value to “the price of carbon”.

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