Commodities | ESG & Climate Change | US
One of the Biden administration’s first moves was to rejoin the Paris Climate Accord. The scientific community believes limiting net new carbon emissions in coming years is critical to capping the rise in global average temperatures from pre-industrial levels at 1.5°C. The expert consensus suggests this will require major countries to lower the net increase in carbon (CO2) emissions (the main form of greenhouse gases, GHG) steadily to zero by 2050 (Chart 1). ‘Net zero’ does not mean that all CO2-producing activity stops by 2050. Rather, it means that alternative energy production and the pace of activities which absorb CO2 from the atmosphere are stepped up.
Net new GHG emissions rose steeply through 2012. Since then, their pace of growth has moderated. This shift corresponds to the rise in the use of carbon pricing. The global 2020 recession caused a cumulative decline in CO2 emissions of about 6% to their lowest since 2011 (Chart 2). This cyclical reduction will not last. The reduction in net new GHG emissions necessary to meet goals over the next 30 years will require a significant structural adjustment.
There are two ways to bring about this adjustment. The first approach – to mandate changes – raises concerns about economic dislocation (and so their political viability). Economist should naturally prefer the second approach – to use the price mechanism to foster private sector adjustment. The key to the latter is to develop further effective mechanisms for carbon pricing. Carbon pricing is any mechanism which puts an explicit price on GHG emissions, such as carbon taxes and emission trade systems (ETS). In so doing, the externality of global warming is (in theory) mitigated as the (lower) private cost of activities generating carbon emissions is raised to align with their higher social cost. Firms and consumers responding to economic incentives would then shift resources out of carbon-producing activities.
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Summary
- The global political tide is turning towards the increased use of carbon pricing.
- The price mechanism is the proven, trusted way to generate resource shifts.
- Voluntary carbon markets are likely to show rapid growth in coming years.
- A major (global) policy dilemma is determining how much to compensate losers.
One of the Biden administration’s first moves was to rejoin the Paris Climate Accord. The scientific community believes limiting net new carbon emissions in coming years is critical to capping the rise in global average temperatures from pre-industrial levels at 1.5°C. The expert consensus suggests this will require major countries to lower the net increase in carbon (CO2) emissions (the main form of greenhouse gases, GHG) steadily to zero by 2050 (Chart 1). ‘Net zero’ does not mean that all CO2-producing activity stops by 2050. Rather, it means that alternative energy production and the pace of activities which absorb CO2 from the atmosphere are stepped up.
Net new GHG emissions rose steeply through 2012. Since then, their pace of growth has moderated. This shift corresponds to the rise in the use of carbon pricing. The global 2020 recession caused a cumulative decline in CO2 emissions of about 6% to their lowest since 2011 (Chart 2). This cyclical reduction will not last. The reduction in net new GHG emissions necessary to meet goals over the next 30 years will require a significant structural adjustment.
There are two ways to bring about this adjustment. The first approach – to mandate changes – raises concerns about economic dislocation (and so their political viability). Economist should naturally prefer the second approach – to use the price mechanism to foster private sector adjustment. The key to the latter is to develop further effective mechanisms for carbon pricing. Carbon pricing is any mechanism which puts an explicit price on GHG emissions, such as carbon taxes and emission trade systems (ETS). In so doing, the externality of global warming is (in theory) mitigated as the (lower) private cost of activities generating carbon emissions is raised to align with their higher social cost. Firms and consumers responding to economic incentives would then shift resources out of carbon-producing activities.
The Externality Curse
Global warming is the toughest externality nut to crack, since the spillover is global. The geographic reach of the Paris Accord was both important and impressive. Global warming is the result of cumulative GHG emissions. DM economies were their major cause in the 20th century. More recently, the rise of incomes, consumption of carbon-intensive goods and services, and consequently emissions has been most rapid in China and India (Chart 3).
China is now by far the world’s largest emitter of CO2 (Chart 4). There are about 0.35 cars per household in China; there are about 1.9 per household in the US. So it is no surprise that China is far ahead of the US in the development of electric vehicles. The largest emitters per capita are either large carbon fuel producers (energy prices have historically been kept low in such countries) or those with relatively large industrial sectors (Chart 5).
The Invisible Hand of Carbon Markets[1]
As noted, the rise in carbon pricing has corresponded to the phase in which the pace of new CO2 emissions has levelled off. In 2021, 61 carbon pricing schemes will be in place, covering about 22% of GHG emissions (Chart 6). The most notable innovation in 2021 is the introduction of a national scheme in China. The country’s significance as a source of GHG will grow in coming years. It must make a massive shift in the pattern of its primary energy generation (mainly away from coal) if it is to get anywhere close to its objective of achieving net zero emissions by 2050.
The US carbon market exists in states with political leaderships sympathetic towards GHG concerns. These are California and 11 states on the East Coast that make up the Regional GHG Initiative (RGGI). Carbon pricing systems are most extensive in Europe. This is true not just of the extent to which emissions are covered (the carbon price equivalent of the tax base), but also the extent to which prices have already been raised (Chart 7; the equivalent of the tax rate). If it is assumed that social, economic and political forces will eventually push all (major) countries to converge on a high, similar carbon price in order to push net emissions to zero, then Europe can be viewed as ahead in this game.
There are three broad types of carbon pricing. The first is a tax on specific activities generating CO2 emissions. In this case, the ‘price’ is simply the tax rate and does not vary month to month. The other two are can be thought of as market mechanisms: mandatory trading schemes (Emission Trading Systems or ETS); and voluntary trading schemes.
The most extensive mandatory trading scheme is the European Union’s ETS, which has been operating since 2005. It covers about 40% of the EU’s GHG emissions, targeting power stations, industrial plants and airlines. A declining cap is set each year and covered institutions then buy-and-sell allowances needed to meet those emission constraints. Emissions from installations covered by the EU ETS fell by about 35% between 2005 and 2019. Over the same period, overall EU emissions fell by 22%, while US emissions fell 14%.
Voluntary trading schemes are in their infancy but offer considerable promise.[2] At first, a demand side of a ‘voluntary’ carbon market sounds like a contradiction. Why would a profit-maximizing agent willingly want to internalize the full social cost of its carbon footprint? There are a variety of explanations, ranging from the purely benign, through the belief that the reputation boost of a net zero emissions objective can improve firm value, to the recognition that financial regulators and investors are increasingly coming to view carbon dependency as an unacceptable financial risk.
The supply side of a voluntary market is provided by schemes that provide credible, verifiable carbon offsets, either in the form of alternative energy provision or projects which absorb carbon emissions (nature-based and technological). Many of these projects could well be in poorer, emerging economies, which could also foster the flow of capital.
The challenge in developing these markets from their infancy is (as with any market) developing the infrastructure to bring buyers and sellers together. One powerful incentive for investors is that they can see an evolving market with considerable upside price potential that will likely come with the support of the global official sector. In a world where the QE-trade appears close to being maxed out, this combination of conditions has obvious appeal.
The Law of One Price
The global dispersion of carbon prices is more uneven than the dispersion of GHG in the atmosphere. The resulting climate, social and economic damage will affect some areas far harder than others. It is no coincidence that the US states participating in carbon pricing are the coastal states – with the conspicuous exception of those in the south east.
There is a compelling argument for global carbon pricing to converge on the level that will create both the supply and demand conditions necessary to meet the net zero objective by 2050. The magic of the price mechanism (and its resulting effect on capitalist innovation) is such that no-one can (or need) say exactly what that price is (the general supposition is that it is about $50). Effective channels to allow for arbitrage credits across jurisdictions would help with global coordination. The latest EU carbon price is about $42 per ton of CO2 (Chart 8). The latest US RRGI price was just $7.4 per ton (Chart 9).
For market participants, there is an obvious question of what rising carbon prices will do for oil prices. In the first five years of the EU ETS, the oil price and carbon price were positively correlated (12%). Since 2011, however, a stronger negative correlation (28%) has been established. That relationship is more intuitive.
Winners vs Losers
Perhaps the most challenging aspect of carbon pricing is the distributional issue. As with any product-specific tax, the owners of the asset being levied will suffer a loss in the value of the assets. From a geopolitical standpoint, this raises concerns about areas and countries excessively dependent on oil and coal production. Understandably, they are liable to lobby hard and aggressively against stepped-up carbon pricing. The Trump administration was unusually sympathetic to such lobbying.
The consumers of carbon-producing activities (e.g., buyers of gasoline) will inevitably see higher prices for these products. This relative price change is integral to generating the demand and resource shifts needed to achieve net zero. The underpricing of carbon emissions in the past 20 years is an example of how inflation measures have understated true global inflation, and some catch up will be necessary.
The growth implications of more aggressive carbon pricing are likely to be positive. This is because the investment spurred in new energy production and other offset activity will far offset the ongoing decline in traditional carbon sectors already experiencing contracting conditions (e.g., coal). The main policy challenge will be encouraging voters to accept this necessary structural change. Carbon taxes and officially sponsored ETS schemes generate significant revenue, which will rise over time (Chart 10). This can be used to help offset direct losses from the necessary relative price change.
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The most valuable survey is provided by The World Bank: State and Trends of Carbon Pricing, May 2020 ↑
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See the report of the IIF-led Taskforce on Scaling Voluntary Carbon Markets, November 2020 ↑
Phil Suttle is the founder and principal of Suttle Economics.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)