Rising Climate Risks Revive Debate on Carbon PricingPatricia Hudson State Street Center for Applied Research

Key Points

• Carbon pricing is top of mind again as greenhouse gas levels and risks hit new records

• First wave of carbon reduction programs faltered on politics and pricing

• Challenge now is to align both political and economic interests for greater durability and impact

• Urgency rises as investors and regulators focus on value destruction and financial stability risks

• Investors need to heed portfolio implications of the energy transition

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Contents

2 Introduction

2 Harnessing market efficiency

3 Renewed urgency to reduce greenhouse gases

5 Price it right, tax it smart, do it now

6 Lessons from the past: carbon tax vs cap and trade

8 Internal carbon prices

9 The complexities of carbon pricing

13 Pocketbook versus planet

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Record-smashing storms, floods, droughts and sea level rises are focusing the minds of policymakers, companies and investors on effective climate change mitigation and adaptation approaches and reviving the debate on carbon pricing.

As reports suggest that climate change is happening faster than even experts expected, economists at least are in agreement that harnessing market forces through a price on carbon is the most efficient way of reducing the greenhouse gas emissions (GHGs) that are warming the planet at a dangerous rate. That is why more than 3,500 U.S. economists led by Larry Summers, Janet Yellen, Ben Bernanke and others published a full page ad in The Wall Street Journal in January to make their case.1 But the track record of carbon taxes and cap and trade systems around the world has been mixed at best, and it is now clear that implementing a uniform carbon pricing framework that is politically durable and environmentally meaningful is the real challenge facing policymakers.

The next generation of carbon pricing efforts is focused on trying to align political interests with economic interests as well as setting price trajectories that are big enough to be impactful. As the sense of urgency grows around reducing GHGs before the planet’s warming reaches a tipping point, it is worth reviewing the experiences countries and regions have had with carbon pricing over the last two decades and what learnings can be applied

to future frameworks. Investors, too, must carefully follow the issue, because putting a price on carbon in a more comprehensive and meaningful way will have important implications for the value of their portfolio holdings.

Harnessing market efficiency

It is not surprising that economists support carbon pricing, especially in the form of a tax on carbon, because of the clean and reliable price signal it sends to the market. Conceptually, the approach is straightforward: applying what is called a social cost of carbon (SCC) to fossil fuels not only acknowledges the health and environmental damage or “costs” those fuels cause when they are burned but, more importantly, it changes the relative prices of carbon-intensive fuels versus low-carbon or zero-carbon renewable energy sources. Internalizing the true cost of fossil fuels thus helps expedite the transition to clean energy and reduces emissions across the economy. Reinforcing this point, the IMF recently argued that direct and indirect subsidies to the fossil fuel industry globally amounted to an eye-watering $5.2 trillion in 2017.2 The indirect subsidies, it reported, stemmed from the failure to price greenhouse gas emissions.

Rising Climate Risks Revive Debate on Carbon Pricing

80%of global GHGs face no carbon price

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According to the World Bank, there are 46 countries and 28 subnational regions that are putting a price on carbon, either through a carbon tax or a cap and trade system.3 That might sound like a lot, but the reality is that about 80% of global GHGs face no carbon price at all, and less than one percent of global emissions are subject to a price that is even on the low end of what the UN estimates the social cost of carbon should be ($40–$80 per metric ton).

Renewed urgency to reduce greenhouse gases

A combination of developments since the Paris climate meeting in 2015 has generated urgency around the most effective ways to reduce GHGs in general, and carbon pricing’s role in particular. One is the reality that GHG emissions continue to rise, with last year setting a new record.4 Last year’s report from leading climate scientists on the UN’s Intergovernmental Panel on Climate Change (IPCC) announced that keeping global warming below 1.5 degrees centigrade would

Figure 1: Carbon pricing initiatives around the world

Source: The World Bank Carbon Pricing Dashboard

Summary map of regional, national and subnational carbon pricing initiatives

ETS implemented or scheduled for implementation Carbon tax implemented or scheduled for implementation

ETS or carbon tax under consideration ETS and carbon tax implemented or scheduled

ETS implemented or scheduled, tax under consideration Carbon tax implemented or scheduled, ETS under consideration

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require reducing GHGs by 45 percent below 2010 levels by 2030 and reaching net zero emissions by 2050.5 In other words, we have a little over a decade to meaningfully reduce carbon emissions.

The shortness of that timeline, together with the warning from the U.S. interagency report that climate change damage could reduce U.S. GDP by 10 percent (more than double the losses of the Great Recession) by the end of the century, drew attention to what meaningful action will entail

In their November 2018 report, the 13 U.S. federal agencies echoed the UN’s recommendations that policymakers should pursue three solutions:

1. Put a price on carbon emissions

2. Establish government caps on how much greenhouse pollution may be emitted

3. Increase public spending on clean-energy research

Carbon pricing received yet another boost last year as William Nordhaus of Yale was named co-recipient of the Nobel Prize in economics. Nordhaus’s pioneering research in economic modeling in the 1970s helped create the ability to estimate the social cost of carbon. Nordhaus has consistently argued that the most efficient remedy for the problems caused by greenhouse gas emissions would be a global program of carbon taxes that are uniformly imposed on all countries.

Source: Boden, T.A., G.Marland, and R.J. Andres. 2015, Global, Regional, and National Fossil-Fuel CO2 Emissions. Carbon Dioxide Information Analysis Center, Oak Ridge National Laboratory. U.S. Department of Energy, Oak Ridge, Tenn., U.S.A. doi: 10.3334/CDIAC/00001_V2015.

Total and Individual Contributors

Figure 2: Global CO2 emissions reach new highs

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TotalPetroleumCoalNatural gasCement productionGas Flaring

1850 1900 20001950

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Price It right, tax It smart, do It now

The key change in recent years has been the

growing concern among regulators, investors

and companies around the level of value

destruction and instability that inaction on rising

GHGs will cause. In his dual role as head of the

Financial Stability Board and governor of the

Bank of England, Mark Carney has connected the

risks of climate change and global warming to

central bankers’ mandate to safeguard financial

stability. In the context of climate risk, Carney

has evolved the “Tragedy of the Commons”—

individuals acting in their own self-interest at

the expense of the common good—to highlight

the so-called “Tragedy of the Horizon”—the cost

of climate change to future generations that the

current generation has no direct incentive to fix.6

In addition to launching the historic Taskforce

on Climate-Related Financial Disclosures

(TCFD), aimed at getting companies to report

how they are incorporating climate change risk

into their business strategies, Carney has also

joined forces with the Network for Greening the

Financial System (NGFS), a group of 34 central

banks and supervisors, including the People’s

Bank of China, the Bank for International

Settlements and the World Bank (but notably,

not the U.S. Federal Reserve). The group is

focused on identifying and managing the financial

stability risks associated with a warming planet,

whether it is a degradation of the credit quality

of bank loans, insurers unable to cover the

skyrocketing costs of natural disaster claims

or the macro-prudential challenges of entire

economies transitioning to a lower carbon state.

The IMF and the World Bank have also strongly endorsed comprehensive carbon pricing, with IMF head Christine Lagarde succinctly summarizing their view: “Price it right, tax it smart, do it now.”7 The One Planet Summit, co-launched with former World Bank President Jim Yong Kim, has brought together local, regional and national leaders as well as representatives from public and private finance to speed the transition to a low carbon world.8

In the U.S., President Trump’s announcement to pull out of the Paris climate accord has galvanized state and local leaders to focus on climate change action, including carbon pricing options. Former New York mayor Michael Bloomberg has organized mayors from around the world to focus on reducing greenhouse gas emissions, pointing out that cities account for 70% of GHGs.9 Bloomberg himself has launched the largest philanthropic effort ever to combat climate change in his Beyond Carbon initiative aimed at closing the remaining coal-fired plants in the U.S. by 2030. As the 2020 presidential election period begins, climate policy features prominently in every Democratic candidate’s platform and a growing number of Republicans want their party to focus on climate change action as well.

70%of GHGs generated by cities

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The Climate Leadership Council, founded by former U.S. Secretaries of State George Schultz and James Baker, has enlisted major energy companies, NGOs, corporations, economists and leading political conservatives to advocate for a comprehensive carbon tax for the U.S. that would return revenues directly to citizens.

Lessons from the past: carbon tax vs cap and trade

In the 30 years since Finland became the first country in 1990 to introduce a carbon tax as an instrument for climate change mitigation, there has been a wealth of experience with different forms of carbon pricing, both carbon taxes and cap and trade, with mixed results. Each approach has pluses and minuses, and the good news is that each attempt at implementation has generated valuable lessons for the future. Carbon tax levels vary widely around

the world, from $1 per metric ton or less in China, Mexico and Poland to more than $130 in Sweden. The UK and British Columbia are often cited as carbon tax success stories. In the UK, greenhouse gas emissions have fallen to their lowest levels since 1890, largely due to a carbon tax that incentivized electric utilities to move from coal to gas or renewables.10 In 2013, the UK introduced a carbon price floor for certain sectors, including electricity, which amounted to a carbon tax of around $25 per ton.

The conservative party in British Columbia introduced North America’s first carbon tax in 2008, applying it to a tax on carbon emissions from businesses, families, cars and trucks and starting at $10 per ton with plans to increase the price each year until it reaches $50 per metric ton in 2021. Key to the success of the program was how the government used the

Figure 3: UK carbon emissions fall to 1890 levels

1860 1880 1900 1920 1940 1960 1980 2000

200

400

600

800

UK CO2 emissions 1858–2017

Annual UK carbon emissions from all sources between 1858 and 2017 CHART BY CARBON BRIEF USING HIGHCHARTS.

CO2 emissions Emissions in 2017

MtC

O2

CO2 emissions have fallen to below 1890 levels

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revenues from the tax to provide rebates to all citizens, with targeted relief for groups most vulnerable to higher gas and heating fuel costs. More importantly, the tax did not collapse the economy as critics feared; in fact the province saw better growth than the rest of Canada even as its carbon footprint declined.11 The success of British Columbia’s program was one reason Prime Minister Justin Trudeau enacted a nationwide carbon tax on oil, coal and gas, with plans to refund the revenue to Canadians on their tax bills. The tax is a centerpiece of Trudeau’s commitment to reduce the country’s carbon emissions 30 percent below 2005 levels by 2030.

Cap and trade programs, or emissions trading schemes (ETS), set a ceiling on overall carbon emissions and then allow companies to buy and sell carbon permits. Proponents of cap and trade stress that setting a cap and issuing a corresponding number of allowances establish a clear environmental goal, and the cost of reaching that goal is determined by market forces. By contrast, carbon taxes, they point out, achieve certainty about the costs of compliance, but do not predetermine the reduction in GHG emissions.12 Perhaps the most successful example of cap and trade was the dramatic reduction in sulfur dioxide emissions, or “acid rain,” in the U.S. and Canada during the early 1990s.

Figure 4: Internal carbon prices for U.S. companies

Source: https://en.m.wikipedia.org/wiki/Carbon_tax

Company Internal carbon price (US$) CO2 emitted in 2013 (million tonnes)

Exxon Mobil 60 127

BP 40 60

Shell 40 72

Total 34 47

Ameren 30 56

Xcel Energy 20 54

Google 13 0.04

Disney 10–20 0.9

ConocoPhillips 8–46 24

Microsoft 6 0.05

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In some instances cap and trade programs have been less effective because a glut of permits has kept the carbon price fairly low, and therefore lowered the incentive to switch to cleaner forms of energy. Cap and trade systems introduced in the European Union, California and among nine Northeast states in the U.S. under the Regional Greenhouse Gas Initiative have struggled with that challenge to varying degrees.

The cap and trade system introduced by Australia’s labor government in 2012 quickly foundered on a lack of political consensus, with opposition conservatives immediately repealing the program when they came to power the following year. As the world’s largest coal exporter, Australia faces stronger opposition than many other countries to imposing a meaningful price on carbon.

While cap and trade systems have strong supporters, many economists prefer carbon taxes, as they believe the tax provides a clearer market signal and avoids the creation of new markets that might be manipulated. David Victor of the Brookings Institution says that cap and trade are in some instances less efficient when they are layered upon existing policies

that already meaningfully reduce carbon emissions.13 China will be rolling out the world’s largest cap and trade system starting next year, after several regional test cases. Victor says he believes China’s top-down command system, which has already managed to create the world’s largest market for electric vehicles, might ultimately be more effective than cap and trade.

Regardless of the mechanism, most supporters of carbon pricing agree that the biggest lessons of the past have been structuring the price properly and achieving broad-based stakeholder buy-in.

Internal carbon prices

In the absence of uniform carbon pricing systems at the local or national level, especially in the U.S., many companies have set their own internal price of carbon. This is especially true of oil and gas companies, which are on the front lines of the energy transition. The internal price is used to assess the risk value of future projects when making capital allocation decisions or to reduce a company’s own emissions in their daily operations. By 2017, almost 1,400 companies were using an internal carbon

Regardless of the mechanism, most supporters of carbon pricing agree that the biggest lessons of the past have been structuring the price properly and achieving broad-based stakeholder buy-in.

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price, representing an eight-fold jump over four years and highlighting the growing recognition that climate change risk is a material financial and strategic business issue.14 The main problem is that there is no uniform approach to determining the price. Some companies base their prices on existing policies in the countries in which they operate, which can result in a dramatic range of prices (see Figure 4).

The TCFD has also helped to drive the adoption of internal carbon pricing. In addition to asking companies to disclose their climate-related financial risks and opportunities, the TCFD recommends that companies and investors report the internal carbon prices that are used to manage those risks and opportunities. In addition, companies are asked to describe the parameters used for climate-related scenario analysis, including internal carbon price scenarios. As companies struggle to determine an appropriate internal carbon price, efforts like the Carbon Pricing Corridor Initiative have emerged to help companies identify the carbon prices needed to achieve the 2 degree or below warming limit. For example, for the power sector, the initiative determined that carbon prices in the range of $24–39 per metric ton by 2020 and $30–100 per metric ton by 2030 are needed to decarbonize the sector by 2050.15

The complexities of carbon pricing

Because of the uncertainties around the pace and severity of global warming and its effects, calculating an appropriate carbon price is

highly complex. The social cost of carbon (SCC) is the preferred metric and is defined as the marginal cost of the impacts caused by emitting one extra metric ton of carbon at any point in time, including “non-market” impacts on the environment and human health.

Economists seek to estimate the SCC using sophisticated models that predict climate change effects under different scenarios and allow for calculating monetary damages. One of the most widely used models is the Dynamic Integrated Model of Climate and the Economy, or DICE, developed by Nobel prize winner Nordhaus. Calculating the SCC involves estimating future increases in CO2 emissions due to population and economic growth and the potential damage that would cause across multiple sectors, but so far without including wildcards around climate-driven mass migration or extensive wildfires.

Trying to model that on a global scale adds even greater complexity. And Mark Carney’s “Tragedy of the Horizon” comes into play as well. Because the SCC is focused on future damages, a discount rate is applied. Choosing a higher discount rate lowers the SCC, but essentially places a higher value on the well-being of today’s generation than that of future generations. Climate experts hope that the combination of big data and more sophisticated computer programming can better model the highly granular and interrelated variables around climate change and its effects in order to come up with better pricing estimates.

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Six Carbon Pricing Lessons for the FutureSo while calculating a uniform and accurate carbon price is difficult, the more urgent challenge for policymakers is to create the political buy-in to support carbon pricing over multiple election and business cycles, at levels that will have a meaningful impact on reducing GHGs. Carbon pricing experts have focused on six major areas that policymakers need to get right and socialize with their stakeholders in order to maximize the probability of success16.

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1. What’s in a name? Believe it or not, what to call the policy is a critical ingredient. Given widespread aversion to the word “tax,” policymakers around the world have scoured thesauruses to come up with alternatives: “carbon dividends” (if the revenues will be returned to taxpayers), “price on pollution,” “green fees” (not to be confused with golf).

2. How much should it be? The starting point of any carbon price as well as how quickly it will be ramped up over time is crucial. Experience has shown that starting with a lower price leads to wider acceptance, but that it is important to establish a trajectory that increases the price meaningfully, based on pre-determined targets or economic performance. At the very least, the price needs to rise above inflation and be high enough to incentivize switching to cleaner energy.

3. Which sources of emissions should be taxed? Carbon in fossil fuels and other CO2 emissions from landfills and coal beds are highly taxable. But other sources are much more difficult to tax, so this needs to be determined up front.

4. Who should pay the tax? This could range from the owner of the source of the fossil fuel, to the extractor to the household consuming fossil fuel-powered electricity. In general, economists prefer assigning responsibility high up in the supply chain because it leads to fewer entities and the price signal is more easily transmitted across the rest of the supply chain.

5. How should the emission tax revenue be used? For many carbon pricing programs, such as in British Columbia, this has been critical to achieving enduring support. The carbon tax plan recommended by the Carbon Leadership Group in the U.S. takes a similar revenue-neutral approach, suggesting that the revenues are returned to taxpayers. Another important question is how the revenues are used to support stakeholders who are disproportionately hurt by the policy. For example, proponents of the 1990 Clean Air Act in the U.S. recognized that reducing sulfur pollution would have a significant impact on coal communities. Therefore, part of the political compact was agreeing to provide direct compensation to communities that would be hardest hit by the regulation.

6. How should cross-border carbon pricing arbitrage be managed? Many opponents of carbon pricing in the U.S. have argued that imposing it would make U.S. businesses less competitive against countries like China. But most big businesses in the U.S. are international and face similar moves around the world. French President Emmanuel Macron has already raised the possibility of imposing carbon tariffs and a pricing floor on U.S. imports to the European Union in the interest of protecting Europe’s internal industries.

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The CDP recently reported that the world’s biggest firms anticipate close to a $1 trillion climate cost hit, which they will need to absorb over the next five years.

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Pocketbook versus planet

Given the political hurdles carbon pricing has faced and the mixed track record of many programs that were either ill-conceived or short-lived, many climate activists, especially in the U.S., are beginning to rethink their focus. While continuing to push for carbon pricing, they also want to extend to other states the success California has had in introducing clean energy standards along with subsidies to expedite their achievement. While such approaches are not nearly as efficient as carbon pricing, at least in the U.S., they appear politically more feasible.

Another important lesson has been in how to frame the issue of GHGs. Focusing on the mechanism for reducing GHGs (carbon tax vs cap and trade) has proven less galvanizing than emphasizing the positive outcomes from the effort: cleaner energy and better health outcomes. The numbers involved in keeping global warming below 2 degrees centigrade seem to suggest that a multi-arsenal of approaches will be required, including but not limited to carbon pricing. There is no silver bullet, but carbon pricing in some form seems like an unavoidable part of any effective solution.

What is different now is a heightened sense of urgency, as the physical devastation of climate change has become measurably real and is affecting larger parts of the world beyond coastal areas vulnerable to rising sea levels. That is forcing a broader group of stakeholders, including former climate change skeptics, to demand action from their political leaders.

At the same time, there is growing recognition that the top-down efforts of global initiatives like the Paris climate accord need to broaden to include the bottom-up efforts of local business and political leaders. As Dan Esty and Peter Boyd of Yale’s program on climate change have said, “Presidents and prime ministers have limited policy control over the actions that shape their nations’ carbon footprints…it is time to recognize subnational actors for their critical role in meeting the climate change challenge…by allowing cities, states and companies to officially sign on to the Paris Agreement.”17

The world’s largest companies and investors are also increasingly focused on both the huge costs and opportunities climate change presents. The CDP recently reported that the world’s biggest firms anticipate close to a $1 trillion climate cost hit, which they will need to absorb over the next five years. But those same companies see more than double that amount in investment opportunities in clean energy, electric vehicles and in renewables.18 In the battle between planet and pocketbook, proponents of a well-designed carbon pricing framework argue that it might lead to greater prosperity, not less, and that the cost of inaction is much greater. Finally, internalizing the price of carbon would certainly help investors better assess the impact of climate change risk on the value of the companies they are holding and make better decisions about the companies that are likelier to generate better long-term value.

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1. Economists’ Statement on Carbon Dividends,” The Wall Street Journal, January 17, 2019.

2. Global Fossil Fuel Subsidies Remain Large: An Update Based on Country-Level Estimates, IMF Working Paper, May 2, 2019.

3. As of February 2019.

4. International Energy Agency, Global Energy & CO2 Status Report 2018, March 26, 2019.

5. USGCRP, 2018: Impacts, Risks and Adaptation in the United States: Fourth National Climate Assessment, Volume II, U.S. Global Change Research Program, Washington, D.C., USA, 1515 pp. doi: 10.7930/NCA4.2018.

6. Mark Carney, “Breaking the Tragedy of the Horizon: Climate Change and Financial Stability,” speech at Lloyd’s of London, London, September 29, 2015.

7. Christine Lagarde at the Second Annual High Level Assembly of the Carbon Pricing Leadership Council, Washington D.C., April 27, 2017.

8. State Street Global Advisors is a member of the One Planet Summit.

9. Michael Bloomberg, Climate of Hope: How Cities, Businesses and Citizens, St Martin’s Press, New York City, 2017.

10. Brad Plumer and Nadja Popovich, “These Countries Have Prices on Carbon. Are They Working?” The New York Times, April 2, 2019.

11. Eduardo Porter, “Does a Carbon Tax Work? Ask British Columbia,” The New York Times, March 1, 2016.

12. “Cap and Trade v Taxes, “Climate Policy Memo #1, The Pew Center on Global Climate Change, March 2009.

13. Adele Morris and David Victor, “Carbon Pricing: Harnessing Market Efficiency in Pursuit of Clean Energy,” The Brookings Institution podcast, April 26, 2017.

14. CDP (formerly the Carbon Disclosure Project), June 2019.

15. The World Bank, Carbon Pricing Dashboard, June 2019.

16. Based on Adele Morris, “Eleven Essential Questions for Designing a Policy to Price Carbon,” The Brookings Institution, July 8, 2016.

17. Daniel C. Esty and Peter Boyd, “To Move Paris Accord Forward, Bring Cities and Companies on Board,” Yale School of Forestry and Environmental Studies, March 20, 2018.

18. “Major Risk or Rosy Opportunity: Are Companies Ready for Climate Change,” CDP, June 2019.

Endnotes

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