Valuing the environment: how a price on carbon can lead to lower emissions

Aligning the costs of climate impact with those responsible for carbon emissions can spur investment in low carbon solutions. How is a carbon price established and why is it important for climate conscious consumers and investors?

By GreenPortfolio Team

July 28, 2021

Mountains air pollution

What is the cost of emitting one metric ton of CO2? The impact of global warming, a result of increased greenhouse gas emissions, is predicted to cause damages to agriculture, health, and property. The cost of natural disasters, extreme weather events, air pollution, and food scarcity, referred to as negative externalities, however, are incurred by the economy as a whole rather than accruing to the firms that are the source of emissions. Without a price on carbon, energy-intensive industries that create higher emissions such as power generation, oil refineries, and cement producers have little economic incentive to make the investment needed to decarbonize.

 

One way of achieving a carbon price is through a carbon tax, optimally set at the social cost of carbon – an estimate of the resulting estimated economic costs of future emissions and their climate impact. A second way of pricing carbon is through market-based mechanisms. Where technology and infrastructure may not yet be in place to shift business operations or individual consumption, carbon markets can play a role in offering a way to offset emissions in the near term and incentivizing investment in low carbon solutions in the longer term.

Carbon markets

There are two main types of carbon markets: compliance markets, which cap emissions from regulated industries and are administered by a government, and voluntary markets, which offer offsets to companies and individuals seeking to lower their net emissions.

trees offsetting emissions

Compliance markets

Carbon markets operated by governments set emissions targets for sectors of the economy with higher emissions. Emissions are capped through emissions allowances which are granted or auctioned at prices set by the market. Over time, the number of allowances is reduced in line with emissions reduction goals. Carbon markets, while potentially more difficult to administer than a carbon tax, have the benefit of establishing the amount of emissions, while the market sets the price.

 

The EU Emissions Trading Scheme (ETS), the world’s largest carbon market was established in 2005, covering energy-intensive industries, the power sector, and regional airlines – about 40 percent of greenhouse gas emissions in the region. Emissions from the sectors covered by the EU ETS have fallen by 40 percent since 2005, according to the EU. In response to the expectation of stronger commitments by governments to reduce emissions, the price of credits increased in 2021 and falls within range of what experts would say is required to make an impact. However, some maintain concerns that it may still be too low to encourage adequate investment in a low carbon transition.

Reforms recently proposed include setting up an ETS to cover additional sectors, such as transportation and buildings, as well as tightening supply of allowances in order to reach further emissions reductions have been met with some resistance due to their potential to disproportionately impact lower income households. With any carbon market or carbon tax, the planned use of the proceed is a critical element in establishing a fair transition.

 

In the US, the first regional compliance market, the Regional Greenhouse Gas Initiative (RGGI) was established in 2005 and now encompasses 11 states on the east coast. The RGGI functions as a cap and invest system for the power sector, auctioning allowances and using the proceeds to invest into the local economies as well as energy efficiency initiatives. Over time, like within the EU ETS, emissions allowances decline. The National Resource Defense Council estimates that emissions from the power sector have fallen by half since 2005 while the economy grew and notes additional improvements in health and lower energy costs in the region.

 

California’s cap and trade market, covering 80 percent of greenhouse gas emissions in the state, has also contributed to a decline in greenhouse gas emissions according to the Environmental Defense Fund.

oceans rising due to climate change

Voluntary carbon markets

According to the Taskforce, a private sector initiative looking at how to improve the functionality of carbon offset markets, the market for carbon offsets while expanding would need to grow by 15 times the current level by 2030, in order to achieve 1.5°C warming targets, with the market predicted to be valued at $5 to 30 billion. Among the issues on the Taskforce’s agenda are market structure and integrity, including transparent pricing, liquidity, demand indications, and standardization of credits.

For companies and individuals that do not fall under compliance markets, voluntary carbon markets offer a way to offset emissions. Voluntary carbon markets facilitate the purchase of credits, representing a unit of carbon emissions that have been removed or avoided. McKinsey & Company, an advisor to the Institute of International Finance’s Taskforce on Scaling Voluntary Carbon Market, categorizes projects into four categories: “avoided nature loss; nature-based sequestration; avoidance or reduction of emissions; and technology-based removal of carbon dioxide from the atmosphere.”

Voluntary carbon markets for consumers and investors

Consumers

The MIT Environmental Solutions Initiative translates what it means to emit 1mt of CO2 into everyday terms: Food consumption for a typical person, including production, transportation, and waste, requires 1mt of CO2. A passenger on a transatlantic flight from New York to London, roughly 3,000-miles round trip, also accounts for a 1mt of CO2. A person contributes about 1mt of CO2 for every 2,500 miles driven, the equivalent of a cross-country trip in the US. The average American drives five times this distance in a year.

On average, a person in the US emits 16mt of CO2 per year, much of which comes from economy-wide activities such as electricity generation or manufacturing. Some of these emissions can be reduced by adopting energy-efficient options. Switching to an electric car, for example, decreases the emissions from driving by nearly two-thirds (ie a person can drive nearly three times further for a given level of emissions). Where low emissions technologies are not yet available, carbon offsets offer a way to reduce net emissions.

 

Without oversight by the government, voluntary carbon markets require careful research by consumers. Among the criteria of carbon offsets that need to be considered:

  • Additionality: ensuring that a project would not have been otherwise funded
  • Permanence: providing transparency into the longevity of carbon reductions
  • Leakage: accounting for the creation of additional emissions outside of the project scope
  • Double counting: ensuring that the credit for a project is not sold more than once

 

Purchasers of offsets should look for independent verification of carbon offset programs.

green working space

Investors

As pledges to achieve carbon neutrality increase, more companies are looking to voluntary carbon markets to offset their emissions. Inexpensive carbon credits have caused concern that rather than undertaking more difficult emissions reduction decisions and investments, companies may instead simply purchase offsets. Pricing of carbon offsets can vary from under $1 to $20 per mt CO2 in many markets. Climate-conscious investors should be wary of carbon reduction commitments that rely heavily on offsets rather than emissions reductions.

 

Carbon markets will play a critical role in reducing global emissions, according to Nationally Determined Contributions (NDCs) submitted under the Paris Agreement. Half of the commitments, representing 31 percent of global emissions, will be impacted by international carbon markets according to the World Resources Institute, making it a priority for countries to strengthen and facilitate cooperation in the market for carbon credits.

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