Understanding the carbon price
With European carbon prices hitting an all-time high, we introduce the role of carbon pricing and ask what it means for investors, in the first of a new blog series.
Carbon dioxide is the key greenhouse gas warming our atmosphere: its concentrations are rising due to the burning of fossil fuels, and we’re emitting the gas at an alarming rate of circa 40 billion tons per year. In order to limit the average global temperature increase to 1.5 degrees by the end of the century, widely accepted by the scientific community as necessary to avert a climate disaster, our carbon emissions need to be net zero by 2050. We face a formidable challenge.
It seems strange that while we’re in a climate emergency, the fossil-fuel industry is still receiving subsidies. They come in two forms. Production subsidies appear in the form of tax breaks or direct payments that reduce the cost of producing coal, oil and gas. R&D, drilling and depreciation allowances are examples that can be found in developed countries. Consumption subsidies are direct cuts to fuel prices for the end consumer, for example by fixing the price at the petrol pump below what the market rate would otherwise have been. These can be found in developing and middle-income countries.
An obvious way to help the transition to a low-carbon economy is to level the playing field, removing fossil-fuel subsidies in favour of renewables. However, this only recognises a small part of the subsidies that the fossil-fuel industry receives. A recent report from the IMF estimates that ‘post-tax subsidies’ – defined to include the externality cost to society of local pollution, traffic congestion and global warming – are over $5 trillion per year, which is over 6% of global GDP.
Reflecting some of these externalities to businesses in a direct monetary way would speed up the transition away from fossil fuels. The externalities represent a market failure – a ‘free rider’ problem. In other words, the true price of the consumption of scarce natural resources is not being paid by those that consume them, at the expense of the global community realising the effects of global warming.
The cost of carbon varies significantly
Establishing a price of carbon helps shift the externality back onto the emitters. However, the process for establishing this price varies significantly today. There is no one indicator or market that you can point to. Instead, carbon pricing instruments come in many shapes and sizes: carbon taxes (a direct price), emissions trading systems (like the EU’s scheme), crediting mechanisms, results-based climate finance, while a recent development has been voluntary carbon markets.
The World Bank and OECD have provided guidance as to how nations and bodies should structure effective carbon pricing mechanisms, but inevitably principles become diluted by national interests and political horse-trading. The carbon price is not politically neutral. This is demonstrated in the range of carbon prices below.
There is a range of carbon pricing initiatives adopted in different countries, ranging from nothing to the EU’s emission trading system. You’ll notice a few things from the chart: the price varies significantly, the coverage of carbon emissions in the price varies significantly, and it’s un-coordinated (i.e. no universal carbon price exists in the US or China).
Altogether, carbon pricing covers circa 20% of global greenhouse gas emissions, which is low. And the price in comparison to the IMF’s $5 trillion per year externality cost also looks pitifully low.
Expectations for the future price of carbon
As nations around the world tackle climate change and place a financial burden associated with greenhouse gas emissions back onto the emitters, the price of carbon will increase.
LGIM’s Destination@Risk climate scenarios estimate that the price of carbon increases to $380/tCo2 by 2050 in a below-2 degrees world (an optimistic scenario to avoid significant and potentially catastrophic changes to our planet with an orderly decarbonisation transition).
At the other end of the spectrum – in the disorderly scenario where nations do not get to grips with decarbonising economies straight away, delaying meaningful action for 10 years – the carbon price rises to $1000/tCo2 by 2050. This is because achieving the same decarbonisation outcome in 20 rather than 30 years entails ramping up carbon prices quicker and further, which is likely to cause much more significant disruption to the global economy.
The delay to decarbonisation necessitates the ‘reversal’ (through sequestration) of another 10 years’ worth of historical emissions growth, which is far more expensive than preventing it from happening in the first place.
What does this mean for investors?
The under-pricing of carbon emissions represents a market failure. However, momentum is gathering for externalities to be more accurately priced. Companies, asset owners and investors are already acting themselves, understanding that the externalities associated with carbon emissions will transpose into financial risks over the medium term.
Some companies are becoming more transparent in how they disclose their carbon footprint and are acting now to decarbonise their business models. These firms inherently understand that carbon-intensive assets will be re-priced lower at some point in the future. Those firms that do not recognise this, and fail to act for one reason or another, risk being taken over by events – be it innovation disruption, legislation change or shifting consumer preferences.
Sophisticated long-term investors are beginning to recognise these risks and put in place objectives to decarbonise portfolios. For some, that’s through cutting the weighted average carbon emission score (WACI). For our climate-aligned portfolios, we use a forward-looking temperature alignment metric, scoring companies on their progress on their pathway to alignment to net zero as a way of recognising and helping mitigate these inherent unpriced externalities.
A universal carbon price would be a huge step towards decarbonising the global economy, going some way to putting the cost associated with externalities back onto the emitters. Given disparate national policies, we are a long way from this. However, all is not lost. A universal carbon price forms only part of the policy mix. Disruptive emerging technologies, a shift in corporate responsibility, changing legislation and actively engaged asset owners and investors form a formidable climate alliance.
In my next blog, I’ll discuss some of the pros and cons of emission trading systems as a method of delivering a market-led carbon price. And I’ll look at the reforms that the EU has recently made to its system, a cornerstone of EU climate policy, providing a potential blueprint for other regions to follow.
Other sources used include https://ourworldindata.org/electricity-mix, https://www.worldbank.org/en/programs/pricing-carbon, https://icapcarbonaction.com/es/news-archive/788-eu-proposes-major-reforms-to-ets-and-new-policies-to-meet-2030-target and https://www.carbonpricingleadership.org/
 Source: IMF Fossil Fuel Subsidies, December 2021