What price carbon?

The government’s shadow pricing tool needs sharpening, says Rebecca Willis.

If you want to cut carbon, put a price on it. That’s increasingly the focus of climate change policy. The reasoning is obvious. If it costs an individual or company nothing to emit carbon dioxide or other greenhouse gases, there’s no economic incentive to reduce emissions, even though their adverse impact is enormous – amply justifying the now famous description of climate change as “the greatest market failure the world has ever seen”.

The Stern Review, which gave the world that phrase, was by no means the first attempt at carbon pricing, but it had a big impact on the government’s willingness to use it as a policy tool. Instruments such as the Climate Change Levy, a tax on non-domestic energy use, and the European Emissions Trading Scheme, were already attempting to correct this ‘market failure’ through pricing carbon. Now the logic is being applied, within the government’s own decision-making processes, through the development of a ‘shadow price of carbon’.

This shadow price is to be used in the cost-benefit analysis of all government policies or investment decisions, whether a new road or a new tax. Having assessed the likely quantity of emissions associated with different options, ministers must factor this in as a cost,at a set price per tonne of carbon dioxide – or the CO2 equivalent in other greenhouse gases. The price set last December (subject to review) started at £25.50 per tonne of CO2 for 2007, rising year on year to £59.60 a tonne for emissions in 2050.

In theory, this approach could prevent carbon- intensive developments from happening at all. More likely, it could make lower-carbon alternatives more attractive. So, for example, a new hospital boasting green design features and on-site renewables might be more expensive, in cash terms, than a rival scheme, but could come out as the cheaper option once a carbon price is included.

Sounds sensible. But since its introduction it has generated a huge amount of controversy. Things came to a head in February when the Department for Transport launched a consultation on a third runway for Heathrow. Using the shadow price, the DfT said that the carbon cost of the new runway would amount to £5 billion. This and other costs were offset against an estimate of benefits to the economy, including the jobs created, the increase in passengers bringing business into the UK, and the reduction in delays. After crunching the numbers, the DfT could say that the benefits of the runway outweighed the costs by around £5 billion – and that this analysis was “entirely consistent with the Stern Review”.

Predictably, many disagreed. Criticisms centre around two aspects of the policy:

• Is it right to try to cost carbon in this way at all?
• If you do price carbon, how should the price be decided?

Nick Mabey, founder of E3G and an expert in carbon markets, worries that using a carbon price in cost-benefit analysis is profoundly misguided. He accepts that it might help in deciding between two similar options, such as choosing between different types of fuel. But for big infrastructure projects like the third runway, he warns against “collapsing the comparison between scenarios into a single metric of price”. There are too many uncertainties over the monetary value of both costs and benefits to place much confidence in the figure that emerges. Neither does such an analysis acknowledge the issue of ‘lock-in’ – building a third runway is not easily reversible, and will make it harder to move toward more radical carbon cuts by reducing aviation in future.

“Fair decisions depend on a single, unambiguous price”

Simon Dietz disagrees. An economist at LSE, he was previously a member of the Stern Review team. Like it or not, he points out, all government policies and plans are subject to a cost-benefit analysis, and “carbon will not be given the same level of importance as other considerations unless we can price it”. He also points to the need for a predictable, straightforward approach that offers some certainty to businesses and policy makers: “A single, unambiguous price on carbon means that all decisions are being treated with parity.”

This brings us to the second area of controversy: how to calculate that price. What the Stern Review team did was to estimate the damage likely to be caused by climate change – the reduction in economic output caused by floods, changes to agriculture, sea-level rise and so on. Acknowledging that the more carbon we emit, the more catastrophic the effects of climate change are likely to be, Stern arrived at the conclusion that “if we don’t act, the overall costs and risks of climate change will be equivalent to losing at least 5% of global GDP each year, now and forever. If a wider range of risks and impacts is taken into account, the estimates of damage could rise to 20% of GDP or more.”

By putting price tags on climate change damage at different CO2 concentrations in the atmosphere, Stern made possible a calculation of the cost to the global economy of each tonne emitted. And that’s what the government has done for its ‘shadow price’ – using the lower end of Stern’s estimates.

Paul Ekins, professor of energy and environment policy at King’s College London, is highly sceptical about this. Taking a low-end figure is based on an assumption that we are already on a path to drastic emissions reductions, thereby averting the worst effects of climate change (and making the ‘costs’ of carbon less). As Ekins points out, this is circular logic of the worst kind. The use of a low price is only justified by the assumption that we are taking strong action on climate change. Yet the low price itself guarantees that we do not take the necessary action, as it does not send a strong enough price signal. Hence the third runway. As an exasperated Ekins wrote in The Guardian, this is “Alice-in-Wonderland economics. One can just imagine the White Queen, who taught herself to believe six impossible things before breakfast, saying: ‘we are on a low-carbon emissions trajectory because I say we are, and that means I can emit as much carbon as I like!’”

Instead, says Ekins, the shadow carbon price should be set at a level that drives action to mitigate climate change, based on the actual costs of abatement – in other words, the cost of introducing measures that reduce emissions through low-carbon technologies or behavioural change. Dietz agrees that a carbon price based on the cost of abatement (rather than damage) would be a more meaningful basis for calculation. And government figures show that these costs, using some forms of renewable energy or carbon capture, could be £100 or more per tonne.

So where does this leave us?

There is general agreement that pricing carbon is a necessary, but not sufficient, way of ‘climate-proofing’ policy. It should be seen as one of a range of decision- making tools. Government is keen to see it widely adopted by industry too [see box]. But there is a danger, as in the example of the runway, that complex calculations, backed by questionable assumptions, become a fig leaf for highly dubious, business-as-usual decisions.

“Complex calculations, backed by questionable assumptions, could become a fig leaf for highly dubious, business-as-usual decisions”

The Climate Change Bill, soon to become law, will set mandatory emissions targets, with a clear trajectory over the decades ahead. It is this that should define the overall direction of policy. Within this framework, the shadow carbon price – if set at the right level – could help to decide between competing policy and investment possibilities. For example, if a target is set for carbon emissions from transport, what balance should be struck between improving vehicle efficiency, providing better cycle facilities, or investing in public transport? Factoring a carbon value into these deliberations will help to uncover the best way forward.
 
Applying a shadow carbon price to policy decisions could also provide a useful stepping-stone to wider carbon trading, as more sectors of the economy prepare for emissions trading schemes. It could help us meet carbon reduction targets in the most efficient way. But it must be handled with care.

Shadow of the grid

In something of a mutual backslapping fest, National Grid has won government praise for showing the way forward on carbon pricing by UK business – and the company has said it will use both the government’s approach and its annual shadow price.

The power distributor’s new decarbonising drive, announced in April, targets an 80% cut in CO2 emissions by 2050. Annual and five-year reduction targets will be set next year, and the performance of managers will be measured against the resulting ‘carbon budgets’ as well as against more traditional business metrics. Using the government-approved shadow spot price for carbon, the company says, will not only help it account for the environmental impact of investment decisions, but also be good preparation for operating under any future carbon tax or mandatory cap-and-trade regime.

Rebecca Willis is an independent researcher and writer, and vice-chair of the Sustainable Development Commission.

27 June 2008

Rebecca Willis

Add new comment