Carbon Pricing: Putting a Cost on the Environmental Instigators of Climate Change

Earlier this year, the World Resources Institute published a handbook for U.S. lawmakers on the benefits and strategies associated with carbon pricing.

It was, at its core, as much an appeal to action as it was a lengthy cheat-sheet on carbon control and reduction in the 21st century. It echoed what former Treasury Secretary Henry Paulson said more than a year earlier: The world is at the brink of action when it comes to climate change. If governments want to ensure that global warming is controlled, then limits must be imposed on carbon emissions. Carbon pricing, said Paulson, is the way to do it.

There was one major difference between WRI's explanation and Paulson's, however. The WRI defined carbon pricing largely as having two distinct models: carbon taxation and cap-and-trade systems, whereas Paulson limited his definition to "placing a tax on carbon dioxide emissions," much like a tax we pay on gasoline or cigarettes, only determined by the carbon generated by large emitters.

As both Paulson and the WRI allude, politics drive the choice between the two more than economic benefits or outcomes.

So, what's the difference between the two systems?

A lot, says EOS Climate CEO Joe Madden. The carbon cap-and-trade system is managed by "policymakers that govern a jurisdiction" who "set a cap on carbon and issue allowances," Madden explained. Since the objective is ultimately to reduce carbon emissions, the program usually implements reductions over time, what Madden called "[ratcheting] down the cap" to create shortages that will ultimately prompt a price signal.

Whether regulated regionally or determined by market demand, the cap-and-trade system serves to a) reduce emissions and b) incentivize investment in low-carbon-emitting alternatives, like technology upgrades that will allow the industry to function more efficiently (less carbon emissions) or convert to alternative forms of energy, like renewable resources.

Carbon taxation on the other hand, Madden told us, involves a fixed assessment: a tax that is usually applied against large emitters, particularly in the fossil fuel industry.

"A carbon tax will raise fossil fuel prices — that’s the point," the Carbon Tax Center notes on its website, arguing that "a briskly rising carbon tax will transform energy investment" and incentivize innovation. Proponents also argue that it allows regulators to reduce taxes in other revenue streams and provide rebates to households -- two benefits that have been particularly popular in the province of British Columbia, Canada.

But to be fair, British Columbia's dependence on hydroelectricity and the Vancouver Mainland's historical outlook toward innovative technologies have helped to pave the way away from high-emitting technologies for years. Vancouver is considered a bedrock when it comes to green technology, construction and planning, and carbon taxation has been only one of many mechanisms that has inspired the province's green revolution.

Carbon cap-and-trade: The regulated approach

While both carbon taxation and cap-and-trade systems offer platforms for innovation, Madden pointed out that the cap system is defined by a variety of diverse approaches. Two principle structures are those regulated by a governing body, such as a state, a province or a federal government, and a privately-monitored model, which lets the market set the confines of the system.

The European Union's cap-and-trade system is considered one of the earliest regulated programs to emerge. As with many new initiatives, it took time before the program settled on what it considered to be the ideal approach to address greenhouse gas emissions. But the program helped create a platform for improvement in later, similar programs as well.

"Effectively what they did is they allowed the capped emitters within the system to report their emissions, and they set the cap based on the collective reporting of the cap emitters," Madden explained. "And then that cap was reduced over time based on the percentage of emission reductions they wanted to achieve.

"But what happened was the initial reporting was inflated. It was overstated." As a result, the starting-point for the cap was too high when European companies began to report, Madden continued. "They issued allowances in accordance with the recorded amount of emissions. So, what you have is what is called an over-allocated market: If you have too many allowances, then the price goes to zero."

Some sources believe this is because the European ETS model did not set a baseline before initiating the program, as California did years later. This resulted in what Madden called "phase 2," in which Europe lowered the number of allowances. "And they have struggled since."

California, however, did its homework, which entailed taking several years of carbon emission recording before launching its program. "So, it gave them the ability to really assess what was going on and to more accurately predict what the starting point for emissions was for that market," Madden said.

He explained that while the government-regulated approach has its benefits, there are some advantages to allowing the markets to set the price of carbon, rather than artificially doing so through regulation.

"[There’s] a radically increasing awareness among the institutional investment community that carbon risk is material within their portfolios, and there aren’t simple mechanisms for them to assess, quantify and price that risk today." Going forward, he said, markets need to price risk themselves -- and they need a mechanism with which to do so. "I don’t think regulated markets are particularly effective or necessarily the best. If we can use our existing capital market infrastructure to price carbon, that would be fantastic."

One of the biggest problems with regulatory systems, Madden contends, is that they are isolated. "The California market and California’s policies are very different than, for example, the Regional Greenhouse Gas Initiative, which is a number of Northeastern states, largely focused on the utility sector, and has different trading rules, different political underpinnings. Linkage between two distinct systems can be difficult."

Linkage facilitates trading opportunities between two distinct programs. "And if you go further, you have a European market [that], again, has all its own particular design elements ... according to what was acceptable within the confines of the political world of the EU."

None of these carbon markets are linked, Madden explained. And linkage can be very difficult when each system has its own political and regulatory design that, by definition, is "generated within whatever the local structure is."

Linkage does occur between regional programs, he said, as has now become the case between California and the Canadian province of Quebec. But they have no control over markets in, say, New York, Boston or Taiwan.

Moreover, there is the tendency to think of carbon programs as they relate to Scope 1 emissions, which are direct GHG emissions, such as the carbon tax structure is designed to address, and Scope 2, those emitted from power generation. But as we now know, carbon emissions aren't limited to oil and gas production and power generation. They occur throughout the supply chain. That is difficult to address with a regional cap-and-trade system.

For example, a company with a deep supply chain, like a fashion or product company, may try very hard to do the right thing for the environment. "[They] may have LED lights and be incredibly adept at managing their corporate footprint in their buildings in San Francisco. However, it is very difficult for them to manage their greenhouse gas emissions across their supply chain, which is much bigger than their corporate footprint," particularly if that supply chain is in Asia, or another region of the country not regulated by that particular cap-and-trade program.

"For Scope 3, which is a significant portion if not most of the multinational organizations, carbon exposure is very difficult under the current approach to cap-and-trade."

For this reason, markets can benefit from cap-and-trade systems that can extend beyond regional boundaries and where carbon pricing is set and adjusted by the market, rather than by regional goals. Today, a number of systems exist in the private sector, and they are helping to drive further innovation.

"It is still an evolving stage, but you can see the elements of it emerging. SASB [Sustainability Accounting Standards Board] has also been evolving to be a more meaningful framework within companies’ overall reporting," Madden said, noting that products like Green Bonds, which help fund projects that are environmentally beneficial and help accentuate the goals of carbon pricing, by posing the question: "How can you put value on the preservation or regeneration of natural capital?"

It's a challenge that carbon pricing, with the ultimate goal to benefit the environment and motivate the reduction of climate change, is designed to address as well.

Toward a comprehensive carbon pricing model

Earlier this month, the Obama administration and leading businesses announced further steps to reduce emissions of hydrofluorocarbons (HFCs) -- a particularly potent greenhouse gases used in refrigeration and air conditioning systems and other applications.

This commitment is yet another step toward realizing the benefit of a market-driven carbon pricing system. It considers GHG emissions for given industries (like heavily-traded commodities timber, soy beans and palm oil) and offers the global community a way to assess and impose a price on an instigator of one of the greatest economic and environmental risks we face today.

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