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With recent spikes in electricity costs, the debate around ‘carbon pricing’ is gaining more attention than ever. But what is it exactly? How is it interlinked with electricity prices? And what can we expect from the carbon pricing discussions at COP26?
CARBON PRICING: A SHORT INTRODUCTION
Carbon pricing is a tool to reduce carbon emissions. It aims at capturing the external costs of carbon emissions by putting a price on a unit of emitted CO₂ equivalents. The two main approaches are ‘carbon taxation’ and ‘cap-and-trade’ systems, which influence the market in different ways, and face their own respective challenges:
‘Carbon taxation’ sets a fixed price on CO₂ emissions and allows the market to determine the quantity of actual emission reductions.
PRO: fixed price on pollution, set by the governing body. If the price is set correctly, all externalities are captured within the price (but difficult).
CON: not cost efficient and there is no clear view on the amount of abatement. The market decides how much is reduced.
‘Cap-and-trade’ sets the quantity of allowed emissions (i.e. the ‘cap’), hence controlling reductions. Also lets the market determine the price, by allowing the trade of carbon allowances.
PRO: fixed allowed emissions volumes (‘cap’). Market sets the price, i.e. cost efficient.
CON: defining the appropriate cap is crucial yet difficult, market factors influence pricing, abatement cost can exceed estimated benefits of abatement.
Although many national carbon tax initiatives have seen the light of day (35 to be exact), a ‘cap-and-trade’ system is often preferred in an international context (29 existing initiatives). Europe already implemented such a ‘cap-and-trade’ system back in 2008 (the European Emissions Trading System [EU ETS]). Having faced significant growing pains, it has gradually been evolving towards a robust system.
The EU ETS ensures that all available carbon allowances can be traded on the market. This means polluters can either buy permissions to emit carbon or invest in emission reductions or carbon abatement. The system is not perfect: Free allowances are still allocated to avoid ‘carbon leakage’1 risks. Fortunately, the EU’s reduction of these free allowances by 2025 and a carbon border tax should limit this going forward.
ELECTRICITY PRICES ARE SOARING, IS THIS DUE TO CARBON PRICING?
Let’s examine the link between carbon pricing and the recent spike in electricity prices:
In Europe, utility companies are required to buy carbon credits to use fossil fuels.
The high electricity prices are mostly a result of increased gas prices due to shortages. In fact, only 1/5 of the electricity price hike is linked to the EU ETS2.
However, due to increased gas prices, utilities increasingly switched back to coal, driving up the price of the EU ETS allowances.
Nonetheless, the soaring gas prices shake up the debate on the potential (social) impact of elevating carbon prices. As such, one should also consider the potential social unrest fuelled by overly delayed, sudden and steep carbon pricing actions.
However, a global carbon pricing mechanism will likely offer a more level playing field across the world and is increasingly brought forward amongst others due to the EU’s ambition to implement cross-border carbon pricing systems. The upcoming COP 26 will hopefully expand on Article 6 in the Paris Agreement, which lays the groundwork for such an international carbon market.
ALL EYES ON NATIONALLY DETERMINED CONTRIBUTIONS AND AN INTERNATIONAL CARBON MARKET
If we want to limit global warming to 1.5°C, we need to significantly reduce the world’s annual carbon emissions (51 Gton). Only a ‘cap-and-trade’ system allows for control over the acceptable emissions volumes. It needs to be aligned with the available global carbon budget, which must be fairly reflected in the countries’ respective National Determined Contributions’ (NDCs). However, this might require an international market for several reasons:
New, more ambitious NDCs cannot be expected without an international carbon market (remember that the so-called emissions ‘cap’ or carbon budget is linked to the NDCs), as even several of the existing NDCs already rely on international cooperation through carbon markets.
By 2030, an international carbon market has the potential to reduce roughly 5 Gtons of CO₂/year and create up to USD 250 billion/year of cost savings3.
A global system can drive up the carbon price, which will incentivise emission abatement. Advanced economies will need a carbon price of USD 130/ton of CO₂e (by 2030) and USD 250/ton of CO₂e (by 2050) to reach Net Zero emissions4.
How do international carbon markets work?
Countries that struggle to meet their emissions-reduction targets under their national climate plans, or want to pursue less expensive emissions cuts, can purchase emission reductions from other nations that have already cut their emissions beyond their pledge. The result can be a win-win for everyone involved5.
According to Article 6 of the Paris Agreement, negotiations on international carbon markets are a key element of the upcoming COP26 negotiations. But the discussions will be challenging, as the world has already tried for decades to establish an international market6.
TOWARDS A CREDIBLE, PRINCIPLED AND RELIABLE MARKET?
In the past, two carbon markets resulted from Kyoto Protocol on climate change. The Clean Development Mechanism (1) allowed developed countries to reduce their emissions by financing abatement projects in developing countries. Although the system failed massively, important lessons were learned. The more-successful EU ETS (2) is one of the more robust ‘cap-and-trade’ systems and is still evolving. Discussions on carbon markets at COP26 will likely focus on these two markets, especially since Europe is also putting pressure on imports through a carbon border adjustment mechanism, through which imported goods will be assessed on their production’s carbon intensity and charged accordingly.
Several points still need to be clarified: Will we create new carbon trading mechanism or expand on an existing instrument, like the EU ETS? Will we rely on a global trading mechanism or one with regional variations? With carbon prices reaching different levels globally (with Europe leading the way), one might suggest to latter.
In short, we need a just, credible and reliable carbon market, with high levels of integrity. It needs to be linked to increasingly ambitious National Determined Contributions. The ‘cap’ is key. In addition, the system needs to result in real world emissions reductions via a credible trading system/market, characterized by (amongst others) additionality, verification, social justice and no double counting.
1“Under the EU emissions trading system (EU ETS), industrial installations considered to be at significant risk of carbon leakage receive special treatment to support their competitiveness. Carbon leakage refers to the situation that may occur if, for reasons of costs related to climate policies, businesses were to transfer production to other countries with laxer emission constraints. This could lead to an increase in their total emissions. The risk of carbon leakage may be higher in certain energy-intensive industries.” (source: EC).
2According to Frank Timmermans, Vice President at the European Commission.
3Source: International Emissions Trading Association.
4Source: International Energy Agency.
5Source: World Resources Institute.
6Interesting sidenote: due to the complexity, Article 6 was not agreed to until the last morning of the Paris negotiations in 2015.