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role of carbon prices in energy transition

June 2021

The world needs a much higher carbon price

Carbon pricing has so far failed to take off. But it could soon become a pillar of the green economy.

The transition from a fossil-fuelled economy to one powered by renewables carries the promise of being as transformational as the agricultural and industrial revolutions.

But as things stand, hopes for containing climate change look ambitious.

New net zero pledges from the US, China and Europe are inadequate. They still leave the world far short of the Paris Agreement goal of limiting global temperature rises to below 2 degrees Celsius from pre-industrial levels.

This is why carbon pricing is essential.

According to members of the Pictet Clean Energy Advisory Board, a fully functioning carbon pricing mechanism could be the difference between halting climate change and allowing it to spiral out of control.

Market forces, they argue, can be a powerful ally, helping change the behaviour of businesses and consumers.

The problem is finding a way to harness them effectively.

Currently averaging globally at just USD2 per tonne of CO2, the carbon market is clearly not doing the job it was set up to do. The International Energy Agency says carbon prices need to rise to as much as USD140 by 2040 to meet Paris goals.


Breaking the tragedy

Getting there will not be straightforward.

As former Bank of England Governor Mark Carney warned, the battle against climate change is hampered by the “tragedy of horizon”. In other words, the current generation has no direct incentive to fix the problem when catastrophic impacts of climate change will not be felt for decades.

By making carbon emissions more costly today, however, there is the possibility of avoiding that tragedy.

The World Bank’s modelling has shown that carbon pricing has the potential to halve the cost of implementing Paris targets, saving some USD250 billion by 2030.

One problem is that carbon pricing schemes don’t cover nearly enough of the world’s emissions.

Globally, the carbon pricing market accounts for about 12 gigatonnes of CO2 equivalent – which translates into just under a quarter of all annual global greenhouse gas emissions.1

The US, the world’s biggest polluter, does not even participate in carbon trading at the federal level while the Paris climate agreement did not include a provision for pricing carbon.2 Industry lobby groups in coal, oil and gas sectors had been fierce opponents too.

And then there is a wide divergence in prices from country to country.

European countries set the example.

Sweden levies the highest carbon tax in the world at SEK1,190 (EUR117)/tonne CO2, covering about 40 per cent of its greenhouse gas emissions.

In Europe, the world’s biggest and oldest market, carbon prices rose more than five-fold since 2018 to a record high in May (see Fig. 1).


Fig. 1 - Pay-as-you-pollute
European Union Carbon Emissions Allowances (EUA) December 2021 futures
EUA futures

Source: Bloomberg, data covering period 01.01.2017 – 28.05.2021

But elsewhere, carbon remains under-priced.

According to the IEA, the average carbon prices would need to rise almost 50-fold to USD75-100/tonne by 2030 and then USD125-140 by 2040 to meet Paris Agreement goals.

University of California San Diego researchers believe even that will fall short.

Their study puts the social cost of carbon – which takes into account empirical climate-driven economic damage estimations and socio-economic projections – at a staggering USD417/tonne.3

The lack of a harmonised market and a unified global carbon price are perhaps the most significant problems.

Businesses, especially in energy-intensive industries, may relocate out of countries with high carbon costs into those with laxer emission constraints – in a phenomenon known as “carbon leakage”.

Our advisory board members say renewed international efforts to fight global warming could encourage more countries and regions to start adopting carbon pricing schemes. That should push prices higher in the long term and prevent carbon leakage.

The signs are encouraging. In China, which launched its national carbon market in February, market participants expect the price to average RMB66/tonne (USD10) in 2025 before rising to RMB77 by the end of the decade.4 It has the potential to be the world’s biggest carbon market.

Elsewhere, the American Petroleum Institute, the powerful fossil fuel lobby, is now endorsing the introduction of carbon prices in a major policy reversal that underscored seriousness in tackling climate change.

What’s more, Brussels plans to present proposals to revise and possibly expand its emission trading system in line with the European Green Deal and its new target to reduce greenhouse gas emissions by at least 55 per cent by 2030.

One way to improve the emission pricing system is to expand the use of carbon credits. Governments can give out credits to businesses that lower their carbon footprint with carbon capture and storage (CCS) technology, reforestation activities or energy efficiency solutions.

This way, companies can gain flexibility in complying with carbon pricing regulations.

The discussion on carbon pricing and credits is likely to feature prominently during the landmark UN climate talks in Glasgow later this year as potential cornerstone to supporting climate goals.

Accelerating innovation

An overlooked benefit of effective carbon pricing is that it can also accelerate the pace of innovation in clean energy technologies and promote a faster and broader adoption of products and services that have yet to become commercially viable.

For example, our Advisory Board members say, certain types of hydrogen power generation that combines carbon storage could become cost competitive if carbon prices are set around EUR60-70 per tonne of CO2.

Other technologies that could become viable at higher carbon prices include advanced power transmission mechanisms and next-generation batteries.

This would have significant benefits. The IEA estimates such technologies alone have the potential to cut global energy sector CO2 emissions by nearly 35 gigatonnes of CO2 by 2070, or 100 per cent of what’s considered sustainable in the same period.


Fig. 2 - Innovate to reduce
Global energy sector CO2 emissions reductions by current technology readiness category
emission

Cumulative emissions reductions by 2070 in the Sustainable Development Scenario (the IEA’s goal in line with energy-related components of the Sustainable Development Goals) relative to the Stated Policies Scenario (which assumes all the currently stated policies have been implement) Source: IEA, 01.07.2020

The transition to a decarbonised economy will be among the most wrenching socio-economic shifts humans have ever experienced. Yet even though the survival of the planet is at stake, resistance to change is proving difficult to overcome. A higher carbon price can smooth the path.