December 7, 2015
To Recognize the Social Value of Mitigation Actions in a Climate Agreement
By Dominique Finon , CNRS Research Director Emeritus; Researcher at the CIRED; World Bank Consultant on the impacts of carbon pricing on energy policies conducted in the emerging countries.
Economists generally agree on putting a single price on carbon emissions through an international agreement, whether by a binding price (carbon tax) or by an emissions trading system (ETS) based on binding commitments, which would be theoretically the most efficient means to encourage the reduction of emissions to the desired global level (see e.g. Gollier, Tirole, 2015). But, in theory, uncertainties about the costs of the low carbon policies implemented by each country to meet the emissions quota imposed by the agreement make it unlikely that any credible agreement could be reached or respected, either because countries would be reluctant to commit, or due to opportunistic cheating. Moreover, given the realities of inter-state relations without a supreme authority to which sovereignty has been delegated, it is not feasible to reach an agreement based on constraints, threat of penalty for non-compliance and obligations of financial transfers from Northern to Southern countries to ensure the acceptation of developing countries. This explains the setting aside of a uniform carbon price in the international negotiation process.
That said, recognizing the need for a reference price of carbon in the climate agreement would not be vain, since it would guide investment decisions and would base new financing modes of low carbon options; those would take into account the social value of the emissions abatement that is not really internalized in countries lacking a significant and credible carbon pricing system. In no case this would be a comeback to enable a carbon price to emerge on the basis of binding commitments, as discussed during past negotiations, but which is too much time-consuming. The aim would be to give a pragmatic guide for investment decisions of firms and public administrations, to put some economic rationale, and eventually to make the financing of low carbon equipment easier by developing new financial architectures. It would only apply to future equipment, and not at all to emissions of existing equipment and vehicles. This makes it very acceptable for the negotiation of a climate agreement.
A coalition of emerging and developing countries, reinforced by French and Japanese facilitators, managed successfully to introduce the principle of such a recognition into the draft agreement: the parties “recognize the social and economic value of voluntary mitigation actions and their co-benefits to (…) health and sustainable development” (Draft decision, ADP Workstream2, Section II Mitigation, §4, October 2015). This recognition could stay in the final agreement.
Bridging the Gap between Private and Social Values of Low Carbon Investments
To trigger long-term decisions in terms of low carbon equipment, infrastructure programs (buildings, mode of transport, urban planning), or reforms of land use which have an additional cost compared to ordinary emitting options, requires to rely on a credible signal of carbon price. Such decisions need to refer to the social return on investment, not just the private profitability, by a guaranteed level of internalization of the social cost. Without a credible value of carbon by a tax or a well-designed ETS, the current alternative is a quite frequent use of a package of measures: modes of special subsidies for low-carbon energies, emission standards and measures of “command and control” (emission limits by sector, closure of old emitting equipment, bidding for long-term fixed price contracts with a public agency in power markets, etc.), public investment programs in infrastructure favoring low carbon options, with the drawback of having quite different costs of avoided emissions per ton. In the absence of credible monetization of carbon, the definition of a reference value of carbon at the global level, or at least in the club of voluntarist countries, would be useful to provide a relevant index of carbon value for private and public investors. This would ensure consistency between the policies and measures inside a country, or between countries, even encourage the emergence or the fixing of carbon pricing mechanisms (taxes, ETS), sending thus a credible long-term price signal. This would also ensure more consistency between the policies and measures between countries, and help to establish links between carbon pricing mechanisms.
The existence of this reference price of carbon meets the wishes of companies that are calling for the establishment of a credible carbon price in countries with no reliable carbon tax or emissions permit system to guide their long term choice. In the absence of it, the most active companies choose to self-regulate by defining their own internal reference price, as an incentive for choosing lower carbon investment, but sometimes artificially because of the main objective to preserve their image of socially and environmentally responsible.
Such a reference value would also help governments to design public policy measures (vehicle emissions standards for instance). It guides public investments towards less carbon emitting options by the cost-benefit assessment of different policy alternatives. As such, a reference value of carbon is already used in the United States, Canada, Mexico and Europe, in Germany, the UK, Norway and France (since 2009).
To boost low-carbon investments on basis other than voluntary and self-regulation, innovative financing mechanisms could also be a way to internalize their additional economic and social values, compared to baseline investment options, through private loans. Internalization would materialize in a financial asset corresponding to carbon certificates which would be recognized as such by the financial and banking system at the national and international level. This financial asset would be backed by a guarantee given by respective governments on the carbon reference value. This value would be agreed upon at the global level in the UNFCC framework. By bridging the gap between private and social value of carbon, it would remove one of the obstacles to invest in low carbon equipment and infrastructure, related to the non-internalization of the carbon value or the non-credibility of the carbon price when it exists. Indeed these investments are capital intensive with high risk management constraints related to uncertainties from their economic environment (fossil fuel prices, …) and their construction cost, to which a carbon pricing could add a new dimension, as shown by the EU-ETS price. The risk management issue of low carbon investment alone would already justify the establishment of risk-sharing arrangements, such as loan guarantees from government (see Canfin & Grandjean, 2015, "Mobilize Climate Finance", report of 18 June). The purpose of a superior financing mechanism is to add a value of carbon to profitability of projects and a guarantee on the value of the ton of CO2.
The avoided emissions allowed by low carbon project should become carbon certificates which have to be recognized as a new financial asset by central banks and valued at the reference price of carbon. They would constitute a new vehicle of intermediation between the banks which would lend to low carbon investors which will partly reimburse with their carbon certificates on one side, institutional investors (pension funds, insurance companies, sovereign funds) which could buy the carbon certificates to lending banks on another side, and to central banks (to the IMF also) which accept refinancing these loans including these carbon assets on a last side hand. The reference value of carbon should be introduced before the other rules which structure this mechanism. These rules are a credible system of validation of carbon certificates for low carbon projects by an international agency, a possibility for borrowers to partly repay their loans with their carbon certificates, new prudential rules that recognize these certificates as assets in the balance sheets, possibilities of refinancing bank loans by central banks in exchange for these carbon certificates (Aglietta, Espagne, Perrissin-Fabert, 2015 ; Hourcade, 2015 ; Hourcade, Perrissin-Fabert, Rozenberg, 2013).This system could be set up as a G20-type club and with the coordination of the involved central banks, gradually aware of the need to fight against climate change.
How to Fix the Reference Value of Carbon?
To set the carbon value, one option focuses on the social cost of carbon within a global cost-benefit approach; another more realistic one refers to the marginal cost of actions, allowing to be set on the right trajectory of emissions for 2030-2050, in an either globally or nationally cost-effectiveness approach. The first approach is that of the US administration since 2005 and proposed by the Stern Report (Stern, 2006). It leads to choose the value of a ton of carbon that achieves the optimum level of GHG concentration: at this optimum the marginal damage for the planet of an additional GHG emission equalizes the cost of the marginal abatement action to limit the emissions allowing this level of concentration. But it assumes that one can correctly measure the cost of all damages resulting from global warming associated with the marginal ton emitted at some time which is its main weakness.
There are and there always will be many uncertainties, especially in the relationship between temperature and damages due to the difficulty of integrated models to estimate them with a good relevance, of taking into account the location of damages while there are differentiated values of damage in relation to income levels (can we assume the same disutility by country?). The others difficulties concern the time spread of the effects of a marginal ton emitted at a specific date, and the discount rate to be used. The debate on the social cost of carbon has focused on this point over the past fifteen years, with those advocating the use of a very low rate (e.g. 0.001% as Stern 2006 did in some political scenarios), and those advocating normal levels of 4-5% which highlight the effort of the current generations: the first position could lead to a result 100 to 150 times greater than that obtained with the second approach, with estimates ranging from $60 per T.CO2 to $1025 per T.CO2 (for a summary of the controversy, see Grubb, Hourcade and Neuhoff, 2015, chapter 1, section 1.3). In addition the value of marginal damage also depends on the policies pursued by countries and their effectiveness, which is difficult to anticipate.
The "cost effectiveness" approach, used in France since the Quinet report (2009) and in the United Kingdom since the 2009 DECC report, assumes that the targeted objectives of reducing emissions will not overcome the +2°C. The carbon value is then equal to the shadow price of the constraint of emission reduction. This means that we must be prepared to pay between X and Y in 2030 and, say, 2X and 2Y in 2050 for example, to reach the target. But if our willingness to pay is lower than 50%, we should resign to a rise in temperature of +3°C. That said, this approach requires to make accurate assumptions about policy implementations that can vary over time, and about the development of new low-carbon technologies, which constitutes two sources of uncertainty. However an agreement on the reference value is easier to find with this approach based on the marginal price, since the marginal cost of carbon abatement actions is more easily visible. This avoids having to agree on the social cost of carbon. More countries could accept a similar reference values in a perspective of global emissions reduction. It might happen, despite their views that may differ on the relevant distribution of the burden to reach the limit of global emissions, that might be reflected in the diversity of the costs induced to reach the respective voluntary commitments (INDCs).
The choice between these approaches will be guided by pragmatism, the second one having the merit of consistency and being less exposed to disagreements. To choose aligning the carbon value on the marginal cost of abatement means to seek a consistent valuation with the objectives of limiting the growth or reduction of emissions included in short-term and long-term programs adopted by countries. This being said, a debate will probably develop on the inclusion of co-benefits of abatement actions in carbon reference value for two reasons. On the one hand, since Rio 1992 and Cancun 2010, the fight against climate change is linked to the development of emerging and developing countries, reconciling it with the constraints of sustainability. This implies to identify measures and emission control policies that offer important co-benefits in terms of environmental externalities and induce effects on development. On the other hand, emerging and developing countries feel doubly concerned by the inclusion of co-benefits in this reference value because they could benefit from higher funding for the set of their low carbon projects for which they seek private and foreign financing, given the higher value of the reference price when it includes co-benefits.
Such integration would be consistent with the cost-effective approach when it considers only the costs of achieving a given emissions target. Indeed the economy of the country is not on the "economic and social efficiency area", given the presence of non-optimal taxation, non- internalization of environmental externalities, and also the potential induced effects of development (dynamic efficiency). Add co-benefits of low carbon to shadow price of abatement constraints is strictly in line with the recognition of the effects of carbon abatement measures on health through the reduction of air pollution (lower mortality and respiratory diseases) in transports (reduction of congestion, etc.), agriculture, buildings, electricity production, energy security, etc., as did the latest report of the IPCC Working Group III. In the emerging and developing countries, further ascendant approaches have emerged that do not place emission reduction at the top of the political agenda but simply integrate climate issues into development policies, which leads to jointly taking into account the benefits of reducing emissions and the benefits of these actions in terms of development (e.g. Shukla and Dhar, 2011).
If the countries involved are truly determined to make the decisions, they could easily agree to fix the social and economic value of carbon emission reduction and its rapid growth trajectory. In a context marked by proactive commitments of some countries, nothing would prevent them from fixing the reference value of carbon and its trajectory at a high level from the start: for example, $50 per T.CO2 in 2020, and then $100-150 per T.CO2 in 2030, etc.
The Advantages of a Reference Value of Carbon over a Binding Carbon Price to Reach an Agreement
The advantage of a reference value of carbon as compared to an explicit carbon pricing that could only come from binding rules (taxation or binding commitments) for reaching an agreement is threefold.
- First the use of a reference value of carbon only applies to future equipment, not existing technical capital in industry, commercial and domestic sectors. It does not involve direct payments that would weigh on industrial firms, transporters, households for emissions of their present equipment. It implies cost increases in the cost of products and services offered by new low carbon equipment and infrastructures whose investment will be decided taking into account the social value of abatment action. The use of such a reference value which does not weigh on installed capital, has much less redistributive effects and does not oppose to industrial interests. We could then agree more easily on the rapid growth of the value of carbon, which could be much faster than that of a carbon price by taxation or ETS at worldwide level.
- The adoption of a reference value of carbon does not oblige a country to adopt a high carbon price as a tax or permit system which reflects its voluntary commitment. For developing countries, it introduces a carbon price of reference at the global level, which will contribute to guide external funding towards investment in low carbon equipment by guaranteeing the value of carbon assets in financial intermediation. For those who have already introduced a carbon pricing system, it would be an additional incentive to invest in low-carbon options, especially if the carbon tax or the ETS price is low and ineffective to send effective price signal.
- The definition of an economic and social value of mitigation actions would not at all be conflictual exercise on the opposite of what would be the definition of a burden sharing between countries on which would be based binding commitments. Given its importance for enabling access to new financial instruments by developing countries, it is fully consistent with the desired cooperative game between North and South. Moreover the existence of a reference value of carbon does not at all require compensations between North and South countries as opposed to seeking a single carbon price at the global level.
Such a reference value for new private financing channels between North and South could be a determining factor for introducing the principle of development in the Paris agreement. But even without the establishment of such innovative funding channels, a reference value of carbon will be useful for investment decisions taken by businesses and governments in each country without effective carbon pricing mechanisms. Therefore it will be a chance if the Paris agreement includes the provision recognizing the social and economic value of mitigation actions and their co-benefits.
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 There exist some places for coordination of central banks where these common rules could be defined, including the Financial Stability Board, which brings together the most important. Recently this board have been made aware of the issue by the mandate that the G20 has entrusted to study the potential impacts of climate change on financial stability.