How high do carbon prices need to be?

Putting a price on carbon places the burden for carbon emissions released into the atmosphere (the environmental externality) firmly on those responsible. What is known as the polluter pays principle.

But instead of dictating who should reduce emissions, where and how they do it, a carbon price provides a price signal. If emission cuts fail to meet targets then the price of carbon will rise, and vice versa if targets are overachieved. Polluters must then decide for themselves whether to stop their carbon emitting activities altogether, act to reduce their emissions, or simply carry on regardless and pay for it via the carbon price.

In theory the overall environmental goal is achieved in the most flexible and cost efficient way to society. For example, that same polluter that simply carries on regardless must pay the carbon price multiplied by its carbon emissions, helping to support the carbon price. This then provides an incentive for others (more able and / or willing) to either cut emissions or invest in more carbon efficient technologies. In this way carbon pricing incentivises innovation while also facilitating healthy competition between different technologies. In that sense carbon pricing is agnostic, or at least it should be.

The most advanced emissions trading scheme is the EU Emissions Trading Scheme (ETS). It has been successful in incentivising the power generation sector to move away from coal, and towards lower carbon gas powered electricity generation. In theory the high cost of carbon emission credits makes coal generation less economic than gas or renewables.

In theory yes, but not necessarily in practice. Remember, it’s the switching cost that matters, and if the low carbon fuel has gone up in price more than the high carbon fuel then emissions could still increase. Back in late 2018 the price of EU emission credits rose to what was then a record high of ~€27 per tonne. That should have been bad news for coal. Instead, coal fired power stations roared back to life as the price of natural gas had soared to levels previously seen a decade before.

Most of the gains from coal-to-gas switching have already been captured. Of the coal plants that remain in the EU many are in the process of being switched to alternative fuels such as biomass, or like many of those in Eastern Europe are there for security of supply issues (the alternative being 100% reliant on Russian gas pipeline deliveries).

Up until now it has really only been the power generation sector that has been impacted by EU carbon prices. Industry has seen little or no impact, but that is about to change. The price of carbon may need to be much higher if it is going to result in the behaviour change and technology investment necessary to contain, and even reverse climate change.

A 2017 World Bank-backed commission concluded that carbon prices would need to be between €42-84 per tonne by 2030 to induce the behaviour change and technology investments required to deliver on the 2015 Paris accord pledges to keep the global average temperature rise well below 2C. Another study by Wood Mackenzie estimated that carbon prices would need to be $135 per tonne by 2030 to meet the target. According to leading European industrial companies, the abatement carbon price for the chemical industry is likely to be around €140 per tonne, while for cement it is nearer €120 per tonne.

Furthermore, EU carbon prices may need to be even higher if 2050 targets are to be achieved. According to the European Commission’s recently launched strategic vision for green hydrogen, net-zero emissions by 2050 cannot be achieved without green hydrogen (produced using renewable electricity) contributing a significant part of the solution. However, according to a new report from German think-tank Agora Energiewende, carbon prices need to be €300 per tonne – 6 times current prices – in order to ensure green hydrogen simply breaks-even this decade.

Each study, as well as many others are based on a lot of assumptions. Crucially, they are based on projections of how the cost of technologies thought necessary to combat climate change are likely to evolve. These carbon price estimates come with a lot of caveats, not least that the outlook for innovation and cost savings are inherently unpredictable. Meanwhile, should the carbon behaviour change comes about quicker than economists and politicians expect then there may be less need for such a high price of carbon.

Importantly, its not enough for carbon prices to simply reach the levels indicated above by 2030. In order to really incentivise action, carbon prices will need to front load their impact. That means prices will need to rise much higher, and much sooner and stay there for a prolonged period to provide the incentives to make necessary investments in low carbon technologies.

Related article: How to bet on higher carbon prices

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