Carbon pricing: changing financial flows for the energy transition

 This article is part of Friends of Europe’s latest discussion paper ‘The overlooked side of the ecological transition’, available here. 

Climate change is a market failure that highlights the core flaw of economic theory. More specifically, it fails to appropriately price carbon at its true societal and environmental cost. The short-term profit/cost optimisation formulas still used in most investment plans seem irrational given that they continue to overlook the exponential growth of negative externalities.

The logic underpinning capital markets today is still one which prioritises self-preservation, as opposed to transformation.If we are to actually meet the Paris Agreement’s ambitious goals, it is clear that we will need to rewrite the current economic model so that it supports a swift, cost-effective energy transition. Carbon pricing is an essential tool to this end as it can speed up rapid emissions reductions, support innovation and enable sectoral and cross-sectorial transformation.

In fact, a combination of several forms of carbon pricing within the same jurisdiction, i.e. at both the regional and national levels, seems to work well and can be designed to support a wider portfolio of targeted transition policies. For example, the UK has been operating a national carbon price support system on the top of the EU-wide price set by the Emissions Trading System (EU ETS). This has allowed the country where the industrial revolution started to reduce its coal-generated emissions by 80% emissions in just five years. It has also allowed them to undergo a whole coal-to-renewables transition in a little over a decade (without needing to rely on new gas).

While policy interactions do need to be managed to avoid offsetting each other, it is possible to accelerate emission cuts through enhanced interaction. Additionally, setting carbon pricing as the main catalyst generates revenues which can then be recycled. In the case of the EU alone, well managed policy interactions supported by the EU ETS could increase our 2030 reductions beyond a 50% reduction by 2030, as compared to the current 40% target.

In 2018 alone, we have concluded a revision of the EU ETS which has led to a rapid fourfold increase in the EU-wide carbon price in just one year. Sandbag was very active in trying to fix some of the core issues plaguing the scheme during the previous phases. The next phase now looks like new territory for carbon markets.

The price increase for allowances has had ripple-like beneficial effects in the direction of increasing revenue streams created specifically to support innovation and modernisation of the sectors covered. More specifically, with a fourfold increase per tonne of CO₂ equivalent emitted, we also have a quadrupling of the amount of money available for investment in industrial innovation or the modernisation of the wide range of energy system upgrades needed over the next 10 years. This was made possible through the creation of an Innovation Fund and a new Modernisation Fund under the EU ETS. These funds are meant to support transformations that less well-off member states of the EU need.

In addition to this fund, a solidarity top-up was also introduced for these countries, as well as a Just Transition Fund intended to alleviate some of the social costs of these policy measures. However, the positive reception of this news is still lagging and there is a real risk that the importance of the funds made available for the next decade will be poorly managed in order to slow the transition, instead of accelerating it, despite having resources in place to cushion the impact.

Positive stories exist but the true cost of undoing more than four centuries worth of fossil fuel-powered growth is hardly something anyone can estimate. At the time of this contribution’s publishing, we live in a world which has exceeded 415 Mpp CO₂ concentration in the atmosphere – the highest CO₂ concentration in the atmosphere in human history. Given the scale, scope and exponential nature of this emergency, the number one priority has to be on the slowing down and, where possible, phasing out all together and swiftly transitioning from the largest emitting sources of CO₂.

Fossil fuels, industrial processes and exponentially rising aviation emissions are all concerns which need to be urgently prioritised. This is where carbon pricing can be a real game changer. Unfortunately, the political will to take swift action does not match the level of responsibility required. Each continues to be protected either by the delaying of a scheme to address them or by free permits.

Carbon pricing is still perceived solely as a burden by some stakeholders. Heavy industry, to name but one, believes that such a price on emissions will expose them to trade competition from regions with lower carbon prices and might force them to relocate. At the same time, the funds mentioned previously are not available in other regions around the world and incentivises them to remain and take part in the transition inside the EU. Relocating is expensive in itself and does not remove the risk that carbon pricing schemes will emerge in their new locations within the next five years of the Paris Agreement timeline. We can expect this reality to come to fruition as the Agreement’s Article 6 has paved the way for it.

The free allocation model used for industrial installations under the EU ETS created mixed incentives embedded in the scheme through the formula used to award the top 10% of performers and shield industry from the impact of the price. Sandbag supported a tiered approach, or a dynamic one, to free allocation, to better reflect the trade intensity of carbon intensity of products. However, the status quo of up to 100% allocations prevailed, despite the longer-term negative impact of this system. The tiered approach was endorsed by the European Parliament but, following heavy and concerted lobbying by heavy industries, the system went back to what it was during Phase III – one that does not incentivise innovation.

We also carried out a call for evidence accepting submissions from industrial actors covered by the carbon market only to find out that this incentive has also worked to deter ground-breaking solutions to come to the market in the EU. This would have ‘upset’ the balance of allowances that the majority of installations were planning on receiving into their accounts. Product substitution was a disincentive, for example in the steel and cement sectors, and low-carbon solutions were placed at a competitive disadvantage.

In previous studies, it was discovered that some industries have been gaming the rules of the EU ETS to secure windfall profits. This continues to be a challenge for the EU ETS and will be so for the next decade. Incentives aimed at aiding industrial efforts to decarbonise in a cost-effective manner will have to come from outside of this mechanism through additional policies.

The type of lobbying which overlooks our current climate crisis is the key stumbling block in moving the conversation closer to a focus on the innovations that need our financial support. It also ultimately contributes to increasing the cost of the energy transition. We have yet to unleash the power of markets in supporting the transition but we still rely on the markets to lower the costs of low carbon technologies. Clearly, we can’t solve a problem with the same mindset that created it and carbon pricing instruments will have to be used swiftly, creatively, in tandem and as effectively as possible.