THE IMPORTANCE OF CARBON PRICING

It is an occasional fallacy that we can have a successful market-based policy for our energy needs and for tackling climate problems and that this can always be easily reconciled with continuous downward trends in energy prices.  Markets and prices are essential components of an effective energy policy, especially one designed to attack the large hidden costs of environmental damage and climate consequences. However the essence of markets is that they allow costs and prices to go up as well as down. Reflecting environmental costs in energy markets helps in stimulating low carbon investment, in promoting low carbon operation of the capital stock, and in encouraging lower and less wasteful consumption. But that will on occasions mean that prices rise as part of the natural process, market or otherwise, by which societies adjust to resource limitations and other constraints.

The Case for Carbon Pricing

A general and common sense principle of economics is that if commodities are produced and sold at a price below the cost of producing them, then this is a prime indication that something is wrong. Fortunately market economies do not usually allow this to happen.  Planned economies in which prices are set without reference to cost are a different matter. That is why so much of the former Soviet economies was characterised by waste, inefficiencies and shortages.

But market economies are also in trouble when the largest costs are not carried directly by either producers or consumers, but are imposed on the world at large. This prevents an efficient allocation of resources and will reduce human welfare. That is what is happening with fossil fuels and CO₂ emissions. It is an annoying and inconvenient truth that: “if damaging externalities are not internalised in prices, there is no basis to assume that free markets and free trade will improve human welfare”.[1] In other words market economies that fail to deal with environmental costs will also suffer the historically documented weaknesses of the Soviet system, with excessive and wasteful use of energy produced in an environmentally destructive way, inefficient choice between technologies, and ultimately a shortage of the common good that we call environment.  

When an activity is damaging to society, one option is to prohibit or limit it; we try to do this with dangerous drugs, excessive speed on our roads or various forms of water pollution, usually through regulation but occasionally through a price mechanism. Arguably, “health” taxes on tobacco or sugar also fall in this category. We are beginning to understand, collectively and globally, the scale of our problem with burning fossil fuels and emitting CO₂. Immediate cessation may be an impossibility, but limiting harmful CO₂ emissions through a price or tax penalty is widely seen as necessary and desirable.

The costs of not pricing carbon

A market-based approach that fails to incorporate adequate carbon pricing is unable to deliver low carbon investment or even to ensure the most carbon-efficient operation of an existing stock of plant.  In other words additional policy instruments become a necessity. This impacts on all the main economic features of the sector – incentives for investment, true costs against which the operation of existing plant can take place, and retail prices that encourage economic use of resources (allocative efficiency).

The largest adverse consequence of failure to internalise costs may be the effect on low carbon investment incentives, such as the failures to incentivise the carbon capture investments widely recognised as key, at least with known technologies, to decarbonisation of the power sector at a reasonable cost.  But it can also lead to perverse operational choices between fuels, an obvious recent anomaly (in Northern Europe) being the closure of highly efficient gas power stations, while coal stations continue to operate baseload due to cheap coal. To a significant degree this can be blamed on deficiencies in the EU ETS have given rise to very low carbon prices. In climate terms this is an expensive anomaly, even though the immediate financial implications for the utilities were relatively trivial.

Recent UK experience is an illustration of the scale of the issue at the operational level. Between 2009 and 2012 the substitution of coal for gas, induced by changes in gas/coal price relativities, increased UK coal consumption by about 15 million tonnes. This increased annual CO2 emissions by around 20 million tonnes, to which past Treasury guidelines [2] might have attached a notional “social cost of carbon” value of around £ 1.2 billion. Actual fuel savings to generators are likely to have been at most 10% of this amount.  In other words this single failure to price carbon will, on the basis of UK Treasury guidelines, have generated a real but hidden long term net “social cost” of up to £ 1 billion per annum over that period.

Conditions for a successful policies towards carbon pricing

In some senses carbon pricing is a transitional issue. Since the direction of travel is to a near zero carbon economy, the regulation and organisation of the sector in the very long term will not depend on carbon markets or taxes. Energy prices can then reflect only the cost of supply from zero carbon sources. But this is a very long term perspective. In the short and medium term, even comparatively modest levels of carbon prices can assist attainment of cumulative emission objectives in the timescales with which we are concerned, even if they remain insufficient to incentivise investment.[3]  An important role for carbon prices is to counteract the “rebound effect”, when higher energy efficiency induces (through lower costs to the consumer) additional use. This is particularly important for the heat sector, where energy efficiency programmes are a major instrument of policy.

If the cost of CO₂ emissions is at least partly internalised, explicitly through a tax or cap and trade regime, or implicitly in policy, then consistency matters. Inconsistent or incomplete coverage will lead to “leakage” between sectors or geographies, with perverse effects that can drive up total emissions and damage the competitiveness of more carbon-efficient producers.  Inter alia that implies a strong argument for regional carbon markets such as the EU ETS. The ETS has had many deficiencies which deserve a separate comment, and needs a serious overhaul, but the principle of a wider international market is an important one and should be retained.

It also implies that the coverage of the policies needs to be as wide as possible in sector terms, so that it covers all fuels giving rise to carbon emissions, in all parts of the economy, and not just particular sectors. Without this condition there is again a risk of distortions. 

An example of such a potential distortion was the “twin track” approach implicit in UK Treasury guidelines, in which carbon prices differed as between “traded” sectors governed by the EU ETS, and “non-traded”, governed by an assumed “social cost of carbon”.

Finally, as in shown in a fuller discussion of the power sector, it is quite clear that carbon prices alone are unlikely to be a sufficient measure to achieve the low carbon infrastructure investments that are a necessary part of meeting emissions and climate related targets.

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[1] This expression of the idea is acknowledged to Michael Grubb, speaking at a BIEE Climate Policy Seminar.

[2] Valuation of energy use and greenhouse gas emissions for appraisal and evaluation.  October 2011.  DECC and HM Treasury.

[3] €15/ tonne may be sufficient to induce early gas for coal substitution in existing plant, for example.