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COP26: Last chance for carbon trading?

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Leaders at the COP26 climate conference will consider how to create a framework for global cooperation on carbon markets, which could be a key breakthrough for climate change mitigation.

Carbon pricing mechanisms have long been considered an effective way to galvanise clean technology adoption and global emissions reductions, yet current schemes have been lacklustre. The imminent COP26 conference in Glasgow could change this.

In 2005, the European Union (EU) established the world’s first international emissions trading system (ETS). Since then, similar mechanisms have proliferated, and today the World Bank records 64 carbon pricing arrangements in operation, up by six from the previous year. Most significantly, this year China launched its domestic ETS, which covers 30 per cent of its national greenhouse gas (GHG) emissions and is the world’s largest.

Under Article 6 of the Paris Climate Change Agreement, brokered in 2015, leaders are tasked with negotiating a framework from which these domestic carbon markets could be connected to each other to, in effect, create the foundations for a global emissions trading system. In theory, this would help nations decarbonise faster by supporting investment from one country to the next and by reducing the cost of emission reductions by trading carbon at the most efficient price.

Yet, with competing domestic responsibilities, finding common ground on what is at its core a new cost for business has proved one of the most difficult components of the Paris Climate Accord and the planned discussions at COP26 are widely seen as a ‘now or never’ moment for global carbon pricing and trading.

In theory, carbon pricing mechanisms incentivise big polluters to reduce their emissions by making them pay for the carbon they emit, therefore encouraging them to invest in abating measures, such as more efficient processes and/or cleaner fuels. To work, the costs of the emission-reduction action must be cheaper than the price of the carbon. In this way, the EU ETS was, in large part, successful in making gas-fired profits better than coal-powered ones. For almost everything else, carbon markets have failed to reach this equilibrium, with weak pricing, poor market design, and liberally distributed exemptions meaning current mechanisms have barely dented emissions.

For example, four-fifths of global emissions remain unpriced, and the global average price is only $3 (£2.16) per ton, with countries too scared to impose taxes on their industries for fear of driving up prices too steeply. Only 3.76 per cent of emissions are covered by a carbon price above $40(£29)/tCO2e – yet experts believe it should be double this to spur change.

What’s more, cap and trade systems like the EU’s – where a cap on future emissions is decided and permits sold accordingly – are often rendered ineffective by economic downturns, and indeed pandemics, which have lowered consumer demand and seen emissions fall without big polluters needing to do anything. For example, as coronavirus spread last year, the price of carbon fell 30 per cent in the three months to March.

How carbon pricing works infographic - inline

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Carbon leakage has also been a key factor holding back domestic carbon pricing. When big polluting industries such as the steel sector start incurring increased taxation they might be motivated to move offshore. This wouldn’t remove the emissions from the atmosphere but simply shift them elsewhere.

This is partly why in Europe free allowances are given to most energy-intensive industries, which Carbon Market Watch says has led to companies profiting from the market by up to €50bn (£36bn) between 2008 and 2019.

“This is one of the reasons why the European system has been very focused on the power sector, because you can’t offshore your power by trading electricity with China or the US,” explains Seb Henbest, BloombergNEF chief economist and lead author of the recently published New Energy Outlook (NEO) report.

In theory, a global carbon pricing mechanism could mitigate the carbon leakage risk, while also raising the standards of manufacturing and the speed of clean energy adoption across the globe.

“The more countries joined together under the same carbon price regime, the harder industry can be pushed, which will then drive innovation and solutions and create competition between manufacturers to get their carbon emissions down,” explains Henbest.
Countries that struggle to meet their nationally determined contributions under the Paris Agreement could purchase emissions from other nations that are overachieving on their pledges. Such cooperation under Article 6 has potential cost savings of $250bn (£180bn) per year in 2030, according to the International Emissions Trading Association.

‘The more countries joined together under the same carbon price regime, the harder industry can be pushed, which will then drive innovation and solutions and create competition between new manufacturers to get their carbon emissions down.’

Seb Henbest, BloombergNEF

To develop such a system is fraught with challenges, however. To start, leaders will need to make sure two trading countries can’t claim the same mitigation credit.

“It needs to deliver a global reduction in GHG emissions, rather than just shifting forms of CO2 around. It also needs to deliver sustainable development benefits on the ground, and make provisions for stakeholder consultations and grievance mechanisms,” says Sam Van den plas, a policy director at Carbon Market Watch.

Linked carbon markets tend to see price equalisation, with the lower system taking on the higher system’s price. This is likely to be unpalatable for emerging markets that are trying to grow their economies and standard of living in line with that in the West.

“Often governments don’t want to damage their economic growth, or improvements in living standards, so there’s a really big difference in what’s considered an acceptable carbon price between countries,” says Mark Johnson, technical director for energy and carbon regulation at engineering and environmental consultancy Ricardo. “That’s why the EU can link with Switzerland, which has a similar economy, but not Argentina, who’s got a $5 (£3.60) price,” he adds.

Agreeing on a globally accepted carbon price floor could be a positive outcome if a trading framework cannot be achieved. “From a regulatory perspective, it might be easier to navigate a carbon tax, rather than a market,” says Joshua Firestone, principal petroleum economist at energy consultancy Wood Mackenzie. “But no one’s interested in passing carbon taxes on a massive scale.”

In this respect, the International Monetary Fund has proposed the creation of an international carbon price floor arrangement that would start with the biggest emitters and the G7 and gradually expands to other countries. It suggests two or three different price levels that vary according to accepted measures of a country’s development. As an example, it outlines a three-tier price floor among just six participants (Canada, China, EU, India, UK, US) with prices of $75 (£54), $50 (£36), and $25 (£18) for advanced, high and low-income emerging markets respectively. In addition to current policies, this could help achieve a 23 per cent reduction in global emissions below baseline by 2030, it notes.

Many support such an idea. The Net-Zero Asset Owner Alliance, which is convened by the UN and whose 43 members include some of the world’s biggest pension schemes and insurers, has said a coordinated global price on carbon would give certainty to investors and provide stable and reliable incentives for stakeholders to adopt or develop low- or zero-emission technology. Others such as British economist Dieter Helm in his book ‘Net Zero: How We Stop Climate Change’ believe a carbon price is better than a trading system because “...having an auction over a continuous period of time is wide open to lobbying and political manipulation”, as has been seen with EU ETS.

Map Of Carbon Taxes And Emissions Trading Systems - inline

Image credit: World Bank

Though carbon pricing is expected to be an efficient and effective mechanism for reducing emissions, experts say that on its own it will not be a silver bullet.

“The EU is taking revenues from selling cars and putting them into an innovation fund to support new R&D activities to develop demonstration activities, so clearly, all the EU economists don’t think the ETS carbon price is going to deliver the innovation needed,” explains Johnson. “Investment in early-stage research and development and other types of support mechanisms are also important.”
Neil Hirst, senior policy fellow for energy and mitigation at the Imperial College London’s Grantham Institute, agrees. “It’s only easy to shift from one technology if others are available. In the UK, carbon taxes were successful in helping run down the coal industry because it could be easily and cost-​comparatively replaced with gas and subsidised renewables. The opposite has proved true for gas,” he says.
Yet Helm, who advocates for everything people consume to be subject to a carbon tax, not just the most polluting sectors as currently happens, is unequivocal about the necessity: “If there is not an appropriate carbon price, then decarbonisation at scale will almost certainly not happen.” Because to not have a carbon tax is to pretend that decarbonisation doesn’t cost anything extra, which it does, he goes on to say.

Of course, one of the draws of carbon taxes or emissions trading schemes is that they can provide the capital needed to make the big investments in R&D and pilot projects or to support the poorest nations to decarbonise.

Yet, the fact remains that finding a consensus on a global tax mechanism will be tough, and the experts aren’t hopeful it can be done. “Pursuing a global carbon price requires many countries with very different geopolitical, commercial and economic interests to agree – there’s no sign that can be achieved,” says Henbest. Summing up the general sentiment, he adds: “There’s definitely a real sense that carbon taxes may miss their moment or never really materialise into the solution promised.”


The EU’s Carbon Border Adjustment Tax

When it comes to carbon taxes, the EU has an ace up its sleeve... the carbon border adjustment mechanism (CBAM). Part of a package of climate measures announced in mid-July, CBAM would impose the equivalent of tariffs on imports from countries where producers pay a carbon price below that of the EU’s, set either directly or through an ETS. 

It would work by importers buying CBAM certificates (reflecting carbon content) that cost what the EU’s ETS permits do on domestic producers, thus effectively imposing the EU’s carbon price on importing countries. The adjustment tax will at first only apply to electricity, iron, steel, cement, aluminium and some fertilisers, but could be extended to other products.

The hope is that it will end carbon leakage and the need to handout free credits for the EU ETS.

“CBAM effectively levels the playing field between EU-based companies subject to the ETS and those exporting steel from China, for example,” explains Joshua Firestone, principal petroleum economist at Wood Mackenzie. “It sort of creates a global tax scheme, and if other big players like the US followed suit it would effectively set an international carbon rate, but I don’t see the appetite for that.”

The proposal is controversial, with many countries getting upset about it, largely because it does move away from the voluntary spirit of the Paris Climate Change agreement. “Once you have carbon borders, you make it competitive, even adversarial,” says Neil Hirst, senior policy fellow for energy and mitigation at the Grantham Institute. “Suddenly the climate effort goes from being a cooperative global one to something the West is trying to enforce on the developing world.”

Sam Van den plas, a policy director at Carbon Market Watch, believes the policy could work if the EU recycled some of the revenues back to developing countries to help them decarbonise. “If there are unfair impacts on countries which are highly dependent on specific exports to the EU, they should look at ways to avoid that.”

However, it has already sparked an international response in the direction the EU wants. Mark Johnson, technical director for energy and carbon regulation at Ricardo, who works with governments, including the EU Commission, to design carbon markets and taxes, says countries such as Russia and (so it is rumoured) China, started to look at developing their own national carbon tax systems because they’d rather collect the revenue themselves.

“Countries are definitely taking notice of what Europe’s doing and they’re trying to plan accordingly,” he says.

However, the International Monetary Fund does not support CBAM, saying that, from a global climate perspective, “border carbon adjustments are insufficient instruments, as carbon embodied in trade flows is typically less than 10 per cent of a country’s total emissions”.

Johnson says it is being done in a measured way and people shouldn’t panic. “The headlines seem more dramatic than it actually is, but CBAM covers a relatively narrow set of sectors and they’re doing it in a very gradual way,” he explains.

Although the proposal is likely to be difficult to implement in practice, with the EU needing to find ways in which to rigorously monitor, track and trace carbon footprints, Johnson believes it will go ahead. “There’s a lot of political commitment and capital invested in taking the proposal forward, so they will,” he predicts.

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