L'AGEFI Hebdo - Visible green hand needed!

A global minimum price for carbon was centre stage at the recent COP26 UN climate change conference. Welcome as it would be to see such an instrument become a reality, it is no panacea for the climate transition.

While there is a strong textbook case that once a correct carbon price is set then market mechanisms will automatically drive a pathway to effective decarbonisation, this is challenged in the real world by several important caveats. Addressing these, will require determined and well-designed policy action at both the national and international level.

Carbon pricing today come in several shapes and sizes, but common to all is the challenge of setting the right price and preventing leakage.

The carbon price level can be thought of as an accelerator pedal, determining both how quickly producers and consumers switch to lower carbon alternatives and change spending patterns, and how quickly parts of the current capital stock in an economy become obsolete and drive new investment.

Preventing leakage, where emitting industries shift production to outside the scope of the carbon price and so gain an unfair competitive advantage, is in the textbook case addressed by erecting carbon borders, for example, with a carbon border tax. Ideally, all countries around the world would find incentives to pursue a carbon price and avoid such trade barriers from arising.

Avoiding a negative supply side shock, be it from a shrinkage of the capital stock or trade barriers, requires action on several fronts. Finance sits on the flipside of new capital stock and the idea of a carbon spread on financing costs is very much part of the carbon pricing literature, helping to drive capital flows towards the needed new investment. This is indeed also part of the thinking behind the climate dimension of the ECB’s new monetary policy, along with risk reduction in the financial system.

It’s worth note that as individual companies engage their own voluntary emission reduction pledges many are adopting internal carbon prices with similar effects, be it scrapping capital stock not aligned to the pledges or greening supply chains. Those companies that sit on the sidelines and fail to decarbonise risk being cut off from supply networks, financing and final customer demand.

The market mechanisms of carbon pricing will undoubtedly work but several concerns arise that require well-designed policy action. Top of the list is the concern that carbon prices will hit lower income households the hardest. Highly correlated to this point is that while new jobs will be created in decarbonised sectors, others will be lost with low skill workers likely to be hardest hit. Next are landlord-tenant hurdles, where tenants cover energy costs while landlords are responsible for the investment to drive energy efficiency. Then there are the well-known challenges of securing sufficient supplies of R&D to advance new technologies and ensure that these can be widely adopted. And finally, there are the challenges of the inevitable and sizable price changes that decarbonisation is set to drive.

These challenges, moreover, are not just present within individual countries but also across countries, where there is significant risk of seeing a green divide arising between higher and lower income economies. This in turn has the potential to become a source of geopolitical tensions and drive large disorderly migration flows.

The faster the speed of carbon prices is set, the greater these challenges will become. Conversely, setting that speed too slowly risks not only a more disorderly transition further down the road but also irreversible damage to the natural environment.

Public funds and investment are an obvious answer to many of these challenges, but even if carbon revenues can be redistributed this may not suffice to keep public finances from coming under significant pressure given the many challenges listed above, and not least in low income economies. The assumption, moreover, that the cost of government funding will stay low forever, even in the advanced economies, is far from certain.

The call for well-designed public polices, addressing the structural issues of economies and well-coordinated at the international level, is often heard but there can be little doubt that a visible green hand is needed to aid the market mechanisms of carbon pricing and ensure a less disruptive pathway to urgently needed decarbonisation.