Advances in technology are not the only means of reducing the emissions of greenhouse gases and slowing the pace of dangerous global heating: legal, financial and trading structures are equally vital in the battle to keep carbon emissions in check. In this article, Ricardo experts – working on the frontline of bringing nations together via international mechanisms that aim to rebalance the global climate – share their thoughts on the future of carbon management and changes on the horizon.

Carbon is everywhere – quite literally. Not just at the top of every news bulletin or all over our newspaper front pages, but in plants, trees, animals, in the soil, the seas and oceans and, most critically for our climate, in the air. And it is the fast accelerating concentration of carbon in the atmosphere that is the central cause of climate change – which many believe is the biggest existential challenge ever to confront humanity.

Many years of political and diplomatic negotiations, including the Kyoto and Copenhagen agreements, culminated in the 2015 Paris Agreement on Climate Change, which finally achieved consensus within the international community. Drastic and sustained cuts in carbon emissions would need to be made if the doomsday scenario of runaway global heating was to be averted, and all nations needed to play their part.

“Being able to meet the Paris warming target of 1.5 degrees requires a steep downward trajectory in carbon emissions”

“Being able to meet the Paris warming target of 1.5 degrees requires a steep downward trajectory in carbon emissions,”says Mark Johnson, carbon markets business manager at Ricardo Energy & Environment.
“What the Agreement did was to create the framework and the international political commitment to be achieving that goal, through a process where each government makes its own nationally determined contribution, or NDC. For the first phase, to 2030, this is based on the country’s economic circumstances and its capacity to make reductions.”

Despite the severe blow of President Trump withdrawing the US from the accord, the vast majority of the Paris Agreement’s 197 signatory nations are on board and carbon reduction has become the keynote issue of our times. But while the necessary carbon-descent trajectory is plain for all to see, how the burden will be shared is still an intensely political question, laden with economic, societal and individual consequences that will affect millions, if not billions, of people and the lifestyles they lead.

Yet, as Johnson readily concedes, even with the first round of promised national reductions aggregated together, the combined total was never going to be enough to achieve the 1.5-degree target. The expectation has always been that the pace of those reductions will need to be stepped up substantially to keep carbon in check: already eight countries have submitted updated NDC targets and two more are at the proposal stage.

Instruments for carbon control

Many of the lower-level measures for driving down carbon emissions are already in operation: consumer product labelling and standards that encourage energy efficiency; taxation on fuels and congestion charges for inner-city zones and state support for low-carbon innovation. The net zero carbon targets announced by many governments and businesses have brought added focus to the issue, and in several countries products are now taxed on their notional carbon content.

Less obvious are the behind-the-scenes mechanisms that are contributing to greenhouse gas (GHG) reductions and the targets set out in the Paris Agreement. Many countries, regions and economic blocs are determining their own targets, establishing policies, incentives and timetables for individual industries to cut their emissions, and monitoring and verifying the reductions actually taking place. And at the core of enabling these mechanisms to function smoothly and transparently is the concept of putting a value on every tonne of carbon emitted, saved or captured.

“carbon pricing is one of the most important mechanisms we have”

“Carbon pricing is one of the most important mechanisms we have,” says Johnson. “It works by sending out an economic signal and it provides the incentive for emissions to be reduced wherever it is cheapest to do so.”

The common currency of a carbon price is already allowing trading in carbon, most notably in the EU’s Emission Trading Scheme (ETS), but elsewhere too. Emitting industries must purchase allowances (EUAs) to enable them to emit carbon; the cost of these allowances is passed on to the end customer in the form of higher prices. Taking the example of the electricity generation sector, the higher consumer prices then make it even more advantageous for zero-carbon energy suppliers – who will not need to buy allowances – to invest in additional and improved generation capacity.

By capping the number of allowances issued, authorities have a tool to effectively limit the total amount of carbon emitted in any given period. In some variations of the trading mechanism, low-carbon producers can be allocated credits which they can then sell to higher-emitting businesses. In addition, further markets are evolving in carbon futures and carbon derivatives.

Already, around half of Europe’s GHG emissions are covered by the ETS scheme. It encompasses the most carbon-intensive heavy industries, such as power generation, steel and cement, glass and even some aspects of transport such as internal EU aviation. Trading systems in general can also provide credits for removing carbon from the atmosphere through schemes such as forestry or carbon capture and storage (CCS); the proportion of removals is still small, but is set to grow as technologies improve. Globally, according to the World Bank, some 22 percent of GHG emissions are covered by ETS or carbon trading schemes.

The Paris Agreement also makes provision for the trading of allowances between nation states, so countries such as Suriname and Bhutan, which are both net absorbers of carbon rather than emitters, have the opportunity to be rewarded for their favourable GHG performance.

Carbon leakage and the limitations of markets

Carbon cap-and-trade systems have been shown to work well when it comes to heavy industries in fixed locations: across Europe, GHG emissions from these sectors have fallen by more than 16 percent since the ETS started in 2005. But for obvious reasons the system is less effective when an industry straddles the borders of many jurisdictions, as in the case of aviation. How, for instance, should international carrier Air France register its transatlantic flight emissions?

Though airline emissions are still relatively small at two percent of global GHG output, the steeply rising trajectory of air travel has raised alarm and has led to the establishment of another form of carbon control – CORSIA, or the Carbon Offsetting and Reduction Scheme for International Aviation. This is the first sector-specific global agreement and is designed to allow the industry to continue to grow, but only on a carbon-neutral basis – see adjacent box out. Work on an entirely different parallel scheme for the shipping industry is at an earlier stage.

A potentially bigger limitation of regional or even continent-wide carbon trading schemes is the problem of carbon leakage, as Mark Johnson explains: “Take the example of the EU’s steel sector, which needs to improve its carbon performance in order to be part of the EU’s reduction trajectory. Overall system emissions are capped, so this imposes extra cost and makes European firms less competitive compared with producers in other countries – China, for instance – where carbon emissions are cheaper.”

It could then follow that less steel is made in the EU and more in China. And if Chinese steel plants are less efficient, warns Johnson, this will actually push global emissions up, “which isn’t what we want”. These global disparities in carbon pricing also risk distorting the siting of international investment: in the absence of an agreed international price for carbon, the closer alignment of the various jurisdictions would be a positive step.

Why is the price of carbon so low?

Given that emitting carbon to the atmosphere is the root cause of dangerous climate change, it is legitimate to ask why the price of carbon is so low. In principle, the carbon price in any jurisdiction will be determined by how expensive it is for the local industries to meet their carbon targets – so the looser rules in, say, China would lead to a lower price per tonne in that market. The problems come, as we saw above, when the differentials are so large that they influence decisions on procurement and investment.

The IMF has estimated the average carbon price around the world at just $2 per tonne of CO2 equivalent (tCO2e). This is somewhat concerning in the light of the independent High-Level Commission on Carbon Pricing’s calculation that carbon prices of at least $40–80 per tCO2e by 2020 and $50–100 by 2030 are required to costeffectively reduce emissions in line with the temperature goals of the Paris Agreement. As of today, reports the World Bank, less than 5 percent of GHG emissions currently covered by a carbon price are within this range, with about half of covered emissions pegged at less than $10.

These low prices, notes Johnson, have little to do with the carbon pricing mechanisms themselves: “Instead,” he says, “they reflect low levels of government ambition. If it’s a carbon tax, then it’s a treasury decision – what that government sees as the price necessary to drive the emissions reduction outcome that it wants; this is also coupled with the political and economic willingness to pay. If it’s on a trading system, then the price emerges from the cost of meeting the particular carbon budget.”

The marked difference between countries is explained by the level of climate ambition displayed by each nation, suggests Johnson. With a carbon price pegged at almost $120, Sweden places a very high value on reducing GHG emissions, and its citizens are prepared to accept the cost; countries with heavy GHG emissions from legacy industries hardly value carbon at all. Local and regional trading schemes evolve their own prices, and many are clustered around the $15 band, with the EU’s ETS rising steeply past $19 as of April 2020.

A possible inflection point was noted by the Financial Times in June this year. “Although at the current levels the benchmark EU [carbon] Allowances contract is still below its all-time high of €30, in another sense EUAs have in the past two weeks traded higher than ever before,” the paper reported. “This is because for the first time in their 15-year history, EUAs are now trading above the upper end of the so-called fuel-switching range – the range in which EUA prices incentivise less carbon-intensive gas plants to displace more carbon intensive coal plants.”

Strong commitments needed

The significance of the EUAs’ recent upward trend is clear. Even a widespread switch from coal to gas will not be enough to keep emissions on track to the EU’s declared net-zero target by 2050: carbon reduction investment must shift into other technologies and other sectors.

But the EU is an exception: it is a highly organised and regulated market, and one with a clear Green Deal pathway towards net-zero GHG. The EU’s strong commitment to carbon reduction is supporting the ETS and its derivative markets, and most of the mechanisms can be seen to be working effectively.

Regrettably, however, that is not yet the case everywhere in the world. For global decarbonisation to gather the necessary momentum, what is now needed is for governments to engage with the international co-operation mechanisms already in place, most of them defined by the Paris Agreement. And it is here that Ricardo specialists are most active, assisting governments as far afield as South America, South Africa, Turkey and Jordan in developing climate-change law, strategies for transport, for carbon markets, and for taxation and offsetting.

The key to all these initiatives, (as is clear from the accounts in the boxouts included in this article) is to enable governments to participate more fully in both internal and international carbon-reduction protocols; nevertheless, many emerging economies have conflicting priorities such as the alleviation of poverty, and their embracing of the Paris processes may be slower than that of richer nations with greater capacity to make the necessary reductions.

Parallels with financial accounting

After many years of holding back, the business community is now beginning to accept the need to reduce its impact on the global environment, acknowledging that this requires monitoring and disclosure as well as low-carbon investments and even divestment away from fossil fuels. In 2015 the Task Force on Climate-Related Disclosure drew up its guidelines for corporate reporting of future risks related to climate change (see RQ Q1 2020), and Ricardo has worked actively since 2012 with the World Bank’s Partnership for Market Readiness, which seeks to bring together innovation and funding to support capacity building and the scaling up of climate change mitigation actions.

Also founded in 2015 is the originally Dutch-based Partnership for Carbon Accounting Financials, which is expanding globally and will launch harmonized and transparent global carbon accounting standards in January 2021. Pointedly, on its website it observes that since the Paris Climate Agreement the largest banks have still invested nearly $2 trillion into the fossil fuel sector. This, said the PCAF last year, is equivalent to $2.4 billion for every working day since the end of 2015, with no downward trend and no assessment of the carbon impact of that finance.

However, recent fossil-fuel divestment decisions by some financial institutions may begin to reverse that trend, as may the net-zero pathways announced by some of the major oil companies.

What next?

The direction of travel for carbon markets is clearly towards a much greater prevalence, where they will draw in fresh sectors and increase
the scale of their ambitions. It is likely, says Johnson, that carbon instruments will become more substantial over time as countries need to deliver more change and carbon prices rise.

“For a while now,” he explains, “there has been a trend away from the economically pure vision of carbon markets only as a price signal, and towards a more nuanced view where governments have a bigger role in protecting industries and supporting research and innovation in a way that is pragmatic but not necessarily so free-market ideal.

“We have already seen this in the responses to the financial crash of 2008, when the carbon market didn’t work so well and had to be reformed,” he continues. “What will be interesting to see is how the markets evolve over a five-year timescale as a result of the present pandemic.”

As the more advanced economies make progress towards their netzero GHG targets there will clearly be a much greater role for carbon markets in creating incentives for carbon removals. Carbon pricing provides enormous potential for contributing to international efforts to meet the Paris Agreement goals to limit global heating – but, equally, there is a huge amount of work to do this in a way that is equitable, that recognises each country’s own circumstances and which avoids challenges like the risk of carbon leakage. And it is in these areas that Ricardo is especially active in helping to shape that all-important political agenda.