Economists have long been familiar with the concept of “negative externalities”, which may be defined as a cost that is suffered by a third party as a consequence of an economic transaction.
One hundred years ago the British Economist Arthur Pigou advocated the adoption of taxes to remove market inefficiencies and ensure that the full social cost of the economic activity was reflected in the price.
Greenhouse gas emissions are an example of such a negative externality. In 2005 the European Commission introduced the EU Emissions Trading Scheme (EU ETS) to reduce the level of emissions within the EU, in a cost-effective and economically efficient manner. The EU ETS is a cap and trade scheme and remains the largest multi-country scheme of this type in the world. For much of the decade to 2020 the underlying price per tonne was less than 10 Euros, mainly driven by a surplus of emissions allowances as a consequence of reduced emissions from weak economic growth, and therefore the effect of the scheme has been relatively benign.
However, it is clear that the 2020s will be a very different decade in terms of carbon pricing. In tandem with EU Green deal, the European Commission has issued a series of consultations on matters relating to the EU ETS, including the proposal for a Carbon Border Adjustment Mechanism (CBAM). The purpose of the CBAM is to prevent carbon leakage – that is the displacement of carbon emissions from the EU to non-EU countries, where the goods and services produced from these activities are imported to the EU. Such carbon leakage frustrates the efforts to address climate change and impacts the global competitiveness of EU businesses. The CBAM will impose a tariff or other levy on certain imports into the EU and will be an extra-territorial mechanism to drive a reduction in emissions in no- EU countries. Although the precise mechanism hasn’t been determined the intention is that the CBAM will be in place by 2023.
In the meantime, revisions to the EU ETS are gathering momentum with a consultation on changes to the scheme concluding on the 5th of February. These changes will underpin the EU’s revised target of a 55% reduction in emissions by 2030, compared with the previous 43% target (both against a 2005 baseline emissions figure). The proposed changes are widespread including a one-off reduction in the emissions cap in 2023 (in addition to an increase in the linear reduction factor to 2.2%); the expansion of the scheme to the maritime, buildings and transport sectors; and the inclusion of all emissions from fossil fuel combustion.
These changes have contributed to a very significant increase in the EU carbon price which is at an all-time high of 38 Euros at the time of writing this article. That represents more than a threefold increase since January 2018, with analysts predicting a price of 89 Euros per tonne by 2030 as a result of the proposed changes to the regime.
Although the UK has left the EU, and therefore is outside of the EU ETS, the government has introduced a new UK ETS. It is similar in design to the EU ETS, and whilst the schemes aren’t linked at present, they could be in the future. As there will be no auction of emission allowances until later this year there is no UK carbon price at the moment, other than the reserve auction price of £15 per tonne. However, the UK’s stated emission reduction targets are more aggressive than the EU and therefore we should expect that the price projections for the EU scheme are a good indicator of the future UK price. There are no specific plans for the introduction of a UK CBAM at present but perhaps it is inevitable that the UK will also go that route.
Looking further afield, China has introduced an ETS, albeit only applying to the power sector and with a price of $6 per tonne, but it is a first step in line with their net zero emissions target of 2060. With the new US administration making an immediate commitment to re-joining the Paris Agreement it is possible that the US will also opt to introduce an ETS.
What is clear is that even as the world continues to wrestle with the COVID pandemic the focus is increasingly (re)turning to climate change. Carbon pricing has been a recognised means of addressing emissions but, to date, there has been little political will to employ it properly. That is no longer the case.
It is imperative that businesses recognise the need to assess both their own carbon footprint and the footprint embedded within their supply chains. Not only will carbon pricing begin to function as a significant economic stick to compel emission reductions across companies value chains, new rules on the reporting and disclosure of emissions, and the movement of the capital and debt markets away from recalcitrant carbon-heavy business models will bring about massive change. It is better to recognise that now and navigate the change than to be left behind.
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