A case and approach for a price for Carbon

There is already a price for Carbon in every country on earth. In most it is not explicit. However, the wider acceptance of at least partial responsibility for the unequivical and observed changes in the climate has provided changes in expectations that are impacting prices today. This maybe higher employment costs for organisations that do not explicitly incorporate climate change in their corporate social responsibility policies, lower yields from delayed adaptation effort raising food prices, or higher energy prices due to the integration of mitigation effort costs and a lack of response to demand signals due to uncertainty in explicit carbon pricing.

This could be considered a step forward, yet there is no design to this impact and as such whatever response it creates is not only unclear but unattributable. A lack of allocation blurs cause and effect and mires analysis in uncertainty. This is a worst of all outcomes as it fuels further inaction and delays purposeful response.

Clarity in the value of our actions will require the certainty provided by a price for Carbon.

The world is currently attempting to establish a common method to evaluate the scarcity of Carbon and thus form a price. Unfortunately the failure to achieve this may be more fundamental than a lack of will or a breakdown in the institutional processes. Instead, the failure maybe more directly attributable to the structural disimilarities in the Carbon intensity between nations and sectors of thier economies.

One sectors' ideal price to drive action may represent a microeconomic disaster for the government and society as it is applied unilaterally to all sectors. This inconsistency is all the more significant as it crosses borders and passes through the barriers of currency exchange, disimilar general tax regimes and potentially Carbon driven tariffs. It is therefore fairly clear that there is no one price for Carbon at least in terms of its application into an economy.

In traditional economics this doesn't appear to make sense. In what way can Carbon be all that different to any other globally trading commodity? The difference is twofold. The economy is already dependant upon this commodity based on a zero price and in most cases the demand is completely inelastic with no practical substitute. This difference is fundamental. The only practical approach to increasing the price from zero is to provide subsitution alternatives and the capacity for demand to become progressively elastic.

In the two hundred years since the industrial revolution began, economic development in each national economy as it has industrialised has been directly correlated to Carbon emissions. The nominally free cost of Carbon intrincally within our economy will not be de-coupled from economic prosperity without substantive change. This change is of a scale such that the destination beyond the change is likely to be just as different to our current economic and social fabric as we are to that of pre-industrial times. The difference is that we have only two generations to restructure what took eight to construct.

A clear long term price guide is paramount

The global economy and the less than hoped for progress in the Millenium Development Goals provides more than sufficient uncertainty to the lives of every man, woman and child. Planning to purposefully take the leaps of faith towards this contrasting future adds a layer of uncertainty that is surely insummountable and naturally causes a paralysis in our global institutions. Those called upon to lead must then strive to provide as much certainty as far into the future as possible.

The timescale of the response to climate change is in the order of several decades, yet many of our institutions are structured around periods not longer than five years with deregulated energy sectors having horizons measured in minutes. To provide long term certainty the solution, including a price for Carbon needs to be based on the long term levers and tools of our society. Therefore, a Carbon price cannot be solely dependant upon a market mechanism or defined by the political cycle.

Clearly the pricing of Carbon within any nation is defined by legislation within that nation. The law may also be a suitable place to define its price, but there are other examples of non-market centric long term pricing mechanisms. A Carbon price could be estabished in the same fashion as the price for money is in many economies, by a benchmark guided by political policy but set independantly. Whichever of these two or other methods to mark a price, this does not address the discontinuity of carbon intensity that our zero-Carbon-price economy has created.

Transitioning to a Carbon constrained economy will require sector specific transitional pricing for Carbon.

In every national economy there is a sector where it will take the highest Carbon price to achieve a behavioural response to lower the carbon intensity within that sector. At first glance in high petrol/gas taxing economies such as those of Europe and Australia the transport sector is a likely candidate. It may take a Carbon price beyond US$100 to reduce travel demand, drive modal shift and shift driving behaviour. If the much lower forecasted pricing were to occur, then the transport sector in these countries will not respond to price signals until sometime in the mid-2020s or beyond. This is clearly far too late for such a large, slow to change and signficant contributor to begin its shift. Certainly legislation and changing social values will move the sector's carbon intensity but price will not being playing its part.

An alternative approach is available. Set the price at the level of the highest price in the economy and define in law entry and transition rates of discount for the other sectors. In the high fuel tax economies with coal dependant electricity it is quite likely a price above 20% of that for petrol/gas for the energy sector will be high enough to drive behavioural change and foster the transition to renewables. However as the transition to renewables requires a small number of players to make signficant investment decisions, the nominal 80% discount should have a predetermined transition to no discount over perhaps a 20 or 25 year period providing investment certainty. It is also possible although counter productive to delay any application of the Carbon Price to a sector much in the same way that food or other 'essential'/'basic' products are justified not to have a goods and services tax applied in their supply.

Finally, it should be noted that this approach is not seeking to define the actual market price, but a certainty to the application of the market price to the economy of a suitable investment and decision making time frame. It is expected that as markets only function well with knowledgable market makers and market participants that in the initial stages a price floor would need to be defined in the Carbon pricing framework and that the 'initial stages' may be the entire period while discounts apply to any economic sector - that is, more than 20 years.

A low carbon future is about human behaviour

There are profound changes ahead for our way of life, the choices we have and the choices we don’t, in an affluent global community maintaining a CO2 concentration below 450ppm. A few of the changes are simply common sense efficiency for which there hasn’t been an excuse not to make for some time. Unfortunately, most are expensive risks that will cause inconvenience and at times distress to those whose lives are affected. The only incentive to tolerate this predicable impact on our lives being the precautionary argument which states that the incurred risk and investment embarks you along a path that is far less harmful than the cost and pain of the unplanned or unforeseen events that are spurred by inaction.

It is a good argument, but not one that reflects the reality of human behaviour. This point has not passed unnoticed, leading to policies that seek to steward and encourage the community and economy towards a low carbon pathway. In western democracies the policy responses focus on cap-and-trade market mechanisms to price carbon and in some cases a more direct method, a carbon tax. The IMF has made statements noting the preference for a carbon tax, citing the lack of certainty carbon trading markets provide industry and the dependency of the approach on the benchmarking of the cap.

The signals in the economy from the pricing of carbon are too haphazard to shift human behaviour onto the sustainable pathway.

A price for carbon, whether set by a market or a tax, does not provide clear pricing signals and thus behavioural changes in the use of carbon intensive products. Consider the consumption of petrol or gas for private vehicle use. In order to apply a 10% impost on the price of fuel via a carbon price in the United States, a US$34 per tonne carbon price would be sufficient. However, due to the existing dissimilar tax imposts and variations in supply chains between jurisdictions the carbon price in Australia would need a US$63 per tonne and in United Kingdom US$87.

To exacerbate the disparity, US citizens have higher demand elasticity for the price of gas or petrol than the United Kingdom meaning that the 10% impost created by only a US$34 carbon price would do more to the behaviour of the domestic consumers than the US$87 carbon price would in the United Kingdom!

Next, consider the effect these various domestic carbon prices would have on electricity prices in each of the jurisdictions noted above. Assumed the electricity has the carbon intensity of their respective national averages, US electricity receives a 19% impost from the US$34 carbon price or near double the impact, the United Kingdom 28% or nearly triple the impact and due to the high dependence upon coal, Australian electricity would increase by 44% or approaching five times the impact. This may reflect the carbon intensity of the consumption, but the uneven relative domestic impact and the need for unequal cross-border pricing to create the same signals and behavioural responses represents a significant challenge for policy makers.

It therefore clear that a global price for carbon is undesirable. Any price level would cause supportive price signals for some, destructive price impacts for others, and yet for many, no price signal at all (at least in terms of affecting behaviour). However in order to minimise the global cost of the transformation there must be a mechanism for shifting carbon abatement across borders and by implication shift capital to those least capable of responding. The two appear mutually exclusive – the key is not to convert the carbon emissions or abatement to money too early in the process.

Foreign Carbon Exchange & Carbon Import Duties

In developed economies, the only valid currency for domestic trade is the local currency and so it should be for carbon. The concept is a core component to preventing the leveraging of domestic market disparities and foreign currency fluctuations to evade the impost of any price on carbon. The approach has two significant implications: a foreign exchange in carbon; and the modification of the World Trading Organisations rules to allow an import duty to address carbon price disparities.

The internalisation of the environmental cost of excessive carbon dioxide and other greenhouse gases so as to have price signals is paramount in order to enact change on a broad scale. Nevertheless, it is clear that by simply pricing carbon, in isolation and without regard for the unintended consequences and complexities, will not by any means lead to a shift onto the low carbon pathway.

Price signals, even heavy ones, aren’t enough to shift behaviour.

The daily commute for many is in their car and for some this isn’t a choice. The lack of a viable alternative at any price provides for a very inelastic demand for car use and consequently the use of the petrol or gas. For this group the 10% impost isn’t a price signal, just a tax. However, if the receipt for the next tank of fuel wasn’t just 10% more, but also included the detail “123kg CO2” then behaviourally some would seek to do something about it – whether that entailed an inconvenient mode shift or an attempt to reduce their emission in private vehicle use.

Renewables are the wrong target

In responding to climate change national policy often targets the proportion of the electricity generation that will be from renewable sources in 2020 or beyond. These targets are important and, in the absence of any other metric, they are fundamental.

The metric of a renewable generation ratio is however indirect. Coal with carbon capture and storage, when and if the technology is available, is not a renewable generation source. Coal gasification, nuclear power and on-site natural gas co-generation are also non-renewable, yet each is an effective response to climate change.

Each country will have its own options in respect of these alternatives. Each country will assess the benefits and costs of these options in conjunction with renewables differently. In order to ensure that energy supply progresses along the lowest Carbon emissions pathway, the metric should incorporate these types of responses. This metric is the carbon intensity of the supply, measured as CO2e/kWh.

A renewable energy generation ratio provides no guidance on the cleanliness of the electricity supply

Focusing only on the marginal emissions for each kWh produced at generation, the current non-renewable electricity generation facilities have a wide range of carbon intensity - from the 1.4kg CO2/kWh for 'brown coal' to the 0.2kg CO2/kWh for next generation nuclear.

Australia's reliance on coal provides an 860g CO2/kWh carbon intensity - the highest for any OECD country. If Australia were to shift to a 50% renewable electricity generation by 2020, the carbon intensity overall would not be lower than presently exists in The Netherlands, United Kingdom, or Japan - all of whom have negligible renewable generation today.

Significantly, with the possible exception of Poland, the 50% renewable path would result in Australia still having the highest carbon intensity for electricity supply. The weakness of the renewable ratio is that it is a relative one, while the goal is absolute. The sustainability path requires the right targets.

Life-cycle Carbon Cost

The Carbon cost of the power generation is only part of the emissions from energy use. To ensure the investment does contribute to the response to climate change, the evaluation of power generation alternatives should incorporate two additional considerations:

1. Renewable or not, the alternatives have asset life-cycles with very different Carbon cost profiles. That is, the Carbon emissions in the design, build, maintenance, decommissioning and disposal of the power generating asset vary greatly between one alternative and another, with each alternative progressing through these stages over different time scales; and


2. The minimum commercial scale, responsiveness to changes in demand and reliability of each alternative greatly impacts the Carbon costs in the supply at the point of use of the power. Coal fired and nuclear generation operate at a scale resulting in the requirement for long transmission distances, solar power in only available when the sun shines and so on. The infrastructure to ensure reliable transmission and supply can cost more in Carbon emissions than the generation itself.

The inclusion of these two considerations challenges any response to climate change as no alternative is the right one in every situation. The carbon intensity at point of use of an on-site natural gas generator is lower than for a utility scale photo-voltaic solar generator 500kms away. The key is to consider energy not in terms of how it is generated, but where and when it is used.

The response to climate change is a journey that we have only just started. Today policy is focusing on renewables. Certainly, renewables are needed as part of the energy supply mix but only where and when they lower the carbon intensity of the energy use (not supply) over the life-cycle of the generation and energy transport (transmission and control) assets.

The next step is to shift the focus to incorporate factors such as the advantages of localisation of energy supply, the disadvantages of power conversion, the gains and the penalties in low emission non-renewable sources. This step is the targeting of a new metric, the carbon intensity at point of use – a metric that applies to all energy use.

Good for one is not good for the many

Many jurisdictions are encouraging the installation of residential small scale solar power systems. The economics for this appear simple - invest in the installation now and, for the next 25 years, reduce the electricity demand of the household on the electricity grid. Ignoring any government assistance that may be available, the savings in electricity suggest a payback in as little as 4 or 5 years for some electricity buyers. In fact, even when excluding the effect of the expected rise in electricity prices over the coming decade, a typical installation would save more than $10,000 over its lifetime. This is clearly good for the electricity user, but is it sustainable?

There is no relationship between monetary savings and a reduction of carbon emissions. Unfortunately, any currently proposed pricing of Carbon will not fix this.

In terms of responding to climate change, the scenario still appears to make sense. Every kWh of electricity bought is usually considered to be at least ½kg of Carbon. A single domestic solar panel can produce over 5,000 kWhs over the expected minimum 25 year life - thus providing a 2.5t saving of Carbon. Every little bit helps, right? Not quite.

Life-cycle Carbon Cost

The weakness in the approach taken above is that it is only a snapshot of the life-cycle of the solar panel. A solar panel does not appear on the roof of a house without a carbon cost. No agreed standard for the assessment of this cost exists and there is substantial variation in the data available for considering it. Nevertheless, considering the entire industrial process, the panel will have cost at least 1t of Carbon to manufacture, supply and install. In addition, in disposal, albeit hopefully more than 25 years away, it will cost a further 200+kg of Carbon.

Therefore, the panel has a debt of 1.2+t of Carbon to repay, effectively halving any potential benefit. However, before considering the benefit, let's look back at two assumptions in this scenario. Firstly, a solar panel will provide peak power throughout operation and secondly, the Carbon intensity of the offset electricity will remain constant.

Solar performance is very installation dependent

The output of a solar panel is dependent upon many factors - the amount of hours of sun the installation location receives, how closely the panel is pointed to the mid-arc point of the sun passage on the solar equinox and even the ambient temperature. There are also losses in converting the DC power output to a regulated AC domestic supply, losses due to the inability to use the generated power when it is generated and, for most panel designs, losses due to a shadow across just 10% of the surface shutting off the power generation. The result is that the actual electricity offset can be less than 2,000kWh.

Is all mains electricity supply Carbon intensive?

The Carbon intensity of electricity is dependent on the method of its generation. Generally, the worst is brown coal and the best is hydroelectric or nuclear (wind and solar usually have a higher intensity than either of the latter sources when considered in life cycle terms). The on going COP or post-Kyoto discussions provide indication for encouraging energy policy responses to climate change. These policies will guide and accelerate a lower carbon intensity for electricity supply worldwide. This means that the average carbon intensity over the next 25 years is not the ½kg per kWh generally assumed but more likely less than half this level (many supply environments today can already be less than 150g per kWh).

In terms of considering many real world installations over a 25+ year life neither of the former assumptions hold. Certainly, the benefit can still be a net saving but one sensitive to site specific factors. Our analysis suggests the benefit is rarely more than 1t of Carbon per solar panel even in relatively sunny carbon intense energy markets as Australia. Significantly, even before any further 'greening' of the electricity supply in this coal rich country, there is a negative Carbon balance for installations in its most southern state due to the combination of that state's use of hydroelectric supply and its distance from the equator. Negative Carbon balances can also be found in certain parts of the United States, Japan and even China, as well as all grid connected residences of France, Iceland, and Brazil.

Every saving counts and the value of this approach to climate change should not be lost. However, caution is required as there is a significant risk for misplaced investment due to the perceived efficiency improvements and financial return available.

What is carbon economics?

Economics is the defined as the study of how people use their limited resources in an attempt to satisfy unlimited wants. Using this as a base, Carbon Economics can be defined as:

The study of how individuals, society, business, government and nations address the limited capacity of the planet to sustainably absorb greenhouse gases in an attempt to maintain and improve their quality of life.

That is, the limited resources become how much greenhouse gas the planet can absorb without changing the climate and the unlimited wants become the quality of life. Perhaps the more accurate term for this is Greenhouse Gas Economics, but as the main greenhouse gas by volume is carbon dioxide, the label Carbon Economics seems more clear.

The term is not new, however it does not have a fixed definition. This is counterproductive and so this blog seeks to lock down a meaning to support better understanding and clearer communication.

It isn't about money

The key departure of our approach from the general discussion on this subject is that we do not monetise greenhouse gases. Carbon Economics is not about the trading of carbon credits; or the investment analysis for the projects that lower the carbon footprint of an industry sector; or analysis of the effect the pricing of carbon has on the cost of living. These are important considerations and form part of the study within Carbon Economics. They inform the policy to solve the unexpressed problem (which will be covered in later posts). They do however miss the point.

The wants are not a product or service and the resource is not money (as is the typical situation in economics). The resource is an "overdrawn account" against the capacity of the planet to absorb greenhouse gases and the want is avoiding the impact that increasing or even maintaining the "overdrawn account" will have on the quality of life. There is no money involved at this level of the study.

Why does this departure matter?

Money has a meaning of its own, a meaning that is not equal between people. Money is not a common global mechanism for value - US$1 does not buy the same amount of an equivalent product or service globally even excepting for local taxes and similar distorting influences. Money is not a single item - we don't use just one currency globally.

Carbon (measured as CO2e) means little to anyone today. Unfortunately, when it will mean something most people will see it as the harbinger of personal catastrophe (the loss of home or a lack of drinking water, etc). Carbon has the same impact to the climate regardless of where on the planet it is released and a unit of carbon is still a unit of carbon. Carbon isn't like money.

Hence we might conclude that Carbon is a commodity, simply a new product to price. However all commodities have a different value depending on where on the planet they are and involve the exchange itself of the commodity or right to the commodity. Certainly if we monetise Carbon we may have something that is tradeable, but the distinction should be made that we are not trading the carbon itself, but a contract about it. Carbon is no more a commodity than an insurance contract is.

The need for new tools

More than a century of modern economic theory has provided a great many tools to analyse and compare the value of money over time and the value of alternatives for how money is used. These theories and tools are part of our ability to have increased the quality of life so significantly for so many over the same time period.

A fundamental premise for these tools is that the value of money changes over time due to a single factor - inflation. This provides for money spent or earned in the future to be evaluated in terms of the meaning of money today by discounting it back in time. There are, of course, the different perceptions for the need to spend or the chance to earn in the future. This difference gives rise to dissimilar valuations and much of the trade seen in markets. This apparent variable for the value of money, or more correctly what it can purchase of be invested in, is an emergent outcome from people working with uncertainty regarding the future, not an outcome from the money itself.

The value of Carbon changes over time due to (at least) two factors:

1. The amount of carbon emissions in a given year relative to the sustainable level; and
2. The ease with which the emissions can be addressed.

The first factor is conceptually the inflation of Carbon. The more our emissions depart from the sustainable level, the more valuable the avoidance or absorption of the Carbon. However, it is a significantly more dynamic consideration than monetary inflation as most sources of Carbon remain in the atmosphere impacting the climate for more than a century (so the sooner the emissions stop happening, the less accumulative the stock of Carbon in the atmosphere and thus the lower the effect of Carbon on the climate).

The second factor has no conceptual equivalent as it relates to a change in the relationship for the supply of Carbon. The mechanism for the supply of money does not change, the government of a country mints notes and coins, banks distribute them and money is created through the payment of interest and trading of risk (this is an overly simplistic picture, however it is illustrative).

Over time technological development and production scaling will change the relative ease with which the emitting of Carbon can be avoided or absorbed from the atmosphere. This is a key variable for the consideration of carbon emissions in different time periods.

Consider the ability to have zero emission private transport. Today it is impossible, as emission free power to mobilise a car is not available. In 2050 it will be available and most likely at a price that is competitive with less Carbon friendly options. This variation in supply availability makes the Carbon in 2050 less valuable than in prior periods. That is, the harder it is to do something about it, the more valuable doing something is.

This difference means that new tools are required to support decisions about Carbon and the study to develop them and consider their impact is the core of Carbon Economics.