As the old joke goes, if you get three economists together, you are likely to get at least half a dozen different opinions! But there is one thing that economists do agree on: you need to price carbon effectively if you are to shift economic activity towards a lower carbon future.
About 40 countries around the world, covering about one quarter of the world’s greenhouse gas emissions, currently have some form of carbon pricing. Usually, these carbon prices result from carbon taxes and/or emissions trading schemes on carbon emitting activities, like power generation or industrial processes.
Companies currently use a wide range of assumptions on carbon prices in making their investment decisions. bp, for example, recently increased their carbon price assumption to $100/tonne by 2030, up from the $40/tonne they assume today. This change will have major implications for their investment plans, shifting more into renewables and low-carbon technologies and reducing spend on oil and gas exploration and production.
The incidence of carbon pricing across different sectors of the economy is also highly uneven. For example, here in the UK, tax represents about two-thirds of the price we pay for petrol and diesel at the pumps. Yet, we have a reduced rate of VAT (5 percent) and (currently) no carbon tax on the gas we use in our central heating, despite both activities contributing to global warming.
This uneven incidence of carbon taxes creates distortions and that, in turn, ultimately means higher costs for consumers of getting to Net Zero. Similarly, the uncertainty over the future trajectory for carbon prices creates uncertainty and risk for investors, which pushes up the costs of capital. Again, the result is higher costs paid by consumers for meeting any given carbon reduction target.
This problem is particularly acute in the energy sector because assets like wind farms, nuclear power stations, and gas networks that can carry hydrogen and biomethane, have such long-life spans. Investors are making decisions today on assets that will still be in the ground in 2050 and beyond.
In assessing their options, investors in the UK only have visibility over actual carbon tax rates for one year ahead. The government has stated that there will be a UK Emissions Trading Scheme (ETS) to replace the EU ETS from 2021, given Brexit. But investors have no certainty about the expected trajectory for carbon prices under that new scheme, as many of the design details are still being worked through; it remains to be decided whether the UK scheme will be linked to the EU ETS and over what timescale.
This uncertainty will mean higher costs for consumers. The UK Government should look to address this as a matter of urgency in the run up to Conference of the Parties (COP26) with a full review of the future of carbon pricing, as part of its review of the costs of net zero due in early 2021.