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Pricing carbon

Taxing polluters is the only way forward

To curb the growth in emissions, we urgently need to establish an effective price for carbon.

Climate change is a problem of the ‘commons’. The atmosphere is shared between countries and while a carbon dioxide-abating country incurs the full cost, it receives only a fraction of the benefits. As with any public good, the self-interested response is to ‘free ride’ in the hope others will foot the bill.

The famous Kyoto negotiations in 1997 tried to create a global cap-and-trade system, whereby a limit on emissions was set at a global level following which individual countries would commit to cutting emissions to varying degrees to meet that cap. The result was a patchwork of weak and unenforceable commitments.

Nations have since stumbled to find a replacement without success. Although the 2015 UN Conference of the Parties (COP21) meeting in Paris received the usual victory statements, the agreement was seen by some as a step back from Kyoto.

There was no longer any serious discussion of a common commitment to reduce emissions through a global cap. Countries merely agreed to non-binding, non-enforceable, incomparable ‘intended nationally determined contributions’ (INDCs).

According to Dr Stephen Stoft, co-editor of the 2017 book Global Carbon Pricing, establishing a global minimum carbon price as a starting point would give the negotiations a much better chance of success. 

The price is right?

Establishing what that carbon price should be is not straightforward though. From an economic efficiency perspective, the price ought to match the social cost of carbon (SCC), the marginal damage caused by one extra tonne of emissions.

One way forward could be for countries to agree to price carbon emissions at least as high as a global floor

While estimates of the SCC are uncertain, this is no excuse for prevarication. “One way forward could be for countries to agree to price carbon emissions at least as high as a global floor. Others would be free to set a higher price,” says Steve Waygood, Aviva Investors’ chief responsible investment officer.

Carbon pricing schemes have been growing both in number and ambition. According to the World Bank, as of April 2020 there were 61 initiatives – 31 emissions trading schemes and 30 carbon taxes.1 However, those covered just 22 percent of global emissions.

Worse still, the size of levy on taxed emissions is inadequate. According to Germany’s statistics office, global COemissions reached a record 38 billion tonnes in 2019, with G20 states responsible for around 80 per cent.2

Theoretically, countries or trading blocs could be given leeway to determine how to price emissions, whether via taxation, a cap-and trade system or a combination of the two. Most economists believe taxation is the cleanest, most readily comparable, and optimal method.

Pricing power

For the system to work, the thorniest issue would be the need for richer nations to transfer money to poorer ones. Luca Taschini, associate professorial research fellow at the London School of Economics’ Grantham Research Institute, says that as well as the carrot of transfer payments to induce developing countries to set a minimum carbon price, a stick would be needed to discipline free riders and prevent carbon leakage.

Estimates of the potential for carbon leakage vary wildly. An analysis of 25 studies suggested countries risked giving up between five and 25 per cent of their total emissions reductions due to companies moving high-carbon production elsewhere.3 To avoid this, Taschini says the obvious stick to use would be tariffs on the imports of countries that refused to join the club.

This explains why the EU in July said it planned to introduce a carbon border levy by 2026. By holding products such as imported steel, aluminium, fertiliser and cement responsible for their GHG emissions the same way domestically produced products are, the aim is to maintain the bloc’s competitiveness, prevent carbon leakage, and encourage others to match the EU’s ambition.

One of the most frequent arguments against carbon taxation is that it is regressive, with poorer members of society hit hardest. However, since taxes would be levied and retained at the national level, there is nothing to prevent countries redistributing those tax receipts progressively.

The world’s ongoing failure to price carbon has led to a mishmash of command-and-control policies

Ultimately, the world’s ongoing failure to price carbon has led to a mishmash of command-and-control policies that come at a high cost and are of questionable benefit.

In many instances, with politicians unwilling to grasp the nettle, the problem is being outsourced to the private sector. While not denying the private sector has a vital role to play, Waygood says it needs a carbon price to perform this function efficiently.

As Waygood says: “We have the world's biggest market failure in climate change, and this will go on until we start to price at least a significant chunk of worldwide carbon emissions more appropriately. While no one would suggest we immediately stop driving, flying, or using steel, the sooner we admit these activities come with a cost, the better.”

Investing in anticipation of higher carbon prices

While the world may have so far failed to impose a sufficiently high price on carbon to limit the consumption of fossil fuels, investors should not bet on this persisting.

In May 2019, over 75 businesses, including BP, eBay, Nike, Mars, Microsoft, Nestlé, PepsiCo, Shell, Tesla and Unilever, met with US lawmakers to call on Congress to pass meaningful climate legislation. Placing a price on carbon was high up their agenda.4 Influential policymakers, including Janet Yellen, Christine Lagarde and Ursula von der Leyen, have also called for action.

The growing clamour to start pricing carbon closer to its true societal cost means investors should be trying to incorporate higher carbon prices into their valuations of securities issued by a wide range of companies, not just fossil fuel producers and energy suppliers.

“While an effective carbon price may be some way off, the direction of travel is clear. Companies that better manage climate transition risks – for example by minimising potential externalities such as the impact of the imposition of a carbon price on their operations and hence earnings – should outperform in the long run,” says Julie Zhuang, global equities portfolio manager at Aviva Investors.

This helps explain her “fairly negative views” on steel and fertiliser producers. Zhuang believes many firms in high-emitting sectors face years of materially increased capital expenditure in lower-emitting technologies, and potentially diminishing returns if their businesses are to avoid being rendered uncompetitive by tougher regulations and/or higher carbon prices.

Similarly, Justine Vroman, investment grade credit portfolio manager at Aviva Investors, says while the introduction of an explicit and meaningful carbon price may be some way off, bond investors need to recognise the risks.

“With the introduction of the EU Emissions Trading System, many European utilities have become pioneers in terms of investing in renewables and smart grids and decommissioning thermal-coal facilities. Meanwhile, their US counterparts still have a long road ahead to decarbonise. As a result, the cost of debt of some US utilities may not fully reflect the amount of capital expenditure needed,” she says.

In the absence of more effective action from governments, it is often left to companies to introduce some form of internal carbon pricing mechanism. They are doing this both to help determine projects in which to invest, and to reduce carbon emissions within their supply chains.

According to a May 2020 report from CDP – a not-for-profit charity that runs the global disclosure system for investors, companies, cities, states and regions – of more than 5,900 companies worldwide who disclosed information, 853 said they already use an internal carbon price, representing a 43 per cent increase in two years. A further 1,159 said they planned to do so within two years.5

Vroman says the climate transition credit strategy she co-manages uses this information to help identify leaders and laggards in the transition to a low-carbon economy.

“Companies that use an internal carbon price are more likely to be taking steps to incorporate climate risk into their business strategy and committing to set science-based targets,” she says, adding the adoption of these targets is an effective way of driving change as it puts pressure on emissions reduction throughout the value chain.

However, both she and Zhuang concede that, while the growing prevalence of internal carbon pricing is welcome, it is a far-from-optimal solution.

As Zhuang points out, several oil majors have in recent years begun adopting internal carbon pricing to evaluate new projects, under pressure from investors. In many instances that has led the likes of Shell, Total and others to divest assets.

Unfortunately, all too often this has merely shifted assets from a publicly listed owner to private companies or foreign state-run operators, who are often under little or no scrutiny from investors and other stakeholders.

“If all we’re doing is shifting assets from one type of company to another, that’s not going to tackle climate change. It’s another argument for a carbon tax mechanism that would apply to companies, regardless of who the ultimate owner is,” says Zhuang.

As for Vroman, she says while the accuracy of carbon accounting remains an issue, especially for Scope 3 emissions that factor in supply chains and product use, regional carbon pricing initiatives have had an impact by forcing companies in various sectors to adapt faster. She concludes a more coordinated approach applied by governments across the board with regards to carbon pricing would be “a powerful catalyst for global decarbonisation”.

Unfortunately, that still appears some way off. In the absence of governments imposing an explicit price on all activities that emit carbon, markets will struggle to accurately gauge the climate transition costs facing individual companies.

Nonetheless, Vroman says investors can seek to identify the long terms winners and losers of a transition toward a low-carbon world. She and her team are investing in both solution providers to climate change, enabling the transition towards net-zero, and transition-ready companies that are making their value chains resilient to climate change.

“The push for further climate regulation globally is inevitably going to accelerate the gap between leaders and laggards. Companies that are pivoting ahead will outperform over the long term,” she says.


  1. ‘State and trends of carbon pricing 2020’, World Bank Group, May 27, 2020
  2. ‘International statistics: Environment’, Statistisches Bundesamt, 2021
  3. Frédéric Branger and Philippe Quirion, ‘Would border carbon adjustments prevent carbon leakage and heavy industry competitiveness losses? Insights from a meta-analysis of recent economic studies’, Ecological Economics, March 2014, vol 99.
  4. Mark Evans, ‘Businesses march on Washington to demand action’, Better Society Network, May 23, 2019
  5. ‘Putting a price on carbon: The state of internal carbon pricing by corporates globally’, CDP, April 2021

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