Putting a price on carbon

The Stern Review on the economics of climate change (2006) estimated the total cost of unmanaged climate change to be equivalent to a one-off, permanent loss of at least 5 per cent, and perhaps as much as 20 percent, in global mean per person spending in today’s money. The damage caused by each extra tonne of carbon dioxide (known as the social cost of carbon) emitted under ‘business as usual’ was estimated to be around US$85 (based on prices in 2000).

Researchers at the ESRC Centre for Climate Change Economics and Policy, led by Professor Simon Dietz, have updated the economic modelling that they produced for the Stern Review.

They have showed that the social cost of carbon calculated in the Stern Review had a high level of uncertainty. They conclude that the most robust measure of the price of carbon for cost-benefit analysis should be the cost of cutting each extra ton of emissions (known as the marginal abatement cost).

Professor Sam Fankhauser and colleagues also looked at the specific tools being proposed to impose a price on carbon, such as carbon taxes and emissions trading (also known as cap-and-trade). The latter was an approach in which governments set a limit or ‘cap’ on emissions of greenhouse gases and polluting companies could sell or ‘trade’ the unused portion of their limits to companies that were struggling to comply.

The researchers examined important design elements of emissions trading systems. These included: how to bank and borrow emissions permits and how this process interacted with other markets, taxes and subsidies; and ways to keep the permit price from rising too high or falling too low.

They also documented how carbon pricing policies had been implemented across the world so that countries could learn about what other jurisdictions were doing and become aware of good ideas and practices being tested elsewhere.

The research has influenced policy thinking, as well as the design and substance of carbon pricing legislation in the UK and elsewhere in the world.

In 2009, the UK Department for Energy and Climate Change (DECC) changed its guidance on the price of carbon for cost-benefit analyses, from using the social cost of carbon to using the marginal abatement cost of cutting emissions, as the Centre’s research had proposed.

DECC’s report cited Professor Dietz, who had been one of six independent peer-reviewers of the interim guidance produced in 2007. He was employed as a consultant by DECC for the preparation of the new guidance in 2008-09.

This change in carbon pricing was expected to increase the likelihood that the UK government would meet its statutory obligation under the Climate Change Act (2008) for the UK to reduce its annual emissions by at least 26 per cent by 2020, and by 80 per cent by 2050, compared with 1990.

Professor Dietz has also assessed the estimates of the social cost of carbon used by the United States Government.

The research on carbon pricing mechanisms has also had an impact on legislation to introduce new carbon pricing policies in Australia, China, Mexico and South Korea, all of which have adopted new measures or are in the process of doing so. It was also used as the basis of discussions between UK and EU legislators and China’s chief negotiator, Minister Xie Zhenhua, in the House of Commons in October 2011 when the two sides examined examples of good practice.

The Centre’s researchers have worked closely with GLOBE International, a global forum of parliamentarians. Their research fed directly into an international policy paper that aimed to help national legislators understand the nuts and bolts of carbon markets as they draft their own country-specific legislation.