Costing the climate: Four ways to price carbon

A recent study put the social cost of emitting a tonne of CO2 at US$220. An EU allowance costs $8. Why the gap?

The correct price for carbon dioxide emissions depends on where you're sitting (Pic: Flickr/kris krug)

The correct price for carbon dioxide emissions depends on where you’re sitting
(Pic: Flickr/kris krug)

By Will Evison and Jonathan Grant

Two Stanford academics caused a stir last week suggesting that the true social cost of carbon is $220. This is six times higher than the figure the US government uses to guide policymaking.

The contrast with the market price of carbon is even greater: an EU carbon allowance currently costs around $8. Many in business also focus on mitigation costs and then use a different ‘shadow’ price for planning purposes. So which one is right?

The social cost of carbon is based on estimates of the total cost of climate impacts. Assessing these costs is challenging and subject to a range of assumptions. The choice of discount rate is often critical but other factors are relevant, such as the climate model used, the approach to valuing damages and the potential for impacts on economic growth.

As a result, estimates range from below zero, implying that net climate impacts could be slightly positive, to over $1,000 per tonne, suggesting they could be catastrophic. Clearly, these are extreme outliers.

As climate models and economic valuation methods have improved, estimates have significantly converged, but the latest Stanford study shows that differences persist. The Stern review, an influential UK study published in 2006, estimated the social cost of carbon at $86, and with inflation that figure would be even higher today.

Rather than generate our own social cost from first principles, we analysed over 60 recent papers containing 350 different estimates to derive our figure. We selected studies that meet a number of criteria and take an average. This approach allows us to reflect the diversity of scientific opinion which exists, while providing a helpful estimate for decision-making: $87 in 2014.

This number is still a long way off the current market price for carbon, which in the EU is around $8, and in California is around $13. These prices reflect the supply and demand for those credits.

So in theory, the market price should reflect the marginal cost of mitigating a tonne of CO2 given the current emissions cap and economic growth projections. In practice, the EU Emissions Trading Scheme is not working optimally and the marginal cost of abatement is not an important driver of today’s carbon price.

Many companies estimate their own marginal abatement cost. Energy managers want to understand how much a given level of reduction would cost them. Others in the company may use a ‘shadow’ price of carbon when evaluating capital investment decisions.

Some use prices of around $40-60 for planning purposes to assess the company’s profitability in different policy scenarios. But the market price, the mitigation cost and the shadow price are all fundamentally different from the social cost, which aims to represent the actual impacts of emitting that tonne.

When talking to companies about measuring the total impact of their carbon emissions we spend most of our time explaining why the social cost is so different from the three other prices of carbon. And rather less time on our methodology for estimating the social cost.

So, the answer to the question “what is the right price?” is they are all right. It depends on the user. The folk on the trading desk will use the market price, the head of strategy may use a shadow price and the energy manager will use the mitigation cost. The head of sustainability will probably use the social cost, but keep a close eye on the other three.

Will Evison is assistant director of environmental economics and Jonathan Grant is director of sustainability and climate change at PwC

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