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The carbon floor price—a hammer in need of a toolbox

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“If your only tool is a hammer, every problem looks like a nail,” goes the saying. In the context of climate policy, the leading hammer is carbon pricing. To many economists and carbon market enthusiasts, putting a price on carbon is by far the preferred tool to drive down carbon pollution. So, whenever carbon prices fail to reduce emissions fast enough, those advocates simply conclude that the price isn’t high enough. The real message should be that price alone isn’t enough.

In response to the persistent problem of low carbon prices within the European emissions trading system (ETS), we now hear calls for high carbon floor prices—which would require covered emitters to pay, usually to national treasuries, the difference between the current ETS price and a higher set floor price. In 2013, the U.K. created a national carbon price floor with the aim of raising carbon prices to 70 pounds per tonne by 2030. Due to public concern over its high cost and modest benefits, the carbon price floor is now frozen at 18 pounds/tonne. Despite the U.K.’s experience, in March 2018 officials in the Netherlands announced plans to impose a minimum carbon price rising to 43 euros/tonne by 2030, almost triple the current allowance price. French President Emmanuel Macron recently stated that France would push for a minimum carbon price regionally; discussions are underway in Germany as well.

Fortunately, the key partner to the carbon pricing hammer is already in the toolbox: carbon revenue recycling.

Carbon prices can be an important tool, and creating a predictable carbon price corridor in Europe would be a useful ETS reform. But higher carbon prices by themselves are both too expensive and too limited in what they can deliver. We will not achieve our Paris objectives if we continue to overlook and underfund the other useful tools in the low-carbon toolbox. The policy mix should be guided not by a goal of high carbon prices, but by the principle of carbon efficiency: How much does a given policy cost the public per tonne of carbon actually reduced? Carbon prices can be important—but their contribution will be much greater if we pay close attention to how the resulting carbon revenues are spent.

There are three main reasons a clean energy investment strategy must be part of any proposal to establish a carbon tax or a minimum floor price.

Power markets magnify the consumer cost of carbon prices

Most carbon price proposals focus on the sectors the EU ETS covers. Within that scheme, the largest sector subject to a floor price would be electric generation. Unfortunately, due to the way wholesale power markets are designed, when carbon prices are added to generators’ costs, electricity consumers end up paying far more than the market price of carbon for each tonne of carbon the new policy actually reduces. Here’s why:

  • In today’s “single-price” power markets, when carbon prices drive up the cost of coal-fired power plants, they also drive up the market price of gas, nuclear, and even some renewable power plants—resulting in a price increase for most power consumed.
  • Meanwhile, even though coal and gas power are made more expensive, this doesn’t necessarily lead to large changes in total hours during which those fossil power plants will run over the course of a week, a month, or a year—so total emissions don’t change much.
  • Therefore, because market clearing prices go up across the board, but there are relatively small changes in system operations and fossil emissions, end-use consumers can pay dearly in electricity costs for each tonne of reduction achieved across a power system.

This problem has been studied repeatedly but is still rarely discussed. In a study for the European Commission in 2008, the Energy Research Centre of the Netherlands (ECN) found that a carbon price of 20 euros would, on average across 20 EU power markets, end up costing power consumers 248 euros per tonne actually reduced. In a later study for RAP, using the same models, ECN and Cambridge Econometrics found that if carbon prices were to reach 80 euros, the cost to consumers for every tonne reduced in power markets would be 478 euros. This is not a uniquely European problem. Similar results have been modelled for power markets in the United States.

Energy efficiency is the low-cost carbon “scrubber”

What we need is to link carbon prices and carbon revenues to create a ”virtuous circle“ that can sustain the political will to achieve economywide decarbonisation.

If the purpose of a carbon price is to actually reduce emissions, and it’s not just a tax-raising scheme in disguise, designers should look for the lowest-cost way to rapidly reduce emissions, using both carbon prices and carbon revenues as tools. Across Europe there are many low-cost energy efficiency options where well-run programs can cut energy bills for families and businesses while reducing emissions. Carbon revenues are an ideal source of funding for these efficiency programs. One RAP study, which analyses years of energy efficiency expenditures in the U.K., reveals that investing carbon revenues in well-run efficiency programs can save seven to nine times more carbon for a given price rise than just hammering consumers to use less through higher energy prices.

Carbon revenues are just as important as carbon prices

European policymaking is stuck in a vicious cycle in climate debates, in which ETS advocates lament the oversupply of allowances, while consumer advocates and some national governments object to tighter carbon caps because they fear they will be too costly. Carbon floor prices by themselves will not solve these problems: They don’t reduce the surplus and may not even reduce emissions, while they increase costs to consumers. What we need instead is to link carbon prices and carbon revenues to create a ”virtuous circle“ that can sustain the political will to achieve economywide decarbonisation.

What’s the answer?

First, ask the right question. Any carbon price or tax regime should focus on the principle of carbon efficiency, which critically asks, “How much will this action cost the public per tonne of carbon actually reduced?” If we are to sustain the long-term political support needed to meet the Paris goals, carbon schemes need to deliver large-scale savings efficiently and affordably.

Fortunately, the key partner to the carbon pricing hammer is already in the toolbox: carbon revenue recycling. The final cost of carbon reductions will be much lower if we recycle carbon revenues back into the economy strategically, especially in low-cost energy efficiency measures that lower bills for families and businesses.

We do know how to do this

Many Member States already dedicate significant carbon revenues, or their equivalents, to clean energy initiatives, as promised in the ETS. Leading examples include Germany’s Energy and Climate Fund and the Czech Republic’s Green Savings Program. In the U.S., the leading example is the Regional Greenhouse Gas Initiative, where nine states have invested more than 60 percent of their carbon revenues in energy efficiency programs, lowering emissions and saving money.

To those seeking to speed the pace of carbon reductions, here is a simple message: It’s time to look deeper into the low-carbon toolbox and pick up more than just the carbon pricing hammer.