Anticipating the future: a close look at carbon pricing - Climate Change

Climate change has come into sharp focus in 2021, featuring prominently in newsrooms, courtrooms and boardrooms as the impacts, causes and solutions are grappled with more frequently, and more urgently, than ever before.

Attention is now on global leaders and policy makers, who have converged on Glasgow for the COP26, and there is much anticipation as to what can and will be achieved at the UN Climate Change Conference.

One of the priority items for COP26 is to 'finalise the Paris Rulebook'. In other words, to agree the detailed rules to give effect to the commitments made in the Paris Agreement. A key element of this is an international mechanism for pricing carbon, which the parties have been unable to agree on to date.

Against this context we take a look at carbon pricing mechanisms, including what they are, what they strive to achieve, how they can be imposed, and why this matters to Australian businesses.

Key takeaways

The key things you need to know around carbon pricing are:

the number of carbon pricing schemes around the world continue to grow, and there are rising concerns about 'carbon leakage' (that is, shifting rather than avoiding overall emissions) and ways to prevent it, such as through levies on imports (so-called border adjustment mechanisms);
there are also concerns about the complexity and compatibility of a patchwork of unilateral pricing schemes in a global economy;
against this context, experts predict that it 'seems inevitable that a price will. be put on carbon around the world';
one of the key items on the COP26 agenda is the 'detailed rules' for an international mechanism for pricing carbon, envisaged by Article 6 of the Paris Agreement;
whether those negotiations succeed or not, the trajectory seems clear: the price on carbon may come to affect businesses around the world; and
Australian businesses should pay attention to this rapidly evolving issue and adopt appropriate risk mitigation measures having regard to their carbon exposure.

What do we mean by 'carbon'?

We need to recognise that in climate related discussions, 'carbon' has broader meaning than just its elemental form and can mean different things in different contexts. In this Insight, we refer to 'carbon' as a moniker for greenhouse gases which include, but are not limited to, carbon dioxide. This means that 'carbon emissions' is intended to capture all greenhouse gas emissions, and 'embodied carbon' means the greenhouse gas emissions associated with production of a particular item. With this in mind, 'carbon price' describes the price attributable to greenhouse gas emissions, determined by reference to carbon dioxide equivalence.

For further information regarding carbon emissions, refer to our recent Insight where we discuss Scope 1-3 emissions, what they are, and how Scope 3 emissions in particular are regulated in Australia.

Why price carbon?

The need for a carbon price has been justified in many ways. For example, given emissions unequivocally contribute to global warming - and that the impacts of climate change 'already [affect] every inhabited region across the globe', as reported by the IPCC - emissions can be viewed as an economic externality that should be priced so that the person responsible for the emissions bears the 'climate cost', rather than that cost falling to the environment and society at large.

In another view, pricing carbon is an emissions reduction tool that is impactful where an entity would not otherwise be motivated (for example, out of altruistic concern for the environment) to minimise emissions. Further, from a market perspective, a carbon price is understood as a mechanism to 'level the field' for equivalent products that have different emissions profiles.

Whether it is justified by one or all of these reasons, pricing carbon encourages emissions-conscious decision making. For this reason, it is becoming widely regarded as a promising if not essential tool for reaching global net zero emissions. With the number of countries and companies announcing net zero commitments continuing to grow, experts have observed that 'it seems inevitable that a price will eventually be put on carbon around the world'.

Who has priced carbon to date and how?

To date, there are more than 60 carbon pricing schemes deployed at the regional, national and subnational level, covering around 20% of the global emissions. The EU's emissions trading scheme was 'the world's first major carbon market' and used to be the biggest but was recently overtaken in size after the commencement of China's national emissions trading scheme earlier this year. China's scheme is estimated to cover approximately 40% of national carbon emissions, which is reportedly 12% of global carbon emissions.

The two most common forms of carbon pricing are:

a carbon tax, being a tax payable on the embodied carbon or emissions associated with a product or activity; and
emissions trading schemes, whereby businesses must surrender allowances or permits for each tonne of carbon emissions, with the supply of allowances or permits limited to reflect a cap on overall emissions that progressively tightens over time.

Comparing these, a carbon tax offers price certainty and is considered simpler but does not limit the overall quantum of emissions permissible. An emissions trading scheme, on the other hand, caps total emissions but leaves the price of allowances to be determined by the market.

A third form of (indirect) pricing is through emissions reduction funds, such as is in place in Australia, which by itself does not limit or impose a financial cost on emissions but rather incentivises voluntarily emissions reductions through eligible projects, as doing so generates credits which can be sold to government or other businesses.

In practice, there is scope to tailor these pricing options to address particular concerns. For example, it has been suggested that the variability in price in an emissions trading scheme can be stabilised through price floors and ceilings and provision for allowances to be held-over for future years.

The merits and concerns about these different approaches - in terms of complexity, price certainty, flexibility, impact and coverage, for example - have attracted much attention, and these debates are likely to continue at COP26.

The call for a global price

The call for an international carbon price has existed for some time but is currently attracting attention given the move towards a universal commitment to net zero emissions by 2050.

This is also driven by concerns about the complexity and compatibility of multiple independent pricing schemes in a global economy and about potential 'carbon leakage', such as when a company can 'forum shop' to reduce cost, by choosing to establish or relocate production to jurisdictions with low or no carbon ambitions where they do not need to 'pay' for their carbon emissions.

Such behaviour shifts, rather than avoids, emissions and undermines the original nation state's emissions reduction objectives and the global commitment to pursue efforts to limit global warming to 1.5 degrees Celsius above pre-industrial levels. It can also distort markets by putting those companies who comply with the nation state's carbon requirements at a competitive disadvantage.

Mechanisms to address these concerns are beginning to emerge, such as the EU's proposed 'carbon border adjustment mechanism' which, if implemented could effectively impose a carbon price on certain Australian products to the extent that they are exported to the EU market. Whilst the detail of such mechanisms, and their compatibility with international trade laws remains to be seen, the trend is clear: it is likely that carbon will be priced, one way or another.

Arguments favouring an international pricing mechanism point to its simplicity and superior depth compared to a patchwork of independent schemes. As an example, a recent article in The Economist argued that 'a carbon price would align the profit incentive with the goal of reducing greenhouse gases' and so is crucial if 'finance is to be transformational' and facilitate the transition to a net zero future.

Moreover, as noted above, the commitment to an international carbon pricing mechanism is already entrenched in Article 6 of the Paris Agreement. In particular Article 6 anticipates 'internationally transferable mitigation outcomes' to incentivise and facilitate global emissions reductions. It also emphasises the importance of transparency and integrity, including through the 'avoidance of double counting', and commits to adopting 'rules, modalities and procedures' for this emissions mitigation mechanism.

If the rules for how this mechanism could work are negotiated and formalised, nation states (including Australia) that are party to the international treaty will be legally bound to comply.

Possible solutions include a global minimum carbon price that escalates over time and which is scaled to accommodate the different socio-economic realities faced by advanced, emerging and developing economies. It would also provide flexibility for individual nation states to impose a higher price floor in order to meet their nationally determined contributions pledged under the Paris Agreement. Careful consideration would need to be given to determining the minimum price to ensure that it is effective in triggering the change necessary to realise a net-zero-by-2050 target.

Why does this matter, and what should Australian businesses do?

It is possible that a legally enforceable carbon pricing mechanism will be resolved through climate change negotiations already underway at COP26. Even if this does not occur, however, it is clear that this issue has its own momentum and a price can be imposed on carbon in a myriad of ways.

This matters to Australian business because it is becoming less and less likely that the status quo will continue. Accordingly, Australian businesses must pay attention to this rapidly evolving issue.

To prepare for change, businesses should start to measure their carbon exposure (in terms of emissions and carbon intensity), forecast their potential liability under various pricing scenarios and strategise ways to minimise the economic impact on their business going forward, through carbon-data-driven decision making.

Once a strategy has been formulated and articulated, it will become increasingly more important for businesses to regularly report to investors and regulators on their analysis and progress, and ensure that such disclosures are clear and reasonably based.

Any failure or delay in doing so may expose businesses to significant loss and risk, including:

significant loss reflecting their current hidden emissions liability, aptly described as a 'carbon short'. This could be triggered by the introduction of a legally mandated carbon price, but also indirectly by foreign market regulation or pressure from finance, supply chains, customers or investors reaching a threshold which means a business must price carbon in order to remain viable;
reputational, financial and litigation risks, because it is clear that stakeholders are increasingly motivated to take action, in any way that they can, to challenge businesses that are not (or are not appearing to) proactively transition towards a net zero future; and
financial reporting liability, because in the absence of a clear and detailed strategy, forecast earnings and the value of potentially stranded assets may be burdened with increased risk premiums.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.