Pricing Carbon -- Part Two

Last week I discussed the various ways carbon might be priced. This week I discuss what prices might emerge from these different pricing mechanisms and how this affects you and me through the prices we pay for gasoline and electricity.

Before we get into that, we need to talk about units. GHG emissions are normally measured in CO2 equivalents, but some people quote the price per tonne (a.k.a. metric ton) of carbon and some per tonne of carbon dioxide. 1 tonne of CO2 contains about 0.27 tonnes of carbon. Also, estimates may be in different currencies, so I have converted all to US$ per tonne of CO2. (“US$/tCO2”) I have used approximate exchange rates: 2 US$ to the pound sterling, 1.5 US$ to the euro, and 1.25 NZ$ to the US$.

The best-known cap-and-trade system is the European Union’s Emissions Trading Scheme (EU ETS) which started in 2005 on a trial basis and became fully operational at the beginning of 2008 when the Kyoto commitment period started. It covers industries like power generation, iron and steel, glass and cement which between them accounted for about 40% of the CO2 emissions of the EU’s 25 member states at the time. The EU is required by the Kyoto Protocol to cut its emissions by 8% from 1990 levels by 2012.

The idea was that permits would be issued to match the target amount of emissions, and these permits were to be given away rather than auctioned. Since the target was less than the previous level of emissions, affected industries would have to reduce their own emissions or buy permits from other companies who were better able to reduce theirs. A third option was to buy CERs, or Certified Emission Reductions, from third world countries. These CERs fund projects which reduce emissions in those countries and which would not be economic without the sale of CERs.

That was the theory anyway. Unfortunately, each member country got to decide how many permits to give away, and it soon became clear that too many had been issued. The result was that the price, which was expected to be over 40 euros per tonne, at one point plummeted to only 8 euros. This was expected to be corrected when the scheme became fully operational on January 1st 2008, but it has been somewhat derailed by the global credit crunch which has reduced expectations of energy demand. The price of carbon on the ETS is currently about 20 euros and for CERs about 15 euros.

Another approach is a carbon tax, but there are few if any examples. (The city of Boulder, Colorado does have a small carbon tax and there may be other examples. Clearly this needs to be done on a National – or better still, international – basis.) http://www.carbontax.org/ is a good resource for the carbon tax debate in the US. As for what the rate should be, this could be based upon an estimate of what is needed to achieve a certain emission target, or by estimating the actual cost of the damage. In the first case, we might expect the price to be commensurate with the market price in a cap-and-trade system. A 1997 report on a possible carbon tax in New Zealand considered tax rates starting in 2005 between about US$12/tCO2 and US$31/tCO2 (depending upon the target amounting of abatement) and gradually increasing to US$17/tCO2 to US$44/tCO2.

Estimates of the actual cost of climate change are not surprisingly all over the lot. A 2004 meta-study by Richard Tol analyzed 103 estimates from 28 published studies, yielding estimates from slightly negative (because some people benefit from climate change) to US$450/tCO2. The median value was US$4/tCO2 and Tol concludes that the cost – and therefore any tax -- is unlikely to exceed US$13.5tCO2. (All these values converted from US$/tC.)

The Stern Review, commissioned by the UK government and issued in 2006, is perhaps the most comprehensive attempt to estimate the cost of unabated climate change. It came up with a higher value, largely because of the use of a lower social discount rate and equity weighting as discussed last week. It estimated the cost of doing nothing to be about US$85/tCO2, while the cost of reducing emissions was only about US$25/tCO2. (For the key findings, see http://politics.guardian.co.uk/economics/story/0,,1935208,00.html.) In 2007, The UK government’s environmental agency, DEFRA, adopted a social cost of US$50/tCO2 to be used in all cost-benefit analyses of public projects.

So, what does all this mean? It looks like a carbon tax would likely be in the range of US$10/tCO2 to US$50/tCO2.

A gallon of gasoline generates about 20 pounds of carbon dioxide. A tonne is about 2200 pounds, so that is less than one hundredth of a tonne. The tax would therefore amount to only about 10 to 50 cents per gallon. With gasoline at $3, that would be an increase of between 3% and 17%.

For electricity generated from coal, the tax would amount to between 1 and 5 cents per kWh. For natural gas it can be as little as half that, though this depends more on the upstream cost of producing the gas. I currently pay about 16 cents per kWh, so that would be about 6% to 30% on my electricity bill. Note that the proportional effect on the electricity bill is much greater than on gasoline. In absolute terms, the difference could be even greater.

Last year my wife and I spent $3000 on electricity (down 25% on two years ago due to CFLs and other measures I will blog about at a later date) and maybe $2500 on gasoline for two cars. So, the total cost of a carbon tax (or the equivalent) for these two items would be somewhere in the range of $250 to $1300 per year. My feeling about this is that it is that it needs to be nearer the top of this range to have a serious impact on behavior.

There will also be costs for manufacturing, transport, etc. for pretty much everything we buy, which of course is the whole idea. We need these price signals to guide our purchase decisions. For example, given that I do relatively few miles, right now I actually do not know whether it would improve my carbon footprint if I were to buy a new and more efficient replacement for my 16-year-old RX/7. (Tomorrow I will post about how the amount of meat we eat affects our carbon footprint more than the cars we drive; again, we need the cost of this represented in the price of the meat.)