Pricing carbon - The challenge and the key to finance low-carbon infrastructure

Investment in green infrastructure lags behind our climate goals and part of the reason is that it is difficult to ensure that actors pay for the emissions they emit. This is an obvious observation, yet unpacking it gives us insights into both the challenges and solutions to increase finance for projects that contribute to mitigating climate change. By looking at both economic theory and carbon market designs, this article provides an overview of the current state of affairs on carbon pricing with a focus on investment in green infrastructure.

The challenge of financing low-carbon infrastructure

In anticipation to the signing of the Paris Agreement in 2015 which committed us to limiting global warming to “well below 2 degrees”, the International Energy Agency (IEA) estimated that it would take close to USD 3 trillion a year in investments until 2035 to get on a path aligned with the objectives of the treaty. However, by 2020 total spending had only reached USD 632 billion according to the IMF.

Concretely, this figure represents a lack of funding for projects reducing or mitigating our greenhouse gas (GHG) emissions at a pace that meets the "well below 2 degree" target. And so, almost 10 years later, the IEA is still urging decisionmakers to increase investment in clean energy, particularly in developing countries.

So why, despite the growing political momentum, are we still lacking climate finance?

A big part of the reason lies in the challenge of evaluating and rewarding projects that mitigate climate change. Prior to launching big infrastructure projects, stakeholders need to evaluate whether the project benefits outweigh the costs. When public authorities do the evaluation, for example for projects requiring public support, they look beyond the costs and benefits that are actually paid for by the stakeholders of the projects to analyse the general costs and benefits to the community. This is necessary because in imperfect markets, the cost of products and services does not always reflect the true costs to society. In economic terms, we consider that the producers and consumers do not ‘internalize’ the full costs and benefits, which instead fall on the community.

Using a reservoir hydropower plant as an example, while the operator may receive payments for providing electricity to the community, a fair analysis of the benefits of the plant would also look at the contribution of the plant to a cleaner air, as it may replace polluting coal plants that emit harmful particles. The analysis would also incorporate the cost of loss of plant cover to make way for the reservoir. These costs may not necessarily be directly paid for by any stakeholder of the project, but they nonetheless have an economic impact that needs to be accounted for before deciding whether the project should go ahead.

These costs and benefits that are not internalised by market participants are particularly important for low-carbon projects. Indeed, a key reason for building low-carbon infrastructure is the benefits of the GHG emissions it avoids. However, similarly to health benefits, mitigating climate change is not something that markets naturally reward. Nonetheless, when conducting an analysis of these projects, we need to put an economic value on the avoided GHG emissions in order to assess whether the infrastructure benefits outweigh the costs.

How can we assess the real cost of our emissions?

Estimating the value of avoided GHG emissions is something that economists and scientists have been working on for many decades now. By linking climate models with economic ones, they estimate the extent to which CO2 emissions today will contribute to climate change later and the additional costs that this will incur.

To do so, experts look at the consequences of climate change such as lower crop yields or sea level rise and evaluate their associated economic costs. They then estimate how much these costs increase when an extra tonne of GHGs (usually measured in tonnes of CO2 equivalent) is emitted. This value, the total cost of additional emissions today, is what we usually refer to as the social cost of carbon (SCC).

More than a simple figure, the SCC can be a tool for policymakers and decision makers committed to mitigating climate change. It allows them to evaluate how much we should be willing to pay now to avoid suffering too much from climate change later. The American government has for example recently announced that it would start incorporating the SCC in most of its procurement decisions. This will have concrete consequences as it will redirect billions of dollars in public spending towards greener projects.

However, although it is becoming more common for public authorities to use the SCC, it is still rare for private investors to look at the benefits of avoided emissions when making investment decisions. This is particularly problematic as private capital is expected to provide the bulk of climate finance. A recent report from the IMF estimated that 80% of the finance to combat climate change will come from the private sector. And yet, despite the growing urgency of climate change, mechanisms to compel the private sector to pay for its contribution to climate change are still relatively nascent.

How can CO2 emissions savings create revenues for green projects?

If market players won’t naturally pay for climate change mitigation, how can we ensure that they do? Carbon markets are currently the most common way of making the private sector pay for carbon emissions. A carbon market is a system where participants trade carbon credits. These credits represent a certain amount of carbon that actors such as firms, organisations or individuals buy to compensate for their emissions.

There are two types of carbon markets: Emissions Trading Schemes (ETS) and Voluntary Carbon Markets (VCM). Under an ETS, a government issues a right to pollute to all actors from a specific sector. For example, under South Korea’s ETS, participants in the domestic aviation sector must take part in the ETS. If they intend to emit more than what their credits allow them to, they must buy additional credits from the market, while participants who intend to pollute less are allowed to sell their avoided emissions to the first group. The price of carbon emissions is thus determined by how many credits are available and by how much the economy emits. This follows a similar logic to any good on a market, higher/lower demand or lower/higher supply will naturally make the credits more/less expensive. In this regard, the initial allocation of rights to pollute is a major market driver. When set right, it can significantly contribute to reducing carbon emissions in an economy.

While the ETS covers specific sectors in certain regions, VCMs are open to everyone who wishes to compensate for their emissions. In this case, the carbon credits are not waivers to pollute issued by the market organizers, but are instead issued by projects that mitigate climate change, either by capturing carbon or by replacing carbon-emitting activities by clean ones. These credits are traded on private platforms and need to be certified by independent actors that make sure the credit does represent the amount of carbon it claims to avoid.

Currently, there are 28 ETS mechanisms, covering 17% of global emissions, with 20 additional systems under development or consideration, particularly in Latin America and in the Asia-Pacific regions. When set right, ETS can act as an important mechanism to level the competitiveness of low-carbon projects with their carbon-intensive alternatives. In 2022, ETSs have collected more than USD 63 billion in auctioning revenues globally, and renewable energy projects received USD 101.5 million from voluntary carbon markets in 2020.

Is it enough?

While ETS markets provide a revenue stream to finance low-carbon infrastructure projects, it is nowhere near enough. The IEA estimates that we now need USD 4.5 trillion a year in investment in renewable energy by the early 2030s to stay within a 1.5°C scenario pathway.

Why such gap between the amount we should be dedicating to low-carbon projects and the current investments?

The SCC gives us another clue. If we compare the most recent estimates of the SCC to the price of emissions on the different carbon markets, it is clear that even the most mature carbon markets fail to reach a socially optimal price. For instance, the European Union’s (EU) ETS, currently the carbon market with the highest price of carbon, has peaked last February at above 100€ per tonne of CO2 for the first time, a progress from the early stages of the ETS when it struggled to surpass 10€ a tonne. However, if we compare the market value of a tonne of CO2 in the EU ETS to the SCC, we can see that even the European carbon price is not yet high enough.

The carbon price on the EU ETS has yet to match the SCC.

Source: Trading Economics and EPA.

While the European ETS’s price is picking up and is progressively aligning with the SCC curve, the European ETS merely covers 2.6% of global emissions and in 2019 more than 50% of global carbon pricing measures were below 10€ a tonne.

VCMs are also facing their own challenges. Different certifiers have different rules for what counts as a carbon removal or avoidance credit. This has led to doubts regarding the reliability of these schemes in mitigating global emissions. Furthermore, multiple reports accused the main certifiers of voluntary credits of over-estimating the extent to which the credits contribute to reducing GHG emissions, which led to a sharp decline in trading activity. Concretely, turbulent carbon markets reflect a lack of incentives to finance low-carbon projects because their full benefits are not entirely incorporated when actors make investment decisions.

Trading of carbon credits on VCMs has dramatically declined

Source: S&P Global

A changing landscape

Nonetheless, there is room for optimism. Since the inception of its ETS in 2005, the EU saw a 36% decline in GHG emissions in the sectors covered. While it is difficult to establish the extent to which this decline is due to cuts in GHGs or simply a transfer of carbon-intensive activities to markets outside the EU (a process called carbon leakage), it is clear that the ETS has contributed to this reduction. Additionally, the recent increase in the cost of carbon in the EU ETS provides a good example of how carbon markets can be managed. Furthermore, the EU recently implemented the first phase of the Carbon Border Adjustment Mechanism (CBAM). The CBAM will be a levy applied on goods entering the European market from sectors that are covered by the ETS. The idea behind is to make sure that European producers that have to pay for their carbon emissions under the ETS are not at a disadvantage compared to producers outside the EU that do not have to pay, or pay less, for their emissions. Because of the size of the European market, there is hope that the CBAM will create a strong incentive to decarbonize for producers aiming to export to the EU. In a way, it extends the scope of the ETS to markets with a strong reliance on European demand.

In parallel, VCM organizations are in the process of strengthening their carbon reduction certification procedures in a bid to regain the credibility they lost from investors. Developing countries have also been working to ensure that VCMs can benefit them. Currently, only 11% of traded voluntary credits went to projects in Africa. In response, the Africa Carbon Markets Initiative was launched at COP 27 with the support of UN Climate Change High-Level Champion with the hope of attracting more investment in low-carbon and nature-based solutions in the continent. The initiative has set the ambitious objective of unlocking 6 billion US dollars in revenue from carbon markets by 2030. If these initiatives are successful, low-carbon projects in developing economies may benefit from billions of dollars of new investments, which would contribute to both climate change mitigation and increasing access to a clean and affordable energy.

Work in progress

Pricing carbon is difficult. Reaching the socially optimal price is both economically and politically challenging, and carbon markets are particularly tricky to design. In fact, the international community has yet to agree on clear guidelines and principles to regulate voluntary carbon markets to ensure that they contribute to global decarbonisation efforts.

Despite their flaws, we expect them to evolve to constitute a key tool for infrastructure developers to unlock funding for low-carbon projects. Getting their design right and ensuring their accessibility could be the key to meet our climate objectives.