Demand Side Carbon Prices make no sense. Here are 2 ideas for making them more rational
By: Neel Blair
Tags: Climate Change, Carbon Tax, Carbon Markets, Climate, Carbon Emissions

There are many organizations, innovators, and companies seeking to address Climate Change through the removal of carbon from the atmosphere. From companies proposing the sell agricultural services that sequester carbon to those literally sucking it out of the air so it can be used in products, stored as stone, locked into concrete, etc.

These companies spend lots of time working out how much it costs them to sequester a ton of carbon. Sucking it out of the air and turning it into rocks could be expensive but long-term. Storing it in farmers’ soil could be cheaper, but more temporary. Challenges in this space include quantification (how much C did we capture), verification & trust (are you really doing it?), and permanence (is it still there?).

That’s the supply side of the equation — how much can we sell sequestered carbon for and still make money selling carbon credits alone or farm products or concrete? Lots of work is happening in this space. And that work allows us to more or less rationally compare the solutions, on the supply side.

Then there’s the demand side. If you need to release more carbon into the air, how much are you willing to pay? Relative to the scope of the problem, which includes all carbon emissions worldwide, there are very few mandatory carbon markets right now. And the smattering of markets we do have put the prices all over the place - British Columbia says it costs $40 per ton to emit carbon. California in their February 2020 auction said it costs about $18 per ton. One of the first regional carbon markets (RGGI in the US Northeast) says companies are willing to pay $7-$8 per ton. The EU auctions them off at around $25 per metric ton. Sweden just straight up taxes carbon at $133 (110 EUR) per ton. Some companies are forced to bid at least more than x for the stuff by a government, some are only forced to participate, and others are there because they volunteered. They all have radically different reasons for being in these markets, and so they all have radically different ideas about what they should pay.

Which is weird, because not ONE of these companies nor countries will escape paying some very significant amount of money now and in the future because we collectively failed to address Climate Change.

Climate Change costs real, actual money, right now, and will cost more in the future. There are myriad examples. Fixed assets like infrastructure will be inundated by sea rise, and need to be rebuilt. Production capacity will wither because of heat waves (agriculture) or water shortages (industrial processes). But the people buying the right to pollute don’t have a lot of pricing signals to decide how much to pay now, and the ones they do have can’t be readily compared, because they’re so radically out of alignment.

Hypothetically, how much more is a strawberry farmer charging for strawberries this year based on the fact that their farm will literally not have the water to operate in 2040 (see Southern CA)? How much more expensive is a gallon of gas right now based on the fact that refinery capacity near sea level will need to be completely rebuilt in 2050 (see Houston)? What if it needs rebuilding in 2040? 2030? How much more do our companies charge us now to account for these inevitable outcomes?

I think the answer, right now, is very close to 0%. Things are zero percent more expensive now to pay for what we know we be massive costs in the future. Those products don’t have sufficient reason to charge more, because very-little-to-nothing more is being asked of them. Their water isn’t more expensive yet. They don’t have to rebuild anything yet. Their costs are what they are and nobody/nothing they work with is requiring anything different.

Yet we all know we and they are going to have to pay later. And it’ll be a lot. Someone’s going to lose out when the impact arrives. And we are really sure it’s going to arrive.

Luckily, we have mechanisms already in our economy to address this. I want to focus on two— cost of capital, and cost of risk transfer.

Put simply, for companies & governments, does it cost more to borrow money now and insure operations now due to future costs we know are arriving? If we’re making all our future impacts more expensive (because we’re doing nothing/not enough right now to stop those impacts), then we should shoulder more burden now. Banks do this all the time. They ask “how likely is it that the money gets paid back and what are the risks 10, 20, 30 years from now?” They then charge more for more risk and less for less risk. The bank basically says to people taking big risks likely to cost later, “Pay more for capital now because you’re risking all our capital later.” Insurance companies do this too, saying to customers taking big risks “Pay more for insurance now because the chances we will draw on it later have increased.”

Right now, every company in the economy can be evaluated for their level of risk. This is the core of every bank’s business!

Also, once running, when a company goes to get insurance for anything — business interruption, worker liability, product liability, property, etc. — they pay a certain rate. The higher the risk your business is interrupted, the higher your business interruption insurance costs. This is the core of every insurance provider’s business!

If banks and insurance companies start to increase capital and insurance costs, which they should do for their own reasons, then companies have a hard-cost basis for deciding what to pay for carbon credits. They have money they are paying because of the risk associated with their business.

Based on the incentives in place today, and the forecast costs of inaction, I find it hard to believe the cost of capital and the cost of insurance adequately address these future risks. Indeed, look no further than 2007–2008 for indications that the financial markets are far from immune to radical miscalculations of risk, and the associated real financial costs.

The next questions to ask are simply: Are banks and insurance companies charging business customers more based on their exposure to climate change risk? And if so, do those banks and insurance companies discount rates when companies agree to offset carbon emissions (like through the purchase of carbon credits)?

I think they should, but I don’t think they do. I think this is one of the more market-friendly mechanisms available to us. But given the price is currently way out of whack with what we know the downstream costs will be, then we need to do better.