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June 22, 2022updated 02 Aug 2022 10:33am

NZAOA: Carbon pricing crucial for tackling energy policy trilemma

Policymakers must accelerate the shift to net-zero emissions by implementing carbon pricing schemes right away, writes the chair of the $10.6trn Net-Zero Asset Owner Alliance. He outlines the five policy design principles in the alliance’s new position paper that can form a basis for such moves.

By Günther Thallinger

Gathering clouds: There is growing urgency for implementing carbon pricing schemes. (Photo by Drbouz via iStock / Getty Images)
  • Concerns over energy security and spiking fuel prices, combined with the climate crisis, underline the importance of accelerating the shift to a lower-carbon world.
  • Carbon pricing is a tool that policymakers must employ to help achieve net-zero emissions and should be implemented as soon as possible.
  • The Net-Zero Asset Owner Alliance proposes five policy design principles to help underpin fair and effective carbon pricing; they incorporate concepts such as revenue recycling and ending fossil fuel subsidies.

Now is a critical time for energy markets. A quarter of the 2015 Paris Agreement on Climate Change’s “decade of delivery” – as Cop26 president Alok Sharma put it at the climate summit in November – is already behind us. And yet households and the economy more broadly are facing the biggest spike in energy prices in recent memory, fuelled at least in part by Russia’s invasion of Ukraine.

In addressing this energy policy trilemma – energy security, affordability and climate change – it is critical that policymakers accelerate the structural shift towards net-zero emissions.

Carbon pricing, a means to capture the external costs of greenhouse gas (GHG) emissions, is one of the tools available to them. It is not a magic bullet to address climate change and the present energy crisis, but it is essential for creating incentives to drive structural change. The net-zero transition may not be possible without it.

Such policy mechanisms will take years to implement, which only increases the importance that they are initiated without delay. But how can policymakers do this at a time when businesses and consumers are already facing high and rising energy prices?

The Net-Zero Asset Owner Alliance (NZAOA) – incorporating 73 institutions, including insurance companies, pension funds, foundations and sovereign wealth funds and managing $10.6trn in assets – highlights in our latest position paper, published today, five key policy design principles that can provide a basis for effective yet fair carbon pricing schemes.

Consistency on carbon pricing

First, there needs to be a consistent approach to carbon dioxide across the economy. At present, only 5% of global emissions are covered by a carbon pricing scheme consistent with reaching a 1.5°C target, with most schemes only covering half of their respective economies (see first chart below). Scaling up coverage and ambition of pricing levels or other regulatory measures is necessary to realise a net-zero economy.

The second principle is that ensuring a just transition is the litmus test of a successful carbon pricing scheme – it minimises any negative distributional impacts on communities and households. A case in point: rising energy bills tend to have the greatest impact on lower-income households. Carbon pricing, similarly, may have a much larger impact on communities more reliant on emission-intensive industries, such as petroleum refining, chemicals and metal/mineral products.

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There are ways to mitigate such effects. Revenue recycling, for example, allows authorities to earmark revenues – raised from a carbon tax or the auctioning of allowances in an emissions trading scheme (ETS) – for retraining, lump-sum transfers or broader policy changes, such as lowering income taxes for affected populations. Revenue recycling is practised in California, the EU and Canada’s British Columbia.

Carbon pricing: predictable trajectory?

Moving to principle number three. As the carbon price should be rising to capture progressively the depth and scope of emissions reductions, a clear, predictable price signal provides investors and companies with greater certainty for effective capital allocation. Building on NZAOA’s discussion paper last year, covering a binding carbon-pricing corridor, we find that carbon taxes can have an announced, steadily increasing rate, while ETSs can include market stability measures, such as price floors, ceilings or corridors, to avoid excessive price volatility. To ensure an orderly transition to a low-carbon economy, transparency on the broad trajectory of carbon prices remains key.

Our fourth policy design principle is that carbon pricing can be designed to protect companies against loss of competitiveness. It also minimises carbon leakage, whereby total emissions are not reduced but merely shifted from one place to another. Design choices that minimise this risk include revenue recycling, allocation of ETS allowances (particularly for emission-intensive, trade-exposed sectors) and carbon border adjustment mechanisms (CBAMs).

Implementing CBAMs places a charge on imported carbon-intensive goods from jurisdictions that lack a carbon price, which in turn levels the playing field between domestic and non-domestic producers. CBAMs will only work if free carbon allowances are terminated, as no importer will agree to pay if another country continues to subsidise its own industries in that way.

Encouraging cooperation

The fifth and final principle is that the increasing complexities and connectiveness of global supply chains underlines that no country can overcome the climate crisis alone. International cooperation through carbon pricing can reduce the cost of mitigation actions and raise climate ambition.

In this light, we particularly look to Germany’s current presidency of the G7 to spearhead the discussion on implementing effective, equitable global climate clubs – that is, coalitions of countries that encourage high levels of participation in international climate agreements. To ensure they work effectively, climate clubs should set out clear objectives that shape what the incentives will be, such as knowledge sharing, financing and trade gains.

The evidence from the past few decades of policy experience is that carbon pricing works best when it is part of a wider policy package. The public funding of research and development, for example, is crucial to the development and commercial deployment of clean energy substitutes, and climate legislation is vital to ensuring the durability of policy beyond election cycles, as major investors have pointed out.

Fossil fuel subsidies

Moreover, fossil fuel subsidies – through the direct transfer of funds, price supports or tax benefits – must be phased out. Several G20 countries are simultaneously subsidising fossil fuels and renewable energy while taxing carbon – policies that counteract each other. In 2009, G20 countries pledged to phase out fossil fuel subsidies, a move that investors have long supported. However, 13 years on, this pledge is still to be implemented.

Overall, Europe and the wider world finds itself on the crossroads in terms of both its energy and climate future. As the Intergovernmental Panel on Climate Change noted in April, staying on a path to a 1.5°C temperature rise and below 2°C  requires “immediate and deep emission reductions across all sectors of the economy”. Carbon pricing has an important role to play in this regard and efforts to implement or enhance such schemes should not be postponed.

As asset owners, we call on policymakers to follow through on their commitments outlined in the Paris Agreement and draw on the design principles outlined in the paper to promptly implement reliable carbon pricing, so the world can get on track to halving emissions by the end of the decade.

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