Climate change and carbon emissions are a good example of what is known as a market failure since the market is not functioning to maximise the welfare of society as it does not factor in the damage caused by carbon emissions. Carbon emissions, like other polluting activities, are referred to as an externality since the true cost of emitting carbon dioxide is not factored into the cost of production by the emitting companies. Instead, the cost is external to the company, since the cost and impact of the CO2 emissions are borne globally and not only by the polluting entity. A localised example would be a factory situated on a river that pollutes the water, causing health problems for people living downstream.
It is generally accepted that the best way to correct a market failure is to place a price on the externality that reflects it's true cost. In the case of climate change, this requires putting a price on a tonne of carbon that reflects the net cost to society. For example, the amount of CO2 emitted from activities include:
Putting a Price on Carbon
A single passenger’s emissions on a flight from London to New York: 2 tonnes of CO2.
The heating/electricity for the average home in Europe for one year: 5-7 tonnes of CO2.
The average middle-aged adult in Europe has a total annual carbon footprint of 10-20 tonnes.
There are principally two types of carbon markets. Firstly, there is the voluntary carbon offset/credit market. In the voluntary market, there are a wide number of carbon schemes with different levels of certification and rigour. The voluntary market allows individuals and businesses to offset their emissions by purchasing carbon offsets that, in effect, absorb CO2 from the atmosphere. Due to the nonstandard methods used across the voluntary market, there is a wide dispersion of the price for a tonne of carbon offset with prices ranging from as low a $0.30/tCO2 to $10/tCO2. Some of the positive effects of the voluntary market are its ability to test new approaches, new standards, and new methods of calculating a carbon offset. Voluntary offset projects are mainly located in emerging markets and normally provide some co-benefits to the local communities that live nearby or who will be directly involved in the project. From an investment point of view, investing in voluntary carbon offsets would be a difficult proposition to justify since the supply of offsets is very large and the secondary market for trading offsets is opaque and illiquid.
The second carbon market is the compliance market which consists of emission trading systems like the EU ETS and which are governed by mandatory national or regional carbon reduction programmes. The compliance market is tightly regulated and the compliance entities (typically large emitting companies) are mandated by national laws to adhere to the rules and regulations of the programme; including detailed reporting of their emissions and tracking of their compliance obligations. Compliance markets typically deal with allowances rather than offsets/credits, with each allowance giving the holder the right to emit 1 tonne of carbon dioxide. The larger compliance markets have well-established liquid trading markets, allowing companies to trade carbon allowances between them. The overall supply in the compliance market normally declines annually in line with the government objective to reduce emissions to a targeted level by a target date. This means that the supply of carbon allowances is shrinking each year, decreasing supply and potentially raising the carbon premium. These demand and supply features ensure carbon markets are attractive for investors driven by financial as well as environmental returns.
When analysing the potential price change in the compliance allowance carbon market, one has to consider the level of the carbon price that would stimulate enough carbon abatement activity to meet the Paris Agreement objectives. Economists and energy analysts have assessed the major emitting activities in order to calculate the price of carbon required to stimulate switching to lower or zero-emission activities (such as wind and solar in the case of electricity generation). Multiple studies, including one by economists Joseph Stiglitz and Nicholas Stern, have concluded that in order to meet the climate goals in the Paris Agreement, the global carbon price needs to be in the range of USD $50 to $120/tCO2 by 2030. Richard Tol and William Nordhaus also survey the academic literature and arrive at a range of USD $10 to $400/tCO2.
Additional studies on the required global carbon price include:
The price of carbon in the European ETS is currently $20/ton (October 2018) and the supply of allowances is reducing by 1.74% next year and then by 2.2% each year starting in 2021. This reduction in supply, combined with growing economies that require more energy, may mean that carbon prices rise significantly in the future.