To Recognize the Social Value of Mitigation Actions in a Climate Agreement

Economists generally agree on putting a single price on carbon emissions through an international agreement, whether by a binding price (carbon tax) or by an emissions trading system (ETS) based on binding commitments, which would be theoretically the most efficient means to encourage the reduction of emissions to the desired global level (see e.g. Gollier, Tirole, 2015). But, in theory, uncertainties about the costs of the low carbon policies implemented by each country to meet the emissions quota imposed by the agreement make it unlikely that any credible agreement could be reached or respected, either because countries would be reluctant to commit, or due to opportunistic cheating. Moreover, given the realities of inter-state relations without a supreme authority to which sovereignty has been delegated, it is not feasible to reach an agreement based on constraints, threat of penalty for non-compliance and obligations of financial transfers from Northern to Southern countries to ensure the acceptation of developing countries. This explains the setting aside of a uniform carbon price in the international negotiation process.

That said, recognizing the need for a reference price of carbon in the climate agreement would not be vain, since it would guide investment decisions and would base new financing modes of low carbon options; those would take into account the social value of the emissions abatement that is not really internalized in countries lacking a significant and credible carbon pricing system. In no case this would be a comeback to enable a carbon price to emerge on the basis of binding commitments, as discussed during past negotiations, but which is too much time-consuming. The aim would be to give a pragmatic guide for investment decisions of firms and public administrations, to put some economic rationale, and eventually to make the financing of low carbon equipment easier by developing new financial architectures. It would only apply to future equipment, and not at all to emissions of existing equipment and vehicles. This makes it very acceptable for the negotiation of a climate agreement.

A coalition of emerging and developing countries, reinforced by French and Japanese facilitators, managed successfully to introduce the principle of such a recognition into the draft agreement: the parties “recognize the social and economic value of voluntary mitigation actions and their co-benefits to (…) health and sustainable development” (Draft decision, ADP Workstream2, Section II Mitigation, §4, October 2015). This recognition could stay in the final agreement.

Bridging the Gap between Private and Social Values of Low Carbon Investments

To trigger long-term decisions in terms of low carbon equipment, infrastructure programs (buildings, mode of transport, urban planning), or reforms of land use which have an additional cost compared to ordinary emitting options, requires to rely on a credible signal of carbon price. Such decisions need to refer to the social return on investment, not just the private profitability, by a guaranteed level of internalization of the social cost. Without a credible value of carbon by a tax or a well-designed ETS, the current alternative is a quite frequent use of a package of measures: modes of special subsidies for low-carbon energies, emission standards and measures of “command and control” (emission limits by sector, closure of old emitting equipment, bidding for long-term fixed price contracts with a public agency in power markets, etc.), public investment programs in infrastructure favoring low carbon options, with the drawback of having quite different costs of avoided emissions per ton. In the absence of credible monetization of carbon, the definition of a reference value of carbon at the global level, or at least in the club of voluntarist countries, would be useful to provide a relevant index of carbon value for private and public investors. This would ensure consistency between the policies and measures inside a country, or between countries, even encourage the emergence or the fixing of carbon pricing mechanisms (taxes, ETS), sending thus a credible long-term price signal. This would also ensure more consistency between the policies and measures between countries, and help to establish links between carbon pricing mechanisms.

The existence of this reference price of carbon meets the wishes of companies that are calling for the establishment of a credible carbon price in countries with no reliable carbon tax or emissions permit system to guide their long term choice. In the absence of it, the most active companies choose to self-regulate by defining their own internal reference price, as an incentive for choosing lower carbon investment, but sometimes artificially because of the main objective to preserve their image of socially and environmentally responsible.

Such a reference value would also help governments to design public policy measures (vehicle emissions standards for instance). It guides public investments towards less carbon emitting options by the cost-benefit assessment of different policy alternatives. As such, a reference value of carbon is already used in the United States, Canada, Mexico and Europe, in Germany, the UK, Norway and France (since 2009).

To boost low-carbon investments on basis other than voluntary and self-regulation, innovative financing mechanisms could also be a way to internalize their additional economic and social values, compared to baseline investment options, through private loans. Internalization would materialize in a financial asset corresponding to carbon certificates which would be recognized as such by the financial and banking system at the national and international level. This financial asset would be backed by a guarantee given by respective governments on the carbon reference value. This value would be agreed upon at the global level in the UNFCC framework. By bridging the gap between private and social value of carbon, it would remove one of the obstacles to invest in low carbon equipment and infrastructure, related to the non-internalization of the carbon value or the non-credibility of the carbon price when it exists. Indeed these investments are capital intensive with high risk management constraints related to uncertainties from their economic environment (fossil fuel prices, …) and their construction cost, to which a carbon pricing could add a new dimension, as shown by the EU-ETS price. The risk management issue of low carbon investment alone would already justify the establishment of risk-sharing arrangements, such as loan guarantees from government (see Canfin & Grandjean, 2015, "Mobilize Climate Finance", report of 18 June). The purpose of a superior financing mechanism is to add a value of carbon to profitability of projects and a guarantee on the value of the ton of CO2.

The avoided emissions allowed by low carbon project should become carbon certificates which have to be recognized as a new financial asset by central banks and valued at the reference price of carbon. They would constitute a new vehicle of intermediation between the banks which would lend to low carbon investors which will partly reimburse with their carbon certificates on one side, institutional investors (pension funds, insurance companies, sovereign funds) which could buy the carbon certificates to lending banks on another side,  and to central banks (to the IMF also) which accept refinancing these loans including these carbon assets on a last side hand. The reference value of carbon should be introduced before the other rules which structure this mechanism. These rules are a credible system of validation of carbon certificates for low carbon projects by an international agency, a possibility for borrowers to partly repay their loans with their carbon certificates, new prudential rules that recognize these certificates as assets in the balance sheets, possibilities of refinancing bank loans by central banks in exchange for these carbon certificates (Aglietta, Espagne, Perrissin-Fabert, 2015 ; Hourcade, 2015 ; Hourcade, Perrissin-Fabert, Rozenberg, 2013).This system could be set up as a G20-type club and with the coordination of the involved central banks, gradually aware of the need to fight against climate change.[1]