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Climate 101 —
Carbon prices: Green swans?

Alan Hsu
Alan Hsu
Global Industry Analyst
Boston
Climate 101 is an ongoing series designed to enhance basic understanding of climate change, including terminology and concepts, and to communicate our current research themes.

Author and financial commentator Nassim Taleb introduced the concept of black swans, rare occurrences — often macro or market shocks — viewed after the fact as obvious or bound to happen, but that were difficult to predict or prepare for. Carbon prices may be black-swan-like for their potentially substantial impact on markets coupled with a lack of collective preparation or understanding. Let’s call them green swans.

What are carbon prices and why do they matter?

Carbon prices are costs, or taxes, placed on each metric ton of CO2 produced. The objective of a carbon price — derived via regulation or the market — is to quantify negative externalities from the production, distribution, or consumption of fossil fuels. Carbon prices create mechanisms that incentivize decarbonization, which can be enforceable caps on emissions or carbon adders, which set a price per incremental ton of carbon. Market participants seem to have scant understanding of carbon-pricing schemes and doubt will be implemented, yet they could profoundly affect asset values.

Why is carbon pricing useful?

I believe the root of society’s inability to prepare for climate risks is a combination of short-termism and lengthy, insufficient feedback loops, as climate change often seems amorphous or distant. Lack of accurate measurement and economic incentives compounds the issue. Governments, companies, and individuals display a cognitive dissonance by acknowledging climate-related risks but failing to effectively mitigate them. Changing behaviors to combat climate change is difficult if one’s lifestyle or financial interests depend on not changing them.

Carbon pricing shortens the feedback loop inherent to curbing climate change by making fossil-fuel production more expensive, dampening demand, and lowering utilization of thermal production. As utilization declines, renewable power becomes more economic on a relative basis, drawing capital away from carbon-heavy entities.

What are the market implications of carbon prices?

Carbon prices would impact some companies’ earning power, depending on regional power mix. In the US, for example, most power markets rely on natural gas or a mix of coal and natural gas. I estimate that a carbon price of US$10/ton would translate to a US$4 – $10 per megawatt-hour (MWh) increase for fossil-fuel-sourced electricity in the US, potentially up to a 30% rise. This would dampen the earning power of traditional energy assets while widening the advantage for renewable-power assets. The marginal cost of electricity production for renewable companies is already nearly zero given the absence of fossil fuels. Under carbon pricing, they would have even higher relative utilization rates than conventional energy-production assets, which would become commensurately more expensive to run, and thus less competitive.

While pricing tends to punish the suppliers of carbon directly, the effects will flow through to the demand side as well. A US$10/ton tax could raise prices at the gas pump for US consumers by US$0.10/gallon. This would potentially catalyze shifts in consumer behavior, creating headwinds for conventional automotive companies and tailwinds for the automotive electrification industry. Carbon markets will evolve. Today, the focus is on raising the cost of CO2 production as a means of incentivizing decarbonization. Longer term, with better consumption data and measurement, I believe we can expect an equal focus on shifting CO2 demand.

Are carbon prices already being implemented?

Several countries are already implementing pricing policies. China has announced plans to gradually institute a national carbon trading plan, and the European Union has taken steps to reinvigorate the regional carbon credit market as part of a carbon trading scheme. While a US national carbon price is unlikely to happen anytime soon,1 several US states are forging their own path. About a dozen US states participate in the Regional Greenhouse Gas Initiative (RGGI), a cap-and-trade initiative. California has a localized carbon trading market. New York and Pennsylvania offer zero-emission credits for select low-carbon assets, and Illinois is considering the same. Most carbon-pricing discussions focus on national programs; however, in my view, regional markets may be just as effective in promoting carbon pricing.

While capital markets have begun to recognize climate change as a tangible risk, that risk remains underpriced. I believe ambitious, pervasive carbon prices are likely to materialize in the next few years and that few market participants are prepared. Investors should consider the eventuality of carbon prices to avoid being surprised by these green swans.



1
The US Commodity Futures Trading Commission recently published a report identifying climate risk as a “major risk” to the US financial system, and citing carbon prices as an effective tool for incentivizing decarbonization.

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For professional, institutional and accredited investors only. The views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. While any third-party data used is considered reliable, its accuracy is not guaranteed. Forward-looking statements should not be considered as guarantees or predictions of future events. The value of your investment may become worth more or less than at the time of original investment. Past results are not a reliable indicator of future results. Commentary provided should not be viewed as a current or past recommendation and is not intended to constitute investment advice or an offer to buy or sell securities. Wellington assumes no duty to update any information in this material in the event that such information changes.
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