All too modest goal

The call for a global carbon price was raised before the Rio Earth Summit of 1992, but it has gained new momentum in connection with the Paris Climate Agreement. A uniform price could result either from a tax on carbon or from some kind of global emissions trading. Such a price, however, would have to be enforced within a homogenous world-trade area. This is an unrealistic notion. Such an area neither exists nor is it needed. There is also no globally valid energy price, it varies from place to place.

For another reason, the idea that “the” global energy price – and a surcharge for carbon emissions – is what guides the global energy business is at best half true. The point is that the market price, which applies to everyday transactions, differs from the shadow price, which is used to plan long-term infrastructure projects with regard to energy use.

Typically, multiple factors affect the production of goods. Energy consumption is only one of them. How factors are assessed varies very much. After all, the factors themselves vary very much, particularly with regard to operational life spans and planning horizons. For example, taking a road trip by car requires three things:

1. fuel (the operational life span of which is measured in hours or days),
2. a car, with its specific energy needs (operational life ten years or so), and
3. a highway system, which has an impact on vehicles’ energy consumption due to maximum allowable speeds and construction aspects such as curve radii (life span approximately 100 years).

The guiding idea of carbon pricing is to shape decisions concerning all relevant factors. An economically appropriate price should be taken into account.

Obviously, a carbon surcharge will raise the costs of fuel consumption. It is utopian, however, to think that it would ever mark – or even less guide – how a car’s energy requirement is designed. Reality has shown that the opposite is true. Yes, cars have been becoming more fuel-efficient, but their size has increased so much that new models now mostly need more, not less fuel.

As for decisions regarding the third road-trip factor – highways and their design – German planners have been taking carbon prices into account for decades. This is done within the framework of the Federal Transport Infrastructure Plan. Currently, a price of € 145 is assumed per metric ton of carbon-equivalent emissions for the year 2030. This price is assumed to reflect the costs of the damage carbon emissions cause.

Common practice for development banks

It is common practice to use shadow prices when planning infrastructure projects in developing countries. Doing so is actually a planning maxim of international development banks (IDBs). Of course, any project proposal must be cost-efficient, in the sense of returns amortising the costs. Nonetheless, “cost-efficiency” is a vague notion. Project reviews therefore normally rely on two analyses, with both an “economic analysis” and a “financial analysis” being done.

Development banks typically lend money to a government or a government-run enterprise. It is the government’s job to ensure that its people get the maximum economic benefit. That, at least, is what foreign donor institutions require. Accordingly, the government should base its decisions on the economic analysis. The supplementary financial analysis is meant only to guarantee that it – or its company – stays viable under the pressure to deliver public goods.

This double assessment was included in IDB rules for a simple reason. Economic and fiscal data most likely diverge. That is the case, for example, in countries with regu­lated exchange rates or regulated labour markets. The typical results include black markets for foreign currencies and labour, respectively. The prevailing black market prices reflect scarcity far more accurately than do the administrated prices on regulated markets. Since a regulated market is not a free market, its function of balancing supply and demand is distorted.

If one accepts that state interventions distort market dynamics, a logical conclusion is that foreign-exchange markets and labour markets tend to be distorted too. For decades, IDBs have been using shadow ­prices to adjust planning to such distortions. In principle, shadow prices could serve to offset all kinds of external effects.

Insufficient commitment

At the “One Planet Summit” in Paris in December 2017, the World Bank committed to applying a shadow price on carbon and other greenhouse-gas emissions in the economic analysis of future projects concerning high-emission sectors. That is its contribution to decarbonisation.

The World Bank Group has not provided much information on this process, which is already underway. However, there is a guidance note that took force in November 2017. It addresses the use of greenhouse-gas shadow pricing in economic analysis. It includes a graph of dollar prices for carbon-equivalent emissions, spanning from the present to the year 2050. It has a low-price and a high-price scenario. For 2050, the shadow price thus ranges from $ 80 to $ 160 per metric ton. However, highly respected climate economists currently reckon that $ 400 will be appropriate in 2050 (see Rockström et al., 2017).

According to the guidance note, the shadow prices are to be used in the analysis of all projects for which greenhouse-gas emissions must be applied. This applies in particular to projects in the energy sector, and it is especially relevant when a choice must be made between fossil fuels and renewable energy sources.

Unfortunately, the World Bank’s shadow-price scheme only reflects the “social value” of reducing emissions, rather than the entire “social costs”. It is true what the guidance note explicitly states: that the purpose of shadow pricing is “[to] account for carbon externalities in economic analysis of the project”. Nevertheless, it is geared only towards the “social value”, which does not reflect the damages done by climate change. Instead, the shadow price is designed only to reflect the emission-reduction targets the countries in question have adopted. It thus corresponds to the estimates made by the High-Level Commission on Carbon Prices last year. The Commission was led by the renowned economists Joseph Stiglitz and Nicholas Stern.

The World Bank’s guidance note points out that it is necessary to factor in the abatement costs in the (actually quite probable) event of governments not implementing the policy measures needed to live up to their emission-reduction pledges. The scheme is merely designed to compensate for such policy deficiencies.

The “social value” of greenhouse gas emissions must therefore not be understood as an attempt to internalise external effects and take account of damages. It only serves a much more modest goal. It simply reflects the abatement costs of governments’ failure to take appropriate action after signing the Paris Climate Agreement and submitting Nationally Determined Contributions (NDCs).

Hans-Jochen Luhmann is an emeritus expert at the Wuppertal Institute for Climate, Environment and Energy.
jochen.luhmann@wupperinst.org

Sources

World Bank Group’s announcements at the One Planet Summit:
http://www.worldbank.org/en/news/press-release/2017/12/12/world-bank-group-announcements-at-one-planet-summit

World Bank guidance note on the use of shadow prices of greenhouse gases:
http://documents.worldbank.org/curated/en/621721519940107694/Guidance-note-on-shadow-price-of-carbon-in-economic-analysis

Rockström, J., Gaffney, O., Rogelj, J., Meinshausen, M., Nakicenovic, N., Schellnhuber, H. J., 2017: A roadmap for rapid decarbonization. Science. 355 (6331): 1269-1271. DOI: 10.1126/science.aah3443.