IMF support for carbon pricing raises the prospect of a global consensus on this theme at November’s Paris climate talks, but its implications for capital markets remain unclear.
When future economists look back at our era’s debates over climate change, they may identify in 2015 the first glimmer of a global consensus on carbon pricing.
It is even possible that they will see as the unlikely progenitor of this consensus an oft-maligned institution that has made it its historical mission to champion painful reform – the IMF.
The Fund’s contribution to the battle against global warming could prove to be transformative at November’s climate conference in Paris when it adds its weight to growing support for carbon pricing – with potentially major implications for financial markets.
Chris Ragan, chairman of Canada’s Ecofiscal Commission – created by economists to explore the potential for carbon pricing – said: “I don’t think the world has achieved a consensus yet but when you get the IMF unequivocally saying this is a good thing, and you get conservative Republican leaders in the US, the World Bank and the OECD all saying we need to do this, then it’s pretty mainstream. It is clear we are moving in that direction.”
Investors are not far behind, racing to get to grips with the implications of carbon pricing. In June, for example, six large European energy companies called for a tax on emissions.
Alex Bowen, principal research fellow at the Grantham Research Institute on Climate Change and the Environment at the London School of Economics, said: “Carbon pricing will affect the direction and levels of investment. Most analyses suggest that prices should rise steadily over time for quite a long time and should provide a strong incentive to switch to low carbon technologies; so it is going to introduce churn by altering patterns of investment.
“Inevitably with any kind of structural change like this, nobody is going to be certain where the new investment will be needed or how profitable it will be, so there is scope for turbulence.”
Laura Nishikawa, executive director of ESG research at investor intelligence group MSCI, said a growing number of clients were now exploring ways of incorporating carbon pricing into investment decisions.
“We are seeing a lot of investors, including those in the US, asking this question. There is a lot of pressure on them to footprint their portfolios and understand their exposure to potential carbon regulatory risks. We are getting more and more questions about performing this kind of analysis on fixed-income portfolios. There is a very big movement in the institutional investor community committed to systematically measuring these risks,” she said.
Most economists interpret the problem of climate change as a failure of markets whereby pollution costs are borne by society, and the obvious way to fix this is to put a price on carbon – providing market incentives to reduce emissions. There are two ways of setting a price: a carbon tax and a carbon market (“cap and trade”).
Tax the preferred policy
A growing number of countries are pricing carbon but even though most have opted for carbon markets – which in some cases have been rocked by price volatility or discredited by corruption – a tax is the economists’ preferred policy tool.
IMF support for carbon pricing since 2011 originates in its aversion to pervasive energy mispricing and subsidies. The Fund believes a carbon tax is the simplest, most effective and least costly way to reduce emissions, and has indicated that falling energy prices, fiscal pressures and the need for emission pledges before the Paris conference make the time ripe for action.
A new development appears to be hints of conservative support for carbon taxes in the US. In June, for example a bill sponsored by Democrats proposing carbon taxes was unveiled at the conservative American Enterprise Institute.
Ragan of Ecofiscal Commission said: “Conservative support for carbon taxes is raising eyebrows. So when former Republican Treasury secretary Hank Paulson stands up and says we need carbon pricing, saying it will actually reduce business risk if we price carbon, and when Christine Lagarde at the IMF says carbon pricing is absolutely essential moving forward, that’s when things start to change.”
A key issue to making carbon taxes effective will be pricing. The current US proposal starts at an optimistic US$45 per tonne of CO2, but Sean Kidney of the London-based Climate Bonds Initiative says a price of US$50 to US$100 is needed for a meaningful impact. He said: “US$20–$25 a tonne simply isn’t going to cut the mustard.”
Pricing aside, however, there is no doubt investors are trying to second guess the longer-term implications of carbon pricing – which will drive up the cost of carbon-intensive activities – for financial markets.
Ragan said: “There is going to be a change in relative prices and some rates of return are going to be impacted right away. As relative rates of return change, financial capital is going to flow away from some things and towards others – so in financial markets there will be both winners and losers. It’s like saying what would happen if the world price of oil went from US$50 to US$100 – does it have an effect? Sure it does.”
Academic studies of the policies necessary to keep temperature rises below 2C suggest the revenues from carbon pricing could eventually amount to several percentage points of world output. As a result, debates are under way about how these revenues will be put to use, especially the leeway they give governments to reduce deficits and debt issuance.
By constituting an important new source of liquidity for governments, carbon taxes could potentially have an impact on sovereign issuance.
Nishikawa of MSCI said: “We are getting more and more questions from investors globally who believe this can actually affect their bond investments, but the answer is complicated: there is still a lot of research to be done but there is potential that carbon pricing could have an impact as an increased source of revenue. Is it just put in the pot or actually invested towards green infrastructure, for example? That’s a big variable.”
Some observers believe carbon taxes also pose uncomfortable questions for nascent climate finance markets: why issue labelled Green bonds if the entire market is already subject to carbon taxes?
However, Kidney of the CBI plays down these implications. He said: “Green bonds are primarily a discovery tool, they don’t depend on a carbon price or subsidies necessarily, so it’s not an either/or situation, it’s a tool to make it easier for investors.
“It’s a complementary measure, so if you are creating investment products that help finance whatever it is you want to do, the green labelled market simply makes it easier for investors to buy, sell, trade; and through that reduction of friction you lower the cost of capital.”
“We are seeing clients develop strategies by using our data and tools to actually hedge against that to limit their long-term risk”
Bowen of the Grantham institute thinks that far from threatening the existing climate bonds market, carbon pricing could boost it. He said: “Carbon pricing means a lot more firms are going to want to introduce low carbon technologies. So there is likely to be increased demand for investment finance and some of it will be packaged as green finance.”
Perhaps more significantly, any flight from carbon threatens to “strand” fossil fuel or high-emitting assets, prompting dire warnings that institutional investors are sitting on a carbon-asset time bomb.
China, for example, is already curbing imports of seaborne thermal coal and India has pledged to do so. The value of US coal companies has plummeted in the last few years, and Australia’s coal industry faces similar problems.
Yet while capital is likely to flow away from energy majors, it could also flow between them as some devise innovative responses to carbon pricing.
Nishikawa of MSCI said: “Globally speaking, the direction is towards a carbon tax and that has clear implications on the price of and demand for oil globally as well as coal and other fossil fuels. So the revaluation of those potential physical assets will have an extremely strong impact on the balance sheets of those fossil-fuel holding companies and, of course, on their creditworthiness. We are seeing clients develop strategies by using our data and tools to actually hedge against that to limit their long-term risk.”
Concerns about stranded assets are already having an impact on investment decisions, with some firms claiming to be “shadow carbon pricing” in anticipation of global norms.
Nonetheless, Kidney of the CBI believes carbon taxes are no magic bullet and that governments already possess tools with which to engineer change – but have not been using them.
He said: “To be frank we have spent 25 years focusing on a carbon price as our silver bullet – we have forgotten there is an alternative toolkit in the bottom drawer of all our treasuries, which is the toolkit we have been using to drive capital to infrastructure investments for the last 100 years. We now simply need to use that to drive it to low carbon investments.”
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