What is shadow carbon pricing?

By Vanora Bennett

Why it matters for action on climate change

If carbon emissions had a market value reflecting how much they cost society, it might completely change the way people priced their businesses.

This is the idea behind the shadow carbon pricing methodology that the EBRD introduces this month - a new way to assess big power and heavy industry plants that the Bank might finance. Its ambition is to make environmental costs part of a broad economic analysis of whether to invest in a project of this type, identifying the price of pollution in a transparent way.

Until now, it was never that complicated to analyse the benefits and costs of (say) your gas plant. You just needed to know how much money you’d make from selling the gas you produce, then subtract the costs of building and running it through its life cycle. That financial analysis would tell you enough to know where you stood and to get finance.

But what if you also had to factor in the extra cost of the greenhouse gas emissions your plant was putting into the air, and figure out the relationship between them and the tsunami that had just ravaged your nearest coastline? What if you paid for your pollution?

“If we were looking at that gas plant with just a financial analysis, it might look financially viable. But if we take into account the broader costs to society it might no longer look so good,” explained EBRD economist Russell Bishop, who has been working on developing the mechanism for the past year.

“The big thing here is to measure the costs of the pollution. Although it sounds esoteric, it has the potential to change the shape of our investments - because when we use this analysis it could change our whole view of the project,” he added.

The market does not yet fully capture the cost of pollution, especially in the many countries where the EBRD works where fossil fuel use is subsidised. Even measuring the cost of pollution is complex. But finding a more complete way to assess the broad economic effects of emissions and correlate them with environmental alteration is becoming a top priority for business as concerns grow over the impact of climate change.

In 2015, the world came together in Paris and agreed to limit global warming to less than 2ºC, and make best efforts to limit warming to 1.5ºC. Last year’s widely heeded report by a UN scientific body, the Intergovernmental Panel on Climate Change or IPCC, painted a stark picture of the environmental damage we faced if we fail to limit warming to the more ambitious 1.5ºC figure.

Soon afterwards, at last December’s international climate gathering, COP24, in Poland, multilateral development banks pledged to align their own work with the Paris Agreement’s principles.

The EBRD’s new shadow carbon pricing methodology brings us in line with other multilateral development banks – notably the World Bank and IFC – which have also recently adopted a similar approach. Inside the European Union, the European Investment Bank has been pricing pollution in its economic analysis since the 1990s.

Introducing shadow carbon pricing is a natural next step forward for the EBRD, following the launch of the Bank’s updated Energy Sector Strategy last December in which, the EBRD formally turned away from financing investments in coal and upstream oil. The Strategy committed the Bank to publish its methodology and put into practice shadow carbon pricing as part of an economic assessment of projects which significantly increase greenhouse gas emissions.

Designed to assess potential investments in the power and heavy industry sectors, and ensure that the EBRD only invests in the most economically and environmentally viable options, the methodology was fine-tuned for a year before it went live on 1 January 2019. From now on, it is to be applied to projects being considered for investment.  

The methodology is adapted from one used several years ago within the Bank to test potential investments in coal – a way of investigating whether there was a cleaner alternative available. Although the EBRD only formally swore off coal, considered the most polluting fossil fuel, with the 2018 Energy Sector Strategy, the Bank had not made any investments in the coal sector for at least seven years before that.

In setting the “shadow price”, the EBRD follows recommendations by the High-Level Commission on Carbon Prices, which was set up in 2016 as part of international climate change talks to benchmark pollution costs. Led by economists Joseph Stiglitz and Lord Nicholas Stern (the latter a former EBRD Chief Economist), the Commission recommends that carbon should be priced at US$ 40-80 in 2020, rising over time and reaching US$ 50-100 by 2030.

The EBRD economic analysis is sensitive to multiple factors, says Bishop: “it has about 10 questions baked into every stage.”

After running the analysis, it might turn out that it would be more economically viable to invest in, say, a renewables project than our hypothetical gas plant. But the sophistication of the model allows for nuanced responses appropriate to the complex needs of some of the more coal-reliant countries where the EBRD works, where, sometimes, other fossil fuels, notably gas, can be a helpful answer in transition towards greater use of renewable energy sources.

“This analysis makes it very transparent what the costs, benefits and trade-offs are of a project,” says Bishop. The EBRD’s years of investing in one of the most polluted parts of the world, and supporting governments as they update obsolete infrastructure and move towards cleaner air and lifestyles, has given it unparalleled expertise in negotiating these trade-offs.

“We must also continue to support countries in our region moving from shadow to real carbon prices, and here there is growing momentum. There are already carbon pricing schemes under development in Morocco, Jordan, Tunisia, Turkey, Kazakhstan, Ukraine and other places.”

“It’s too straightforward to see any fossil fuel project and say it shouldn’t be done because of the Paris Agreement, but we need to take into account all the factors before deciding. If a fossil fuel project still looks economically viable when you apply the shadow price, then it gives us comfort”.

Shadow carbon pricing methodology