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Seeking A Market Price For Carbon

Carbon dioxide emissions occur in the natural environment.  Environmental scientists exploring the relationship between human-generated CO2 emissions and climate change advocate pricing these emissions.  Economists now seek ways to endogenize the value of carbon emissions within financial models.  Carbon pricing is a relevant topic for financial analysts if their models accurately encompass reality.

The Ceres Carbon Asset Risk Initiative looks sane at first glance.  It does not write off all hydrocarbon reserves as stranded assets and allows room for energy companies to use their carbon reserves productively.  The Global Investor Coalition on Climate Change gives the Ceres initiative credibility, although the language I read in some of the coalition's public materials takes a harsher tone than Ceres.  Carbon Tracker Initiative takes the hardest line on stranded assets and I am not convinced their analysis will withstand long-term improvements in energy technology.  More efficient internal combustion engines are one way to curtail emissions.

One widely known approach to estimating carbon costs is the social cost of carbon SCC.  The flaw in using a comprehensive approach like SCC is its inability to account for whatever the IPCC's climate models cannot estimate.  Approaching a financial estimate this way invites political meddling and artificial adjustments.  Regulators need to set the bar somewhere, but allowing for too many variables sets the bar too high.  An artificially high SCC risks exposure to Black Swan shocks from technology advances that will render it harmful to energy producers.  Lawrence Berkeley Lab's early work on insurance risks from climate change is so intertwined with IPCC model assumptions that it shares the same drawbacks as SCC.

Analysts can find helpful ways out of carbon pricing problems.  The CBO studied potential carbon taxes in May 2013 and balanced potentially high revenues with the regressive effects on low-income households and energy-intensive regions.  The SCC's framework would be stronger if it used a Monte Carlo simulation of different discount rates.  The World Bank noted in September 2014 that carbon pricing looks different in many parts of the world.  Local costs for extraction and transport matter very much.

The financial sector should take the same approach to pricing carbon as it does to pricing oil.  Investment banks track a global cost production curve for oil and gas fields.  Tracking a cost production curve for major carbon emitting energy companies and nations is a logical next step.  The IEA statistics on CO2 emissions are the first input for country-level analysis.  Energy producing companies' annual financial statements contain annual production statistics.  These are the starting points for a fuller understanding of the carbon cost curve.  Simplifying the SCC and running it through a Monte Carlo simulation will give the carbon cost curve an elegance divorced from political agendas.