Carbon values literature review Prepared for BEIS by Vivid Economics BEIS research paper number: 2021/049 September 2021 Acknowledgements This report has been prepared by Stuart Evans, Fabian Knoedler-Thoma, Christian Mortlock and Thomas Kansy Prof Simon Dietz and Prof Sam Fankhauser (London School of Economics, Grantham Research Institute on Climate Change and the Environment) provided valuable comments and review © Crown copyright 2021 This publication is licensed under the terms of the Open Government Licence v3.0 except where otherwise stated To view this licence, visit nationalarchives.gov.uk/doc/open-government-licence/version/3 or write to the Information Policy Team, The National Archives, Kew, London TW9 4DU, or email: psi@nationalarchives.gsi.gov.uk Where we have identified any third-party copyright information you will need to obtain permission from the copyright holders concerned Any enquiries regarding this publication should be sent to us at: enquiries@beis.gov.uk Contents Executive summary _ Principles for carbon valuation _ Approaches to carbon values _ 10 Social cost of carbon _ 11 Developments in the literature 12 Uncertainties on emissions, climate responses and abatement _ 12 Calibrating damage functions _ 14 Discounting _ 16 Alternative approaches 17 Policy developments 19 Case study: the USA’s use of an SCC 19 Case study: Germany’s calculation of an SCC 21 Assessment against criteria 21 Mitigation cost approaches _ 24 Developments in the literature 25 Policy developments 28 Case study: modelling costs of mitigation in New Zealand _ 28 Case study: developing carbon values in France 30 Assessment against criteria 30 Conclusions for the UK _ 34 Carbon values literature review Executive summary The development of carbon values, representing the societal value of carbon emissions impacts, is central to the evaluation of all policies or investments that increase or reduce greenhouse gas emissions The UK developed its approach to calculating carbon values in 2009, using a target-consistent price path for sectors not covered under the ETS and a traded carbon value approach for ETS sectors This report seeks to inform BEIS’s review of UK carbon values, by reviewing subsequent academic research and international practices in developing carbon values for policy appraisal Specifically, we seek to identify whether the current approach is still fit for purpose given the increased ambition of emissions targets, and significant advances made in the carbon values literature The discussion below considers the advantages and disadvantages of different methodologies for carbon valuation, discusses the sources of uncertainties within different models and available mitigation strategies, and explores cases studies of approaches taken in other jurisdictions Policymakers regularly conduct evaluations based on cost-benefit analysis (CBA) to support decision-making in different areas of public policy, including decisions on policy design and evaluation of investments CBA allows policies to be comparable, allowing for prioritisation based on value for money 1, and helps increase transparency in decision making, allowing for greater accountability To assess climate policies and other policies that have an impact on emissions2 requires the valuation of carbon emissions, for which it is necessary that carbon has an associated price Regardless of the methodology chosen to estimate a carbon value for policy appraisal, these remain essential for informed decision making The two broad approaches most used to develop carbon values for policy appraisals remain unchanged since the government’s approach was developed, these are: • calculation of a social cost of carbon (SCC), which quantifies the damages of climate change stemming from an additional/marginal greenhouse gas emission, and • a mitigation cost approach, which quantifies the cost of reducing an additional/marginal greenhouse gas emission on a feasible least-cost path to achieve a jurisdiction's emissions reduction objectives, or as the expected market price in a carbon market5 There are two different mitigation cost approaches: the target consistent price path approach uses techno-economic analysis to identify the carbon price path needed to achieve a given emissions target; the traded values approach uses observed and expected carbon prices in existing carbon markets Quinet A., 2019, The Value for Climate Action, https://www.strategie.gouv.fr/sites/strategie.gouv.fr/files/atoms/files/fs-the-value-for-climate-action-final-web.pdf DEFRA (2005) Social Costs Carbon Review - Using Estimates in Policy Assessment Department for Environment, Food and Rural Affairs For arguments against monetisation of damage, please refer to Pearce (2002) Smith, S, Braathen, N A (2015) Monetary Carbon Values in Policy Appraisal: An Overview of Current Practice and Key Issues OECD Environment Working Papers No 92 DECC (2009) Carbon Valuation in UK Policy Appraisal: A Revised Approach Department of Energy and Climate Change Carbon values literature review The literature on SCC has developed significantly but key uncertainties remain A significant part of the literature has focused on uncertainties around the climate system and damages of climate change Particularly a better representation of severe climate impacts, including tipping points, and a precautionary approach to avoid them has produced multiple large estimates for SCC, although this approach remains subject to debate Similarly, no consensus has emerged regarding the discounting of future costs and benefits, which has a strong impact on the resulting carbon values Altogether, the SCC approach incorporates compounding uncertainties that are unlikely to be resolved in the future These continued uncertainties mean the range of SCCs estimated in the mainstream literature has not narrowed in recent years and may have indeed widened The mitigation cost approach has not seen such an extensive debate and developments have focused on uncertainty analysis and improving the techno-economic modelling suite This report focuses on the target consistent price path approach, since the traded value approach is not suitable to obtain economy-wide estimates for carbon values Where this literature has developed it has focused on the inclusion of uncertainties regarding prices and technological change It has also seen a development of models and model suite that are able to better represent broader segments of the economy in greater detail, increasing the overall credibility of mitigation cost estimates Drawing on recent literature the report develops four key criteria for the assessment of metrics for carbon valuation: • Robustness; the metric is comprehensive in accounting for the climate-relevant impacts of a policy and is robust to small changes in underlying assumptions • Timeliness; the metric should support efficient public decision-making, by being flexible and easy to update for changed information and circumstances • Policy alignment; the metric should be capable of responding to meaningful changes to government policies and goals and contributing to their achievement • Credibility; the metric is transparent to stakeholders in both the method of its calculation and conclusions, and both should stand up to rigorous public and academic scrutiny The SCC approach scores poorly against these criteria and is not recommended for use Estimates of the SCC remain contentious, with small alterations to underlying assumptions leading to vastly different valuations, with the range of estimates widening in recent years SCCs score poorly against all elements of our assessment, particularly on robustness and policy alignment The latter is particularly relevant for the UK SCC analyses are generally not Meta-analyses on SCC estimates include: Pindyck, R S (2019) The social cost of carbon revisited Journal of Environmental Economics and Management, 94, 140-160; Wang, P., Deng, X., Zhou, H., & Yu, S (2019) Estimates of the social cost of carbon: A review based on meta-analysis Journal of cleaner production, 209, 1494-1507; Tol, R S (2014) Correction and update: The economic effects of climate change Journal of Economic Perspectives, 28(2), 221-26 A meta-analysis on the mitigation cost approach is provided by Huang, S K., Kuo, L., & Chou, K L (2016) The applicability of marginal abatement cost approach: A comprehensive review Journal of cleaner production, 127, 59-71 Carbon values literature review aligned with the net zero target, with most estimations drawing on emissions scenarios that are not aligned with UK reaching net zero in 2050 The target-consistent price path approach scores better against assessment criteria despite uncertainties This approach is preferred in two main areas: First, the approach is more credible as the methodology is more transparent and relies less on unobserved functions that are common in Integrated Assessment Models (IAMs) used for SCC analysis Second, the approach is responsive to changes in emissions targets and can therefore be well-aligned with the UK’s net zero target Nevertheless, this approach involves challenges particularly given its sensitivity to uncertain model assumptions A target-consistent price path approach does not seek to determine the optimal level of emissions reductions, so is only appropriate for use given sufficiently stringent targets The presumption underlying the target consistent price path is that the emissions reductions target is aligned with a socially optimal outcome Given international consensus on limited warming to well below two degrees Celsius under the Paris Agreement, a domestic target that is broadly consistent with that objective is sufficient The UK’s net zero by 2050 target meets this criterion, but the use of a target consistent price path may be inappropriate for countries with a less stringent target Given recent developments in the academic literature and international experience regarding the calculation of carbon values, the UK’s continued use of a target-consistent price path appears appropriate However, given uncertainty regarding future mitigation costs, the approach to developing this price path should be revised The UK’s climate targets are not conditional on future technological or economic developments, and an appropriate target consistent price path should be consistent with achieving net zero even under contrary circumstances The targetconsistent price-path should also be updated on a regular basis to reflect the latest evidence and utilise advancements in modelling and analysis This will ensure that an appropriate precautionary approach is being adopted, while relevant new information is being regularly accounted for The remainder of this paper is structured as follows: • Section develops a set of principles for the evaluation of different approaches to carbon valuation • Section introduces recent developments in the literature • Section outlines developments in calculations of an SCC • Section outlines developments in using approaches based on mitigation costs for reaching targets • Section concludes and provides recommendations for an updated approach Carbon values literature review Principles for carbon valuation There is extensive literature on potential approaches to calculating carbon values, but for these values to be useful in regulatory analysis requires other attributes There is little specific literature on the principles for developing carbon values, but based on the literature and common practice from jurisdictions implementing carbon values, we propose four criteria for the assessment of these approaches: • Robustness; the approach is comprehensive in accounting for the climate-relevant impacts of a policy and is robust to changes in underlying assumptions consistent with the prevailing literature • Timeliness; the approach should support efficient public decision-making, by being flexible and easy to update for changed information and circumstances • Policy alignment; the approach should be capable of responding to meaningful changes in government climate ambitions, and policies contributing to their achievement • Credibility; the approach is transparent to stakeholders in both the method of its calculation and conclusions, and both should stand up to rigorous public and academic scrutiny These criteria align with general principles for good governance and with several public documents regarding the evaluation of carbon values discussed below Robustness requires the approach to demonstrate comprehensive coverage of impacts and insensitivity to changes in underlying assumptions that remain consistent with the prevailing literature A comprehensive approach will account for the most important social impacts, broadly defined as the potential societal cost of emissions and the societal value of emissions reductions This was emphasised by the US EPA’s preference that a social cost of carbon provides “a comprehensive estimate of climate change damages” and is reiterated by the OECD which suggests “making a full assessment of the consequences of an investment decision” in terms of the costs to social welfare from higher emissions and the benefit to social welfare increased emissions This does not require that all impacts are considered but considering all impacts that substantively change likely values will be important Robustness also requires that there is relative consistency in values for a range of underlying assumptions that are consistent with the prevailing literature That is, that the use of assumptions that would not be considered outliers in the prevailing literature would not substantively change the estimated carbon value and therefore a policy or investment decisions This draws on the early discussion from Pearce regarding social costs of carbon, that suggests a key role for such approaches is in “determining whether ‘too much’ or ‘too little’ abatement is being considered”, Smith, S, Braathen, N A (2015) Monetary Carbon Values in Policy Appraisal: An Overview of Current Practice and Key Issues OECD Environment Working Papers No 92 7 Carbon values literature review where an approach is excessively sensitive to such changes in assumptions, it cannot adequately play this role Timeliness relates to the capability to update the approach and its inputs to reflect the latest information Carbon values can be used for decision making on specific projects or policies, and in decisions regarding the overall allocation of resources where these policies are competing for scarce resources with other projects offering non-climate costs and benefits It is important that the inputs to the approach can be regularly updated to ensure that the approach chosen remains fit for purpose as external circumstances change The need for the approach to be updated regularly can be seen through recent rapid technological change, which has seen a steep drop in the cost of renewable electricity and electric vehicles10, which have far exceeded rates projected in modelling exercises Alignment of approaches with government policy is needed to ensure that evaluation of policy or investment is consistent with achieving climate targets and commitments In practice, this means that shifts in government policy, particularly shifts in terms of the ambition of mitigation should be associated with shifts in carbon valuation in a predictable direction, and of a scale, that aligns with these changes A carbon valuation seeks to help make short-term decisions aligned with long-term policy This decision making is made difficult by the inconsistency between climate change as a global problem regarding the “stock” of carbon pollution and the “flow” nature of targets and nationally determined contributions (NDCs) under the Paris Agreement As discussed in Quinet (2019): 11 the rapid shrinking of global carbon budgets is now leading to the stock objectives – responsible management of a multi-year carbon budget – being rounded off with flow objectives: a "net-zero" objective regarding human-driven greenhouse gas emissions An approach that sheds light on the global objective of carbon mitigation is insufficient, it must also reflect the ability of governments to meet their national commitments, and in the UK’s case, its net zero target An approach that fails this test will fail to adequately inform policy and risks lacking social legitimacy A credible approach is fundamental, as legitimacy in the eyes of stakeholders is a necessary step for social decision making and continued public support for ambitious climate action This requires that the method for calculating a carbon value is transparent, with a clear presentation of the methods used in the analysis, the assumptions used and their rationale This may also require a degree of public input into the determination of valuation and the assumptions and approaches used Indeed, a transparent approach to the development of a methodology to Pearce, D (2003) The Social Cost of Carbon and its Policy Implications Oxford Review of Economic Policy, 19(3), 362–384 doi:10.1093/oxrep/19.3.362 Smith, S, Braathen, N A (2015) Monetary Carbon Values in Policy Appraisal: An Overview of Current Practice and Key Issues OECD Environment Working Papers No 92 10 IEA (2019) Global EV Outlook 2019 IEA Paris https://www.iea.org/reports/global-ev-outlook-2019 11 Quinet A., 2019, The Value for Climate Action, https://www.strategie.gouv.fr/sites/strategie.gouv.fr/files/atoms/files/fs-the-value-for-climate-action-final-web.pdf 8 Carbon values literature review calculate carbon values was central to the US government’s development of a social cost of carbon (Interagency working group on Social Cost of Carbon, 2010): Numerous agencies met on a regular basis to consider public comments, explore the technical literature in relevant fields, and discuss key model inputs and assumptions The main objective of this process was to develop a range of SCC values using a defensible set of input assumptions grounded in the existing scientific and economic literature In this way, key uncertainties and model differences transparently and consistently inform the range of SCC estimates used in the rulemaking process The use of a transparent, evidence-based and open approach to the development of carbon values is also consistent with the UK Government’s broader approach to climate policy This includes open engagement and consultation on major regulatory changes, such as through the current net zero review and consultation on carbon pricing, as well as the ongoing role of the Committee on Climate Change as an independent source of expert advice The subsequent sections of this report focus on the two main approaches to developing carbon valuation, the social cost of carbon and mitigation cost approaches In subsequent sections, we apply these principles to the assessment of these approaches and develop broad recommendations for potential improvements to the UK’s current approach to such valuations Carbon values literature review Approaches to carbon values This literature review considers recent literature on approaches to carbon values This literature review focuses on publication on carbon values since 2009, when BEIS conducted a comprehensive review on carbon values This review considers publications in peer-reviewed academic journals but also grey literature such as government documents, consultancy reports and work by international organisations such as the OECD and the World Bank’s Carbon Pricing Leadership Coalition (CPLC) This report analyses recent developments in the academic literature and jurisdictions’ practical experience of using social costs of carbon (SCC) or mitigation cost approaches to develop carbon values for regulatory appraisal It then assesses these approaches against selected criteria The literature review did not identify other established methodologies to obtain carbon values in wide use This report discusses developments in these approaches in recent years and their use in policy and assesses the approaches against principles for carbon valuation developed by the project team and the academic experts A compilation of different carbon values and a systematic, quantitative analysis of the differences in values is beyond the scope of this report The literature on social cost of carbon has developed substantially in recent years The literature on social cost of carbon has substantially developed since 2009 as part of a vivid academic debate Major developments include: • Increased focus on uncertainties in the climate system • Changes in damage functions to represent impacts of high temperatures better • Grounding damage functions in empirical evidence • A continued detailed debate on the role of discounting • Alternative approaches to calculate social cost of carbon There have been fewer substantial developments on the mitigation cost approach The main developments include: • Stronger focus on scenario and uncertainty analysis • Improvement of techno-economic modelling in order to represent the economy in greater detail, including better representation of dynamics of technological change The following sections expand on these developments and evaluate the performance of these approaches to developing carbon values considering the principles established in Section 10 Carbon values literature review ratio and therefore in the assessment of policies and projects before and after the UK’s adoption of its net zero targets Targets informed by science, and broader economic and ethical considerations may provide a more solid policy base than the narrow framing of interactions between climate and economics in most SCC analysis64 SCC allows for some timeliness in terms of updating, however, elements like changes in technology would have to be translated into the functions of the IAM Given these challenges, there is a risk that if SCC is used as the basis for developing carbon valuations could face credibility issues As although a defensible approach to developing an SCC is possible, the sensitivity of these measures to alternative reasonable assumptions creates risks for that any SCC calculated may not be robust to rigorous public and academic scrutiny Further, the invariance of the SCC to a certain emissions reductions target creates potentially severe problems for the communication of the metric to the public In addition, the approach to calculating an SCC creates further challenges for credibility The reliance on integrated assessment models reduces transparency for stakeholders IAMs used for SCC are often a black box and many functions lack empirical grounding This can provide a challenge for the credibility of SCC, particularly for higher values Pezzey, J C (2019) Why the social cost of carbon will always be disputed? Wiley Interdisciplinary Reviews: Climate Change, 10(1), e558 64 23 Carbon values literature review Mitigation cost approaches Mitigation cost approaches model the costs of achieving a certain emissions reduction target at lowest cost Mitigation cost approaches take a certain emissions reduction target as given, for example from climate science or existing legislation They then calculate the required carbon value to achieve this target at lowest cost There are two general approaches: A target consistent price path approach relies on techno-economic analysis to estimate the required carbon value that makes the required emissions reductions cost-efficient The traded carbon value approach uses observed and expected carbon prices in existing carbon markets to understand the value of carbon The traded carbon value approach is insufficient to represent economy-wide, societal carbon values Traded carbon values have the advantage that they can represent actual prices of carbon or abatement that are discovered through the operation of carbon markets However, these values only represent a snapshot of current carbon prices in regulated sectors, which may only form a small subset of the broader economy Under current regulation, the EU ETS price would only provide carbon values in electricity, industry and parts of aviation Furthermore, market failures such as myopic behaviour or imperfect information can result in carbon prices that are different from optimal carbon values65 Given its limited utility across the economy and the potentially biased estimates, this approach is not considered further in the analysis A target consistent price path approach can be expert-based or model-derived There are two main approaches to obtain a target consistent price path 66 The expert-based, or technology cost curve, approach calculates bottom-up estimates for certain technologies and their abatement potential and ranks them by their £/tCO2e price The price needed to achieve the required emissions reduction would be the resulting carbon value to achieve the target The model-derived approach uses economy-wide general equilibrium or sectoral partial-equilibrium models to obtain these costs They can be run over a given time horizon to obtain a costefficient pathway Repetitive model runs at different emissions constraints for a given year can be used to obtain a static abatement curve at a point in time While both the SCC and the target consistent price path approach comprise large uncertainties, the target consistent price path relies on fewer assumptions and leads to a narrower range of carbon values across studies This approach is subject to large uncertainties, as discussed in the following sections However, it does not rely as much on as many critical assumptions on unobserved functions as SCC analysis, such as the social welfare function, the damage function or how the climate system reacts to a change in carbon 65 See e.g Edenhofer, O., Flachsland, C., Wolff, C., Schmid, L K., Leipprand, A., Koch, N., & Pahle, M (2017) Decarbonization and EU ETS Reform: Introducing a price floor to drive low-carbon investments Berlin: Mercator Research Instituteon Global Commons and Climate Change 66 Kesicki, F (2010) Marginal abatement cost curves for policy making–expert-based vs model-derived curves Energy Institute, University College London, 1-8 24 Carbon values literature review concentration 67 68 As a result, the range of carbon values obtained from a target consistent price path approach is generally narrower69 The following section discusses recent developments in the literature and how they aim to address key uncertainties Developments in the literature The literature has identified key limitations of the expert-based approach, such as ignoring intertemporal and inter- and intra-sectoral interactions Kesicki and Ekins provide a comprehensive overview of limitations of both approaches70 The expert-based approach cannot consider intertemporal issues and interactions within and between sectors; abatement in a certain project is assumed to not have any impact on the costs of another project or the costs of abatement a few years later Past abatement can trigger innovation and reduce costs over time, and abatement in sectors like electricity changes mitigation potentials across many other sectors The expert-based approach also regularly fails to incorporate behavioural barriers for abatement, such as information failures, financial hurdles or inertia Furthermore, cost estimates are very sensitive to their assumptions such as investment costs or discount rates The model-derived approach overcomes some of these shortcomings, but key uncertainties remain The model-derived approach, particularly with a general equilibrium model, can represent interactions and feedback loops between different abatement decisions However, other elements remain unrepresented, such as behavioural aspects or innovation Furthermore, most models focus on the energy system and sectors like Agriculture, Forestry and Other Land Use (AFOLU) are often not incorporated in detail71 Recent modelling includes a better representation of technological changes in the analysis Multiple papers have aimed to include technological change in more detail within the modelderived approach Wang et al include endogenous technological change through R&D to However, some of these assumptions can apply indirectly as the already set target often relies on other modelling Nevetheless, for many civil servants the target is already set through previous work or politics, and the challenge subsumes to evaluation policies accurately 68 Clarke, L E., Jiang, K., Akimoto, K., Babiker, M., Blanford, G J., Fisher-Vanden, K., & McCollum, D (2015) Assessing Transformation Pathways In: Climate Change 2014: Mitigation of Climate Change Contribution of Working Group III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change (No PNNLSA-102686) Pacific Northwest National Lab.(PNNL), Richland, WA (United States) 69 Rogelj, J., Shindell, D., Jiang, K., Fifita, S., Forster, P., Ginzburg, V., & Mundaca, L (2018) Mitigation Pathways Compatible with 1.5 C in the Context of Sustainable Development Global Warming of 1.5 C An IPCC Special Report on the impacts of global warming of 1.5 C above pre-industrial levels and related global greenhouse gas emission pathways, in the context of strengthening the global response to the threat of climate change 70 Kesicki, F., & Ekins, P (2012) Marginal abatement cost curves: a call for caution Climate Policy, 12(2), 219236 71 Kesicki, F., & Ekins, P (2012) Marginal abatement cost curves: a call for caution Climate Policy, 12(2), 219236 67 25