Explainer

Can Climate Clubs Cut Carbon Emissions?

A more pragmatic approach to raising countries’ climate ambitions might could have a greater impact than explicit carbon pricing.

A new idea for tackling climate change emerged last week from the Group of Seven (G7) leaders’ summit in Bavaria, backed by Germany, which holds the forum’s revolving presidency.

A brief statement committed the world’s leading democratic economies to forming a ‘climate club’, to “support the effective implementation of the Paris Agreement by accelerating climate action and increasing ambition”. The club intends to focus largely on the industrial sector, “addressing risks of carbon leakage for emission intensive goods, while complying with international rules”.

In short, the idea is to build a coalition of like-minded countries willing to incorporate emissions reduction targets into trade deals and other agreements, pooling resources and policies to push carbon out of their economies, collectively and incrementally.

This pragmatic approach is an alternative to squeezing carbon out of business by putting an explicit price on emissions. The most prominent example is Europe’s Emissions Trading System (ETS), a ‘cap-and-trade’ scheme which makes polluters pay for emissions above a certain level.

Europe is in the process of extending its ETS, increasing the cost of emissions and the industries covered, but also effectively taxing carbon intensive imports – through a Carbon Border Adjustment Mechanism (CBAM) – which has the potential to make carbon pricing global. The system is complex, and vulnerable to economic and political headwinds.

Proponents admit the climate club is messier and less opaque than literally putting a price on carbon through border taxes. It is also less likely to help asset owners identify the carbon risks in their portfolios. But they say it stands a better chance of ratcheting down emissions in today’s fractured geopolitical context, pointing to the mixed record of carbon pricing initiatives in cleaning up industry, and the challenges of raising tariffs in a world rediscovering inflation and realpolitik.

This explainer looks at why the climate club idea has gained currency, how it could drive effective climate policy and what it might mean for investors.

How extensive is carbon pricing and why is it important to asset owners?

According to a World Bank report, 68 existing carbon pricing regimes – covering 25% of GHG emissions – raised record revenues of US$84 billion last year, exacting record prices from polluters. But this didn’t stop last year also being a record for emissions levels.

Extension of explicit carbon pricing has been high on the agenda of asset owners for some time and was a key focus of investor expectations ahead of COP26. Part of the appeal lies in its transparency. If you can see how much an investee company is paying to emit carbon, you can understand your portfolio emissions more clearly, which informs your engagement and investment strategy.

As noted recently by Patrick Arber, Head of International Government Engagement at Aviva, carbon pricing offers a clear signal to investors. “If forms of carbon pricing are introduced, that will impact the future costs to certain companies and it will change the way that we invest.”

Taxation is the simplest carbon pricing mechanism, but is viewed as politically unpalatable in many countries. Instead, governments in Europe and China, among others, have developed schemes whereby permitted emissions are capped and traded via free or priced allowance certificates, with firms buying or selling allowances, depending on whether they’re emitting more or less carbon.

This gives asset owners visibility over the costs of investee firms’ emissions, albeit only across the limited number of sectors covered by the schemes. Partly through government control of supply (i.e., withdrawing free allowances), the rising price of permits is supposed to incentivise firms to reduce their emissions, whether through technology innovation or business model changes.

This works too slowly, say many, noting that record prices do not seem to have had much of an impact on emissions levels. “Carbon pricing regimes can work and do have a role, but to say they can work to the exclusion of anything else is not borne out by the facts,” says Brian Hensley, Partner at global climate policy advisory firm Kaya Advisory.

Cranking up the price of emissions does not necessarily drive carbon-intensive firms to use alternatives, especially if those alternatives are also expensive, or not fully proven. Other interventions are also needed, for example, increased research support or stronger efforts to reduce fossil fuel subsidies.

“Explicit carbon pricing offers asset owners an understandable quantification [of climate risk] that they can use as an input, which helps to simplify a complex task. But I’m afraid it’s not going to be simple as climate clubs come along,” says Hensley.

What are the prospects for CBAM and extending the scope of ETSs?

Some critics of cap-and-trade mechanisms such as Europe’s ETS claim they are not punitive or comprehensive enough to drive change, suggesting higher prices and wider remits are needed. The EU is reforming its existing ETS, developing a new one for industries not covered and increasing its geographic reach through the CBAM, scheduled to be phased in from 2023. The plans are seen as a critical element of Fit for 55, the Commission’s strategy for cutting European emissions by more than half by the end of the decade.

For governments imposing carbon prices in their own jurisdictions, preventing cross-border carbon leakage is logical. If making companies pay for their emissions means they offshore their operations or get undercut by imports from countries with different policies, you risk weakening your own domestic economy without reducing overall emissions.

CBAM seeks to address leakage by effectively levelling the playing field between European firms and importers, meaning the former are not disadvantaged for transitioning from carbon. Importers of carbon-intensive goods will have to purchase certificates for each tonne of embedded emissions, the cost of which is based on ETS prices to ensure similar pollution costs to European firms.

Given a following wind, CBAM could work, but these are treacherous times that could easily wreck the best-laid plans of European policymakers. The political difficulties of the past few weeks underline the challenges of operationalising climate goals in the midst of an energy price crisis and a worsening macro-economic outlook.

The European Council has agreed positions ahead of trilogue discussions with the Commission and Parliament on the ETS, ETS2 and CBAM. The extension of ETS will target a 61% reduction in emissions by 2030, partly by expanding to include maritime shipping. The new ETS2 will cover buildings and road transport sectors from 2024. On CBAM, it has proposed termination of free allowances in participating sectors between 2026-35 (aluminium, iron, steel, electricity, cement and fertilisers), both to ensure equity with importers and to accelerate transition. But this will be done gradually, weighted toward the end of the ten-year period.

Observers including the World Wide Fund for Nature were less than impressed. The ETS/CBAM reforms also split MEPs, who initially rejected a plan for the reformed ETS to achieve a 63% reduction in emissions. While some thought the proposals too weak, others worried that companies in sectors covered by the ETS were being pushed too hard in light of energy security concerns.

The political wrangling is likely to further mire attempts to get CBAM off the ground, according to a recent report by Kaya Advisory. Even though CBAM is now set be finalised and adopted, it is likely to stumble during its implementation phase, says Hensley. Many logistical issues around how CBAM will work need to be addressed, in terms of measuring and reporting emissions.

But the bigger problem is political as EU member states experience different impacts to their industrial sectors, based partly on variations in energy costs and supply as they transition away from Russian gas. Bigger still could be the hurdles represented by world trade agreements and the responses of trading partners.

Edward Baker, Senior Policy Advisor on Climate and Energy Transition at the Principles for Responsible Investment (PRI), says Europe’s CBAM proposal has a “narrow but plausible” pathway to implementation, helped by the fact that it impacts only a handful of sectors, making it administratively “feasible”, and will impose costs to few key strategic allies.

He notes that Kaya’s analysis suggests the UK, Russia and Turkey are among those theoretically in line for CBAM charges, but the former is likely to be placed on a ‘white list’ given the strength of its net zero commitments and more or less identical trading scheme to Europe’s.

What does the G7 climate club entail?

It’s in some ways surprising that the climate club should be posited as an alternative to CBAM, in that an early proposal for the former, by William Nordhaus, Sterling Professor of Economics at Yale University, conceived the latter as the club’s membership fee.

But it is less surprising that the idea has been gaining greater attention, as policymakers increasingly look for ways to raise countries’ climate ambition. Today, the climate club concept covers a range of possibilities, says Hensley. “It’s not going to be a neat box with standardised rules for everyone. It will be evolving; it will be political. Certain countries will be in, and others will not. There is no coincidence that it is the G7 that is bringing this up.”

The G7 sets out three broad pillars for its climate club. First, members commit to collaboration on “ambitious and transparent” climate mitigation policies, including efforts to measure and report emissions and prevent carbon leakage across borders. This involves sharing findings on the efficiency and impact of emissions mitigation policies, such as explicit carbon pricing. Second, they plan to work “jointly” to transform carbon-intensive industries and expand markets for green industrial products. Third, they will develop international partnerships to facilitate climate action and promote a just energy transition in developing countries, proposing financial and technical support to decarbonise energy and industrial sectors.

Importantly, the concept is designed to be “inclusive”. Membership is open to all countries committed to the full implementation of the Paris Agreement. “We invite partners, including major emitters, G20 members and other developing and emerging economies, to intensify discussions and consultations with us on this matter,” the G7 statement said. Its brevity may offer room for future manoeuvre, but it may also reflect the “mix of confusion and curiosity” among G7 leaders when German Chancellor Olaf Scholz initially pitched the idea.

How would a climate club work in practice?

Effectively, the Paris Agreement is an example of a climate club, as all countries have signed up to a series of climate-related commitments; the G7 version is more exclusive, containing countries with a higher level of ambition than most, not to mention higher levels of emissions and responsibility for climate change.

As currently outlined, the G7’s interpretation of the climate club is a ‘safe space’ for the discussion of policies aimed at emissions reduction, rather than the more adversarial set of relationships that might develop from the imposition of a carbon levy as a de facto entry fee. An inclusive, informal forum on climate policy is needed, some argue, when leading nations are facing conflict, inflation and deep internal division.

“The climate club could potentially play a useful role in the build-up to events at the end of this year because it can be used as a mechanism to reinforce commitments,” says Baker.

Although it is early days, the climate club concept could lead to the widespread application of an implicit price for emitting carbon among participants. Members of the club could align their policies, either through collective agreement or by more incremental shifts, such that there is no need to impose a carbon border tax.

“A climate club allows consideration of things that a CBAM does not, specifically policies and measures that countries have taken successfully to reduce emissions. If you package those up, you can get to an implicit carbon price,” says Hensley.

The implicit price of carbon for a country can be based on relatively measurable elements, such as industrial policy and related regulations, but it will inevitably also involve an assessment of political context. “There’s a trade-off between robustness and inclusion. It would be great to include everyone, especially the countries who are emitting more at the present. But you also want it to be robust. Getting that balance right will be an evolution and require give and take. The heavy emitters will understandably request things like technology and financing,” he adds.

Who’s in and who’s out?

An ambitious climate club can only be initiated by the closest of allies, some argue, given the fragile state of the post-WW2 rules-based order. A widespread deterioration of trading relationships was in train well before Russia’s invasion of Ukraine made energy and national security synonymous.

Combined, they are driving the trend toward ‘friend-shoring’ – focusing trading and supply chain relationships with those you trust most. The G7 climate club could be seen as an example of climate-based friend-shoring.

“Investors who are allocating money to something as strategically important as the green transition need to be aware that the politics are as important as the cash flows,” says Hensley, noting the potentially significant role of Chinese companies and resources to both the green and digital transitions.

With Chinese and western interests far from aligned in most areas, we could soon see a more intense battle for influence in countries across the global south, in which climate policy will play its part. As well as the climate club proposal, with its third pillar offering renewable energy help to developing countries, the recent G7 summit also unveiled a US$600 billion global infrastructure partnership, which could be seen as a counter-offer to China’s Belt and Road programme.

For now, there is still potential for China to join the G7 climate club, given the US-China commitment to work together on climate policy. Certainly, the G7 is emphasising international cooperation, cutting the Just Energy Transition Plan already announced between South Africa and western nations as a model for the future.

What should asset owners expect next on carbon pricing and climate policy?

Last July, the UN-convened Net Zero Asset Owner Alliance (NZAOA) outlined the principles that governments should follow in order to develop the “effective, robust, reliable and fit-for-purpose carbon-pricing instruments” needed to support its members’ efforts to reduce their portfolio emissions.

Central to the alliance’s proposals was a stable corridor between minimum and maximum price levels to give companies and investors a degree of certainty on future carbon price levels. This would help to support efficient capital allocation, as well as offering businesses reliable incentives for adoption and development of low-emissions technologies.

Although envisaging gradually rising levels for the floor and ceiling over time, the asset owners said a cap on the latter was particularly important as rapid price rises could cause a backlash, potentially undermining political support for carbon pricing. Speaking to ESG Investor, report co-author Thomas Liesch, Climate Integration Lead at Allianz, said policy action was essential alongside carbon pricing, including “complementary sectoral regulation”.

Ahead of the G7 leaders’ summit, the NZAOA updated its position, further emphasising the need for carbon pricing to be supported “by a mix of policy instruments including international coalitions”. Anticipating the G7 announcement, the alliance explicitly noted the role of climate clubs alongside CBAMs and complementary policies such as higher investment in abatement research and the removal of fossil fuel subsidies.

Will the energy crisis see the end of explicit carbon pricing?

Prevailing circumstances will make it politically harder to extend explicit carbon pricing, especially if it is seen as hiking prices and costing jobs. This likely means its expansion will be accompanied by a widening range of other measures. In road transport already, clearly signalled phase-outs have been the primary lever used to change consumer and producer behaviour. “We’ll continue to see the positive growth of carbon pricing, covering more sectors and with prices rising over time. But that will be in combination with other policies,” says the PRI’s Baker.

In recognition of the impact of energy price rises on consumers and businesses, the NZAOA also highlighted carbon pricing’s potential to support a just transition to clean energy, such as addressing negative impacts on consumers through revenue recycling.

“As a government, if you are raising revenue by introducing a carbon price, taxing oil and gas companies or utility providers, which might raise costs for individuals, how are we making sure that we are cushioning the impact?” says Arber, also Policy Track Co-Lead at NZAOA. “Do you want to disperse that revenue in a way that protects the most vulnerable people in society or the people who are most impacted?”

This idea is recognised in the EU’s proposal for a Social Climate Fund, which recycles revenues raised through ETS by investing in energy infrastructure and low carbon transport, as well as making direct payments to vulnerable households and communities.

Alongside such measures, the G7’s climate club could potentially be seen by investors and companies as a much-needed indication of commitment to climate action from politicians at a time when they could easily waver, says Baker.

“It shows there remains an appetite at the geopolitical level to continue to try to make progress on climate change despite the challenging environment in which we’re in. This could become a useful mechanism for just gathering countries together around a single concept.”

 

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