Carbon pricing comes of age

In this episode, Chief Market Strategist Guy Miller is joined by Head of Macroeconomics Charlotta Groth and Macro Climate Economist Brendan Berthold to explore the economic realities of climate transition. The conversation centres on the evolving role of carbon pricing, the acceleration of clean tech innovation, and the persistent link between emissions and economic growth.

Key topics include:

• The global rise of carbon pricing schemes and their economic impact
• How technological innovation is reshaping incentives for decarbonisation
• The role of the EU’s Carbon Border Adjustment Mechanism (CBAM)
• Challenges in aligning climate ambition with economic growth
• The future of carbon offsets and the need for global standards

This episode offers a macroeconomic perspective on climate policy, highlighting the tension between growth and sustainability, and the tools available to navigate it.

Transcript

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Guy Miller, Chief Market Strategist and Economist: 0:01

Welcome to the latest edition of our podcast series. And today I'm joined by Charlotta and Brendan, who are the authors of the paper and we'll go through some of the details and get a little bit more out of them in terms of how they actually see this playing out. Now remember, as always, we look at things from a macroeconomic and a market perspective. So all of the things that we speak about regarding the climate today are going to be really focused on a macroeconomic and a market outlook. Now turning maybe to Brendan and Charlotta, Maybe with you, Charlotta, first. I don't know, but to me, there's been a bit of a move away from the urgency behind climate. You know, I look at the companies report coming out, it seems that they're pushing back on certain things. You know we've had an argument with Brendan about, you know, electric vehicles versus hybrids and all the rest of it. What's happening? Have we become a little bit apathetic? Has the climate situation become, you now, less of an urgent burning platform than it once was? What's happening?

Charlotta Groth, Head of Macroeconomics: 0:56

I don't think so. I think we are seeing very clearly climate change is happening. That's the starting point of the paper. We look at temperature. We look what happened last year, actually. Temperature, global average temperature, breached the so-called 1.5 threshold for the first time. And that's the level of temperature that countries agreed to try to keep the temperature under that in the Paris Agreement, basically, 10 years ago. So that's the starting point, that things are happening.

Guy: 1:24

And it's happened much quicker than the scientific community expected? Was that a surprise that we hit the one and a half, or breached the 1.5 Percent? It was a surprise. That doesn't necessarily mean it's going to stay above 1.5 degrees. So there are a lot of variations, a lot fluctuations and we have to remember that. I think what it made was it made us aware that things are happening. It's happening quicker than many had expected. And of course we are seeing the impact of it. We are seeing impact on extreme weather events, we have flooding, we had wildfires, etc. So I think there is clear awareness and that awareness is broadening out that things are happening. This is not just an illusion, and we need to confront that. Now that is happening, but is it fair to say that there seems to be less urgency to tackle that or am I just reading the wrong newspapers or the wrong TV or social media posts?

Chalotta: 2:19

I think there is both positive and negative aspects around that trend. I think in the paper what we really look at is we're asking questions around carbon pricing and around carbon offsets. But I think the starting point is actually a positive one. We are seeing things changing. First of all, probably around technology. The progress that we've seen around renewable technology, around green energy in particular, that has been much faster and much more impressive than many had expected. And I think a key takeaway from that technological kind of piece is that actually that is becoming a driver, an important driver, of measures the companies and businesses are taking to try to reduce the carbon footprint simply because it's economical to do so.

Guy: 3:07

If the technology is changing, as you say, and things are getting cheaper, does that mean we don't really need to worry about changing our behavior? Because actually the technology's going to bail us out.

Charlotta: 3:15

Yeah, I mean, that would be a nice conclusion, but I don't think we're quite there yet. So we made a lot of progress, particularly on providing electricity and power, but of course there's a lot of difficult areas to kind of reduce the carbon footprint. And the point is that if you look at carbon emissions globally, they are still rising and they are extremely correlated with the global economic cycle. So when growth is stronger, carbon emissions go up and vice versa. So since COVID, we've really seen quite a sharp rebound in the annual kind of pays on carbon emissions. And of course, those emissions, they end up, they get stuck in the atmosphere and they're gonna be with us for thousands of years. And that is really the problem. So you need to break that relationship. And to do so, and here I really put on my kind of economist hat, you need to create incentives. You need to create motives for people to do. And that's really where the carbon price comes in.

Guy: 4:13

Now, I guess you've answered the question, but you either change behavior or you accept lower growth. I mean, have we just become accustomed to too much growth in the world? Do we have to accept, frankly, you know, we can't consume all the things that we want to consume and we just have to accept that growth will be lower?

Charlotta: 4:32

I mean, that's one possible strategy to deal with climate change. I think that's a very difficult one to take, actually, from a political point of view, from a society point of you. And also, a large part of the world's population are still struggling with the basic need. So I think also what the piece around technology has shown that there might be another path, which is one where we have solar energy, we have a wind energy, and we can kind of harness that to create a better balance between growth and carbon emissions. But it is a difficult one, and this is where the carbon pricing piece comes in. And maybe on a note on that, what you are seeing around carbon pricing is encouraging as well. Over the next few years, we've seen more and more of the world's emissions being covered by a price. And we're seeing that price gradually going higher. So that's the other positive piece that we take away.

Guy: 5:36

So Brandan, tell me, look, I want growth, you know, I want to still consume, I'm a bad representative of the consumer behavior. But if I want to consume, and I want the global economy to grow, and I want people to become more prosperous, as Charlotta said, it's maybe not one or the other. It's not a case of no growth. You mentioned, or Charlotta mentioned, carbon pricing, I mean, we've written about carbon pricing for 10 years, I think. Here all the time we say about pricing the externalities, it all sounds great, and yet ten years plus later we're still talking about carbon pricing. So where are we in carbon pricing? Is this the answer? And if it is the answer, why are we still talking about it ten years later?

Brendan Berthold, Macro Climate Economist: 6:18

Yeah, that's a good question, right. As an economist, you sometimes get frustrated that, you know, we talk a lot about carbon pricing feels like it's not put into work. But I think one thing that we talk about also in the paper is that actually there's more progress than one could think from just reading the headlines and whatever. There are actually a lot of carbon pricing schemes that are already in place all around the world. That was really something even surprising to us, I think. There are really more and more countries that are putting those things into place. You have emissions, when you think about emissions, certainly most of the new emissions that will be added to the atmosphere are coming from the emerging world. Think about China, think about India. Both of those countries are actually doing carbon pricing. So in India, you have early phase of a carbon market. In China, this is more advanced. There are talks about linking carbon markets between countries. That's also something we talk about, about the upcoming CBAM. Maybe we can talk about this later on. But this actually progressed. This is happening. Obviously, the price of carbon and the amount of emissions that are covered is still pretty, I wouldn't call it low, but it's not enough. I think roughly a third of global emissions are covered by a carbon pricing scheme. The price of carbon is too low to really drive changes in behavior as you as you mentioned before but we are seeing progress and we're also seeing with you know the EU ETS that it's the European carbon market has been on for close to 20 years now so we we get to see historical evidence of what this has done.

Guy: 8:05

Isn't that a sign of failure, 20 years it's been in place and we're still talking about it, not enough people hearing to it or the price not being right? No, I would strongly disagree on that because when you look at the emission path in Europe, for example, emissions have been going down for past 10 years or something. Even though the European economy has been growing, I agree maybe the growth rate was not that high, but the economy was growing at a time where emissions were declining. Also the evidence is that the sectors that were covered by this carbon market actually saw their emissions decline more than the average. And there's also other studies that look at, you know, all the carbon markets around the world and there's also strong evidence that carbon emissions are actually declining in those sectors. Now, I think the next few years will be very interesting also because these carbon markets are maturing. What we've been seeing is a lot of decarbonisation within the power sector. So all related to electricity. We talk a lot about solar, renewables. Where the economics of this works. And this was also this interaction between carbon markets and technology. Carbon markets are about incentivizing innovation in the clean energy space, et cetera. And actually, this has also driven innovation and that has allowed for renewables to be price competitive. Now we're entering, I think, in a new phase where the industrial sector will increasingly be the center of focus of those carbon markets. So we will certainly need higher carbon prices to actually drive changes in those sectors. You point out in the paper, and I think it's a good way of putting it, is that the cost of polluting is simply too low. If you price the cost to society and the effects that has correctly, we'd be paying a lot more for pretty much everything that we consume. But here's a question I always have, when you speak about 60 schemes around the world, there's no kind of global centralization, governments, let me be cynical here, isn't this a tax way of just raising taxes for governments? You just put a carbon tax, it sounds great. But the money goes to the government, no?

Brendan: 10:20

Yes, absolutely. This is true, this is true in the sense, but I think what really is important and is also putting my economist hat, is really the carbon price is a sort of tax, if you like, but this is, from an economic standpoint, this is the most efficient way to tackle climate change. I think a framing that I particularly like is to see climate change as an externality. So really the idea is polluting is too cheap. The price is not right. So even if you're a die-hard liberal, you should actually support the carbon price because the price is not right. It's a direct tool that really looks at the price, so changing market incentives. This is also, I think, the other part which I like about carbon price is it's decentralized. So it really is agnostic about what kind of technologies companies will have to use to... They're really just facing a certain price of carbon. And then they have to come up with the best way to reduce their emissions. So it doesn't tell you, well, you should use that technology or that other one. It really lets companies find the cheapest way to do the decarbonization. And I think this is also one of the main reasons why carbon price is so efficient. And one last point that I want to mention is that that was also something we had from, that we found out from the analysis is that what really matters for this climate policies to work is they need to be durable, they need to provide clarity, and a carbon market does that because it's a standardized set of tools. It provides a trajectory about carbon emissions, and this is providing clarity also for investors about what will be the playing field over the next five to 10 years. So for those three reasons, really, carbon pricing is the most efficient way to tackle climate change.

Guy: 12:12

Maybe to you, Charlotte, because listening to Brendan there, if you've got all these schemes all over the world, 60 different plus schemes and more are growing, and you say it's an efficient way and it gives companies clarity about the operating environment, isn't there an incentive, being a free marketeer, that company will just relocate or they'll go to the lowest place or they will go where there isn't a carbon tax, isn't up the way forward if you believe in free markets?

Charlotta: 12:37

Yeah, no, absolutely. And to some extent, we've probably seen that as well over the past. And I think that's where the CBAM, so the carbon border adjustment mechanism, comes in. This is really an EU initiative, trying to recognize that there is a significant price of carbon within the European Union. And companies may face incentives to basically outsource production somewhere else. So this is a way of avoiding this so-called carbon leakage. Basically you're saying it's fine you can import here, but if you import we're going to look at the kind of amount of carbon that is sitting in the goods and we're gonna tax you accordingly and that tax, the revenue that is raised, goes into the EU. Now for other countries...

Guy: 13:22

What's it spent on? It goes to the EU. Do they spend it on anything they like or does it have to go back into climate initiatives?

Charlotta: 13:28

So this scheme is not up and running again. But I think for me, the key takeaway is by doing, creating these kind of carbon border, you are changing the incentives for other countries. Other countries are saying, well, if they are forcing us to pay into that coffer...

Guy: 13:45

We might as well do it ourselves.

Charlotta: 13:45

We might as well do that ourselves, and that's exactly what we are seeing.

Guy: 13:50

Are there examples of that? Are we seeing other blocks, are the trading blocks, are other countries changing because of what's happening?

Charlotta: 13:55

Yes, absolutely. We're seeing it right now. We have some countries that are challenging the EU in the World Trade Organization and saying this is tariffs, but it's clearly not a tariff because as soon as you reduce the carbon content you are not being charged any longer. So what we're seeing is particularly larger emerging markets, middle-income countries, they are setting in place their own carbon schemes to try to capture that revenue at home instead of paying it to the EU. So for us, for the next few years, I think this will be critical to accelerate progress at the global level. Now, it is a tricky time. It’s a challenging time for carbon pricing. It's the security considerations. We have a lot of challenges around global trade that needs to be dealt with. But particularly right now, it's really important that the plans remain in place to put this carbon border adjustment mechanism into place because it really has the potential of creating some kind of global price of carbon, not by four countries sitting down and doing it from a diplomatic point of view, but really change in the economics. So it becomes the right thing to do for individual countries. And we're clearly seeing that happening.

Guy: 15:09

So, Brandan, you mentioned that 2026 this comes into Europe. Is this a phased approach or is this overnight, we all wake up and it's in place? And is it skewed towards certain industries? You had mentioned, for example, the energy sector has been one of the early adopters generally, because maybe it's a bit easier, but how does that play out in the next couple of years?

Brendan: 15:28

Yeah, absolutely. So yeah, as you said, the CBAM will be introduced in 2026. There are a few years for adaptation for companies to also comply and all those things. One thing which is very important that comes with the CBAM is this gradual phase out of free allowances. So this is a barbaric term, but essentially the idea is that currently you have a lot of companies that are operating within the carbon market in Europe that have free allowances. So they have the right to emit carbon for free. With the introduction of the CBAM, those free allowances will be gradually removed. So what this means in practice is that more and more, the carbon price will reflect the abatement cost within the industrial sector. Currently, the carbon prices mostly reflect with some simplification, the power sector, which is really the carbon price reflects their abatement cost. Now as the free allowances get phased out, then the carbon price will reflect the carbonization price of the industrial sector. The way usually we think about that within the climate space is through this marginal abatement cost curve, which is basically ranking...

Guy: 16:48

It sounds very technical.

Brendan: 16:49

Yeah, it does. It does. But it's a very simple thing, actually. It's just ranking abatements activities from the cheapest to the most expensive. So the cheapest stuff is really switching. For example, you have a coal plant, power plant, and you want to switch to renewables. Few years ago, it required a positive carbon price to drive the change. Now, because of carbon pricing, all the incentives, actually switching from coal to renewables is not more expensive, and that's also a result of the carbon pricing. So this is the cheap stuff, and now we're moving to the right of this abatement cost curve. So we will face things like... You know, if we have to do green steel, for example, then you need hydrogen, you need to do it with clean energy. This is much more expensive. And the economics of that are maybe not there yet, just as of now, but something that's very important, and I think that's also one of the key message of this paper is that the ultimate goal is not about policy, it's not about regulation, it is really about incentivizing innovation. So it's really bringing this abatement cost curve down, such that what we see currently, the economics of green steel, for example, look very expensive, but maybe in a few years, thanks to technology, thanks to innovation, which is driven by the carbon pricing, this will actually be economical also to decarbonize the industrial sector. And I think that that's also very important.

Guy: 18:19

I mean, one question maybe to you, Charlotta, is coming back to the economic rationale behind all of this. In the last few years, we've seen this massive decline in the cost of solar, as an example. And perhaps this is correlated with oversupply coming from China. We know there's been a massive amount of production there, domestic consumption has been low. Now, it seems in the last, you know, few weeks that Chinese policy may be shifting. They're realizing that they can't, frankly, give discounted clean net technology to the rest of the world and make it at a loss, that doesn't work. So they seem to be thinking about bringing back excess capacity. Does that mean that we've seen an end to lower and lower prices for technology? Is there a risk now that if China does that, actually these solar panels start going up in value. And actually there's some shortages and the wind technology goes up as well. Is that a risk or do we think now the trends are very clear, the production is becoming cheaper and cheaper and that's not something that we should worry about?

Charlotta: 19:25

No, I think taking a step back, technology tends to move on. It's changing all the time, and I think that's why we are quite positive on that piece around technology. It's really important that there is stability around the policy environment, because without that, you don't get the investment. So that's absolutely key. If you don't get investment into new technologies, there will be no new technology. So for me, that's the key one. You need stability and certainty. And I think during this period we are in right now, where there's a lot of questions, if it's indeed the right way to go to try to tackle climate change. This is precisely when you need that stability and that kind of trajectory that investors can feel certain about. When it comes to oversupply from China, well, that happens whenever there is a new technology, there is lot of potential for reaping benefits from that. You try to move into that sphere, you have oversupply. And yes, I would expect maybe some of that to come off the market because it has caused a lot of tensions globally. At the same time, there's clearly demand for energy coming from, for example, solar, because it's freely available. So I think it's not the end of this. We shouldn't just sit back and say everything is fine because we managed to pull down the price of solar. But clearly there are big issues there and also constraints in terms of the production of those renewable technologies that needs to be improved going forward. But I don't think this is a field which is going to kind of go away over the next few years because coming back the economics are simply kind of a tailwind for this this piece going forward.

Guy: 21:06

And I guess, Brendan, you mentioned in the paper, something along the lines, that actually having this carbon price, it means that you can help price investments better. Because I guess if you're a company who's thinking about going into a new technology or whatever, if you know there's a demand for it, if you know the cost of polluting or not using this new technology as a certain level, you can then think about your return on capital, your return in investment. Is that something that you think is going to be? More of a driver, going back to that question about who's producing this technology, there'll be more producers perhaps incentivised to come up with new clean breakthroughs.

Brendan: 21:44

Yeah, I think it also speaks to a wider theme, and I believe personally that the economics of those technologies will increasingly come into focus. We're talking, you know, an example would be the wind industry, which is very capital intensive and it has suffered quite a bit in recent years because of those higher interest rates because renewables tends to be more capex, less opex. So they're really sensitive to the wider interest rate environment. The things you've mentioned around China are also important. They also show that there are challenges and we need the economics of those things to work. And maybe the past 10 years were, you know, driven a lot by very how does that play out in the next about making climate pledges. Now, maybe we're entering into a new phase where those ambitions meet the reality, the economic reality, the technological constraints that there are also. And because of that, the economics will increasingly come into focus. So I think absolutely it's about the price and carbon pricing is about making this price explicit. So this is also why this is driving the economy.

Guy: 23:03

So I've been listening to all of them. Certainly from my perspective, it seems that if we really are truly to address this and thinking about it from an economic perspective, we need to apply lots of different elements to try and tackle the issue. One thing that we haven't spoken about, but I know I thought it was interesting to read in the paper, the carbon offsets and the fact that actually this is another tool that could be used or is being used to some extent. I mean is there a place now for carbon offsets in the road ahead and how would you see that development?

Charlotta: 23:38

Yeah, sure. So, I mean, there're two ways of dealing with this problem. One is your price for emitting carbon. But the other piece is you actually pay someone for removing carbon. Yeah. And that's really this carbon offset to carbon credit market, which has been in place for quite a long time. The majority of that market is not compliant. anything. That is voluntary. You can offset some of your emissions. For example, we've seen a lot of the IT, the technology sector, doing that on a voluntary basis because simply they don't want to be seen as very large emitters of carbon. So there has been this market working basically in parallel with the carbon pricing market and I think it's most clear in the case of Europe, companies pay a price for reducing carbon but the offset market, there could be another way of doing that, at least temporarily. While the technology is being developed to be able to do this in an economic way, that those two markets have been separated. Companies have not been allowed to use these carbon offset markets. And there's been good reason for it because it's a very difficult market. You have to, in some way, measure and quantify how much carbons are you removing, for example, by planting a new forest.

Guy: 24:57

And is it permanent?

Charlotta: 24:58

Is it permanent? Yes, is it permanent. We know that forests are not permanent. We have forest fires every now and then. And also, how do you value that? How do you think about property rights going forward? So it's a really, really difficult piece when you think about how to make this market something that people trust. So I think right now there is a lot of focus on that and that's a good thing. Focus on making these regulations and the oversight common rules which apply globally. That's the so-called Article 6 that's being worked on. So really creating a global marketplace where companies and governments and countries can trade in the so called carbon credit and actually trust that these things are doing what it says that they are doing. We're still quite far away. I think the next few years, we will need to see a lot of progress around that. But I think when we're thinking about that, the EU, the CBAM, the reforms to the carbon market, that's a piece that definitely needs to be brought into the puzzle. Because particularly, it offers a way for the more difficult to decarbonize industries to kind of have this transition phase. And clearly, we want nature-based solutions are also falling under that.

Guy: 26:16

I'm a very big fan and supporter. I certainly believe that it's part of the equation to try and make this transition. Maybe just to kind of to round things off, thinking about the global economic environment, we've come from a period of very high inflation following the pandemic. We've got different trade tensions as we speak. There is uncertainty all over the place. Our mid-year outlook was called"Living in the land of confusion". You know, listening to the pair of you, much as it's very exciting, and I'm glad to see that it hasn't fallen by the wayside, and we haven't all become apathetic, and the young generation haven't given up, what I think about it with a macro perspective doesn't actually mean, however, that we are going to have to be in a, certainly a lower-ish growth environment, even though you said there's going to be these different ways to perhaps decouple growth from emissions, but it sounds like there's a cost to that, It's not free. And does that either mean that we have to accept perhaps a slightly slower growth dynamic? And does it also mean that, we have accept higher inflation? Because all of this has a price. And when I listen to the pair of you, it sounds great. But part of me says, you know, inflation is high, central banks are struggling to meet their targets. This is going to put prices up in the longer term. What am I missing?

Charlotta: 27:38

Well, if you look over the long run, technology tends to drive inflation down because it creates new solutions. So coming back to the example of solar, which is not perfect, there are still a lot of difficulties there. But what we have now is environment, once you have your system up and running, the cost of taking out additional energy is very low. So you're basically running in an environment where creating electricity, once you have made the investment doesn't cost much. And thinking about AI, thinking about data center, clearly there is an advantage to have that kind of energy where the operational cost is very low. So I would disagree. I don't think technology drives up inflation. I think it pushes down on inflation. We have seen that on the IT side as well. Now the difficult piece is this transition space where you're going to have some bottlenecks within the global trading system, there's going to be certain... Rare earth minerals, for example, that everyone wants to have. But I would say that's similar with other technologies as well. It's nothing specific to this piece. So yes, it might create more volatile inflation, maybe more unpredictable. If you see more technology change, it may also cause disruptions around that. But I don't see it as a driver of higher inflation over the long run. And in terms of growth. Yes, it's a challenging one. Fossil fuel is easy. It's an easy source of energy to kind of internalize. But I think coming back to Brendan's point, I mean, the countries that are really on the forefront of these are countries which are still kind of middle income countries that tend to, not all of them, but many of them are growing at a faster pace than Europe is doing. So on the margin, these countries are going to benefit and that could actually help to support growth going forward. So I wouldn't say this is not necessarily the key driver for the macro outlook going forward. I think a lot of other factors will play in there.

Brendan: 29:44

I would add one thing as well, which I'm really a fan of, is this electrification trend. How I think about it is about efficiency. When you think about electrifying processes, this is about using less energy for the same services and even better services. So for example, you think about electric cars versus petrol or ICE cars. Essentially, you need three times less energy per 100 kilometers because electric cars are just much more efficient. So I would agree there's certainly some sort of inter-temporal trade-offs. Maybe you have to accept higher costs in the short term, but eventually I think this will pay out because the electrification trend and all this energy discussions are about improving the efficiency of the system and ultimately I think it will drive productivity higher.

Guy: 30:36

Look, as a die-hard petrolhead, you and I are always going to argue about this. You know they just don't sound as good, you don't smell as good. But I take the point, and I know that's the direction forward. And I have to say to our viewers, I don't drive very much, even if I do make a noise doing it. Thank you both very much. I think there's been a lot in this. It's a very I think insightful paper. I think it's a thought-provoking paper, so thank you for that. To all our subscribers and viewers, thank you again for joining us. This is a very emotional topical issue, so please do leave comments, your thoughts once you've read the paper. Very good to get your views and opinions around that as well. This the only way we're going to make progress on such a difficult subject. Now remember, as always, please do like and subscribe, and you can read all our work, of course, on Zurich.com. Thank you again.[dramatic music fades out]