22 April 2021

A key priority for any business is measuring risk. Many sectors of the economy are set to undergo major changes due to climate change. They will face sudden price changes and shifts in consumer behaviour — by Luca Taschini.
Electric car power station

Consumers may start to generate more of their own electricity. The popularity of electric cars is on the rise, coal-burning power plants are more likely to shut down. All these trends are interconnected. Institutional investors such as pension funds will have to start using scenario planning in the future when thinking about the long-term consequences for the risks and returns of their investments.

We will have to deal with the physical effects of climate change, such as storms, droughts, and flooding. Climate change also triggers other changes, such as new government policies, new technologies, and changes in consumer behaviour. All these in turn affect each other, thus creating an extremely complex system that is impossible to predict with a high degree of reliability.

My gut feeling is that we are very much behind what we need to do, partly because we do not have the means to precisely measure the distance between the impact of current and future changes in climate and these future scenarios. An added problem is that some of these scenarios are difficult to translate into material information that you can feed into decision-making and risk analysis. The government and the private sector are working hard to try to bridge this gap. After all, if you can not measure the risk, you can not manage it.

The other key priority is for government and it involves taxing carbon dioxide (CO2) emissions, which means that businesses pay a fixed price for every tonne of carbon they emit. This leads to variations in aggregate levels of emissions.

Another approach involves fixing the total quantity of CO2 emissions — known as a cap — and distributing permits or allowances. The prices of these permits fluctuate reflecting supply and demand balance. When the Kyoto Protocol entered into force in 1997, this cap-and-trade mechanism was applied to CO2 emissions in European Union (EU) member states and various other countries.

However, emission allowances were given to businesses at a level representing a fraction of their historical CO2 emission levels. So as not to excessively damage their competitive position in a global market, additional emission allowances were issued for free. The number of free emission allowances has gradually been reduced since 2013. Today, most CO2 emission allowances are sold in fortnightly auctions, and the annual emission cap has been reduced by a small percentage each year. The primary goal is to reduce carbon emissions by 43% by 2030 compared with 2005.

Discussions are currently ongoing about whether the EU can levy a carbon tax on imported products, so as to create a more level playing field. That would have been unthinkable ten years ago, because there was no way of placing a figure on carbon emissions for individual products. Today, however, we are much better able to measure the carbon content of imported products such as cement and steel.

Climate change will have a big impact on the global economy in the years to come. Measuring risk and taxing carbon are crucial steps we need to take if we want to limit that impact.

Luca Taschini is Reader in Carbon Finance at the University of Edinburgh Business School, and is a member of the Centre for Business, Climate Change, and Sustainability.

A version of this article originally appeared on the Cardano website.

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