A benchmark global carbon price to support climate risk metrics – Bank Underground

Mike Knight

In this post, I argue that, to strengthen climate risk metrics, the pricing of carbon should be transparent and consistent. I suggest that lessons can be learned from existing commodities and interest rate markets in the role a benchmark price (for carbon) could play to provide that transparency and consistency. Further, I propose that a benchmark incorporating existing explicit and implicit carbon prices could be sufficiently credible to allow widespread adoption. I then propose a high-level methodology for such a benchmark.

The starting point: an analytical toolkit for climate risk

In a recent paper, the Financial Stability Board (FSB) explored an analytical toolkit for assessing climate risk in the context of financial stability. These tools include the following metrics:

• Credit risks – Carbon earnings at risk – Sectors/firms with higher sensitivity of earnings to carbon pricing may reflect greater credit risk in bank loan portfolio.
• Market risks – Carbon Value-at-Risk (VaR) – Estimates the implied total VaR of securities due to future changes in the carbon price.

The consequential significance of pricing of carbon and current limitations to this

In my view, to optimise the effectiveness of these metrics, it is vital that reference prices for carbon are transparent and consistent. As an input into carbon earnings at risk or carbon VaR, the quality of reference prices used will naturally affect the quality of risk calculations and the basis on which assumptions are made regarding the sensitivity and relationship between carbon prices on the one hand, and earnings and company valuations on the other.

In turn, the quality of the calculations underpinning carbon earnings or value at risk may affect the quality of climate scenarios analyses which the FSB toolkit is intended to support.

So which carbon current and future reference prices should be used?

In reality, there are increasing numbers of carbon price references available; these derive from various sources and initiatives that are fragmented, non-fungible, overlapping and inconsistent. This increases the complexity of climate risk analysis.

For instance, reference prices may be derived from trading in regulated emissions allowances or trading markets. Or, prices may be obtained from various formulations of offsets or credits offered in ‘voluntary’ markets. Each of these sources cover only a small proportion of global greenhouse gas (GHG) emissions. Even a large and actively traded emissions allowance market – the EU’s Emissions Trading Scheme (which is used by some climate risk stakeholders as a proxy live price for carbon) – covers only approximately 2.6% of global GHG emissions.

A lesson from markets – the role a benchmark carbon price could play

A new reference price is needed that can overcome this fragmentation and inconsistency.

I suggest that lessons could be learned from how various existing global-scaled markets operate around a benchmark price. Benchmark prices play an important anchor role in shaping consensus over both current and future prices for a particular asset or activity. This is seen in, for example, markets for commodities and energy (the WTI and Brent benchmarks), and interest rates (eg the SONIA benchmark used in the UK).

Indeed, an FCA paper outlines that ‘Benchmarks are critical to the efficient functioning of financial markets. They are used to …serve as reference rates… [and] increase price transparency for investors.’

Not all oil nor interest rate prices seen in markets, financial instruments, or risk metrics, are at the level of the respective WTI, Brent or SONIA rate, but may be based on or be structured around these benchmark rates.

In this way, benchmark prices provide the accepted and respected methodological foundation on which market pricing and risk decisions are based.

Why a new benchmark is needed (and does not already exist)

The search for a politically agreed, top-down mechanism for pricing global GHG emissions has gone on for decades. However, political agreement has been elusive. Further, global multilateral institutions have not been in a position to create and implement a global level price benchmark for carbon. For example:

• The UN Framework Convention on Climate Change is developing – and has agreed at COP29 – a bespoke Article 6 framework for bilateral carbon agreements between countries and cannot go beyond this without the agreement of member countries.
• Bretton Woods institutions (IMF and World Bank) do not set energy or financial policies and focus on the provision of emergency lending or development finance.
• While the World Trade Organisation has endeavoured to embed carbon pricing into global trade agreements, this will require agreement among WTO members.
• The mandates of finance-sector regulatory authorities do not generally extend to matters of energy policy.

Further, in my view, private sector stakeholders may not see sufficient commercial benefit or rationale for attempting to rationalise a fragmented global-level carbon pricing landscape. In fact, many private sector stakeholders may have existing carbon pricing or data products and services that benefit from this fragmentation and hence may not want to lose any commercial gains arising.

A proposal for a benchmark price for carbon

To address these various issues, I propose that the wide variety of carbon price references can be synthesised into a single, weighted average, ‘umbrella’ financial metric to become the global-level benchmark price reference for carbon.

This would entail combining – via an agreed methodology, and subject to appropriate governance and oversight – existing price references and then making the resulting umbrella price easily available in an open-source format. This is both technically and logistically feasible.

In my view, a methodology would need to revolve around fundamental principles of:

• Having regard to the entirety of global GHG emissions. Total annual global emissions of CO₂ equivalent are estimated to be over 50 Gigatonnes. While almost 75% of this is not covered by an explicit carbon pricing scheme or initiative, global emissions can be considered via effective carbon rates analysis.
• Being agnostic as to the labelling or intention of existing carbon pricing schemes or initiatives – in other words, treating carbon or energy taxes, subsidies, tariffs, emissions trading schemes, credits and offsets in a common and consistent way. Some of these are explicitly designed to create a pricing effect on carbon – for example emissions trading schemes – while others have a pricing effect on carbon implicitly, as a consequence of their design or intention. Energy excise taxes are an example of the latter.
• Multiplying the relative size (as a proportion of global GHG emissions covered) of an existing explicit or implicit carbon pricing scheme or initiative by the prevailing (currency adjusted) price of that scheme.
• Identifying, understanding and eliminating overlaps in scope between various heterogenous explicit or implicit carbon pricing schemes or initiatives.

The World Bank’s ‘Total Carbon Price’ (TCP) formulation achieves many of these principles. But further extrapolation is required to cover the entirety of global GHG emissions – in particular, to cover economies not already within TCP – and to repurpose the TCP to provide a single global price. This can be done credibly through the use of national economy taxonomies within the TCP methodology. The base data for this can be a combination of:

Once an initial price methodology is established, it can be refined and developed and the resulting price updated. Where pricing inputs could be live or dynamic – eg trading in emissions allowances or from voluntary markets – the resulting benchmark price becomes dynamic.

The benchmark itself wouldn’t be tradeable; but could provide the basis for tradable futures. ‘Tradability’ would allow markets to shape a view on the forward pricing of carbon – taking into account, for example, announced but not implemented carbon pricing initiatives.

Separately, a global ‘net zero’ target price – a price that indicates the global climate mitigation required to meet climate goals – could also be created to illustrate a ‘spread’ – the gap between the prevailing metric price and this target.

The criticality of features of a benchmark and the adoption cycle

It’s perhaps stating the obvious, but for a benchmark to be viable, it would need to be widely adopted – and not, for instance, merely remain an academically interesting exercise.

Arguably, widespread adoption is procyclical and self-referencing; the gravitational pull for potential users can builds as they see others using the benchmark. To trigger such an adoption cycle, the benchmark initial methodology needs to be sufficiently credible in the eyes of potential users.

Adoption can be amplified by the endorsement of policymakers and regulators. This includes financial stability regulators as they assess the implications of climate-related vulnerabilities and seek enhanced actions by financial institutions.

Mike Knight works in the Bank’s Financial Market Infrastructure Directorate.

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