NEW MARKET HYPOTHESISRISK COST OF CARBONCENTRAL BANK DIGITAL CURRENCY

NEW MARKET HYPOTHESIS

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RISK COST OF CARBON

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Risk Cost of Carbon

Notice: This web page was updated on 30 January 2018.

 

Despite decades of research into the Social Cost of Carbon (SCC) and related climate mitigation policies, the scholarship on carbon pricing has not attributed a specific objective to policies that offer global rewards for carbon mitigation services. If global rewards represent an unused price signal, then a fundamentally important question is this: what is the economic purpose of a global carbon reward? We claim that a global reward for carbon mitigation services can be used to manage climate systemic risk. Climate systemic risk is the ensemble of financial and biophysical ‘fragilities’ created by climate change.

 

What is the Risk Cost of Carbon (RCC)?

We claim that ‘climate systemic risk’ is actually a second, but previously overlooked, negative externality that can be quantified using a risk-based procedure. We call this second external cost the Risk Cost of Carbon (RCC), and the RCC is described as follows:

…the market price of each metric tonne of additional CO2-e mitigation service that is needed to reduce climate systemic risk to an agreed limit.” (Chen, van der Beek and Cloud, 2017, p. 41).

It needs to be emphasized that the RCC does not replace or substitute the Social Cost of Carbon (SCC), because the RCC is additional to the SCC.

Key differences between the SCC and RCC are that (a) the SCC is internalized with taxes, whereas the RCC is internalized with rewards; and (b) the SCC is a measure of marginal economic welfare loss and is based on expected future climate damages, whereas the RCC is a measure of the cost of limiting the uncertainty of avoiding unwanted climate change events and is based on probabilities.

The RCC is currently an ‘off balance sheet’ cost because a policy for its internalization has not been officially proposed. The policy for internalizing the RCC is a kind of preventative insurance policy, and it is also a macroprudential regulation of central banks and should be insulated from political interference.

 

How is the Risk Cost of Carbon (RCC) quantified?

The Risk Cost of Carbon (RCC) is the monetized value of climate risk. It is the average market price of voluntary mitigation services, in USD per metric tonne of carbon dioxide equivalent (CO2-e), that guarantees a risk tolerance, R, as a percentage probability that a certain level of global warming, ΔT, could be exceeded. ΔT is defined relative to a pre-industrial baseline and a rolling 100-year planning horizon, denoted by the end-year, Y.

A hypothetical example of the RCC, is the market price for a global carbon reward that can limit the probability to 33% (R) that the global average temperature rise could exceed 2°C (ΔT) over 100 years—despite efforts to mitigate with conventional policies. Multiple risk limits (ΔT, R) can be addressed concurrently and in a single international climate policy (e.g. for ΔT of >1°C, >2°C, >3°C, >4°C, and >5°C). These risk limits should be normatively decided in an international forum.

 

How is the Risk Cost of Carbon (RCC) related to the Social Cost of Carbon (SCC)?

The RCC and SCC are interactive costs with possible correlation. The RCC and SCC should be internalized with independent policies, tools and networks under the Tinbergen rule, meaning that the number of policy objectives and tools should be equal.

The SCC and RCC may be summed to determine the Total Cost of Carbon (TCC), which is a notional measure of the total externalized cost of carbon emissions:

TCC = SCC + RCC

where the RCC is assessed each year based on a global risk assessment.

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