The problem of climate systemic risk

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The case for a positive carbon price

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Carbon Quantitative Easing

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Hypothesis for a Risk Cost of Carbon

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Risk Cost of Carbon

Notice: This web page was updated on 21 February 2020.

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, positive 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. The RCC is different to the SCC, because the SCC is concerned with improving social welfare, whereas the RCC is concerned with managing systemic risks that are linked to the economy as a complete system.

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 a positive externality, because the policy for internalizing the RCC is a ‘public good’. It is a public good because it is delivers ‘preventative climate insurance’ and because the physical and social benefits are non-excludable and non-rivalrous.

The RCC is currently an ‘off balance sheet’ cost because the cost is hidden in the environment and climate system, and because the RCC is not officially recognised by the UNFCCC or IPCC.

An international monetary policy for internalizing the RCC will require a new mandate for central banks, so that they can address the physical causes of the climate crisis. This kind of central bank macro-prudential approach 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 internalised 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 are costs that relate to different but complementary objectives,  and so they may be combined to present the Total Cost of Carbon (TCC). The TCC is the total externalised cost of carbon emissions, and the TCC is a two dimensional vector, as follows:

TCC = SCC 𝒶 + RCC 𝒷

where 𝒶 is the unit vector for the carbon tax, and 𝒷 is the unit vector for the carbon reward. The SCC is a measure of the economy’s deviation from market efficiency and is addressed with carbon taxes; and the RCC is a measure of the deviation from climate safety and is addressed with carbon rewards. The RCC should be estimated in a global risk assessment that is undertaken on an annual basis.

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