The Potential of Proxy Carbon Pricing in International Development Finance

Construction of the Noor I solar power plant nears completion on April 24, 2015, by Ouarzazate, Morocco.

Endnotes and citations are available in the PDF and Scribd versions.

This product is an installment of “Rational Decisionmaking in a Carbon-Constrained World,” a Center for American Progress series on the necessity to consider climate change in decisions regarding the viability of long-term investments.

In December 2015, world leaders adopted the Paris Agreement, which aims to limit global warming and build resilience to the effects of climate change. In order to achieve the agreement’s low-carbon vision, participating countries will submit national climate goals every five years; articulate a long-term strategy to decarbonize their economies; and aim to eradicate global greenhouse gas emissions in the second half of this century.

Governments are increasingly placing limits on carbon pollution, either through explicit pricing instruments—such as carbon taxes or emissions trading systems—or through nonmarket regulations that establish an implicit price on carbon. These trends will continue as countries seek to meet the national and collective commitments established in the Paris Agreement.

It is therefore clear that climate change has introduced not only physical risk—through extreme weather, sea-level rise, and other effects of greenhouse gas emissions—but also what is known in financial circles as transition risk. With the continued expansion of government action that explicitly or implicitly prices carbon—and with the continued attitudinal shifts in civil society and among investors to favor clean energy—some projects and technologies will become increasingly costly, while others will become increasingly affordable. Assets will be revalued in the context of the global low-carbon shift.

As the transition risks and opportunities posed by the global response to climate change become better known, the private sector is taking measures to mitigate or capitalize on them. Among these measures is a practice known as shadow carbon pricing—or proxy carbon pricing—which involves assuming a future price on carbon emissions when evaluating the financial viability of potential long-term projects or investments, even in the absence of a current carbon tax or trading system.

Proxy carbon pricing is a practice inspired by fiscal prudence: It helps companies steer capital toward projects that will be profitable in a world with progressively strict carbon limits. Well known in the oil and gas industry, proxy carbon pricing is also gaining traction in other sectors, including the industrial and financial sectors. Major U.S. companies that report using proxy prices on carbon include Chevron Corporation, ConocoPhillips Company, The Dow Chemical Company, Duke Energy, ExxonMobil Corporation, The Goldman Sachs Group, Inc., and Wells Fargo & Company.

To date, proxy carbon pricing is not widely used in the public sector. But public entities—including multilateral development banks, or MDBs—should be even more motivated than private sector actors to use tools that steer investments toward low-carbon projects. This is because MDBs operate under mandates not only to make fiscally sound investment decisions but also to serve the public interest in developing regions. In the case of climate change, this entails an obligation to mitigate future warming.

Dual motivations for proxy carbon pricing in multilateral development banks

MDBs assist developing countries through loans, grants, and other financial instruments—many of which support infrastructure projects, such as those to improve or establish energy and transportation infrastructure. Although they are not profit-oriented, MDBs do seek to make sound lending decisions in order to sustain their operations. Moreover, they are guided by the objective of fostering economic progress in developing regions.

Fiscal prudence should therefore motivate MDBs to use proxy carbon pricing when evaluating potential long-term investments. Providing loans for projects that become stranded assets in the global low-carbon shift, for example, would harm both the bank and the economic health of the country it aims to assist.

In addition, an obligation to help facilitate global decarbonization should motivate MDBs to use tools such as proxy carbon pricing. Climate change exacerbates poverty and therefore conflicts with their overarching development objective.

In fact, many MDBs have explicitly articulated a mandate to help finance global decarbonization and are displaying notable climate leadership. The European Investment Bank, or EIB, for example, aims to dedicate 35 percent of its lending to low-carbon and climate-resilient development by 2020—up from a floor of 25 percent in 2015—and considers its role as one of the primary climate finance channels to be a core part of its mission. The World Bank Group aims to dedicate 28 percent of its financing to climate projects by 2020 and manages the Carbon Pricing Leadership Coalition, which brings together governments and private sector actors to support the introduction of carbon taxes and emissions trading systems. The World Bank Group also serves as the secretariat and trustee of the Partnership for Market Readiness, which helps countries gain the technical capacity to prepare for and implement carbon pricing instruments.

To accelerate the global pivot to clean energy—and to avoid stranded assets, which would be a financial burden on both banks and local economies—MDBs should adopt a proxy price on carbon when assessing the financial viability of potential projects. Proxy carbon pricing is particularly relevant in infrastructure decisions, which will have a major effect on whether the Paris Agreement’s low-carbon vision is achieved. Infrastructure projects can have decades-long lifespans and therefore long-term climate implications.

Initial use of proxy carbon pricing in multilateral development banks

There are signs that the practice of proxy carbon pricing may be gaining traction in the MDB community. Several MDBs apply—or are taking initial steps to apply—proxy carbon prices that are comparable to the social cost of carbon that the U.S. government uses to evaluate potential rulemakings. The social cost of carbon refers to the amount of financial damage to society that is caused by each ton of greenhouse gas pollution.

The European Investment Bank was the first MDB to use proxy carbon prices in evaluating potential projects. Its range is from 10 euros to 40 euros per ton of greenhouse gas pollution in 2010 and increases through 2050—in which the high estimate reaches 120 euros per ton. These figures are in 2006 prices.

The World Bank Group issued guidance in 2014 that recommends a range of social values of carbon for use in the economic analysis of projects. Its central estimate is $30 per ton in 2015 and reaches $80 per ton in 2050. By June 2018, the World Bank Group will review this guidance.

The European Bank for Reconstruction and Development, or EBRD, uses a range of proxy carbon prices to assess some of its potential projects, particularly high-carbon projects. To evaluate proposals for coal-fired power plants, for example, the EBRD applies a proxy carbon price that was set at 35 euros per ton in 2014 and increases over time.

There is scant evidence of proxy carbon pricing in other MDBs, although absence should not be mistaken for indifference to the effects of climate change. The Asian Development Bank, for example, aims to double its annual climate investments to $6 billion by 2020, which would account for 30 percent of its total spending. Similarly, the Inter-American Development Bank aims to double its climate finance to reach 25 percent to 30 percent of its spending by 2020. The African Development Bank, for its part, aims to triple its climate finance to reach $5 billion per year by 2020. Meanwhile, the Islamic Development Bank signed an agreement with the U.N. Environment Programme in 2016 to support implementation of the Paris Agreement and the “2030 Agenda for Sustainable Development,” for which it has pledged more than $150 billion over time.

Importantly, MDBs have also been working collaboratively to harmonize climate finance strategies. In 2012, the six largest MDBs released the first “Joint Report on Climate Finance,” which established a shared understanding of the meaning of climate finance in order to improve transparency and facilitate tracking. They also have outlined common principles for greenhouse gas accounting during project appraisal. In 2015, the MDBs partnered with the International Development Finance Club—a collection of 19 international development banks—to set up a pilot to establish shared so-called greening practices, which may include integration of “a carbon price into the economic assessment of investments.”

As the banks seek to further develop best practices related to climate finance, there is an opportunity for them to establish proxy carbon pricing as a more consistently and broadly used tool to drive low-carbon investment—both among the established MDB community and among new banks, such as the Asian Infrastructure Investment Bank. The proxy carbon price that these banks choose should be sufficiently high to affect investment decisions; should represent a range given the uncertain severity of climate effects; and should increase over time.

The promise and limits of proxy carbon pricing in development finance

Proxy carbon pricing alone cannot guarantee that infrastructure and other funding decisions will be climate-compatible. It is possible for a potential project to be deemed financially viable in the context of a future with increasingly strict carbon limits even if the project has a high carbon footprint. For example, potential projects involving inexpensive, locally sourced lignite coal may require a much higher carbon price than other fossil fuels in order to dissuade investment.

But proxy carbon pricing is promising and has unique benefits as one in a set of complementary tools that may be jointly sufficient to guarantee climate-compatible investments. These tools may include climate investment targets; exclusion lists; limits on portfolio-wide emissions; emissions performance standards for projects; and greenhouse gas footprint analyses.

It is worth noting that proxy carbon pricing not only steers investments away from high-carbon projects but also helps renewable energy projects meet the minimum rate of return required for a project to proceed; an emissions performance standard alone would not make this possible. Moreover, given that high-carbon projects drive climate change cumulatively, rather than on an individual basis, a carbon footprint analysis of a single project may be insufficient to redirect investment toward lower carbon alternatives.

In the Paris Agreement, countries pledged to make “finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.”Encouraging the international finance institutions of which they are members to adopt proxy carbon pricing and complementary tools to drive low-carbon investment would be a step toward meeting this pledge.

Gwynne Taraska is the Associate Director of Energy Policy at the Center for American Progress. Ori Gutin is a former intern with the Energy Policy team at the Center.

For discussions on the practice of shadow carbon pricing, the authors thank Tom Kerr, Marcene D. Broadwater, and Shari Friedman at the International Finance Corporation. The views in this brief do not necessarily reflect the views of those who are acknowledged. All errors are the responsibility of the authors.