Why the federal government should shadow price carbon

A growing number of companies are putting a shadow price on carbon to reduce their carbon footprint cost effectively. Shadow pricing is method of investment or decision analysis that adds a hypothetical surcharge to market prices for goods or services that involve significant carbon emissions in their supply chain. For example, if a firm is analyzing acquisitions of new energy-using equipment, it would use expected energy costs of expected market prices plus a charge associated with the carbon dioxide that would be released when the fuel is combusted. Shadow prices can apply in all sorts of analyses of investments, procurements, and other strategic decisions to give an edge to options that are more emissions-efficient, other things equal. These decisions then allow firms to reduce their emissions gradually up to the incremental cost reflected in the carbon price they apply.

Why would companies do this? Economists widely argue that imposing a price on greenhouse gas emissions, such as through a tax on the carbon content of fossil fuels, is a crucial measure to control the growing risk of global climatic disruption. Carbon shadow pricing is an explicit way to anticipate such future policies and avoid stranded or inefficiently allocated capital. By analyzing capital expenditures and other important corporate plans with an eye to future regulatory or tax conditions, firms can manage the economic risk of a carbon-constrained future and assure shareholders and the SEC they are appropriately forward-thinking. This is particularly important for companies that invest in energy-intensive long-lived facilities such as power plants and oil refineries. Second, shadow pricing is a concrete way to signal to investors and the public that a firm takes its commitment to climate change mitigation seriously. It can also induce more consistently cost-effective abatement than alternative approaches such as targets for renewable energy procurement or internal energy efficiency standards.

A 2013 report by CDP (formerly the Carbon Disclosure Project) identified over thirty companies —including large electric utilities, major integrated energy companies, technology companies, airlines, and more— that set an internal price on greenhouse gas emissions associated with their activities. Gradually, standard approaches for carbon shadow pricing are emerging, but methodologies are not nearly as developed for shadow pricing as they are for greenhouse gas emissions inventories. The price per metric ton of carbon dioxide emissions that firms apply ranges between about $6 to $60, and their approaches vary by year, scope of coverage, and pricing methodology. Companies that wish to adopt shadow pricing have few public examples of how to do it.

The Role for the Federal Government

The U.S. federal government has two key leadership opportunities here. First, the government could shadow price its own emissions in ways analogous to those used by companies but customized to the particular needs of federal agencies. For example, in analyzing energy efficiency retrofits to federal facilities, agencies could use energy prices that take into account the carbon intensity of the fuels and electricity involved, thus economizing on energy where the emissions benefits are highest. This would help manage the federal government’s fiscal risk as a major energy user, harmonize abatement incentives across agencies, and rationalize federal investments across competing objectives.[1]

Second, the government could use the process by which it develops its shadow pricing policy to catalyze an even broader public discussion. Although hard to quantify, the spillover potential of the federal government’s leadership could be substantial as it would raise the profile of shadow pricing, provide practical approaches that other entities can adopt, and further prove the principle that carbon pricing can cost effectively reduce emissions. At the very least, the policy would draw the attention of the firms that receive the over $500 billion in federal contracts annually. With thoughtful stakeholder outreach, the impact could be even broader.

A First Step

One potential first step would be to establish an expert committee and/or interagency process to explore the feasibility of carbon shadow pricing by the federal government. The committee could examine which kinds of federal expenditures and operations are best suited to shadow pricing, and which sources of emissions (direct and indirect) could be reasonably priced. The committee could review methods used by the private sector for possible application in the federal government and consider which federal agencies, such as DOE, OMB, CBO, and GSA, are in the best position to provide leadership for the endeavor. It would also think through potential budget implications and how shadow pricing could be piloted or phased-in across the government.

The committee could also analyze options for how to set an appropriate shadow price trajectory, such as whether the price should be tied to the social cost of carbon the government uses for regulatory analysis or a path that minimizes the cost of achieving a long term cumulative emissions goal. The committee could also propose metrics for monitoring the emissions performance of the policy and, potentially, identify more costly abatement measures the federal government could consider phasing out. Finally, the committee could suggest ways to engage contractors, companies with carbon shadow pricing experience, and other stakeholders in the process to amplify the broader benefits.

[1] This proposal focuses on federal energy management and other emissions-intensive agency activities, but in principle the federal government could also apply carbon prices to other energy pricing policies, such as royalty rates for fossil fuels extracted from federal lands and waters.