The Cost of Carbon Is Rising. Here’s What Companies Need to Know

The EPA’s social cost of carbon could quadruple, posing significant regulatory, economic, and reputational impacts for US and European businesses

When S&P Global released its latest environmental, social, and governance (ESG) scores in May, Tesla’s score of 37 lagged behind gas producers like Chevron (43) and automakers like General Motors (67) and Toyota (45). Even on its Environment score, Tesla trailed General Motors and Conoco Philips by 8 points.

Tesla has criticized ESG ratings as fundamentally flawed, contending, for instance, that an automaker that modestly reduced process emissions at a manufacturing plant could move up in the rankings even as it churns out more gas-guzzling cars and trucks. That’s because emissions may account for only 2 percent of a company’s overall ESG score. Hence, General Motors can report that its customers created 209 million metric tons of emissions by driving the cars and trucks the company makes, and the carmaker’s ESG score still beats Tesla by 30 points.

This state-of-play speaks to a larger issue: as The Economist concluded last year, ESG has been a distraction from “the vital task of tackling climate change.” According to its editors, rather than the current “dizzying array of objectives,” ESG should focus just on the E, and only one part of the E—emissions.

Amid a broad effort to inject credibility into ESG ratings and focus on “real-world impact,” as Tesla calls it, carbon emissions and their cost to society are likely to become increasingly important. Here’s what business leaders should know.

The Growing Cost of Carbon

Companies as diverse as Disney, Cemex, JetBlue, and Shell currently offset carbon emissions to support their ESG goals.

But the $2 billion carbon-offset industry faces its own credibility problems amid widespread claims that the carbon offsets companies buy don’t actually materialize. What’s more, these voluntary offsets recently traded at $0.80 to $1.80 per ton of carbon dioxide, far less than the price of emissions permits in regulated jurisdictions, and farther still from estimates of the cost to society per ton of carbon emissions. Consequently, some firms have backed away from carbon offsets rather than risk legal and reputational harm from claiming carbon neutrality.

At the same time, climate policy risk is getting costlier. The Environmental Protection Agency (EPA) has proposed to quadruple the estimate of the so-called social cost of carbon (SCC) that it invokes when calculating costs and benefits of major regulations like fuel economy standards for cars and light-duty trucks. The SCC is meant to measure the present-discounted harm to society from an incremental ton of carbon dioxide emissions. It is based upon scientific estimates of the impact of the incremental ton of carbon emissions on the climate and of the climate impact on humans though channels such as agriculture, labor productivity, and mortality.

Whereas President Biden had previously instructed agencies to price carbon emissions at $51 per ton on an interim basis, invoking analysis by the Interagency Working Group convened by President Obama, the EPA is proposing to price the emissions at $190 per ton. This value mirrors the cost proposed last year by a group of researchers in an article published in the journal Nature. It is at least twenty-seven times greater than the value employed by agencies during the term of President Trump, which ranged from $1 to $7.

Impacts of a Higher Social Cost of Carbon

An estimate of the cost of carbon emissions is inherently uncertain, relying on the models of climate scientists to convert emissions into changes in temperature, precipitation, and frequency of natural disasters over a long time horizon. It further depends on the work of economists and others to assess how those climate changes affect humanity in myriad ways, and how society may adapt to those changes.

Such uncertainty notwithstanding, estimates employed by US federal agencies are likely to have widespread effects:

• First, a higher US government SCC is likely to influence climate policy around the world. In jurisdictions that price carbon through a tax on emissions, the EPA estimate can be used to hike taxes. Where tradable permit systems are in effect, like in California and the European Union, a higher SCC may warrant a tightening of emissions caps.

• Second, in the US, where climate policy is implemented via statutory authorities like the Clean Air Act, a higher SCC can justify considerably more aggressive regulation, including tightening energy-efficiency standards for cars and appliances and emissions standards for power plants. This heightens the regulatory risk facing companies in the US, which would be forced to comply with new regulations and stricter standards.

• Third, organizations in the US and Europe may be compelled to update their own (voluntary) internal charges to properly reflect regulatory risks and to direct their investment optimally—or they may be compelled to justify why their internal carbon pricing deviates from that of the EPA.

  Fifteen percent of US firms and 28 percent of European companies rely on internal carbon prices to assess their policy risk and direct investments. The median internal price in Europe is $27 per ton. None of 2,600 companies surveyed by McKinsey had an internal carbon price of more than about $100. In short, carbon-intensive enterprises have become more expensive simply by the EPA’s release of the new SCC number.

• Finally, firms wishing to tout their sustainability and remain in the good graces of ESG investors, particularly amid hopes for a credibility revolution in ESG and a reorientation toward climate change mitigation, may determine it is necessary to reduce their greenhouse gas emissions more aggressively or reliably pay for the pollution they cause.

While economists advocate so-called Pigouvian taxes to compel agents in the economy to internalize the harms they impose upon others, companies touting their sustainability could be expected to voluntarily offer these payments for carbon emissions (e.g., via contributions to groups mitigating climate change or its impacts).

The price for this environmental purity, according to the Biden administration? $190 per ton.