The cost of carbon: Could carbon pricing policies lower emissions from the built environment?

In this first article of our series on ‘the cost of carbon’, we look at the use of carbon pricing mechanisms in policy. Do carbon pricing policies have the potential to drastically reduce emissions across the building lifecycle?

Carbon emissions have huge costs in terms of their consequences, but these are rarely primarily borne by those who emit carbon in the first place. The costs are felt everywhere and by everyone, but with great geographical and chronological imbalances. Some regions of the world bear the brunt of the climate crisis through extreme weather events, and future generations will suffer more than current ones. Economists refer to this as the problem of negative externality, namely when the cost of an activity is paid by a different actor than the one conducting it. Carbon emission, as all other types of harmful environmental impacts, are typical examples of negative externalities.

Command-and-control policies

The most direct way to address externalities is for public authorities to regulate against them through conventional command-and-control policies. Regulations can be put in place to eliminate an externality or reduce it within acceptable levels. This is how the issue of the ozone layer depletion was tackled – by banning harmful substances. This is also how carbon emissions are often addressed, as governments introduce regulations to limit emissions across various sectors by force of law. When an organisation is found to have broken the law, the cost of unlawful emissions is usually forced on the organisation via an economic penalty, such as a fine. Even when the law is not broken, organisations still bear the cost of abiding by it and keeping emissions within the accepted limits.

While command-and-control policy is very effective at eliminating unacceptable externalities or ensuring minimum safeguards, it has its drawbacks. It does not encourage nor reward further improvements. Compliance with legal requirements must be economically and technically feasible for everyone subject to the law, otherwise it can end up pushing some organisations out of business. Moreover, this kind of policy can be perverted when an organisation considers the cost (and risk) of breaking the law preferable to the cost of respecting it. In political terms, it can be difficult to introduce new command-and-control policies when governments are reluctant to impose additional costs on businesses.

Carbon taxes and market-based mechanisms

Some of the drawbacks of command-and-control policy can be addressed by allowing externalities to happen while putting an artificial cost on them. This cost  is usually charged to those directly responsible ( the “polluter pays” principle). Such an approach can be used  instead of command-and-control policies, or in combination with them. In both cases, the pricing can be implemented through a market-based mechanism or a direct tax. The former allows organisations to buy and/or trade quotas of externalities, which may be limited to a maximum quantity. The latter is simply imposed on every organisation in proportion to the amount they contribute to the  externality. Both options require the establishment of regulatory bodies and accounting procedures, but they also generate public revenue that can be reinvested into decarbonisation efforts.

In the case of carbon emissions, both taxes and market-based mechanisms are being adopted across the globe. World Bank data shows that, considering both national and sub-national initiatives, 37 carbon taxes and 36 market-based mechanisms have been implemented or schedule so far. As of April 2022, 30 more initiatives are under consideration. The EU Emissions Trading System (ETS) introduced in 2005 is the first and biggest example of market-based mechanism, while the first carbon taxes were established in the early 90’s in the Nordic countries.

Carbon pricing initiatives generally do not apply to the entirety of the economy, but only to specific sectors, thus only a share of carbon emissions fall within their scope. The EU ETS covers about 40% of total emissions, and currently applies to energy generation, carbon-intensive manufacturing, and aviation within EU countries. At the time of writing, the built environment is not in the scope of the ETS, but the EU is planning to introduce a separate system (the ETS-II) for buildings and transport in 2027. This will be the first carbon pricing initiative to directly cover buildings, unless some other country acts sooner.However,  the EU ETS-II will only include  the emissions from energy use, which means that embodied carbon will not be in scope.

Buildings have long lifecycles, which involve a large number of stakeholders and fragmented supply chains. Arguably, buildings do not provide easy conditions for the application of carbon pricing in comparison to other sectors. This comes down to accounting carbon and placing the responsibility of its emissions. Covering energy generation or aluminium production, for example, is relatively straight-forward. The carbon intensity of each industrial process can be measured precisely, and the responsibility for those emissions can be put clearly on the organisation(s) that owns the plant. Conversely, measuring the emissions associated with a building over its entire life cycle is more complex, and always entails a degree of estimation and forecasting. Responsibilities are also more obscure. For example, occupants are clearly responsible for the emissions associated with their energy consumption for heating and cooling. However, some share of the responsibility also lies with the designer, whose choices have determined the energy efficiency of the building. Responsibility also lies  with the developer, whose priorities and budget have affected the choices available to the designer. There is no single stakeholder to which the entire responsibility of life-cycle emissions can be attributed.

Carbon costs and reduction: Striking a delicate balance

The complexity of the sector should not discourage policymakers from introducing carbon pricing in the built environment. Rather, it should warrant a cautious approach with careful consideration of the potential consequences of each type of policy. Any carbon pricing initiative will come with its own difficulties and drawbacks.

First, the effectiveness of the policy is highly dependent on getting the price right. If emissions are too cheap, there is little incentive to reduce them; but if the price is too high, carbon reductions can be too onerous for companies. A price floor and /or ceiling can be fixed to avoid these conditions. Of course, the type of policy affects how the price is determined. In the case of carbon taxes, the price is fixed by public authorities, while under ETS and credit systems it is established by the market.

Second, as with any policy, there is a risk that carbon pricing initiatives could result in unintended consequences with social and economic impact. If companies responsible for emissions are easily able to shift their cost onto consumers without losing competitiveness, there is no incentive to reduce carbon.  Those companies will  only pass the additional economic burden on to households and other businesses. On the other hand, carbon pricing can reduce the competitiveness of domestic carbon-intensive companies against foreign companies that are not subject to the additional costs.

Third, carbon pricing policies also require resources for control and enforcement. Since carbon pricing relies on complex measuring and accounting procedures, there is a chance that loopholes can be exploited. We have seen examples of this in the automotive industry. and fraudulent declarations of emissions performance on a large scale are also a possibility.

Considering the uniqueness of the construction and real estate sector, and the importance of its social impact, experts agree that carbon pricing has a role to play in decarbonisation, but only in conjunction with other policies. Carbon pricing  cannot be expected to be effective by itself. However, public policy is not the only application of carbon pricing. In the next article of this series, we will look at the internal carbon pricing initiatives adopted by organisations as ways to quantify their impact and promote and reward improvements across their operations.