The Pricing of Sustainability in a Supply Chain

For individuals and firms to focus on sustainability, it is crucial that they internalize the “mone­tary value” of the social or environmental cost of their actions. Firms are structured to naturally account for all factors that they have to pay for. Every effort is put into place to reduce these costs. For example, firms optimize the use of water based on its cost. This cost does not, how­ever, include the impact of a water shortage on the firm as well as the surrounding community. As a result, firms use more water than they would if they had to internalize the cost of future shortages on society. Similar inefficiencies exist along a variety of social and environmental fac­tors. To improve sustainability in the supply chain, it is thus important to incorporate suitable prices for the social and environmental impacts of different actions such as emissions. There are, however, significant challenges to setting these prices appropriately. We discuss some of these challenges in the context of emission pricing.

Pricing of Emissions

Decision makers all over the world have devoted significant attention to reducing GHG emis­sions. As discussed in the tragedy of the commons, firms will not put sufficient effort into reduc­ing GHGs unless they are “forced” to reduce emissions or required to pay for the social cost of their emission. The policies proposed include technology mandates, performance standards, and emissions pricing. The theoretical attraction of emissions pricing is that it has the potential to achieve emissions reduction at lower cost than other approaches. A study by the OECD found that charging for emissions was more cost effective than subsidies or mandates in reducing car­bon dioxide emissions.¹⁵ Even though there is general agreement on the need for emissions pric­ing, finding the right price is challenging.

Two approaches used to price emissions are a carbon tax and a cap-and-trade system. By charging for emissions, both methods encourage firms to reduce emissions per unit of output. The prices in the two cases, however, are set differently. Under a carbon tax, the price of emis­sions is the tax rate set directly by the regulatory authority. A carbon tax fixes the price of emis­sions, but the quantity of emissions is decided by the emitters. Under a cap-and-trade system, the total quantity of emissions is set by the regulatory authority and the price is set indirectly. The regulatory authority sets an overall limit on the quantity of emissions by providing allowances equal to this limit. Firms that emit less than their share of allowances can sell the surplus allow­ances to firms that emit more than their share. This market for allowances then yields a price of emissions. A cap-and-trade system fixes the quantity of emissions through the allowances but the price of emissions is allowed to change. A seminal paper discussing the relative merits of setting prices versus quantities was written by Martin Weitzman in 1974. The difficulty in both approaches arises because regulators do not have sufficient information of the cost to individual firms of reducing emissions or the cost to society of emissions. In the carbon tax approach, this lack of information makes it difficult to set the correct tax. Setting a tax that is too low results in insufficient effort by firms to reduce emissions. In contrast, setting a tax that is too high forces firms to make emission reduction efforts that are too expensive. In the cap-and-trade approach, the lack of information makes it difficult to decide the quota of emission allowances. Too large a quota results in too low a price of emissions, whereas too small a quota results in too high a price.

Goulder and Schein (2013) provide an excellent review of both a carbon tax and cap-and- trade. Rather than a pure cap-and-trade mechanism, in which the market sets prices under all cir­cumstances, they recommend a hybrid version of the cap-and-trade, in which the traded allowances have a floor price as well as a ceiling. The ceiling is enforced by adding extra allowances when the ceiling price is hit (the regulatory authority sells unlimited allowances at the ceiling price), whereas the floor is enforced by removing allowances (the regulatory authority purchases any number of allowances available for sale at the floor price). A major advantage of the hybrid cap- and-trade relative to a pure cap-and-trade is that it limits the volatility in the price of emissions allowing businesses to better plan their environmental activities. Goulder and Schein discuss the following dimensions along which any emissions pricing mechanism should be evaluated:

• Cost of administration: The cost of administering an emissions pricing policy depends on the number of sources that need to be monitored. Charging the ultimate emitters can be very cumbersome, given the millions of such entities. It can be cheaper to charge the upstream suppliers (such as energy supply companies) whose products end up as emis­sions because there are fewer of them (compared with the ultimate emitters). Both carbon taxes and cap-and-trade can potentially be applied to upstream suppliers.

• Price volatility: Businesses tend to prefer low price volatility because it allows them to better plan their sustainability activities. A carbon tax fixes the price of emissions, whereas a cap-and-trade system displays price volatility. A hybrid cap-and-trade system limits price volatility, given a floor and ceiling price. Price volatility in a cap-and-trade system can be reduced by allowing intertemporal banking, in which firms can apply future allowances to current emissions or save current allowances for future emissions.

• Emission uncertainty: A cap-and-trade system caps the emissions (except when the ceiling price is hit), whereas a carbon tax can potentially have high emissions if the cost of reducing emissions is greater than the tax. Some environmental activists have opposed the carbon tax because it does not guarantee a drop in emissions.

• New information uncertainty: As new information becomes available about the costs and benefits of emission reduction (for example, with the introduction of new technology), the price of emissions should adjust accordingly. A hybrid cap-and-trade mechanism with the possibility of intertemporal banking (for allowances to be saved for the future or bor­rowed from the future) is better able to adjust the price of emissions based on new informa­tion compared with a carbon tax.

• Industry competitiveness: A country or state that is further along on emission pricing can potentially hurt the competitiveness of its own emission intensive firms relative to firms operating outside its borders. In theory, a tax at the border for imported goods (based on origin) and an allowance for exported goods (based on destination) can level the playing field. In practice, however, such an approach is administratively complex in most instances because it requires different levels of tax based on origin of imports and destination for exports. This complexity makes border adjustments very difficult to implement in practice.

• Wealth transfer to energy-exporting countries: For a country that imports most of its energy supplies, a cap-and-trade system has the potential to shift wealth to energy­exporting countries. The price on emissions is designed to encourage lower consumption of fuels like crude oil. A cartel of oil-producing countries can potentially take advantage of a cap-and-trade mechanism by reducing supply of crude below the level that would be achieved with a price on emissions. This would lower the price of emissions under cap- and-trade to zero because the demand for allowances would be less than the supply. The oil producers would gain revenue because the reduced supply would raise the price of oil. Instead of the local government gaining revenue from the auction of allowances, the oil producers would extract that revenue in the form of higher oil prices. This transfer of wealth does not occur with a carbon tax and is limited by a hybrid cap-and-trade system. Such an outcome is also limited if the energy supply market is competitive, because supply cannot be constrained in a competitive market.
• Revenue neutrality: Several studies have indicated that the costs of emission pricing policies are minimized if any government revenue from these policies (in the form of a tax or revenue from auctioning emission allowances) is returned to the consumers in the form of a reduction in the marginal rates of pre-existing income or sales taxes.

There is general agreement that putting an explicit price on emissions is more cost effective than other policy choices in reducing emissions. In this context, carbon taxes are simple to administer and provide a fixed price that businesses can plan for. They do not, however, guaran­tee a decrease in emissions and it is difficult for the regulatory authority to determine the opti­mal tax rate. Cap-and-trade mechanisms can be used to limit emissions and are flexible enough to incorporate new information as it becomes available but may display significant price volatil­ity. To limit price volatility, it is best to implement cap-and-trade with a price floor as well as ceiling and allow intertemporal banking of emission allowances.

Source: Chopra Sunil, Meindl Peter (2014), Supply Chain Management: Strategy, Planning, and Operation, Pearson; 6th edition.