February 2023
Summary
Net changes in greenhouse gas emissions associated with an activity need to be incorporated in any CBA as they potentially represent and unpriced externality. This is consistent with general principles of CBA to assess all social impacts of a proposal.
The greenhouse externality is unlike others in that is fundamentally an international externality. This needs to be explicitly considered in the CBA.
International accounting frameworks, also adopted within Australia, identify a large number of ways in which emissions could arise from a project.
Incorporating greenhouse gases requires carefully tracing net changes in emissions using these accounting frameworks.
There is no single agreed method to value these emissions, but there is a wide variety of options.
Choosing a specific value requires considering the nature of the externality in the context of the greenhouse policy measures in place.
Introduction
The purpose of this note is to provide a high-level discussion of the factors that need to be considered when measuring and valuing greenhouse gas emissions for inclusion in a CBA. It provides:
An overview discussion of incorporating a value for net changes in greenhouse gas emissions within a project cost-benefit analysis (CBA).
A review of accounting methods to identify emissions changes.
A summary of emissions values that can be used with the CBA.
Discussion of key factors to consider in each of the above considerations.
What are greenhouse gases?
The greenhouse gases that are regulated in Australia (particularly under the National Greenhouse and Energy and Reporting Scheme) include carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), sulphur hexafluoride (SF6) and specified kinds of hydro fluorocarbons and perfluorocarbons.
Greenhouse gas emissions from the different gases are put on a common basis in terms of tonnes of carbon dioxide equivalence (CO2-e). Different gases have different effects on global warming — the so-called global warming potential (GWP). Greenhouse accounting uses these various GWPs to put different gases on a common basis.
For example, from 2020-21, one tonne of methane released into the atmosphere will cause the same amount of global warming as 28 tonnes of carbon dioxide (the GWP of methane is 28). Thus, one tonne of methane is expressed as 28 tonnes of carbon dioxide equivalence, or 28 t CO2-e.
Sources of greenhouse gases
The standard approach to greenhouse gas accounting (see, for example, Australia’s National Inventory Report 2020) identifies 5 key sources or sinks (activities which absorb gases) of greenhouse gas emissions. These are:
energy generation, including stationary energy such as coal fired electricity generation along with energy used in the transport sector such as burning of fuel in vehicles
industrial processes, including, for example, manufacture of cement and steel
waste activities, including for example, methane generated as waste material is broken down
agriculture, including for example, emissions generated by livestock as well as from the use of fertilisers
land use, land use change and forestry. This includes emissions from land clearing as well as the potential sequestration of emissions through forestry activity.
Why value greenhouse gases
From the perspective of CBA, greenhouse gas emissions represent an unpriced externality which need to be accounted for to understand the full social costs and benefits of a project, consistent with the objective of understanding whether the project leads to a net increase in wellbeing.
Each tonne of emissions is associated with a cost (in terms of future damages from the effects of global warming) which is not internalised to individual project participants but is imposed on others within the Australian and global economies.
If these externalities are not properly accounted for, then the relevant infrastructure projects will be associated with inefficient economic outcomes and poor use of resources from a full socio-economic perspective.
The international context
A key feature of the greenhouse gas externality is that it is global — the costs imposed within Australia of a tonne of Australian emissions are a very small proportion of the cost imposed globally for that same tonne of emissions. Looking at the Australian cost only does not internalise the full externality.
This poses a challenge for CBA in that the boundary for externalities are usually set at the Australian border so that CBAs only consider the effects of Australian emissions on Australia. However, this approach needs to be extended for greenhouse gases as the entire policy focus is associated with a wide range of international negotiations and agreements. Put another way, Australian efforts to reduce emissions are all associated with international agreements, and in the wider policy space it is well understood that the benefits of Australia’s emissions reductions extend well beyond Australia’s borders.
Valuation within a policy context
Undertaking a CBA for an activity and choosing values for the greenhouse gases associated with that activity takes place in an evolving climate policy context.
From the perspective of valuing an unpriced externality, it will be important for the CBA to consider the extent to which policy measures in place have the effect of pricing those externalities.
While it is beyond the scope of this note to review the full range of evolving policy responses, at the time of preparation of this note there is a proposal to introduce some form of carbon pricing.
Identifying emissions from proposed activities
There is a long history of development of national and international accounting standards for identifying and measuring greenhouse gas emissions.
In Australia, emissions are reported in the National Inventory Report. This report compiles estimates of greenhouse gases for each of the sources noted above. Australia’s emissions accounting is also associated with an online database (the Australian Greenhouse Emissions Information System) which can be accessed to obtain details of emissions from various activities.
Underlying greenhouse accounting are a set of National Greenhouse Accounts Factors. These ‘factors’ are a set of methods setting out how to estimate greenhouse gas emissions from various activities. The factors, in a sense, provide the technical and scientific link between the activity (for example burning fuel) and the emissions associated with that activity.
The information embedded in the greenhouse accounts provides extremely useful background to understand the magnitude of emissions associated with various activities. The latest version of the factors are set out in National Greenhouse Accounts Factors 2021.
The Clean Energy Regulator provides a wide range of information on current reporting requirements and on the implementation of Commonwealth policies associated with emissions reporting and offsetting.
Regulatory and international emissions accounting
The majority of measurement and regulation of emissions takes place in the context of three different ‘scopes’ of emissions. For the purposes of emissions accounting, these scopes are normally applied to a specific facility (for example, a specific power station or a particular manufacturing plant). At the same time, the underlying concepts can also be applied to a particular infrastructure project which may itself be made up of a variety of activities undertaken by different entities.
Scope 1 emissions
Scope 1 greenhouse gas emissions are the emissions arising as a direct result of an activity, or series of activities at an individual facility or project level. Scope 1 emissions are often called direct emissions. Examples are:
emissions from manufacturing processes, such as from the manufacture of cement
emissions from the burning of fuel in transport vehicles or machinery
fugitive emissions, such as methane emissions from coal mines
production of electricity by burning coal.
Scope 1 emissions are specified under the National Greenhouse and Energy and Reporting Scheme (NGER) legislation and must be reported by the relevant companies to the government via the Clean Energy Regulator.
Scope 2 emissions
Scope 2 greenhouse gas emissions are those released from the indirect consumption of an energy commodity. For example, these 'indirect emissions' arise from the use of electricity produced by the burning of coal in a power plant.
Scope 2 emissions from one facility are part of the scope 1 emissions from another facility. For example, when a power station burns coal to generate electricity, the greenhouse gas emissions associated with this are attributed to the power station as scope 1 emissions. If the electricity is then transmitted to a factory and used to power its machinery and lighting, the gases originally emitted as a result of generating the electricity are then attributed to the factory as scope 2 emissions.
As for Scope 1 emissions, Scope 2 emissions are also specified under the NGER legislation and must be reported.
Scope 3 emissions
Like scope 2 emissions, scope 3 emissions are indirect greenhouse gas emissions but are generated in the wider economy (either within Australia or internationally). They occur because of the activities of a facility or project, but from sources not owned or controlled by that facility's business or directly associated with that project.
Scope 3 emissions are the scope 1 and 2 emission from some other activity in the economy. For a specific project, they include upstream emissions that become embodied in the products of a product as well as downstream emissions as subsequent users take advantage of the output of a particular activity that will have its own emissions embodied in it.
The emissions embodied in cement (the scope 1 emissions of the cement producer), for example, are scope 3 emissions from the perspective of an infrastructure project. From the point of view of the cement producer, the emissions embodied in the use of cement are scope 3 emissions.
There are a wide range of possible pathways for Scope 3 emissions. A careful codification of these is provided by the Greenhouse Gas Protocol. This internationally recognised framework divides scope 3 emissions into a number of categories as set out in the following table.
An example
To illustrate the application of these three scopes, consider a large road project that uses concrete and steel in construction and that will ultimately reduce transport time and distance for road users.
In this example, the scope 1 emissions from construction would mostly comprise fuel used by construction vehicles and machinery. Fuel emissions (which are energy emissions from transport and machinery) can be calculated from the amount of fuel used in construction.
Scope 2 emissions would be any direct use of electricity (provided by the grid, for example) in construction. How electricity is used would vary by type of road project, but it is common during construction to have various forms of lighting in place. Similarly, on-site offices would be powered by electricity. Where electricity comes from on-site generators (petrol or diesel), then this would appear as a scope 1 emission for the project.
The core construction materials, concrete and steel, each involve emissions in their original manufacture. From the perspective of the project, these are upstream scope 3 emissions: the emissions embodied in the concrete and steel projects. These emissions can be derived from the quantities of concrete and steel used using known emission factors (see below).
Often, large road projects involve on-site aggregation of cement into concrete products. In this case, the energy involved in on-site manufacture would be a scope 1 emission for the project. The emissions embodied in the cement (or clinker) used on-site would remain an upstream scope 3 emissions.
These emissions discussed so far are ‘once off’, they happen during construction and are not relevant during the ongoing life of the project’s final product (except for maintenance or other going enhancements).
In contrast, the reduced travel time and distance associated with the new road continues throughout its life. This reduction in user transport energy emissions would appear as downstream scope 3 emission from the perspective of the project. The reduced scope 3 emissions can be calculated from the fuel use savings that users experience. It’s important to note, though, that with the expected introduction of electric vehicles, these savings may not apply for the whole economic life of the road infrastructure.
Broad sustainability concepts and emissions
The three scopes of emissions outlined above are very encompassing. They include direct (or operating) emissions (scope 1), embodied emissions (scope 2 and upstream scope 3) and aspects of lifecycle emissions (downstream scope 3).
As well as the language of these three scopes of emissions, some discussions of greenhouse gases refer to some broader concepts often termed ‘enabling emissions’ or scope 4 emissions. Each of these looks further at the incremental emissions possibilities of particular projects.
For example, the NSW State Infrastructure Strategy suggests a broad sustainability framework for infrastructure and introduces an idea of enabling emissions.
This idea is part of a broader move to capture more flow-on consequences of products and practices in terms of the subsequent behavior they induce in the ultimate users of the products. This change in behavior, enabled by the product, results in a chain of emissions changes, relative to what would otherwise have been the case.
For example, scope 4 emissions can refer to the quantity of emissions change associated with using a new energy efficient product. Scope 1, 2, and 3 emissions associated with this product refer to its emissions from production and transport to the consumer. Scope 4 emissions refer to the emissions avoided (relative to what would otherwise have been the case) from the use of the efficient product versus the less efficient product previously used.
Scope 4 emissions are qualitatively different to the other 3 scopes in that they are explicitly concerned with induced behavioral change and effectively can only be measured against a counterfactual reference case.
Strictly speaking, scope 4 emissions associated with a project are the changes in scopes 1, 2 and 3 emissions induced by behavioral changes in the user of that product or project.
Scope 4 emissions, have a positive and a negative aspect. They can refer to emissions that are avoided through the use of enabling products, or they can refer to an increase in emissions when a particular product is used.
Practical considerations
Using the accounting frameworks to identify net changes in emissions from the lifetime of an activity requires careful consideration and measurement. As for all CBA, it requires establishment of a clear base case and ‘with activity’ scenarios.
Applying the scopes
Each of the four scopes of emissions involve increasing complexity for measurement, both in practice and conceptually.
Direct emissions (scope 1) from an activity are the easiest to measure and require knowledge of the fuels directly burned during construction and ongoing operation. Emissions factors for fuels, for example, are set out in the National Greenhouse Accounts Factors.
Similarly, scope 2 emissions are relatively straightforward and require knowledge of the use of electricity in the construction and ongoing operation of the project. Emissions factors for electricity generation are also in the National Greenhouse Accounts Factors.
Embodied emissions (upstream scope 3) can be calculated from known emissions factors. For example, emissions associated with cement (embodied in the cement) can be calculated from National Greenhouse Accounts Factors and applied directly to the volume of cement used in a project.
Estimates of emissions embodied in cement, concrete and other related products are also available from manufacturer data. For example, Boral publishes a variety of Environmental Product Declarations (EPDs) which can be used to assess the carbon content of different cement and concrete products.
Other downstream scope 3 emissions, and potential scope 4 emissions require construction of a specific scenario (or scenarios) for the operation of the infrastructure. Once this scenario is developed, known emissions factors can again be applied.
For example, net changes in emissions induced in commuters through the development of new road infrastructure (which could be classed as downstream scope 3 or potentially scope 4 emissions) requires a careful comparison of the base and with project cases to provide a basis for measuring emission changes.
Identifying the externality
Related to the double counting issue is the idea that it is possible that the emissions externality (associated, for example, with scope 3 emissions) has already been dealt with elsewhere in the production chain (before the activity under evaluation) and so may not need to be accounted for within the activity itself.
For example, if a cement producer is subject to regulations on its emissions (for example, it may need to acquit ACCUs for emissions above a baseline, which is currently the case under the Safeguard Mechanism) then there may already be an implicit carbon price in place which will at least partly be paid by the project.
Accounting for this within a CBA will require judgement and involves considering whether:
The potential externality has been accounted for in another activity
It can reasonably be considered that the externality has already been priced (either explicitly or as a shadow price for a quantitative constraint) elsewhere in the production chain.
Where there is doubt on either of these points, then the full emissions value should be calculated for the activity.
Valuation of carbon emissions
Two broad concepts for valuation
For example, a common approach to valuing emissions is to use a price which is consistent with a particular abatement pathway. Under international agreements, most abatement targets are expressed as achieving net zero by a particular year, or as achieving a particular percentage reduction in emissions relative to a past base year by a particular future year.
This quantitative target base approach implies an abatement cost — each tonne of new emissions from a project needs to be reduced elsewhere in the economy in order to achieve the target. In this case the externality is relative to the abatement target; as one project increases emissions, other activities need to reduce emissions more. Thus, an appropriate value for incremental emissions is the abatement cost. This leads to the first broad valuation concept.
An alternative view is that the unpriced externality is the (future) damages induced by the emissions (expressed per tonne). This leads to a second stream of valuation concepts related to (net) climate damages. This social cost of carbon (SCC) approach has been extensively used in the United States, for example, for routine evaluation of projects.
While different valuation approaches are often seen as interchangeable, it is important to keep in mind that each has a different conceptual underpinning, and a different conceptual understanding and approach to addressing the overarching policy problem. These are discussed in turn below.
Abatement cost
There are essentially three sources of information on the cost of abatement (or the carbon cost associated with abatement targets). These are:
Australian cost of abatement estimated from model-based simulations.
The cost of abatement implied by Australian market prices based on the idea that current policies leading to purchases of abatement on markets reflect an emission opportunity cost.
The cost of abatement implied by international market prices under the idea first that international prices are relevant to Australia because of the international nature of the greenhouse externality and second that as policy develops, Australian prices may ultimately converge on international prices.
Model-based estimates
Over the past 10 years, a wide variety of modelling studies have been undertaken in Australia. Together, these provide a model-based indication of the cost of abatement associated with abatement targets.
The figure below provides an illustration of abatement costs (expressed in dollars per tonne on the vertical axis) associated with abatement targets (defined as the percentage reduction in emissions relative to business as usual, horizontal axis) that emerges from a meta-analysis of a number of modelling studies. It presents results where both domestic and international abatement are used to achieve the target. The red points indicate results for domestic abatement only.
Several points are evident from this chart:
There is a large spread of results across different models and scenarios. This illustrates the importance of using a variety of modelling studies when inferring the cost of abatement, rather than relying on one or two studies.
All the studies show a strong upward slope to the cost of abatement — as abatement increases, the overall cost of abatement also increases, generally quite sharply.
Comparing the slopes between the top and bottom panels of the chart indicates that the availability of some form of international abatement significantly lowers the marginal cost of abatement for Australia.
Many of the studies do not capture abatement beyond about 70 or 80 per cent relative to BAU, and the main clustering of results is up to around 50 per cent (relative to BAU). This means that care must be taken when considering very high levels of abatement as this may be outside the range of existing models.
The position of the abatement cost curve implied by each study depends very much on the model mechanisms and the particular scenario considered.
Estimates based on representative market prices
The Australian Emissions Reduction Fund (ERF) essentially establishes a carbon market in Australia.
The Clean Energy Regulator administers a number of offset methodologies that allows project proponents to earn Australian carbon credit units (ACCUs) These ACCUs can be sold to the Clean Energy Regulator through an auction process, or they can be sold on the spot market for ACCUs.
Each ACCU represents one tonne of abatement and the price of an ACCU can be interpreted as an indicator of the cost of abatement.
ACCU prices from ERF Auctions
At the time of preparing this note, the latest ERF auction round was in April 2022. The average auction price for this round was $17.35 per tonne of abatement.
Over the 14 auctions that have taken place under the ERF to date, the price has ranged from a low of $10.23, to a high of $17.35. Auction results are regularly published by the Clean Energy Regulator. These auction prices represent one possible indication of the cost of abatement in Australia.
ACCU spot price
In addition to the auction market, there is also a spot market for ACCUs. The ACCU spot price showed considerable variation between January and July 2022. The evolution of the ACCU spot price illustrates some of the challenges in using market prices as a source of information for the price of carbon within a CBA. The ACCU price has shown some dramatic variation. Essentially, these swings in price have related to particular policy changes within the ACCU market, or to particular perceptions about the likely demand for ACCUs. From the perspective of CBA, these swings are not likely to represent fundamentals of the price of carbon but are more subject to variations in policy.
International carbon markets
Several countries have implemented some form of carbon emissions trading policy. Where participation in such a carbon market is effectively compulsory, this is known as a compliance market. At the same time, there are also a number of voluntary carbon markets where firms and individuals are able to trade carbon.
The following table shows recent carbon prices for four compliance markets (in the European Union, California, New Zealand and South Korea) and in three illustrative voluntary markets.
While the table above shows a snapshot of prices, it is important to be aware that prices in carbon markets often vary over time.
As in the case of ACCU prices, if European carbon prices are to be used in a CBA, it is important to carefully consider the point in time at which the price is chosen as there can be significant variations in price for a variety of policy and market reasons that may not necessarily be related to the cost of abatement.
The social cost of carbon (SCC)
The overall concept
According to William Nordhaus (winner of the 2018 Nobel Prize in Economics):
The most important single economic concept in the economics of climate change is the social cost of carbon (SCC). This term designates the economic cost caused by an additional ton of carbon dioxide emissions or its equivalent. In a more precise definition, it is the change in the discounted value of economic welfare from an additional unit of CO2-equivalent emissions. (William Nordhaus ‘Revisiting the social cost of carbon’ available here).
The SCC is well embedded in the economic literature of climate change and has received considerable attention in the United States where it forms the basis of a number of regulatory measures (as discussed in the Nordhaus article quoted above). The SCC is, in effect, a measure of the benefit of abatement and provides a benchmark for how much abatement should take place given a particular SCC.
It is a number that can enter into cost-benefit calculations around particular climate policies or projects, showing the degree to which the cost of emissions offset other benefits of the project.
The SCC is a measure of the externality associated with emissions, and from a theoretical perspective represents the value appropriate for inclusion in CBA.
Estimating the SCC
The SCC is usually estimated using an integrated economic/climate model (termed an Integrated Assessment model, or IAM). There are several steps to estimating the SCC including:
modelling the link between emissions and greenhouse gas concentration levels
establishing the link between greenhouse gas concentrations and changes in temperature and other relevant ‘physical’ climate outcomes such as sea level rise, rainfall changes, frequency of storms and so on
establishing a link between the climate outcomes above and relevant economic variables — known as a damage function
calculating future damages for each year, and then using an appropriate discount rate to bring these back to today’s dollars
This process has two implications: first, that the SCC will tend to increase over time (as damages rise in the future); and second, that the value of the SCC (which is a present value) depends on the discount rate chosen. Calculations of the SCC often use discount rates of between 2.5 and 5 per cent.
An important distinction in estimating the SCC is between the ‘domestic’ and ‘international’ SCC. The domestic SCC refers to the cost to an individual country only from a tonne of that country’s emissions, while the international SCC refers to the cost to all countries of tonne of emissions from any one country.
Because of the global externality associated with greenhouse gas emissions, it is generally the international SCC that is recommended for use.
Values for SCC used in the United States
While it has been contentious, in the United States the current recommendation for the SCC is US$51/t for 2020 and US$85/t for 2050 — assuming a discount rate of 3 per cent. For a discussion of recent development in United States Policy, see Krane and Findlay ‘What is the social cost of carbon’.
With a lower discount rate of 2.5 per cent, the SCC increases toUS$76/t in 2020 and US$116/t in 2050.
Suggested SCC for Australia
The SCC has received less attention in Australia for a variety of reasons; in part because the large modelling exercises undertaken by the Australian Government over the past 10 years have focused mostly on the mitigation costs of achieving a particular target and not on the balance of benefits and costs for that target .
In the 2021-22 budget, the ACT Government began a SCC initiative, considering a variety of possible values for the SCC. The ACT Climate Change Council recommended $70/t as a starting point for the SCC in the ACT.
Good practice for including emission values
The information set out above can be used in a particular project CBA by considering the following key steps for analysis.
Step 1. Decide which emission scopes will be included in the analysis.
The minimum is to include all scope 1 emissions, and in most cases scope 2 emissions should also be included.
Upstream scope 3 emissions are also likely to be very useful to include as it will allow the analysis to distinguish between projects that make more or less efficient use of raw materials that contain embodied emissions — cement, concrete and steel being key examples.
Downstream scope 3 emissions is also likely to be useful in further understanding the longer run implications of a project and may help distinguish projects with different effects on users.
There may be different options for projects that involve different designs or configurations that result in different levels of emissions (as measured from any one of the scopes). Understanding these differences may provide useful information particularly as broader concepts of sustainability start to emerge.
The information to calculate emissions from each of these scopes is readily available using emissions factors and material use in construction.
Step 2. Choose and clearly identify the emission value framework used in the analysis, and the underlying logic for that choice.
At present, there is no single method for valuing the emissions estimated in Step 1, so the most important aspect of good practice here is to be very clear about which options was chosen, and why.
Recognise that there is no certainty about appropriate emissions values by choosing a range to incorporate in the analysis (in the same way that analyses are often presented for a range of discount rates).
Step 3. Pay regard to current greenhouse or policies in place that may be relevant to the project either now or over its construction phase.
Climate policies are rapidly developing and current policies in play may influence the conduct of the project CBA.
It is possible that the externality has already been dealt with by explicit or implicit policies somewhere in the production chain. For example, when considering embodied emissions in cement, it is important to take into account emissions policies already in place for the cement industry
Step 4. When reporting results, report the emissions value as a separate item, this will allow the user to easily modify if new information arises, or if policy changes.
Step 5: If more than one scope is being used, report the values for the different scopes separately. This will allow the user to modify results as new information arise and will also allow the comparison of the project with other closely related projects to help identify any potential double counting across projects.
For further information, please contact David Pearce in our Canberra office.