Beyond the Fixation on Carbon Pricing: A New Framework for Designing Climate Policy

The Case against Carbon Prices

Effects of carbon pricing on inflation

Canadian economists, politicians and even environmentalists are lining up enthusiastically behind pricing carbon as the solution to controlling greenhouse gas emissions in this country. Pricing carbon (or, more accurately, pricing carbon dioxide) is not just a fashionable policy approach; it is the most efficient way we have to ration emissions, as it allows emitters — businesses and consumers — to make the most rational decisions about where it makes economic sense to curtail carbon and where it does not. Painfully costly command-and-control reductions make little sense in Canada, given our marginal contribution to global emissions. When practiced globally, a carbon price deals with Canadian emitters as fairly as it does others. However, a beneficial outcome is not guaranteed: certain rules must be observed in order for carbon pricing to have its intended effect of achieving the optimal balance between emission reduction and economic growth. First and foremost, carbon pricing only works in the absence of any other emission regulations. If pricing is layered on top of an emission-regulating regime already in place (such as emission caps or feed-in-tariff programs), it will not only fail to produce the desired effects in terms of emission rationing, it will have distortionary effects that cause disproportionate damage in the economy. Carbon taxes are meant to replace all other climate-related regulation, while the revenue from the taxes should not be funnelled into substitute goods, like renewable power (pricing lets the market decide which of those substitutes are worth funding) but returned directly to taxpayers. The price of carbon is set according to what is known as the “social cost of carbon” — the quantified value of the impact that an emitted tonne of carbon today will have on humans in the future (adjusted to present value). That cost is not limitless; there is a point at which the cost of abating a tonne of carbon outweighs the cost of the impact that same tonne will have in the future (and some of that impact may be positive, not necessarily negative). Therefore, another important rule for creating a proper carbon-pricing system is to be as careful as possible in estimating the social cost of carbon. Estimates are all we have, and they vary wildly, from negative — meaning any carbon price is too high — to hundreds of dollars per tonne. Minor adjustments to the calculation’s inputs, such as the discount rate used and fluctuating estimates about climate sensitivity, produce dramatically different estimates. The social cost of carbon must be set with extreme prudence in order to set a reasonable carbon price. Whatever the carbon price, it will necessarily detract some degree from economic growth. But when a carbon tax is added in the presence of other taxes, such as income, sales and corporate taxes, its effect will be even more harmful, due to the compounded burden on economic activity. As a result, whatever the social cost of carbon is determined to be, the carbon price must be discounted below it by the marginal cost of public funds (MCPF) — that is, the economic cost of the government raising an additional dollar of tax, on top of what is already being raised. This varies by province, but estimates suggest that in Canada, the optimal carbon tax should be about half of the estimated social cost of carbon. Finally, it needs to be remembered that carbon pricing works because it is a marketbased policy: it works with market forces, not against them. But that means the policy maker needs to let the market play its role. Choosing the price means the market will set the quantity, and vice-versa. In response to a well-designed carbon price, the market may only reduce emissions a little, especially in the short term. Policy makers need to resist the temptation to reintroduce command-and-control rules and arbitrary quantity targets, which will simply unravel the gains from adopting the policy in the first place. There may be many reasons to recommend carbon pricing as climate policy, but if it is implemented without diligently abiding by the principles that make it work, it will not work as planned, and the harm to the Canadian economy could well outweigh the benefits created by reducing our country’s already negligible level of global CO2 emissions.

Social value of mitigation activities and forms of carbon pricing

Carbon pricing is about the explicit pricing of greenhouse gas (GHG) emissions, of which carbon dioxide is the most important. GHG emissions, which are normally measured in tonnes of carbon dioxide equivalent units, are responsible for global warming and hence the greatest environmental externality of our age. Carbon pricing is a mechanism for making society account for the external damage caused by carbon emissions in economic decision making. There are two main ways of pricing carbon dioxide emissions, either via a carbon tax or via the introduction of an emissions trading scheme whereby those emitting carbon into the atmosphere are required to surrender permits which reflect the quantity of emissions they are responsible for. These emission permits are tradeable and hence command a price and, in some respects, operate in a similar way to a carbon tax. Thus, we will discuss both carbon pricing and emissions trading, as the literature on both is closely related. Emissions trading exists for certain other pollutants (such as sulphur dioxide) and we will discuss some of the literature related to this. However, most of the literature on emissions trading relates to carbon dioxide emissions, as these are by far the most valuable traded emissions globally. The literature on carbon pricing and emissions trading is wide ranging and constantly being updated with new analyses. Much of the literature is written by economists who are seeking to apply market-based approaches to the solution of environmental problems. The article starts by looking at the general context in which carbon pricing and emissions trading sits before discussing introductory texts which relate to the subject and going on to introduce the relevant classic literature in environmental economics. It then proceeds to more applied literature, beginning with discussions of early examples of emissions trading and carbon taxation, before continuing to studies of the impact of carbon pricing and emissions trading and those which explain the nature of the schemes we observe. The article continues with literature which looks at the Europe Union Emissions Trading Scheme (EU ETS) for GHGs and other important carbon pricing schemes. It then moves on to the literature on the prospects for a global carbon price, on interactions with other climate policies, on distributional concerns about the imposition of a price on carbon. Finally, it concludes with an introduction to relevant official publications and sources of data on carbon emissions and carbon prices.

Canadian economists, politicians and even environmentalists are lining up enthusiastically behind pricing carbon as the solution to controlling greenhouse gas emissions in this country. Pricing carbon (or, more accurately, pricing carbon dioxide) is not just a fashionable policy approach; it is the most efficient way we have to ration emissions, as it allows emitters — businesses and consumers — to make the most rational decisions about where it makes economic sense to curtail carbon and where it does not. Painfully costly command-and-control reductions make little sense in Canada, given our marginal contribution to global emissions. When practiced globally, a carbon price deals with Canadian emitters as fairly as it does others. However, a beneficial outcome is not guaranteed: certain rules must be observed in order for carbon pricing to have its intended effect of achieving the optimal balance between emission reduction and economic growth. First and foremost, carbon pricing only works in the absence of any other emission regulations. If pricing is layered on top of an emission-regulating regime already in place (such as emission caps or feed-in-tariff programs), it will not only fail to produce the desired effects in terms of emission rationing, it will have distortionary effects that cause disproportionate damage in the economy. Carbon taxes are meant to replace all other climate-related regulation, while the revenue from the taxes should not be funnelled into substitute goods, like renewable power (pricing lets the market decide which of those substitutes are worth funding) but returned directly to taxpayers. The price of carbon is set according to what is known as the “social cost of carbon” — the quantified value of the impact that an emitted tonne of carbon today will have on humans in the future (adjusted to present value). That cost is not limitless; there is a point at which the cost of abating a tonne of carbon outweighs the cost of the impact that same tonne will have in the future (and some of that impact may be positive, not necessarily negative). Therefore, another important rule for creating a proper carbon-pricing system is to be as careful as possible in estimating the social cost of carbon. Estimates are all we have, and they vary wildly, from negative — meaning any carbon price is too high — to hundreds of dollars per tonne. Minor adjustments to the calculation’s inputs, such as the discount rate used and fluctuating estimates about climate sensitivity, produce dramatically different estimates. The social cost of carbon must be set with extreme prudence in order to set a reasonable carbon price. Whatever the carbon price, it will necessarily detract some degree from economic growth. But when a carbon tax is added in the presence of other taxes, such as income, sales and corporate taxes, its effect will be even more harmful, due to the compounded burden on economic activity. As a result, whatever the social cost of carbon is determined to be, the carbon price must be discounted below it by the marginal cost of public funds (MCPF) — that is, the economic cost of the government raising an additional dollar of tax, on top of what is already being raised. This varies by province, but estimates suggest that in Canada, the optimal carbon tax should be about half of the estimated social cost of carbon. Finally, it needs to be remembered that carbon pricing works because it is a marketbased policy: it works with market forces, not against them. But that means the policy maker needs to let the market play its role. Choosing the price means the market will set the quantity, and vice-versa. In response to a well-designed carbon price, the market may only reduce emissions a little, especially in the short term. Policy makers need to resist the temptation to reintroduce command-and-control rules and arbitrary quantity targets, which will simply unravel the gains from adopting the policy in the first place. There may be many reasons to recommend carbon pricing as climate policy, but if it is implemented without diligently abiding by the principles that make it work, it will not work as planned, and the harm to the Canadian economy could well outweigh the benefits created by reducing our country’s already negligible level of global CO2 emissions.

Carbon pricing is a recurrent theme in debates on climate policy. Discarded at the 2009COPin Copenhagen, it remained part of deliberations for a climate agreement in subsequent years. As there is still much misunderstanding about the many reasons to implement a global carbon price, ideological resistance against it prospers. Here, we present the main arguments for carbon pricing, to stimulate a fair and well‐informed discussion about it. These include considerations that have received little attention so far. We stress that a main reason to use carbon pricing is environmental effectiveness at a relatively low cost, which in turn contributes to enhance social and political acceptability of climate policy. This includes the property that corrected prices stimulate rapid environmental innovations. These arguments are underappreciated in the public debate, where pricing is frequently downplayed and the erroneous view that innovation policies are sufficient is widespread. Carbon pricing and technology policies are, though, largely complementary and thus are both needed for effective climate policy. We also comment on the complementarity of other instruments to carbon pricing. We further discuss distributional consequences of carbon pricing and present suggestions on how to address these. Other political economy issues that receive attention are lobbying, co‐benefits, international policy coordination, motivational crowding in/out, and long‐term commitment. The overview ends with reflections on implementing a global carbon price, whether through a carbon tax or emissions trading. The discussion goes beyond traditional arguments from environmental economics by including relevant insights from energy research and innovation studies as well.WIREs Clim Change2017, 8:e462. doi: 10.1002/wcc.462This article is categorized under:Climate Economics > Economics of Mitigation

The Paris Agreement calls for a cooperative response with the aim of limiting global warming to well below two degrees Celsius above pre-industrial levels while reaffirming the principles of equity and common, but differentiated responsibilities and capabilities1. Although the goal is clear, the approach required to achieve it is not. Cap-and-trade policies using uniform carbon prices could produce cost-effective reductions of global carbon emissions, but tend to impose relatively high mitigation costs on developing and emerging economies. Huge international financial transfers are required to complement cap-and-trade to achieve equal sharing of effort, defined as an equal distribution of mitigation costs as a share of income2,3, and therefore the cap-and-trade policy is often perceived as infringing on national sovereignty2-7. Here we show that a strategy of international financial transfers guided by moderate deviations from uniform carbon pricing could achieve the goal without straining either the economies or sovereignty of nations. We use the integrated assessment model REMIND-MAgPIE to analyse alternative policies: financial transfers in uniform carbon pricing systems, differentiated carbon pricing in the absence of financial transfers, or a hybrid combining financial transfers and differentiated carbon prices. Under uniform carbon prices, apresentvalueof international financial transfers of 4.4 trillion US dollars over the next 80 years to 2100 would be required to equalize effort. By contrast, achieving equal effort without financial transfers requires carbon prices in advanced countries to exceed those in developing countries by a factor of more than 100, leading to efficiency losses of 2.6 trillion US dollars. Hybrid solutions reveal a strongly nonlinear trade-off between cost efficiency and sovereignty: moderate deviations from uniform carbon prices strongly reduce financial transfers at relatively small efficiency losses and moderate financial transfers substantially reduce inefficiencies by narrowing the carbon price spread. We also identify risks and adverse consequences of carbon price differentiation due to market distortions that can undermine environmental sustainability targets8,9. Quantifying the advantages and risks of carbon price differentiation provides insight into climate and sector-specific policy mixes.

An increase in policy ambition is needed to close the gaps related to climate change mitigation and those required to meet the targets of Paris Agreement. This article examines the contemporary situation of carbon pricing and suggests how carbon costs would help countries adopt comprehensive climate policies. This paper explores the carbon pricing imitative across different regions and the associated issues and proposes how to format holistic, ambitious approaches for effective implementation of carbon pricing. The carbon taxes and emission trading programs are the primary tools for implementation costs. Carbon taxes, fuel taxes, subsidies for fossil energy, and emission trading systems (ETSs) all contribute to these costs. Different countries have adopted different approaches to adopt and mitigate the adverse effect of carbon emissions, but coordinated and integrated efforts are needed. This paper emphasizes the effective carbon pricing and integrating role of finance departments in climate policy; new synergies can be developed to boost government agencies' ability to implement climate policy. Governments may increase their involvement in carbon pricing beyond direct carbon pricing if they implement efficient carbon pricing. Governments, international organizations, and civil society can all play a role in pushing for effective carbon prices to encourage more ambitious targets. Furthermore, the article stresses the need for open communication and a proper understanding of carbon pricing potential to implement climate policy.

Carbon pricing has been hailed as an essential component of any sensible climate policy. Internalize the externalities, the logic goes, and polluters will change their behavior. The theory is elegant, but has carbon pricing worked in practice? Despite a voluminous literature on the topic, there are surprisingly few works that conduct an ex-post analysis, examining how carbon pricing has actually performed. This paper provides a meta-review of ex-post quantitative evaluations of carbon pricing policies around the world since 1990. Four findings stand out. First, though carbon pricing has dominated many political discussions of climate change, only 37 studies assess the actual effects of the policy on emissions reductions, and the vast majority of these are focused on Europe. Second, the majority of studies suggest that the aggregate reductions from carbon pricing on emissions are limited—generally between 0% and 2% per year. However, there is considerable variation across sectors. Third, in general, carbon taxes perform better than emissions trading schemes (ETSs). Finally, studies of the EU-ETS, the oldest ETS, indicate limited average annual reductions—ranging from 0% to 1.5% per annum. For comparison, the IPCC states that emissions must fall by 45% below 2010 levels by 2030 in order to limit warming to 1.5 °C—the goal set by the Paris Agreement (Intergovernmental Panel on Climate Change 2018). Overall, the evidence indicates that carbon pricing has a limited impact on emissions.

Green industrial policy can strengthen carbon pricing but not replace it

This paper examines carbon emission allowances and pricing mechanisms in the context of climate change, utilizing nonlinear evolution equation theory. Through empirical analysis of European Union EUA option data using the EGARCH model, the study identifies non-normal distribution characteristics in carbon market returns and explores how policy innovations influence price fluctuations. A key contribution is its application of soliton theory to analyze carbon price dynamics. By employing integrable systems like the (1 + 1)-dimensional Boussinesq equation, it aims to develop a mathematical model for carbon price stability. The research calculates the Lax pair for this system and uses Hirota’s bilinear method among other techniques to investigate whether carbon prices can exhibit soliton phenomena with consistent waveforms and amplitudes. This work provides insights into the carbon market’s dynamics and lays a theoretical foundation for better simulation, market behavior prediction, and optimization of climate policies.

The dynamic relationships between carbon prices and policy uncertainties

This research work provides a strategic analysis of the implications of carbon pricing mechanisms for global environmental sustainability and economic growth. This work conducts an orderly review of literature and content analysis in formulating findings from published peer-reviewed journals, reports, and policy releases between the time frame 2010 and 2024. The goal is to find out if carbon pricing works to lower greenhouse gas emissions, to investigate the economic effects of such pricing, to investigate the environmental benefits of such pricing, and to understand why countries need to work together to make carbon pricing strategies more effective. Through the utilization of a stringent search approach that is directed by specific inclusion and exclusion criteria, the research strategy guarantees that the data that is being reviewed is not only pertinent but also of high quality. It is clear from the findings that carbon pricing regimes such as cap-and-trade and carbon taxes are of critical significance in terms of bringing about economic transformation, fostering growth, and combating climate change concerns. According to the most important findings, carbon pricing has the potential to effectively promote the development of environmentally friendly technology, solve issues of social justice, and emphasize the importance of global policy cooperation to handle challenges such as competition and carbon leakage across international borders. Policymaker proposals stress the need for international cooperation, the need for complete solutions combining carbon pricing with comprehensive economic and environmental policies, and the need for continuous research to improve carbon pricing models and strategies. This study improves the present conversation on carbon pricing by offering an understanding of its possible role as a basic component of sustainable economic policy and world climate governance.

Optimal international technology cooperation for the low-carbon transformation