Carbon pricing: yes, but not in isolation

Jul 24, 2017 | Carbon pricing

For all of its ‘wickedness’, solving climate change is actually conceptually straightforward: reduce emissions of greenhouse gases and enhance carbon sinks. Yes, albedo, aerosols and black carbon have roles to play, but climate change mitigation is primarily a gas management issue.

As an aside, if the gases in question were visible, we probably wouldn’t have a problem on our hands: governments would long ago have acted to prevent our skies turning pink, yellow or green. But carbon dioxide, methane, nitrous oxide and the exotic industrial greenhouse gases (such as dichlorodifluoromethane and pentafluorobutane) are colourless. Climate change is an extreme example of ‘out of sight, out of mind’, at least as far as policy-makers are concerned.

In theory, putting a price on carbon is the most effective means of reducing emissions. In the real world, this can be achieved through a price mechanism (such as a carbon tax) or through a quantity mechanism (such as an emissions trading scheme or a carbon credit scheme); in business and policy scenario planning, it can be achieved through imposition of a ‘shadow’ price, such as a Social Cost of Carbon.

Although the details (and the pros and cons) vary, the purpose of all these approaches is to ‘internalise’ the otherwise-unpriced economic costs of carbon emissions into individuals’ and corporations’ decision-making, thereby reducing emissions.

The attraction of carbon pricing is that mitigation decisions are devolved to economic agents, who can respond to higher input costs (for example, of energy and raw materials) and more expensive goods and services by switching to alternatives, adopting new technology and reducing energy consumption. Carbon pricing can thus encompass an enormous range of individual mitigation circumstances without the need for an omniscient government planner or elaborate governance infrastructure.

According to the World Bank, 40 countries and more than 25 sub-national jurisdictions use carbon pricing mechanisms or are planning to implement them. Over the past decade, the number of jurisdictions with carbon pricing initiatives has doubled. In addition, Member States of the International Civil Aviation Organisation (ICAO) have agreed on the first global sectoral carbon pricing initiative, CORSIA. More than 1,000 companies use an internal carbon price, a number that is set to increase rapidly now that the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures has recommended the practice.

Regional, national and sub-national carbon pricing initiatives that are under implementation and consideration. Credit: World Bank.

The prices used vary considerably, ranging from US$ 1/tCO2e to US$ 126/tCO2e. Three-quarters of covered emissions are priced below US$ 10/tCO2e, which falls a long way short of the prices – US$ 40-80/tCO2e by 2020 and US$50-100/tCO2e by 2030 – recently identified by the High-Level Commission on Carbon Pricing as being necessary to stay below 2°C global warming.

The range of carbon prices in use stems partly from users’ different needs (different national circumstances, different cost profiles, different expectations about the future impact of climate change and so on) and partly from the intricacies of estimating the ‘correct’ price – as amply demonstrated by the modelling contortions required to generate a Social Cost of Carbon number.

But regardless of the practical difficulties of estimating carbon prices, such pricing is inevitable. After all, not imposing a carbon price is mathematically equivalent to setting the price to zero – a level that, however evasive the ‘real’ price, is undoubtedly far too low.

So far, so neoclassical.

But carbon pricing suffers from two key weaknesses.

The first – and the most manageable – is that a rapidly-changing carbon price, constantly buffeted by the forces of supply and demand, can just as easily become a brake on investment as it can a catalyst, a business risk rather than a business opportunity. Witness the travails of the CDM, where CER prices are currently trading at US$ 0.24 compared with their US$ 20 peak in 2008, with the result that additions to the project pipeline have slowed to a trickle and many registered projects – perhaps as many as half – have effectively walked away from the Mechanism.

Most obviously, price variability can be addressed by opting for a carbon tax rather than a quantity-based mechanism. And there are technical fixes (the use of banking, imposing a floor price, ex post cap adjustments, ETS linking) that can straightforwardly limit the range of price fluctuations – if the politics allow.

The second weakness is more fundamental. Prices work by sending signals to economic agents. But if those agents are unable or unwilling to react to price changes, then the efficacy of the pricing instrument is fundamentally undermined.

This can be the case, for example, in sectors characterised by sticky prices or high uncertainty (including uncertainty about a government’s or regulator’s commitment to sustaining carbon pricing in the future); where agents do not act rationally (in the narrow economic sense) due, for example, to habits, herd behaviour or status-seeking; and where market barriers – awareness, information, risk aversion, capital market failings, principal-agent problems and others – prevent action even by otherwise motivated agents.

A classic example is provided by the famous McKinsey (actually Stockholm Environment Initiative) marginal abatement curve. This has attracted some criticism over the years but very nicely illustrates the paradox – albeit welcome and albeit only paradoxical to economists who don’t get out much – that a large fraction of mitigation opportunities (possibly as much as 11 GtCO2e in 2030, or 30% of the total abatement potential) can be achieved at negative cost – in other words, at a profit (revenues or cost savings over the course of the investment outweigh the upfront costs). This applies in particular to energy efficiency and renewable energy mitigation solutions.

Global emissions abatement curve beyond business-as-usual in 2030. Credit: McKinsey.

If economic agents act rationally and respond to price signals, such negative cost mitigation opportunities should not exist. The fact that they do exist means either that agents are not fully rational (probably true) and/or that there are non-price market barriers preventing action (undoubtedly true).

In other words, price is not everything. Establishing a carbon price will, in many circumstances, be a necessary but not sufficient condition to catalyse mitigation efforts. A carbon pricing instrument, whether a tax or a quantity-based instrument, needs an enabling environment – a ‘stack’ of barrier-removal policies and instruments, tailored to particular sectoral and technological needs – to function effectively.

To its credit, the High-Level Commission on Carbon Pricing explicitly highlights the need for such complementary policies to augment market failures and imperfections. The Commission could perhaps have drawn greater attention to the potential cost-reduction benefits of policy stacks (as opposed to pricing instruments in isolation), but the message is clear: the future lies in intelligently-constructed policy stacks underpinned by carbon pricing instruments.