Everything You Always Wanted to Know About Carbon Pricing (But Were Afraid to Ask)
By Pegah Jalali
The market helped change the climate. Now can it help save the planet?
We used to think of climate change as a problem for future generations, or something that only affects the Earth’s poles. Not anymore. Climate change is here, and we are experiencing it through extreme temperatures, large and frequent wildfires, air pollution, hurricanes, and droughts. There is a strong consensus among scientists that human-generated greenhouse gases are responsible for the climate changing due to rising global temperatures (Cook et al., 2016). We extract fossil fuels from under the ground, burn them and those gasses become trapped in the atmosphere adding to the thermal energy in the system. This added energy does not leave the atmosphere, and therefore has to manifest itself in one way or the other. If we do not cut our emissions drastically, we will keep adding to the energy trapped in the Earth’s atmosphere, and the results will likely be catastrophic.
In order to soften the blow of climate change and reduce emissions, we will need to change our economic policies to address the problem.
Free market economics is based on the idea that while individuals act in their own self-interests, the market as a whole allocates resources efficiently. The “invisible hand”of the market, or so the theory goes, delivers the best possible social and economic outcomes. There are, however, situations where the market is unable to deliver the most efficient social outcome, which is known as market failure.
One such market failure occurs when externalities are present. Externalities arise when the actions of one person make another person worse or better off, but the first person neither bears the costs nor receives the benefits of doing so. Greenhouse gas emissions are an example of negative externalities: a factory that emits harmful gases to the atmosphere imposes damages to the whole society; however, this social cost is not reflected in the private costs that the factory owner pays in purchasing materials and labor. Thus, the factory’s cost of greenhouse gas emissions is lower than what it should be given the societal cost of climate change, and the factory has no inherent self-interest in reducing emissions. In this case, government intervention is necessary to fix this market failure.
Economists agree that putting a price on carbon is the most cost-effective way of reducing the greenhouse gas emissions created by burning fossil fuels (OECD, 2013). By instituting a price, governments can try to minimize the gap between the actual costs, or what the free market says it should cost, and the true cost of those emissions to society (social cost). There are two general market approaches for regulating carbon emissions: quantity instruments (cap-and-trade), and price instruments (taxes and fees).
Cap-and-trade
Under a cap-and-trade policy, the government issues emissions allowances (or permits) to facilities. Polluters have to buy allowances equal to the amount that they pollute. Allowances can be traded, and the price of carbon is determined by the market. If the cost of decreasing one ton of pollution is higher than the allowance price, the facility purchases allowances from a polluter with a lower cost of reducing emissions. Cap-and-trade has sometimes been seen as a market-friendly approach because it allows the market to dictate the price of carbon, not the government.
The European Union Emissions Trading System (ETS) has been in effect since 2005 and now prices carbon at about $25 per ton. California is an example of a US state with a cap-and-trade system and their price is currently around $17 per ton. There are important considerations to keep in mind when designing a cap-and-trade program:
- Emissions cap:Many governments choose to distribute all or a majority of the allowances for free to avoid political opposition in the beginning years of the program. In this case, having an accurate estimate of required allowances is critical. The European Union did not have accurate emissions data in the beginning of the ETS program, so allowances were over-supplied and therefore the prices were much lower than what would be needed to meet carbon-reduction goals.
- Initial distribution of allowances: Initial allocation is very important if the allowances are distributed free of charge. The firms that receive more allowances than they need may bank allowances and not enter the market for a long time. A thin market increases uncertainty about allowance price and the perceived fairness of the program. A larger market makes it more difficult for price manipulation to happen and a larger quantity of allowances for sale with more participants increases the quality of the price signal (Burtraw and McCormack, 2017). For these reasons, transparency about the allocation process is very important.
- Auctions: In order to avoid the pitfalls of free allocation (and raise revenue) governments might sell some or all allowances in an auction. Auctions are a fast and efficient way of discovering carbon price; however, they might impose high costs on consumers like utility customers, business owners, and even governments themselves if other regulations are not in place to protect them.
- Banking and offsets: To provide more flexibility and protect industries from overly high costs of reducing carbon emissions, cap-and-trade programs allow for the banking of allowances for future use and purchase of offsets (e.g. planting trees). Since offsets usually do not provide local benefits and do not incentivize emission cuts, cap-and-trade programs only devote a small share of emission reductions to offsets.
Carbon taxes
A carbon tax puts a tax on fossil fuels in proportion to their carbon content and therefore their societal cost. A tax increases the costs of burning fossil fuels, thereby decreasing how much carbon is absorbed by the atmosphere. A carbon tax internalizes the externality by assigning the appropriate cost at the point of purchase and removes the inefficiencies of the market. By taxing carbon, the price is fixed, and the quantity of emissions will be determined in the market.
Economists recommend setting a tax based on the social cost of carbon—the dollar value of long-term damages done by a ton of carbon dioxide emission in a given year (EPA, 2016). The social cost of carbon is estimated to be about $50 per ton in 2020 (GAO, 2020). Revenues from a carbon tax can be returned to individuals in the form of a lump-sum rebate or a decrease in other taxes (such as income or sales tax) or invested in climate change mitigation programs. British Columbia’s revenue-neutral carbon tax reduces other taxes to decrease the burden on workers and employers. On April 1, 2019, BC’s carbon tax rate rose from $35 to $40 per ton of CO2.
Which one is best?
A carbon tax is quicker to implement and easier from an administrative point of view. Its implementation requires no extra bureaucracy and no lengthy negotiations like what take place to determine the initial allowances in a cap-and-trade system. It is also more transparent, minimizes government involvement and avoids creation of new markets that raise imperfections and possibility of manipulation. However, under a cap-and-trade system, borrowing, banking and extended compliance periods allow firms the flexibility to make compliance planning decisions on a multi-year basis. Moreover, cap-and-trade is the only instrument that guarantees the desired emission reductions. It is also seen as more attractive politically.
Carbon pollution and carbon prices both disproportionately affect people who earn low incomes. Who is affected by cap-and-trade and tax policies, and how much they’re impacted by them, largely depends on their design and the conditions related to their implementation. A successful carbon pricing mechanism offsets all or parts of these negative impacts on people who are most affected, such as people of color and low-income communities.
Pricing carbon makes polluters pay the cost of their emissions and holds them accountable for the costs they impose on society. By not addressing this issue head-on, we are paying the price of pollution in the form of lost economic opportunities like losing the outdoor recreation, tourism, and ski industries. We also share in the costs of mitigating natural disasters created by climate change like floods and wildfires. Pollution and smoke from wildfires are resulting in increases in respiratory and cardiovascular diseases, and most importantly, people are losing their lives and livelihoods. If we do not price carbon, our society will continue to bear these costs, and we will lose more than just money. We will lose our very way of life.
That’s something you can’t put a price on.
References:
Burtraw, Dallas, and Kristen McCormack. “Consignment auctions of free emissions allowances.” Energy Policy 107 (2017): 337-344.
EPA, Technical Support Document: Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis Under Executive Order 12866, August 2016. https://19january2017snapshot.epa.gov/climatechange/social-cost-carbon_.html
J. Cook, et al, Consensus on consensus: a synthesis of consensus estimates on human-caused global warming, Environmental Research Letters Vol. 11 No. 4, (13 April 2016); DOI:10.1088/1748-9326/11/4/048002
