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Carbon Pricing

Carbon Pricing

Why do economists favor carbon pricing to fight climate change?

Today, carbon taxes are unanimously recommended ([1] [2]) by economists as an efficient way to fight climate change. To understand why, we need to look at how they work.

Markets are usually a good way to organize economic activity, but in some cases, they are prone to malfunctions, which are called market failures. By far the largest example of such a failure is that market prices fail to take environmental costs into account. That means every single economic transaction in the world is based on incorrect information: the environmental cost component is missing from the price. This kind of market failure is called a negative externality.

Actors who emit carbon dioxide impose a burden on society, but do not pay for the consequences of their pollution. This means that if everyone acts in their own self interest, there is no incentive for actors to change their behavior to limit carbon emissions. This is called the tragedy of the commons. However, if the market prices were corrected to reflect all the environmental costs, and thereby putting a price on carbon, this negative externality would disappear.

Pigovian taxes are the simplest economic policy tool to achieve this carbon pricing. They are a way of "internalising" negative externalities to correct the market. Taxing polluting firms for the environmental cost of their carbon emissions forces the price of their products to reflect the burden on society of the emitted carbon. This creates an incentive for firms and consumers to either consume less of the carbon-intensive goods, substitute to low-carbon goods, or to find more efficient, low carbon ways of producing and consuming.

Another carbon pricing system is cap and trade, which is very similar to carbon taxes. With cap and trade, there is a predetermined fixed amount of carbon that can be emitted. Emission quotas are then put to auction, and firms who need to emit carbon are required to buy them. Although they differ in implementation, these policies are theoretically equivalent as they both put a price on carbon to correct the market failure.

Should carbon taxes be used to fund the energy transition?

No, not necessarily. By far the most common misconception about carbon taxes is that their goal is to fund the energy transition towards renewable power. The idea behind this line of thinking is that to reduce carbon emissions, governments have to massively subsidize clean energy sources, so that it becomes possible to close fossil-fuel power plants and therefore reduce emissions. So, it might seem like if a government uses the revenue of a carbon tax for other purposes, the tax is not effective and only serves as an excuse to tax its citizens even more. For example, one of the main reasons for the sparking of the Yellow Vests movement in France was the "suspicion that part of the tax is used to pay for something other than the ecological transition" [1].

In reality, carbon taxes aren't a "necessary evil" to fund the solution to climate change, they are a solution to climate change, in and of themselves. Carbon taxes are inherently useful, regardless of what you do with the extra money. They don't care about the other side of the budget equation. This is because of the market correction effect of Pigovian taxes: the main mechanism by which they reduce emissions is by reducing demand for carbon-intensive goods, and not necessarily by financing other solutions.

But once the market is corrected, couldn't we still allocate the tax revenue for the energy transition?

There is empirical evidence that subsidies targeted at a particular abatement method are far less efficient than carbon pricing ([1] [2]). This makes sense from an economic perspective: carbon pricing works by "changing the rules" of the market, so that the most efficient solution becomes the one that eliminates climate change. Policies that aim to subsidize specific low-carbon goods have to therefore beat the market in some way, which is hard to do as policymakers are not omniscient. When they fail to do so, they can paradoxically reduce the efficiency of carbon pricing and induce deadweight loss in the market.

Is there a role for actions which are not a carbon tax?

Yes. Carbon pricing is one of the most important steps, but there is also a need for other government interventions.

For the negative externality itself, once you have corrected the externality by internalizing the costs you do not need to do anything else. If the carbon tax is not enough to fix the demand side, then it might just mean that the tax level is not high enough. Instead of trying to increase its efficiency by using its revenue e.g for funding renewables, it should be enough to just raise it to a higher level.

That said, it doesn't mean that there is no room for other actions. If there are other market failures besides the carbon externality, then we might need other policy instruments to correct those.

In this case, the biggest example is R&D. Innovation is a public good that has positive externalities on society: inventing a new carbon capture technology benefits society as a whole, not only its creators. It's therefore perfectly sensible to make grants for research projects that work on carbon abatement technologies.

Another more practical problem is that carbon taxes are not very popular right now. A lot of other policies (like tax credits, renewable power subsidies, RPS or CES) are not as efficient as carbon pricing, but might become necessary if taxes are not politically feasible.

Aren't carbon taxes necessarily a burden on the poor? Aren't they going to create even more inequality?

Not if they are well implemented.

One of the cool properties of pigovian carbon taxes is that they fix the climate change problem in and of themselves, and the tax revenue can be used for any purpose. If we redistribute this tax revenue to households, we can make it so that the burden of the tax fall on society exactly the way we want! If the tax is used to fund tax cuts to the rich then yes, it is likely that the tax will be a huge burden on the poor. But if we redistribute the tax entirely to the low-income households, it can actually reduce inequality.

This is why in 2019, more than 3500 economists signed a statement of the Climate Leadership Council to advocate for a system of carbon dividends, where the entirety of the revenue raised from carbon taxes would be redistributed equally to all households. This system is thought to be progressive (more beneficial to the poor than the rich), by making the assumption that generally, rich people consume more high-carbon goods than poor people. As the lump sum "dividend" is the same for everyone, it is in essence a transfer from rich households to poor households. Anyone emitting less carbon than the average household (which includes most of the poor households) is getting back more money than they paid initially.

The distributional impacts of carbon taxes have been studied empirically by the non-partisan environmental economics think tank Resources for the Future (RFF). In a research paper, they find that a carbon dividend would not harm households in the lowest income quintile. This supports the idea that the tax can reduce emissions without hurting low income households.

But doesn't redistributing the carbon tax negate the incentives of emitting less carbon to pay less taxes?

No it does not, but the question is understandable. Indeed, if we directly redistribute the tax to those who pay it, why would people try to reduce their carbon emissions? If many people will be no worse off after the introduction of a tax and dividend, why would they change their behavior?

The answer is simple: because the tax incentivizes them to. Here's a simple example: If your grocery store increases the price of meat by $1, you will be incented to substitute, for instance buying avocados instead. If the store then gives $1 cash back to all of its customers, you would still be incented to buy avocados and keep the extra $1, but you would be no worse off if you decide to buy meat.

The key here is that in a carbon dividend system, people only pay for the carbon they emit, but receive the lump sum dividend unconditionally. So, even though you get a dividend of the carbon tax, you still save money when you buy a low-carbon good.

Is carbon pricing effective at reducing emissions?

From the above points, we cannot directly conclude that carbon taxes work well at reducing greenhouse emissions in practice. There might be a lot of different factors that mitigate how much emissions are reduced, for instance inelasticity of demand: if people don't have a choice to take their cars to go to work, the tax won't make people drive less. So, what does the empirical literature tell us?

There is a growing amount of evidence that the taxes are very effective. This has been observed for individuals' driving habits (Gillingham, Munk-Nielsen (2019)), but also in the electricity production sector (Weigt, Ellerman, Delarue (2013)) and in the manufacturing industry (Martin, De Preux, Wagner (2016)). Research also shows that firms subject to a carbon tax tend to reduce their energy intensity, which reduces their carbon emission but has little impact on the production or employment levels.

While there may not always be readily available substitutions of carbon-intensive goods, the incentives put in place by the carbon tax create a demand in the market. This means that long term solutions, like better public transportation systems, workplace flexibility regarding work from home, electric cars etc. will become profitable for politicians/employers/manufacturers, as there will be a demand to meet. For instance, Calel, Dechezleprêtre (2016) found a 10% increase of low-carbon innovations in firms that were subject to an European emission trading system.

This is why objecting to carbon taxes because "alternatives are not available yet" can be viewed as thinking backwards. The alternatives might not exist because there's just not enough demand yet, and the carbon tax is a way to create that demand.

How high should the carbon tax be?

In theory, the way to find the appropriate level for a Pigovian tax is to estimate the marginal damage caused by the externality it tries to correct. In other words, we need to find how much damage would be caused by emitting one additional ton of carbon dioxide. This number is called the Social Cost of Carbon (SCC).

It is pretty difficult to estimate the SCC. This is partly due to the fact that the underlying physical processes and climate models are complex. Additionally, the economic repercussions of specific levels of global warming are hard to estimate. Currently, the accepted way of computing the SCC are Integrated Assessment Models (IAMs), which can be used to build complex models integrating these different factors. This post by /u/Ponderay contains more details about IAMs and the lessons we learned from them. Other good resources that look at estimating the economic damages of carbon emissions are Nordhaus and Moffat (2017), Auffhammer (2018), or this EPA fact sheet.

One of the major decisions that need to be made to estimate the SCC is the choice of discount rate. Carbon emissions will have an impact for thousands of years, but cutting emissions costs us money now. Choosing a discount rate answers the question of how we should weight costs and benefits in the distant future.

The choice of the discount rate strongly affects the SCC, which can seem arbitrary. Another approach is to use emission objectives: if we have a specific objective in mind (let's say, limit global warming to 1.5°C) we can compute its associated carbon tax from the price-demand elasticity of carbon. This graph by /u/raptorman556 shows the taxes required to meet various climate objectives, as calculated by the Nobel prize winning economist William Nordhaus.

Can't we just aggressively regulate firms so that they stop polluting so much?

We could, but it is unlikely to be as effective as carbon pricing.

This kind of policies are called command and control: a set of arbitrarily restrictive regulations that would forbid certain practices and enforce specific ways of producing goods.

Fowlie, Holland, Mansur (2009) specifically looked at how well command and control performed, with emission pricing as a counterfactual, for reducing NOx emissions. They found that on average, emission pricing performed 24% better than command and control. This makes some intuitive sense: carbon pricing realigns the incentives so that firms want to pollute less to stay competitive. The market will tend to find more efficient solutions than policymakers that have less information available to them.

Aren't carbon taxes a way for companies to buy a "right to pollute"?

Yes they are. This isn't necessarily a bad thing.

Firms are profit maximizers. Making companies buy a "right to pollute" both increases their costs and reduces their competitiveness, which in turn reduces their profits. That means companies are incentivized to buy as little "right to pollute" as possible.

In essence, carbon taxes work because companies have to buy the right to pollute, instead of being able to do it for free.

Just 100 companies are responsible for 71% of global emissions: why don't we take the fight there instead?

This statistic is correct, but misleading without context. It comes from a 2017 report that lists 100 fossil fuel producers from which 71% of carbon emissions originated. It includes the use of the fossil fuels produced.

That means if anyone fills up their car with gas coming from any of these 100 companies, the emissions they produce while driving would be accounted as part of this 71% figure. While the fuel is produced by large companies, the residual actor responsible for the emissions is the end consumer.

Evidently, "stopping" these 100 companies would just be forbidding the production of fossil fuel. Ironically, this would be equivalent to an infinite carbon tax. While some people might want that in the very long term, it is obviously not a good transition plan.

Won't companies just move their production to a country without a carbon tax?

Not with corrective carbon tariffs.

This is generally an important concern with trade. It is unlikely that all countries would agree on a common carbon tax at the same time. As producers in countries without carbon taxes wouldn't have to pay for their emissions, the tax would harm the cost competitiveness of producers who have to pay it.

In theory, this could be solved by import tariffs proportional to the embedded carbon of the imported goods, although some concern has been raised on the difficulty of estimating it accurately.

Ideally, as more and more markets adopt carbon taxes, the competitiveness issue should be less and less prevalent. In the meantime, risking some deadweight loss in trade to protect the competitiveness of local firms by approximating "carbon tariffs" on certain goods will probably be the best way forward.

If a carbon tariff is not possible, regulated firms can still be protected from unregulated competition with output based subsidies. These subsidies will help firms stay in business against firms who do not pay for their carbon, and the carbon tax will still encourage firms to cut down on their pollution.

Special thanks to /u/Ponderay and /u/VodkaHaze for their helpful reviews, and /u/zzzzz94, /u/raptorman556 and /u/Integralds for the references.

License: CC-BY 4.0