What should we do about carbon emissions? Economic Policy tools for carbon pricing

Part 4 in our series Putting a Price on carbon

In the fourth entry of our blog post series “Putting a price on carbon,” we explain the optimal economic policy tools states can use to price carbon: a carbon tax and an ETS system, how they work, and their pros and cons.

What options do states have to curb carbon dioxide emissions?

One widely used instrument to curb carbon dioxide emissions is “maximum emission levels,” e.g., stricter emissions standards for cars or heating systems. However, this option is inefficient from an economic perspective: Emission reductions are best used where emission avoidance costs are lowest.

Governments have difficulty achieving this goal by setting emission ceilings for individual products since the state does not have complete information about the emission avoidance costs of all companies (not even in autocratic planned economies.)

If we start from the assumption that each consumer or firm knows best where it can most efficiently cut its own emissions, then there are two other options left: a carbon tax and an emissions trading system (ETS). Both raise the price of carbon but leave more discretion to market participants on how to deal with the increasing costs.

How does a carbon tax work?

A carbon tax establishes a direct price for emitting carbon. The price is supposed to correspond to the so-far uncovered costs to the environment. The idea goes back to British economist Arthur Cecil Pigou, who came up with the idea of taxing negative external effects in the 1920s.

Such a tax is often called a Pigou tax. A prominent example is raising the gasoline tax. A higher fuel tax gives automobile owners an incentive to drive less or switch to cheaper – and less carbon-intensive – modes of transportation.

As a result, carbon emissions go down. If states can estimate the size of this negative external effect, they can try to adjust the tax rate to reach an emission level deemed optimal. Governments can use the returns from the tax to compensate people who cannot avoid driving or invest in research and development of less-carbon-intensive ways to power vehicles.

What are the pros and cons of a carbon tax?

On the one hand, carbon taxes offer reliable planning for market participants. For a particular time horizon, producers and consumers know exactly what costs they have to bear for their carbon dioxide emissions.

States can improve this certainty by fixing the price or determining a price path well into the future. On the other hand, the tax solution comes with high uncertainty for the state. Since it is not aware of the individual preferences of firms and consumers, it does not know whether it will reach its emissions target, and it can only guess the possible revenue impact.

What about an Emissions Trading System (ETS)?

Carbon taxes set a price to lower emissions to a certain level. ETS – or carbon cap-and-trade systems – work the other way round: They establish a ceiling of permitted emissions. States give out emission certificates whose number and size correspond to the overall emissions ceiling.

Emitters can buy and trade these certificates based on their needs. As a result, the certificates’ price is a result of supply and demand. For example, depending on their needs, drivers can buy a certain number of certificates but are still incentivized to drive less.

At the same time, the state receives additional revenue from the sale of the certificates to avoid social hardship and transition the economy to a more sustainable path.

What are the pros and cons of an ETS?

With the certificate solution, the state can precisely limit emissions to the level it deems optimal. It can easily adjust to more ambitious targets by limiting the number of available certificates. However, as the price of the certificates evolves in the marketplace, it is subject to fluctuations of supply and demand.

This fluctuation brings uncertainty for companies and consumers making investment decisions about low carbon products or innovations. They might refrain from buying a new climate-friendly machine or TV since they expect the costs of certificates to go down in the future.

Companies might even try to hedge the system by buying more certificates during periods of low demand and prices (such as the Corona pandemic) to use them later – undercutting incentives to invest in green technologies. To counter these actions, states can either set a relatively high minimum certificate price or establish an independent institution to buy up certificates during periods of low demand.

What about using both? The “waterbed effect.”

One might think that the best path forward is to combine market-based instruments, such as a carbon tax and an ETS, with regulations such as higher standards. However, introducing standards is inefficient if it does not go hand in hand with reducing the number of certificates.

If standards reduce the emission volume for, say, the production of cars, then car companies need fewer certificates. As a result, demand for them diminishes, or supply increases (because companies sell their unused certificates), and the price for certificates drops.

Companies from other sectors then have an incentive to buy more of them instead of increasing their efforts to lower emissions. In total, the overall emission level stays the same. This relocation effect is called the “waterbed effect.”

Where do cutting climate-damaging subsidies fit in?

Cutting emission-promoting subsidies is a strategy complementary to taxing carbon and/or introducing ETS. Climate-damaging subsidies include

• Financial support by the state for companies from carbon-intensive sectors without any compensation in return,
• Tax breaks, loans or guarantees for such firms in general, individual investments in carbon-intensive technologies or for advancing home-ownership,
• Exemptions from additional costs, such as exemption from fossil fuel taxes for agricultural purposes or from the value-added tax for international fights,

Who is currently using which option?

It is not easy to capture the myriad of different carbon pricing combinations that states have put into place. The World Bank’s carbon pricing dashboard [Carbon Pricing Dashboard | Up-to-date overview of carbon pricing initiatives (worldbank.org)] does an excellent job of giving a decent overview.

In May 2020, a total of 61 initiatives to price carbon were in place: 30 of them use a carbon tax, 31 an ETS. Sweden held the record for the highest carbon tax with $119 per ton of CO₂ equivalents (CO₂e), followed by Switzerland and Liechtenstein ($99 each) and Finland ($68, covering transport emissions only). The highest price for certificates could be found in South Korea ($33).

Read more from our Putting a Price on Carbon Series

Part One: Carbon Pricing – 7 questions on an emerging global economic dynamic

Part Two: Carbon Emissions – Where’s the problem?

Part Three: Carbon Dioxide Emissions – How Do We Arrive at a Price Tag?