Thinking beyond a global carbon price

By MARIANNE FAY AND STEPHANE HALLEGATTE | WORLD BANK

In December talks in Paris involving more than 200 countries may result in a new agreement aimed at reducing carbon emissions. In the months leading up to the conference, The Economist will be publishing guest columns by experts on the economic issues involved. In our last post, Christian Gollier and Jean Tirole of the Toulouse School of Economics explained why a carbon tax, or a carbon cap-and-trade system, should be policymakers' preferred weapon. Here, Marianne Fay and Stephane Hallegatte from the World Bank explain what governments can do to achieve their climate targets.

LAST month the G7 heads of state reaffirmed their commitment to stabilising global temperature rise at no more than 2°C above preindustrial levels. That in itself was not new: the 2°C goal was formally adopted in 2010 by the 195 member countries of the UNFCCC. What was new was the explicit mention in the G7 communiqué of what it will take to stabilise at or near 2°C: the need to reduce net global carbon emissions to zero before the end of the century.

While the science behind this may be complex (and is laid out in the IPCC’s 5th Assessment Report), the intuition is not. As long as we emit more carbon than can be absorbed by natural sinks such as forests, concentrations of CO2 in the atmosphere will keep rising, and the climate will keep warming. So while the 2°C target increases the urgency of action, stabilising climate change at any temperature requires achieving zero net emissions.

What does it take for such a fundamental transition of the global economy to happen? In their recent blog, Professors Tirole and Gollier gave us the standard economist’s answer: put the same price on carbon in all sectors and all countries. This way, the environmental cost of economic activities can become apparent to investors and consumers, and markets can efficiently work to reduce emissions, wherever they are the cheapest.

There are two shortcomings to this approach: countries have different economic and political conditions, and a carbon price alone cannot solve the climate change problem—complementary policies are necessary.

Looking at carbon prices through a narrow climate lens provides only part of the picture. Over and above environmental concerns, carbon and energy taxes make economic and fiscal sense, making them relevant for both developing and developed countries. By taxing the “bads” (carbon), countries can reduce taxes on the “goods” (labor and capital). Carbon taxes are also easier to administer as carbon sources are concentrated. Experience shows that tax evasion for carbon or energy taxes is much lower than for VAT or income taxes (e.g. 1% instead of 17% in the UK). This should make carbon taxes the darling of any tax collector, especially in countries with weak fiscal administration and a large informal sector.

Fossil fuel consumption also affects more than just the climate. Congestion and air pollution are also undesirable by-products. Estimates are that health impacts alone could justify a carbon price well above $30 per ton. Since fiscal needs and local co-benefits vary across countries and contexts, there is no reason for an “optimal” carbon price to be the same everywhere.

Further, introducing a global carbon price may not be realistic. The availability of cheap, convenient low-carbon alternatives to fossil fuels influences the political and social acceptability of carbon prices. Actual, or even perceived, adverse effects on vulnerable populations or opposition by powerful lobbies can make it difficult to put in place the carbon price that theory recommends. Again, these constraints differ across countries, and a global carbon price would be driven by the strictest of these constraints, probably making it too low to have a real impact on global warming.

Today, more than 40 national and 20 subnational jurisdictions, in both developed and developing countries, have put a price on carbon or are in the process of doing so. They do so to mitigate climate change, but also to raise revenue and reduce budget deficits, or to reduce fossil fuel use and its consequences on health, congestion, and energy imports. Carbon prices range from less than $1 per ton in Mexico to more than $100 per ton in Sweden. Asking for a global carbon price could easily play against the current momentum where many countries implement pricing options that are tailored to their political and institutional context. Once countries have carbon pricing instruments, it is also always possible to make taxes converge or to link carbon markets.

And finally, one should not forget that while carbon pricing is an efficient instrument to address the market failure that unpriced carbon represents, multiple market failures and distortions are responsible for climate change and must be addressed if we are to decarbonise the world economy. Complementary measures are thus vital to make prices more effective and politically acceptable.

To ensure that technologies such as solar power or electric vehicles are available and affordable, governments can provide dedicated support to low-carbon innovation, as we discuss in our recent report Decarbonizing Development: Three Steps to a Zero-Carbon Future. Public investments, temporary subsidies, performance standards, regulation, and trade policies can help to address the “knowledge externality” that discourages firms to invest in innovation (as new knowledge can easily be acquired by competitors), our tendency to innovate where we have innovated before, and accelerate the diffusion of new technologies. Similarly, governments need to step in where high up-front costs and distant break-even points prevent markets from providing the necessary infrastructure, such as for large-scale low-carbon transport infrastructure or electricity networks capable of handling high shares of renewable energy.

Governments should also play a role whenever distorted incentives or behavioural biases prevent prices alone from succeeding. Simple (but enforced) energy efficiency regulation can stop landlords from buying inefficient equipment and sticking the tenants with the energy bills. Labelling and certification schemes can help to increase consumer awareness of low-carbon, low-energy-cost alternatives. And finally, governments have a key role to play to smooth the transition and protect those who stand to be most affected–using resources from carbon pricing where implementing, and avoiding concentrated losses.

What each country needs is a policy package that includes carbon pricing tailored to its specific needs and political constraints, and complementary policies to make carbon prices effective and acceptable.

Marianne Fay is the chief economist of the Climate Change Group at the World Bank. Stephane Hallegatte is a senior economist at the Climate Change Group.