The Role Of Carbon Prices In The Energy Transition
Data from the US National Aeronautics and Space Administration (NASA) and National Oceanic and Atmospheric Administration (NOAA) show that the past decade was the hottest on record. The world needs a decisive shift if it is to move to a low-carbon pathway consistent with meeting the Paris climate goals.
The good news is that many of the technologies necessary to achieve such a shift – renewable energies led by wind and solar power, biofuels, and carbon capture, use, and storage – exist today. These energy sources and technologies will improve over time, and their costs will continue to fall as their deployment increases, but the basic elements necessary for a rapid transition to a low- or zero-carbon energy system exist today. The challenge is to harness government and societal willingness to apply them at the necessary pace and scale.
Carbon prices can – and should – play a central role in driving the application of these technologies and alternative energy sources. They provide incentives to everyone – energy producers, consumers, investors, and financial markets – to shift towards low-carbon technologies and activities. This article proposes five principles to help guide future carbon pricing policies.
Principle 1: carbon prices should play a central role in reducing carbon emissions.
Economics is clear that the best policy instrument to deal with the negative externalities associated with carbon emissions is a carbon price. Economists advocate for a so-called Pigouvian tax, which equates the price of carbon with the social cost of its negative externalities. The primary aim of such a tax is to change behaviour rather than to raise revenue (although the resulting revenue can be useful; see Principle 4).
There are two strong arguments in favour of carbon prices. First, a price on carbon (such as a carbon tax or from a cap-andtrade system) directly penalizes the negative externalities according to the ‘polluter pays’ principle, ensuring that energy producers and consumers internalize the costs of carbon-intensive fuels and activities, encouraging the use of alternative lowercarbon energy sources and activities. Second, by ensuring a level playing field for all emitters – and so equating the marginal abatement cost of all sources of emission – their use can help minimize the cost of the energy transition. This second advantage implies that a carbon price should be applied across as wide a range of sectors and regions as possible.
These advantages are not abstract economic ideas; they are central to achieving the widespread support necessary for a speedy and successful transition. Inefficient policy design, which raises overall costs or leads to different prices being paid by different groups or sectors, risks undermining that approval. Efficiency and fairness in policy design will be key to ensuring widespread support and legitimacy for the energy transition.
Principle 2: carbon prices are necessary but not sufficient.
Although economics is clear that carbon pricing should play a central role in reducing carbon emissions, it is unlikely to be sufficient, for a number of reasons. First, the sheer scale of the system-wide changes needed to support a low- or zero-carbon energy system may require other mechanisms of coordination and collective action, in addition to price signals.4 Second, in the short run, introducing a carbon price at a high initial level, or raising the price too quickly, could lead to a premature scrapping of productive assets, which would raise the cost of the energy transition. As such, carbon prices might need to be reinforced in the near term by other measures which affect forward-looking decisions without penalizing past investments – such as policies to support new investment in hydrogen or carbon capture, use, and storage. Third, there is likely to be a need for public support for research and development in low-carbon energies and technologies until they achieve scale.
In practice, there may also be other factors, linked for example to market design or information costs, which limit the effectiveness of the price signals and incentives provided by carbon pricing. This may be particularly important in some emerging economies where market-based mechanisms are less well developed.
These factors mean that there are often likely to be advantages in augmenting a carbon pricing framework with other targeted measures or policies. The key design principle is that these other policy measures should complement the carbon pricing framework, targeting known weaknesses and avoiding policy overlaps.
Principle 3: as carbon prices rise, carbon border adjustments are likely to be an essential part of a carbon pricing policy.
In an ideal world, climate policies would be set and coordinated at a global level, reflecting the global nature of climate change. There are many efforts to achieve better global coordination, but in practice such consensus and agreement seem unlikely in the foreseeable future. Moreover, even in a world of greater coordination, differences in levels of economic development may mean that developed economies choose to decarbonize more quickly than some emerging economies.
The absence of a single global carbon price raises two related problems for the use of carbon prices at a country or regional level. First, the international competitiveness of domestic industry in that region will tend to be reduced, which in turn may undermine political support and legitimacy for a progressive carbon pricing policy.5 Second, from a climate perspective, the socalled carbon leakage triggered by differential carbon prices – in which carbon-intensive activities migrate to countries or regions with less demanding carbon prices and regulations – reduces the effectiveness of any unilateral policy. These problems intensify as carbon prices increase and the differential between carbon prices in different countries and regions widens.
If carbon prices are going to be used as a central tool for reducing carbon emissions at a sub-global level, and free trade is to be protected, the only solution to these twin problems of competitiveness and carbon leakage is some form of carbon border adjustment (CBA) which adjusts the costs of imports and exports in a way that offsets differences in carbon prices. CBAs can be designed and implemented in many different ways, but their essential aim is to promote a level playing field, in terms of embodied carbon, between internationally traded goods and services. In that sense, CBAs should be seen as a way of avoiding trade distortions and increasing the effectiveness of domestic carbon price policies, rather than any sort of protectionist measure.
The precise design of CBAs can give rise to complex trade issues and, as such, can be controversial. Moreover, unless designed carefully, CBAs can impose significant additional costs which in themselves can act as an impediment to trade. Avoiding these pitfalls requires careful policy design. But ultimately, some form of CBA is likely to be essential if carbon prices are to play a central role in reducing carbon emissions at a country or regional level.
Principle 4: revenues from carbon pricing can be used to support a just transition.
As discussed earlier, the primary aim of a carbon price or tax is to change behaviour rather than to raise revenue. Even so, the revenues raised by carbon pricing can be used to help support a fair or just energy transition and, in so doing, help to increase the political and social acceptability of carbon pricing.
There are potentially several dimensions to a just transition. This concept was first raised in the context of people employed in industries particularly affected by the energy transition, such as coal-mining communities. One aspect of a just transition would be to use some of the revenues raised by carbon pricing to help retrain and reskill displaced workers or otherwise support affected communities.
Another dimension of fairness is the recognition that carbon pricing can lead to regressive distributional effects if low-income households spend a greater proportion of their budget on carbon-intensive products, especially energy. This problem can be addressed by returning at least some of the revenues to households in the form of a lump sum or progressive payment. For example, the Climate Leadership Council in the United States proposes that all carbon tax revenues are returned to households on an equal basis.
There is also an international dimension to a just energy transition. What would make the transition just from an international perspective is not obvious. Many developing economies are more exposed to carbon-intensive energies and industries than developed economies and may also lack the social and economic institutions necessary for a successful transition. As a result, they may be disproportionately affected by the transition. In addition, many developed economies historically have emitted proportionally more carbon than developing countries. In a just transition, developed countries might recognize these issues, for example, by reinvesting the revenues raised from CBAs to help finance the transition in emerging economies.
Principle 5: expectations matter.
Energy is a highly capital-intensive sector. Power plants can operate for 30 or 40 years, hydropower and nuclear plants even longer. Similarly, passenger cars persist in the global car parc for as long as 15 years. As such, the effectiveness of carbon pricing can be greatly enhanced if energy producers and consumers have a clear sense of the likely future path of carbon prices. In so doing, a shift in carbon prices today can impact both the current fuel mix (through current consumption decisions) and, potentially more importantly, the future fuel mix (through current investment decisions).
This expectations channel does not require complete certainty on the future level of carbon prices. Indeed, there are good reasons why carbon prices might depend on future developments. But it does require the commitment of public authorities to a clear carbon target and to using carbon prices as a central way of achieving that target. In that context, there is a parallel with independent central banks who commit to using monetary policy to achieve an inflation target, even though the precise path of interest rates depends on future economic developments.
The world is on an unsustainable path, with carbon emissions continuing to increase. Carbon pricing is the most efficient policy tool for achieving the decisive shift in carbon emissions needed for the world to have a chance of achieving the Paris climate goals. The World Bank estimates there are over 50 carbon pricing schemes currently being implemented or scheduled for implementation, covering around 20 per cent of global greenhouse gas emissions.10 The number of these initiatives and the level of carbon prices will likely have to increase significantly over the next decade to achieve the Paris goals. The five principles outlined here can help to guide that policy process.