To most economists, putting a price on greenhouse gas emissions is the best way to fight climate change. It is efficient and allows society to identify the cheapest unit of carbon dioxide equivalent to do without. It’s fair: the polluters pay; The proceeds can be redistributed. And it supports other forms of decarbonization: following a carbon price forces companies to track their emissions and investors to figure out which of their assets are the dirtiest.
According to the World Bank, there are now 73 carbon pricing systems worldwide, covering 23% of global emissions. That’s up from just 7% a decade ago. The bank’s balance sheet includes both emissions trading schemes, where polluters can trade allowances in a market, and carbon taxes, where a government sets a price directly. The largest system is in China and was introduced in 2021. It covers the country’s energy industry and thus 9% of global emissions. Even in America, immune to the lures of federal carbon pricing, more and more states are setting their own prices. Washington state, the most recent convert, launched its emissions trading system in January.
But a growing number of centre-left economists, who might be expected to be vocal supporters of carbon pricing, are angered by the policy. These critics focus on two points. Firstly, carbon prices are not aggressive enough. The EUHowever, , one of the most comprehensive emissions trading system, excludes buildings and transport. Grants are given to airlines and heavy industry in the name of competitiveness. Prices are relatively high in Europe, hitting a record €100 (US$107) per tonne of carbon dioxide equivalent in February, but are too low elsewhere. The World Bank estimates that less than 5% of emissions are priced at or above the level that would be needed by 2030 to limit temperature increases to 2°C above pre-industrial levels.
This tentative approach reflects the critics’ second concern: justice. They argue that the cost of carbon pricing does not make polluters pay, but that the cost of carbon emissions falls too heavily on the poor. Such initiatives raise energy prices – usually the only sector of the economy fully subject to them – and move industrial jobs offshore, where they are no longer covered by emissions trading schemes. In the expectation that there will be resistance for these reasons, the politicians are toning down the plans. As a result, the promised emissions cuts never materialize.
Those are the arguments. How about the evidence? Measuring the impact of carbon prices is challenging. Like interest rates, carbon prices affect and are influenced by the economy. All other things being equal, a higher carbon price will weaken economic activity and increase consumer prices. But a stronger economy will also increase the price of a carbon permit. Politicians might also feel more comfortable with increasing carbon taxes when the economy is booming. You could take steps to reduce them during bad times. For example, last May the European Commission announced an auction of surplus allowances during the energy crisis following the Russian invasion of Ukraine to bring prices down
Luckily, there are ways to disentangle cause and effect. Marion Leroutier of the Stockholm School of Economics uses a “synthetic control” method to study a top-up tax on the EUThe UK Emissions Trading Scheme was introduced by the UK in 2013. To see the impact of this higher carbon price, Ms Leroutier uses data from others EU Countries to construct a hypothetical version of Britain not introducing the tax – similar to a control group in an experiment. In reality, interconnectors allow the UK to import electricity from neighbors, possibly leaving the control group subject to this treatment as well. But taking into account an estimate of such spillovers, Ms Leroutier estimates that the tax has resulted in a 20-26% reduction in emissions from the energy industry.
In a forthcoming paper, Tufts University’s Gilbert Metcalf and Harvard University’s James Stock attempt to explain the broader economic context. They look at 31 European countries and take into account past emissions and economic growth to isolate fluctuations in carbon prices that cannot be explained by economic conditions. The authors find that carbon taxes reduce greenhouse gas emissions to a degree economists have previously predicted. Significantly, they also find virtually no positive or negative impact on economic growth and employment, possibly because there has been more innovation than expected.
A final method of disentangling cause and effect is to conduct an “event study.” These are often used to assess the impact of monetary policy decisions. By looking at the almost instantaneous response of carbon prices to a policy announcement, it is possible to eliminate the impact of background economic conditions that are not changing at the same rate. The effects of the price change can then be tracked throughout the economy. In a recent working paper, Northwestern University’s Diego Känzig did just that, finding that higher carbon prices reduce emissions and encourage green innovation. But these gains come at a price. The higher prices increase energy costs and thus reduce the income of the poor.
Get the green right
Carbon prices have successfully reduced emissions during use. However, they could be tastier. In another article, Mr. Känzig compares the EU‘S Emission trading system and national CO2 prices. Although national taxes are more likely to lead to leakage, with polluting activities moving across borders, they put less of a strain on the economy and help neutralize criticism from centre-left critics. This is because revenue is often recycled through tax cuts that can target the poor.
The World Bank estimates that carbon taxes and emissions trading schemes will net governments $100 billion this year. With the expansion of carbon pricing systems, the amount will only increase. This alone will help address one criticism: that the measures are not aggressive enough. To address the other – that they harm the poor – policymakers need to recognize the importance of recycling. ■
Read more from Free Exchange, our economics column:
What performance-enhancing stimulants mean for economic growth (25. May)
Robert Lucas was a giant of macroeconomics (May 18)
A new world order seeks to prioritize security and climate change (May 11)
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