Regulatory push: What it takes to make carbon pricing effective as a policy tool in combating climate change

In another blog post we looked at the challenges of business adapting to, and managing change. It has been explained that it is crucial to have the right policy framework – the regulatory push – in place to incentivise business “to do the right thing” in the context of sustainable transitions. Regarding the current climate change debates, the primer and most important goal is to significantly bring down global greenhouse gas emissions caused by economic activity. For example, the EU pledged to reduce greenhouse gas emissions by 40 per cent in 2013 compared to 1990 and become carbon neutral by 2050. According to the World Bank Group, the most effective economic tool to achieve this is to put a price on carbon. 

How carbon pricing works

To reach the goal set out in the Paris Climate Agreement in 2015 to limit global warming to one point five degree Celsius requires decarbonising global economies. A major obstacle in this regard is that it is still too cheap to emit carbon. In other words, markets do not accurately reflect the effective costs of emitting carbon in economic, environmental and societal terms. In economic terms this is associated with market failure, since these costs represent negative externalities. Increasing the price of carbon can resolve this problem. The reasoning behind it is simple. Making carbon more expensive makes carbon-intense production more expensive and should thereby incentivise companies to switch to low-carbon alternatives. This way, the social costs of emitting carbon are internalized by polluters. 

There are basically two major options how carbon can be priced. Firstly, a fixed carbon tax can be applied. Hereby the advantage for companies is that they exactly now how much it costs to emit a ton of carbon dioxide. The disadvantage, however, is that it does not account for changes in economic conditions, and if set too low does not incentivise change enough. Secondly, an emission trading scheme can be introduced where allowances to emit specific amounts are traded. Although a market should ensure that prices reflect true costs, the problem is that prices can be kept artificially low by oversupplying the market with allowances or by allocating free emission rights to major polluters. To combat these problems, a cap on total allowed emissions can be set and the number of allowances be reduced each year by a specific percentage. 

The advantage of pricing carbon from an economic perspective is that it does not prohibit specific behaviour but is still corrective regarding market failures. Moreover, it creates additional government revenue that can be used for various purposes regarding sustainable development. 

As of 2019, there were 57 initiatives globally, whereby 28 applied an emission trading scheme and 29 a carbon tax. Through these 57 initiatives, 20 per cent of global greenhouse gas emissions were covered. The prices per ton of carbon ranged from USD 1-127 with 51 per cent being priced below USD 10. According to the World Bank Group, however, prices would need to be in the range of USD 40-80 by 2020 and USD 50-100 by 2030. Only five per cent were in line. Moreover, governments were able to raise USD 44 billions in revenues. As a comparison, fossil fuel subsidies amounted to USD 5.2 trillions in the same year. 

Pitfalls and success factors for carbon pricing schemes

Putting a price on carbon is a very political process. This is why public support is very important in order to implement stringent carbon pricing schemes. A study conducted by the University of Oxford finds that high levels of trust in politicians and low corruption levels yield the best conditions. Countries such as Finland, Norway, Sweden and Switzerland fulfilling these criteria all have prices above USD 40 per ton of carbon. Furthermore, the researchers find, costs are often concentrated, and benefits diffused. Ideally, it is the other way around. For example, benefits are not be immediately tangible for French motorists regarding the planned fuel tax increase while increased costs in the form of higher fuel prices are. 

Due to this, the International Monetary Fund recommends governments to consider options such as cutting other types of taxes, supporting vulnerable households and communities, increasing investment in green infrastructure or to simply pay out a citizen dividend. 

In addition to aspects of political economics, behavioural science can also yield valuable insights into what makes carbon pricing schemes (un-)popular. The researchers from the University of Oxford identify the following factors. 

Avoiding solution aversion. For the population to be acceptant of paying for climate change mitigation measures requires cultural, political and economic values prioritising environmental protection. It is crucial to avoid scepticism among the population triggered by measures that are contrary to their beliefs. Sweden, for example, achieved this through extensive dialogue with the public while ensuring a high level of transparency in the process. 

Increasing visibility of revenue spending. The population needs to be sure that policy yields the desired results. One option to make the corrective effect visible is to specifically designate a percentage of revenues raised to, for example, low-income households that are affected most by such changes. In general, it is advisable to use the funds in a way that can be seen by the population. 

Re-labelling. Furthermore, it may help to re-label carbon pricing under a different name without a negative connotation, as is often the case with the word tax. In Switzerland, for example, the carbon price is known as CO2 levy. 

Conclusion

The way forward seems clear. Carbon pricing is seen to be the most promising solution to decarbonise the global economy through market measures where polluters pay. The biggest challenge in terms of increasing the price of carbon is public support, since higher costs would be passed on to consumers. Nevertheless, raising the price, ideally with a price floor as recommended by the International Monetary Fund, would be the next step in the right direction if the targeted range of USD 50-100 per ton of carbon is to be achieved by 2030. 

In addition, it is important that governments have a specific plan on how they spend incurred revenues. In this regard, it can broadly be differentiated between two categories. Firstly, support for those affected most by a hike in carbon prices such as coal-mining workers or the poorest households. Secondly, providing an economic environment where sustainable innovation is nurtured, and the future economy is built in collaboration with existing players. Ultimately, what is important is that political decisions are made quickly. Although many companies already apply a carbon shadow price when evaluating potential projects and investments, what will really push change will be effective price-floored carbon prices in the near future, implemented through additional regulation.