Dr Chris D’Souza
The best approach to combat climate change, in the opinion of most economists, is to impose a price on greenhouse gas emissions. It works well, enabling society to determine the least expensive equivalent unit of carbon dioxide that they need to forego. It is equitable, as polluters pay this and the money is used by society to alleviate damage caused by climate change. It also supports decarbonisation strategies – having to pay a carbon price compels investors to identify the dirtiest assets in a company’s portfolio and pushes enterprises to track their emissions.
As of now, 73 carbon-pricing programmes exist worldwide, accounting for 23% of global emissions, according to the World Bank. Ten years ago, that was only 7%. Both carbon taxes (in which a government sets a price directly), and emissions-trading programmes (in which polluters can sell permits in a market), are included in the bank’s total.
A rising number of countries are establishing their own prices for carbon. The biggest programme, introduced in 2021, is located in China and covers the nation’s energy sector. As a result, this program accounts for 9% of worldwide emissions. Even in America, which is immune to the allure of federal carbon pricing, many States are establishing their own prices for carbon. The most recent convert, Washington state which started its emissions-trading programme in January 2023.
Interestingly, a rising number of economists, even those who were previously ardent proponents of carbon pricing, have become disenchanted with the idea of setting a price.
Two Objections.
The first is the lack of ‘competition’. There is not enough of an aggressive market price on carbon. Despite being one of the most extensive, the EU’s Emissions-Trading Plan (EUETS) does not include buildings or transportation. In the interest of competition, heavy industry and airlines receive subsidies. Also, while prices are too low elsewhere, they are comparatively high in Europe, where they set a record in February at €100 ($107) per tonne of carbon dioxide equivalent. Less than 5% of emissions, according to the World Bank, are priced at or above what would be necessary by 2030 to keep temperature increases to 2°C over pre-industrial levels.
The second concern of the critics is ‘equity’. They contend that the burden of carbon prices falls too heavily on the poor, instead of making sure polluters pay. Such programmes transfer industrial jobs overseas, beyond the reach of emissions-trading schemes, and boost energy prices—typically the one sector of the economy totally exposed to them. Politicians soften the plans because they expect opposition on these grounds. As a result, the anticipated reductions in emissions never happen.
These are the points of contention. How solid is the evidence?
Policymakers often express concern about the impact of carbon taxes on employment or GDP. Despite carbon pricing and carbon trading markets being around since 2007, it is difficult to gauge how carbon costs are affecting society. Similar to interest rates, carbon prices both have an impact on the economy and are also impacted by it.
A greater carbon price will, all other things being equal, result in reduced economic activity and higher consumer prices.
However, the cost of a carbon permit will also increase in a stronger economy. Raising carbon costs may also make politicians feel more at ease during prosperous economic times. In difficult circumstances, they might take action to cut them. For example, in an attempt to lower costs amid the energy crisis that followed Russia’s invasion of Ukraine, the European Commission stated in May of last year that it would be holding an auction of excess licences.
Fortunately, some work is being undertaken to separate cause from effect.
Harvard University’s James Stock and Tufts University’s Gilbert Metcalf took into consideration the larger economic backdrop in a recently published paper. They examined 31 European nations in order to isolate variation in carbon prices not explained by economic conditions –while controlling for past emissions and economic growth.
Using a new dataset on carbon tax rates, they estimated the macroeconomic impacts of carbon taxes on GDP and employment growth rates for various specifications and samples. There point estimates suggest a zero to modest positive impact on GDP and total employment growth rates. More importantly, they found no robust evidence of a negative effect of the tax on employment or GDP growth. For the European experience at least, we find no support for the view that carbon taxes are job or growth killers. Significantly, they also find virtually no effect, either positive or negative, on economic growth and employment, perhaps because there was more innovation than anticipated.
Another technique for separating cause from effect is to perform an “event study.” They are frequently employed to evaluate the effects of monetary policy choices. The influence of background economic conditions, which vary more slowly than the policy statement, can be eliminated by observing the nearly instantaneous response of carbon pricing to that announcement. The economy can then be used to track the effects of the price shift.
Diego Känzig of Northwestern University accomplished exactly this in a recent working paper where he studied the economic impacts of carbon pricing. By looking at institutional features of the European carbon market and high-frequency data, he shows that a tighter carbon pricing regime leads to higher energy prices, lower emissions and promotes more green innovation.
However, he says that this comes at the cost of a fall in economic activity, which is borne unequally across society: poorer households lower their consumption significantly while richer households are less affected. The poor are more exposed because of their higher energy share and, importantly, also experience a larger fall in income. In other words, there is a price for the advantages. The rising prices cause energy bills to rise, which lowers the impoverished people’s incomes.
Political Implications
When employed, carbon taxes have successfully reduced emissions. Still, they could be presented in a more politically acceptable manner. National taxes are less of a burden on the economy, which helps offset current criticism, even though they are more likely to cause leakage, or the shifting of polluting activity across borders. This is so because tax cuts that target the poor are a common way to recycle funds.
According to World Bank estimates, governments will be able to generate $100 billion this year through emissions-trading and carbon levies. The amount will only rise as carbon-pricing programmes become more prevalent. This will address the first objection –that the measures do not go far enough in their aggression. Politicians need to recognise the value of recycling and the circular economy in order to address the second objection—that they hurt the poor.
Dr. Chris D’Souza is Deputy CEO and CFO of ICMA(ANZ).