Greenhouse gas (GHG) emissions pose several potential economic and environmental risks to property, human health, agricultural productivity, and the ecosystem. Carbon pricing transfers the cost of the damage caused by GHG emissions back to those responsible. Instead of dictating who should reduce emissions where and how, a carbon price sends an economic signal to emitters, allowing them to either change their activities and lower their emissions, or continue to emit and pay for their emissions.
As the world grapples with the threat of climate change, it has become clear that current energy prices do not reflect the cost of GHG emissions. According to a 2018 IPCC report, emissions from fossil fuels and industries are the primary cause of global warming, accounting for 89% of global CO2 emissions. Those who benefit from the use of fossil fuels do not generally pay for the environmental damage caused by their emissions. Instead, this cost is borne by people all over the world, including future generations. Setting up a carbon pricing mechanism can help to correct this externality by raising the price of energy consumption to reflect its social cost.
Market-based approaches that put a price on carbon are the most cost-effective way to reduce greenhouse gas emissions. The two most commonly discussed approaches are a cap-and-trade system and a carbon tax. Either instrument can help correct the market failure that exists when the value of environmental damage is not included in the market price of fossil fuels by establishing a price for GHG emissions. Though effective, they have their unique attributes. A key distinction between the two is that a cap-and-trade system establishes the maximum level of emissions, so the environmental outcome is known but the resulting price is unknown, whereas a carbon tax establishes the price and allows the market to determine the environmental outcome.
Other carbon pricing mechanisms include offset mechanisms, which involve lowering GHG emissions or increasing carbon storage. Carbon offset goes directly toward supporting the use of sustainable energy. Another approach is result-based climate finance (RBCF), which is a funding approach in which payments are made after pre-defined outputs or outcomes related to climate change management, such as emission reductions, are delivered and verified.
A carbon tax, which establishes a price on GHG emissions embedded in fuels and energy-intensive goods, can deliver cost-effective emission reductions across firms and households. In theory, a carbon tax could be designed to produce the same overall level of emissions, emission reduction distribution across sources and sectors, and aggregate costs as a cap-and-trade system. However, because of the uncertainty surrounding consumer response rates, achieving this level may necessitate several adjustments to the tax rate.
Economists recommend that a carbon tax be set at the social cost of carbon, which is the present value of the estimated environmental damage over time caused by an additional ton of CO2 emitted today. The tax rate should also rise over time to reflect the increasing damage expected from climate change. An increasing price over time also signals to emitters that they will need to do more and that their investments in more aggressive technologies will be economically justified. However, one of the challenges of a carbon tax is predicting the level of emissions reduction from a specific tax rate. Building in review and adjustment opportunities can help, but it also reduces one of the benefits of carbon price certainty.
A carbon tax can be implemented at any stage of the energy supply chain. Experts suggest that carbon tax should be levied upstream, where relatively few entities exist, such as coal suppliers, natural gas processing facilities, and oil refineries. Alternatively, the tax could be levied either in the midstream, on electric utilities, or downstream on energy-using industries, households, or vehicles.
The majority of the economic impact of any climate policy is expected to be burdened by energy end-users and households in the form of higher energy and other goods prices. Furthermore, unless changes and legislative policies are made, the impact of a carbon pricing program will unfairly target low-income households. Lower-income families spend a larger proportion of their income on energy than higher-income families. As a result, a carbon tax would raise energy costs, potentially disproportionately affecting the poor. This requires governments to direct a certain percentage of carbon tax revenue toward low-income households to compensate for increased energy costs and to ensure that the tax does not disproportionately affect the poor.
It is critical that as jurisdictions implement carbon pricing, they need to understand the implications on global trade competitiveness. A carbon price could put domestic energy-intensive and trade-exposed industries like chemicals, cement, and steel at a competitive disadvantage when compared to other international competitors who are not subject to an equivalent price. Changes in demand for those countries may result in carbon leakage, reducing the climate benefit of carbon pricing. Carbon leakage has been a factor because of the lack of harmonized policy structure and cross-border carbon pricing, prompting the development of carbon border tax adjustment—a duty on imports based on the amount of carbon emissions resulting from the production of the product in question—as a preferred approach to addressing emissions leakage and incentivizing emission reductions.
A carbon tax has the potential to generate significant revenue for the government. However, how that revenue is spent will ultimately be a political decision. Some or all of it could be returned to consumers in the form of a dividend or rebate. Alternatively, it could be reinvested in climate-related projects such as the advancement of low-carbon technologies or the development of climate resilience programs. According to research by the Center for Climate and Energy Solutions, (C2ES) using the revenues to reduce existing taxes on labor and capital, also known as a tax swap, can minimize economic costs and may result in net economic benefits. They also point out that using the revenue for other government spending programs or simply rebating it in lump sums to all households would be more expensive than using it to reduce or eliminate distortionary taxes on labor and capital.
Governments should also incorporate climate change into their development strategies to have projects ready for implementation using revenue from the carbon pricing market. This will assist them in closing the infrastructure development gap while also meeting their climate commitments under the Paris Agreement. To combat climate change, policies and market innovation are required, and governments and the private sector must work together to achieve global transition and global goals.
Author: Victor O. Nyakinda