Carbon price

Carbon pricing (or CO
2 pricing) is a method for nations to reduce global warming. The cost is applied to greenhouse gas emissions in order to encourage polluters to reduce the combustion of coal, oil and gas - the main driver of climate change. The method is widely agreed^[1] and considered to be efficient. Carbon pricing seeks to address the economic problem that emissions of CO
2 and other greenhouse gases (GHG) are a negative externality — a detrimental product that is not charged for by any market.

A carbon price usually takes the form of a carbon tax or carbon emission trading, a requirement to purchase allowances to emit.^[2][3]

In 2020, carbon pricing generated $53bn in revenue.^[4] 21.7% of global GHG emissions are covered by 2021, a major increase due to the introduction of the Chinese national carbon trading scheme .^[5][6] Regions with carbon pricing include most European countries and Canada. On the other hand, top emitters like India, Russia, the Gulf states and many US states have not yet introduced carbon pricing. Australia abolished its carbon pricing scheme.

Latest models of the social cost of carbon calculate a damage of more than $3000 per ton CO
2 as a result of economy feedbacks and falling global GDP growth rates, while policy recommendations range from about $50 to $200.^[7] Many carbon pricing schemes including the ETS in China remain below $10/tCO
2.^[6] One exception is the European Union Emissions Trading System (EU-ETS) which exceeded €60/tCO
2 (69 $) in 2021.^[8]

A carbon tax is generally favoured on economic grounds for its simplicity and stability, while cap-and-trade is often chosen on political grounds. Trading schemes theoretically offer the possibility to limit allowances to the remaining carbon budget. Current implementations are only designed to meet certain reduction targets.

Concepts[]

Emissions trading[]

In a cap-and-trade design, the government establishes an emissions cap, for example 1000 tCO
2 per year. Then it either gives the allowances to stakeholders in some politically or administratively determined way, or auctions them off to the highest bidder. After the permits have been distributed, they can be traded privately. Emitters without the required allowances face a penalty that would cost more than buying permits. In theory, emissions will be limited to the cap. If the cap is low, permits will be in short supply (scarce) and the price of permits will be high.

Like a carbon tax, a cap is applied to fossil fuel in proportion to its carbon content. Generally, coverage is partial, for example it may be limited to the electric industry. In contrast to a carbon tax, the market for permits automatically adjusts the carbon price to a level that insures that the cap is met, while under a carbon tax, the government and not the market sets the price of carbon.^[9][10] Two or more countries can link their cap and trade markets simply by accepting allowances from each other. The effect of this is to equalize the price between the two markets.

In practice, the EU ETS resulted in a fairly strong carbon price, but that was later undermined by renewables policies (non-price policies) as well as by the Great Recession.

Carbon tax[]

With a carbon tax, the regulator sets the price directly. In principle all sources of CO
2 emissions should be taxed at the same rate per ton of CO
2 emitted. This can be accomplished by taxing all fossil fuel sources in proportion to their carbon content. In practice, different fuels and different fuel uses may be taxed at different rates and the resulting tax may still be referred to as a carbon tax.

Hybrid designs[]

Cap-and-trade systems can include price stability provisions with floor and ceiling limits.^[11] Such designs are often referred to as hybrid designs.^[12]: 47</ref> To the extent the price is controlled by these limits, it can be considered a tax.

Revenue policies[]

Standard proposals for using carbon revenues include a return to the public on a per-capita basis (revenue recycling with steering taxes),^[13][a] use them in place of another tax (a tax swap), use them for energy research, or use them to invest in energy efficiency and renewable energy projects to drive down emissions.^[b]

Social cost of carbon[]

The exact monetary damage caused by a tonne of CO2 depends on climate and economic feedback effects and remains to some degree uncertain. Latest calculations show an increasing trend. Dynamic models include discount rates. This results in lower costs in the current state and higher costs once that carbon budgets are used up.

Source	Year	carbon price per tCO 2	remarks
Interagency Working Group (US government)[14]	2013 / 2016	42 $	Central estimate for 3% discount rate in 2020
		212 $	high impact value for 2050 / 3% discount / 95th percentile
Umweltbundesamt (German Environmental Agency)[15]	2019	206 $ (180 €)	with 1% time preference
		731 $ (640 €)	without time preference
Kikstra et al.[16]	2021	3372 $	including economic feedbacks

Price levels[]

About one third of the systems stays below $10/tCO
2, the majority is below $40. One exception is the steep incline in the EU-ETS reaching $60 in September 2021. Sweden and Switzerland are the only countries with more than $100/tCO
2.

Scope and coverage[]

In the relevant countries with ETS and taxes, about 40 to 80% of emissions are covered.^[18] The schemes differ much in detail. They include or exclude fuels, transport, heating, agriculture or other greenhouse gases apart from CO
2 like methane or fluorinated gases.^[19] In many EU member states like France or Germany, there is a coexistence of two systems: The EU-ETS covers power generation and large industry emissions while national ETS or taxes put a different price on petrol, natural gas and oil for private consumption.

Carbon pricing schemes with more than $ 2 bn revenue

country / region	type	share[20]	coverage / remarks[21]	revenue 2020[22]
			EU		ETS	39 %	industry, electricity, intra-EU aviation	$ 22.5 bn
China	ETS	40 %	electricity, district heating	launched 2021
Canada	tax	22 %	National pricing in Canada, additional taxes and ETS in states	$ 3.4 bn
France	tax	35 %	non EU-ETS	$ 9.6 bn
Germany	ETS	40 %	non EU-ETS: transport, heating	$ 8.45 bn (€ 7.4 bn) expected, launch 2021[23]
Japan	tax	75 %		$ 2.4 bn
Sweden	tax	40 %	transport, buildings, industry, agriculture[24]	$ 2.3 bn

Other taxes and price components[]

The final consumer price for fuels and electric energy depends on individual tax regulations and conditions in each country. Though carbon pricing is playing an increasing role, energy taxes, VAT, utility expenses and other components are still the main cause for completely different price levels between countries.

Economics of carbon pricing[]

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Many economic properties of carbon pricing hold regardless of whether carbon is priced with a cap or a tax. However, there are a few important differences. Cap-based prices are more volatile and so they are riskier for investors, consumers and for governments that auction permits. Also, caps tend to short-out the effect of non-price policies such as renewables subsidies, while carbon taxes do not.

Efficiency of carbon pricing[]

Carbon pricing is considered by many economists to be the most efficient way to reduce emissions.^[2] This means that it reduces emissions for the least possible cost, where these costs include the cost of efficiency measures as well as the cost of the inconvenience of making do with less of the goods and services provided by fossil fuels. This efficiency comes about by eliminating a market failure (the un-priced external costs of carbon emissions) at its source — by pricing these costs.^[25] This is best explained by example:

Consider an example market with 100 emitters, each of which gets a different benefit from using carbon (and emitting CO
2). Each emitter would like to use enough fossil fuel to emit 1 ton per year. Suppose the benefits from that ton range from $1 for the user with the least need for carbon to $100 (in $1 increments) for the user who would benefit most. Now consider this market under two different pricing policies, a cap-and-trade policy and a tax. Further suppose that the tax is $60.01/ton and the cap has been set at 40 tons, so that 40 one-ton permits have been issued.

Under the tax, it is clear that no one with an emission value of less than $60.01 will emit because they would have to pay $60.01 for less than $60.01 in value. So the 40 carbon users with values ranging from $61 to $100 will pay the tax and emit their ton of carbon.

Under cap and trade, suppose the price turned out be less than $60.01 and someone other than a top-40 emitter (ranked by value) got a permit. In that case a top-40 emitter without a permit would offer that “someone” more than $60 and they would sell because that is more than the value they would get from using the permit themselves. This will drive the price up to the point where only top-40 emitters get permits and the price is a little more (say $60.01) than any bottom-60 emitter would pay.

Several conclusions are drawn by economics from a somewhat more rigorous application of this type of analysis. First, the same people end up emitting under a tax and under a cap that pushes the price equally high. Second, only the highest value emitters end up emitting. Third, the total value of emitters is greater than under any other distribution of permits. This final conclusion is the reason carbon pricing is considered “efficient” by economist.

Finally, economics points out that since regulators would have an extremely hard time finding out the value that each emitter receives from emitting,^[c] this efficient outcome is extremely unlikely if the regulator chooses who can emit and who cannot. This is why economics teaches that command and control regulation will not be efficient, and will be less efficient than a market mechanism, such as carbon pricing. In the words of the IPCC, "[renewable energy subsidies] are less efficient alternatives to carbon taxes and emissions trading for inducing mitigation" (section 3.8.1.2).^[12]

Interactions with renewable energy policies[]

Cap-and-trade and carbon taxes interact differently with non-price policies such as renewable energy subsidies. The IPCC explains this as follows:

"A carbon tax can have an additive environmental effect to policies such as subsidies for the supply of RE. By contrast, if a cap-and-trade system has a binding cap (sufficiently stringent to affect emission-related decisions), then other policies such as RE subsidies have no further impact on reducing emissions within the time period that the cap applies [emphasis added]."^[26]: 29

Consider the following hypothetical example of this effect. Suppose the price of permits in the EU would have been €30, and Germany would have needed to purchase 20 million permits. If Germany then decided to subsidize investment in wind turbines that would not have been built with a €30 carbon price, and they were built and operated, then Germany would need fewer permits. Hence the permits it would have used will go somewhere else, perhaps to Poland. Poland would then use them to emit more CO₂, perhaps by burning coal. The result is that Germany emits less CO₂ and this allows others to emit just as much more. So the cap is met, as it must be, and the total CO₂ emitted is unchanged by the renewable subsidies and wind turbines.

Notice that this same effect applies as well to an individual who chooses to buy an electric car under a cap-and-trade system. The car emits less CO₂, so fewer permits are used up by this person's driving. These permits will be bought by others and used. So the same amount of CO₂ (the cap) will be emitted regardless of the purchase of the electric car. It the buyer's intent was to reduce carbon emissions, the cap has thwarted their efforts by encouraging others to emit exactly as much as they abated their emissions. As the IPCC noted, a carbon tax does not have this effect.

Cost pass-through[]

Carbon pricing sometimes charges the emitter and sometimes charges the fossil fuel supplier. Fortunately the right person always ends up bearing the cost imposed by the policy. The government may tax or cap an oil refinery based on all the carbon it buys in the form of oil. But the refinery does not emit 90%+ of that carbon. Instead it makes gasoline and sells that to gas stations, who sell it to drivers, who emit the carbon. In this case the refinery passes on the cost of its carbon permits or carbon tax (just as it passes on all marginal costs), and the gas stations pay those costs. But then the gas stations pass on their cost to the drivers. So drivers actually bear the cost of carbon pricing, and that is as it should be, because driving is the real reason for the emissions.

But economics does not view this as a moral matter. Rather, economics points out that when the cost goes up, if drivers do not find driving their SUV (for example) worth the extra cost, they will switch and drive their sports car, ride their bike or take public transportation. And that is the point of carbon pricing. If all alternatives are unappealing, that means the driver really is getting more benefit that the cost she is causing. So again we have the right outcome — provided the carbon price equals the social cost.

Free permits and windfall profits[]

As noted above, under cap-and-trade, the permits may be given away for free or auctioned. In the first case, the government receives no carbon revenue and in the second it receives (on average) the full value of the permits. In either case, permits will be equally scarce and just as valuable to market participants. Since the private market (for trading permits) determines the final price of permits (at the time they must be used to cover emissions), the price will be the same in either case (free or auctioned). This is generally understood.

A second point about free permits (usually “grandfathered,” i.e. given out in proportion to past emissions) has often been misunderstood. Companies that receive free permits, treat them as if they had paid full price for them. This is because using carbon in production has the same cost under both arrangements. With auctioned permits, the cost is obvious. With free permits, the cost is the cost of not selling the permit at full value — this is termed an “opportunity cost.” Since the cost of emissions is generally a marginal cost (increasing with output), the cost is passed on by raising the cost of output (e.g. raising the cost of gasoline or electricity).

Windfall profits: A company that receives permits for free will pass on its opportunity cost in the form of higher product prices. Hence, if it sells the same amount of output as before that cap, with no change in production technology, the full value (at the market price) of permits received for free becomes windfall profits. However, since the cap reduces output and often causes the company to incur costs to increase efficiency, windfall profits will be less than the full value of its free permits.^[27]

Generally speaking, if permits are allocated to emitters for free, they will profit from them. But if they must pay full price, or if carbon it taxed, their profits will be reduced. If the carbon price exactly equals the true social cost of carbon, then long-run profit reduction will simply reflect the consequences of paying this new cost.^[d] If having to pay this cost is unexpected, then there will likely be a one-time loss that is due to the change in regulations and not simply due to paying the real cost of carbon. However if there is advanced notice of this change, or if the carbon price is introduced gradually, this one-time regulatory cost will be minimized. There has now been enough advance notice of carbon pricing that this effect should be negligible on average.

Carbon pricing and economic growth[]

According to a 2020 study carbon prices have not harmed economic growth in wealthy industrialized democracies.^[28]

Future emissions vs. past emissions[]

A CO₂ price aims to reduce new emissions in the future. However, such a price does not affect past emissions,^{[citation needed]} i.e. the CO₂ concentration already released into the atmosphere since the beginning of industrialization, which has risen from well below 300 PPM to more than 415 PPM (2019).^[29] Without human interaction, this concentration will only decrease over the long term. Therefore, negative emissions are needed in order to reduce the atmospheric CO₂ concentration. The public revenue from a carbon price could be used to subsidize companies that provide such negative emissions. Depending on the technology, such as PyCCS or BECCS, the cost for generating negative emissions is about $150–165 per ton of CO₂.^[30]

In order for such a business model to become attractive, the subsidies would therefore have to exceed this value. Here, a technology openness could be the best choice, as a reduction in costs due to technical progress can be expected. Already today, these costs of generating negative emissions are below the costs^{[clarification needed]} of CO₂ of $220 per ton,^[31] which means that a state-subsidized business model for creating negative emissions already makes economic sense today.^{[citation needed]} In sum, while a carbon price has the potential to reduce future emissions, a carbon subsidy has the potential to reduce past emissions.^{[clarification needed]}

Economic views on carbon pricing[]

In late 2013, William Nordhaus, president of the American Economic Association, published The Climate Casino,^[32] which culminates in a description of an international “carbon price regime.” Such a regime would require national commitments to a carbon price, but not to a specific policy. Carbon taxes, caps, and hybrid schemes could all be used to satisfy such a commitment. At the same time Martin Weitzman, a leading climate economist at Harvard, published a theoretical study arguing that such a regime would make it far easier to reach an international agreement, while a focus on national targets would continue to make it nearly impossible.^[33] Nordhaus also makes this argument, but less formally.

Similar views have previously been discussed by Joseph Stiglitz^[34] and have previously appeared in a number of papers.^[35] The price-commitment view appears to have gained major support from independent positions taken by the World Bank and the International Monetary Fund (IMF).^[36]

The "Economists’ Statement on Climate Change,"^[37] was signed by over 2500 economists including nine Nobel Laureates in 1997. This statement summarizes the economic case for carbon pricing as follows:

"The most efficient approach to slowing climate change is through market-based policies. In order for the world to achieve its climatic objectives at minimum cost, a cooperative approach among nations is required -- such as an international emissions trading agreement. The United States and other nations can most efficiently implement their climate policies through market mechanisms, such as carbon taxes or the auction of emissions permits."

This statement argues that carbon pricing is a "market mechanism" in contrast to renewable subsidies or direct regulation of individual sources of carbon emissions and hence is the way that the "United States and other nations can most efficiently implement their climate policies."

Carbon offsets for individuals ^[38]and businesses^[39] may also be purchased through carbon offset retailers^[40] like Carbonfund.org Foundation.

A new quantity commitment approach, suggested by Mutsuyoshi Nishimura, is for all countries to commit to the same global emission target.^[41] The “assembly of governments” would issue permits in the amount of the global target and all upstream fossil-fuel providers would be forced to buy these permits.

In 2019 the UN Secretary General asked governments to tax carbon.^[42]

The economics of carbon pricing is much the same for taxes and cap-and-trade. Both prices are efficient;^[e] they have the same social cost and the same effect on profits if permits are auctioned. However, some economists argue that caps prevent non-price policies, such as renewable energy subsidies, from reducing carbon emissions, while carbon taxes do not. Others argue that an enforced cap is the only way to guarantee that carbon emissions will actually be reduced; a carbon tax will not prevent those who can afford to do so from continuing to generate emissions.

Besides cap and trade, emission trading can refer to project-based programs, also referred to as a credit or offset programs. Such programs can sell credits for emission reductions provided by approved projects. Generally there is an additionality^[43] requirement that states that they must reduce emissions more than is required by pre-existing regulation. An example of such a program is the Clean Development Mechanism under the Kyoto Protocol. These credits can be traded to other facilities where they can be used for compliance with a cap-and-trade program.^[44] Unfortunately the concept of additionality is difficult to define and monitor, with the result that some companies purposefully increased emissions in order to get paid to eliminate them.^[45]

Cap-and-trade programs often allow "banking" of permits. This means that permits can be saved and can be used in the future.^{[citation needed]} This allows an entity to over-comply in early periods in anticipation of higher carbon prices in subsequent years.^[46] This helps to stabilize the price of permits.^[9]

On January 1, 2005, The European Union introduced the EU emissions trading system (EU ETS) for electricity plants and several branches of industry. The EU ETS sets targets for the CO₂ emissions of some 11,500 plants across the EU-25. Installations have the flexibility to increase emissions above their targets provided that they acquire emission allowances to cover those emissions, while electric plants with emissions below caps are allowed to sell unused allowances.

External links[]

Carbon pricing support:

• Our Climate Put A Price On It campaign
• Citizens' Climate Lobby: Putting a Price on Carbon

Carbon tax support:

• Carbon Tax Center — Argues for a carbon tax
• Carbon tax survey results — Some taxes have majority support
• WSJ: Cap-and-Trade's Unlikely Critics: Its Creators — They are critical of using it for carbon

Cap and trade

• European Emissions Trading System — Web site of largest cap and trade experiment
• Regional Greenhouse Gas Initiative (RGGI) — Cap and Trade in the US Northeast
• California's Cap and Trade Program — The California Air Resources Board
• Environmental Defense Fund — Report on California's Cap and Trade
• The Way Forward Report - Design Principals for Ontario's New Cap and Trade System

Emission reduction commitments (targets)

• CDM Rulebook — Defines Kyoto commitments
• UN Climate Change Framework — Lists national commitments for 2020
• European Commission — EU Overachieves Kyoto targets

Price commitments

• The Price Carbon Project — Quotes & papers from Nordhaus, Stiglitz, Weitzman, Dion, etc.
• Pricing Carbon Initiative — US focused effort for carbon-pricing commitments

Notes[]

Sources[]

• Kikstra, Jarmo S; Waidelich, Paul; Rising, James; Yumashev, Dmitry; Hope, Chris; Brierley, Chris M (September 6, 2021). "The social cost of carbon dioxide under climate-economy feedbacks and temperature variability". Environmental Research Letters. 16 (9). doi:10.1088/1748-9326/ac1d0b. Retrieved September 12, 2021.

• "State and Trends of Carbon Pricing 2021". The World Bank. 2021. doi:10.1596/978-1-4648-1728-1.

• "Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis Under Executive Order 12866" (PDF). Interagency Working Group on Social Cost of Greenhouse Gases (US govt.). 2016. Retrieved September 12, 2021.

References[]