Carbon pricing: Putting a price tag on climate change

Since the beginning of the industrial revolution, over 35 billion tons of carbon dioxide (CO₂) have been emitted, while atmospheric CO₂ has increased by approximately 50% over the same period. CO₂ comprises over 70% of greenhouse gases emitted through human activity which are directly responsible for climate change and its associated detriments. Therefore, to blunt and potentially reverse the damaging impacts of climate change, strategies such as carbon pricing have come to the forefront of reducing CO₂ emissions.

The costs associated with running a business are generally composed of expenses that contribute to manufacturing or selling a final product and/or service. However, these costs often do not incorporate the potential damages associated with climate change through CO₂ emissions from carbon intensive businesses. To account for the detriments associated with CO₂ emissions, carbon pricing—an economic instrument—has been introduced to incorporate these potential costs by setting a price for emitted CO₂. By putting a price on CO₂ emissions and steadily increasing this price over time, this aims to disincentivize carbon intensive practices while providing incentive for future investments in ventures that are more sustainable.

Carbon pricing can be implemented either through a carbon tax, or an emission trade system (ETS). A carbon tax places a specified price on the CO₂ emissions produced by companies. However, since the price of CO₂ is pre-determined, the predicted emission reduction outcome is uncertain. This contrasts with the second type of carbon pricing, the ETS. An ETS is a type of cap-and-trade system where the “cap” is a limit placed on total CO₂ emissions produced for a given industry. The “trade” aspect comes in the form of CO₂ emission permits given to companies within the industry, where companies can freely buy and sell these permits. Therefore, rather than a pre-determined price for CO₂ emissions, the supply and demand of permits dictates the price for CO₂ emissions. In Canada, we have implemented several carbon pricing strategies such as the Canada Federal Output-Based Pricing System and the Canada Federal Fuel Charge which are an ETS and carbon tax system respectively.

But how effective is carbon pricing in reducing carbon emissions in the real world? In a 2020 publication, “Carbon Pricing Efficacy: Cross-Country Evidence”, economist Dr. Rohan Best and colleagues looked at CO₂ emissions across 142 countries from 1997 to 2017, with 43 countries implementing some form of carbon pricing by the end of their study period. Their findings show that countries that have implemented carbon pricing have a 5% reduction in the growth of CO₂ emissions per year compared to countries that have not implemented carbon pricing. After accounting for other factors that may have contributed to this reduction, they estimate that the implementation of carbon pricing was responsible for about a 2% reduction. Although 2% does not seem substantial at first, these annual differences will compound to drastic reductions in CO₂ emissions over decades.

Although the idea of carbon pricing seems ideal, it is not without issues. The price of CO₂ and the regulation of carbon pricing practices are unfortunately not uniform across different regions around the world. As a result, this leads to carbon leakage where businesses will shift carbon-intensive operations to regions where the price of carbon is less expensive, and the regulations and associated enforcement are less stringent. To this end, there have been endless debates on determining the correct price of carbon and the feasibility of implementing this price uniformly across carbon markets around the world. Another issue is that while the implementation of cap-and-trade systems generate a market that favours reduction of carbon emissions, this very market opens the potential for market manipulation and speculation in addition to providing companies with significant windfall profits by providing permits free of charge. A relatively recent example can be highlighted in the 2021 annual filing for Tesla, the largest electric vehicle maker in the world by market cap. Tesla was able to generate 1.46 billion dollars from the sale of their carbon permits, which constituted approximately 26% of their total profits for that year.

The costs of carbon pricing have also been shown to disproportionately impact different demographics, raising concerns regarding equitability. Several carbon intensive industries are essential to everyday life such as generating electricity, manufacturing essential goods, and agriculture. Increases in the costs of these essential services due to carbon pricing could result in increased expenses that are ultimately passed down to the consumer. While this increase may not have a noticeable impact to affluent groups, this has a significant impact on households with lower socioeconomic status where these expenses would take up a more meaningful portion of household budget. However, there are methods to overcome these undesired side effects. For example, the implementation of a carbon tax can generate revenue. In the U.S., some of this revenue has been returned to the public in the form of dividends where the amount given is based on socioeconomic status, offsetting some of the inequities that result from carbon pricing.  

Carbon pricing is currently recognized as the most efficient method in reducing CO₂ emissions. This has been echoed by over 3000 U.S economists including 28 Nobel Prize laureates in the “Economists Statement on Carbon Dividends”, the largest public statement from economists in history. Although the implementation of carbon pricing has been well-received by nations around the world, there are still many areas for improvement. Resolving the issue of carbon leakage and ensuring that carbon pricing strategies are carried out in an equitable manner is of utmost importance. If these issues can be resolved however, then carbon pricing is a powerful strategy to meet our climate change goals.

References

1. Best, R., Burke, P., & Jotzo, F. (2020) “Carbon Pricing Efficacy: Cross-Country Evidence.” Environmental and Resource Economics 77: 69–94. https://doi.org/10.1007/s10640-020-00436-x
2. Böhringer, C., Fischer, C., Rosendahl, K., & Rutherford, T. (2022). “Potential impacts and challenges of border carbon adjustments.” Nature Climate Change 12(1): 22–29. https://doi.org/10.1038/s41558-021-01250-z
3. Boyce, J. (2018). “Carbon Pricing: Effectiveness and Equity.” Ecological Economics 150: 52–61. https://doi.org/10.1016/j.ecolecon.2018.03.030
4. Carbon Pricing Dashboard https://carbonpricingdashboard.worldbank.org/
5. Climate Change: Atmospheric Carbon Dioxide https://www.climate.gov/news-features/understanding-climate/climate-change-atmospheric-carbon-dioxide
6. Economists’ Statement on Carbon Dividends https://clcouncil.org/economists-statement/
7. Global Greenhouse Gas Emissions Data https://www.epa.gov/ghgemissions/global-greenhouse-gas-emissions-data
8. How Cap and Trade Works https://www.edf.org/climate/how-cap-and-trade-works
9. How Carbon Pricing Can Save the World https://www.youtube.com/watch?v=rg_fP2CZYq4&ab_channel=TEDxTalks
10. How Carbon Pricing Works https://www.canada.ca/en/environment-climate-change/services/climate-change/pricing-pollution-how-it-will-work/putting-price-on-carbon-pollution.html
11. How Do Carbon Markets Work? https://www.youtube.com/watch?v=m5ych9oDtk0&ab_channel=TheEconomist  
12. Kaufman, N., Barron, A., Krawczyk, W., Marsters, P., & McJeon, H. (2020). “A near-term to net zero alternative to the social cost of carbon for setting carbon prices.” Nature Climate Change 10(11): 1010–1014. https://doi.org/10.1038/s41558-020-0880-3
13. Kaufman, N., & Krause, E. (2016). “Putting a Price on Carbon: Ensuring Equity.” World Resources Institute Issue Brief. https://files.wri.org/d8/s3fs-public/Putting_a_Price_on_Carbon_Ensuring_Equity.pdf
14. Pricing Carbon https://www.worldbank.org/en/programs/pricing-carbon
15. Tesla, Inc. (2022). 2021 10-K report. https://www.sec.gov/Archives/edgar/data/1318605/000095017022000796/tsla-20211231.htm

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• Carbon pricing: Putting a price tag on climate change - January 30, 2023