Carbon Pricing: The Key to Open the Way Toward a Sustainable Recovery and Long-Term Wellbeing

Authors: Stefano Vrizzi, Jessica Geraghty, Matilda Saarinen, Beatrice Noun, Olivia de Vesci, Philippine Levy

Review by: Paul Malliet

This is a contribution that was created as part of the writing workshop "The Economics of the New Reality – Looking at the World Under the Pandemic from Pluralist Lenses",  hosted by Rethinking Economics Sciences Po, published in July 2021.

Summary

Recovery from the Covid-19 crisis provides a chance to implement economic measures that are also beneficial from environmental and social perspectives. While ‘green’ recovery packages are crucial to support economies tracking a low-carbon transition in the short-term, green measures such as carbon pricing are also key to improving welfare in the long-term. This commentary specifies the need for carbon pricing, outlines its implications for our everyday lives, and explains how it works alongside value-based change in the context of climate action and societal well-being.

Context

Various governments around the world have declared that we are living in a “climate emergency”. Despite international attention and national pledges, greenhouse gas emissions and global temperatures continue to increase. While the costs of addressing climate change are perceived as high, the costs of inaction on wealth and well-being would be even higher.

Meanwhile, the Covid-19 pandemic has dramatically altered our way of living. Countries around the world implemented lockdowns, shutting down the economy to prioritise the health of vulnerable citizens. As restrictions have been lifted and life has begun to return to a new normal, many have found that their values and priorities have changed. Economic welfare is extremely important, but as a society, we also clearly value health, equality, inclusivity, the environment and community.

The recovery from the Covid-19 crisis provides a chance to implement economic measures that are also beneficial from environmental and social perspectives. While ‘green’ recovery packages are crucial to support economies tracking a low-carbon transition in the short-term, green measures such as carbon pricing are also key to improving welfare in the long-term. Our welfare extends beyond just economic factors, and we should be considering these aspects when implementing policies. This commentary specifies the need for carbon pricing, outlines its implications for our everyday lives, and explains how it works alongside value-based change in the context of climate action and societal well-being.

What is Carbon Pricing?

Carbon pricing is an important policy tool to address climate action and reduce greenhouse gas (GHG) emissions. The two main forms of carbon pricing are carbon taxes and emissions trading schemes. A carbon tax sets a price on the carbon content of fossil fuels; polluters must pay this tax for every unit of emissions. The higher the tax rate, the more incentive for polluters to reduce their emissions in order to avoid paying the tax. As at November 2020, there are 25 countries with national carbon taxes, which range from less than €1 per tonne of CO₂ emitted to a high of around €115 per tonne of CO₂ in Sweden. Emissions trading schemes, or cap-and-trade systems, instead restrict the total quantity of emissions through allowances that firms can trade with each other. This system incentivises businesses to reduce their emissions, as they can sell their unused allowances to other firms. An emissions trading scheme is in place in nearly 40 countries, with the European scheme covering 31 countries. 

How will carbon pricing help reduce emissions?

GHG emissions are a ‘negative externality’: prices fail to reflect the social and economic costs of climate change produced by high-carbon goods and services. This fundamental market failure can be corrected by shifting the prices upwards, namely by internalizing the negative externality. In theory, a higher price decreases demand for carbon-intensive products, thus reducing GHG emissions. This price mechanism will essentially provide incentives to minimize emissions, while encouraging investments that facilitate further emissions reductions.

Alongside the need for complementary innovation policies, carbon pricing should be designed to follow a trajectory consistent with the Paris Agreement. Currently, carbon price schemes are not only far below this target, but also present other deficiencies. To implement this price mechanism effectively, governments need to make clear commitments to price levels such that they reassure firms to invest, while offering consumers relevant alternatives to shift their consumption patterns.

Since GHG emissions are a global externality, a uniform carbon price worldwide would be the most effective mechanism to shift activities. However, no top-down enforcement mechanism exists and, in practice, implementation occurs through national initiative. Furthermore, the concept of climate justice acknowledges that countries and groups within societies are affected differently by climate change, with the burden disproportionately falling on the poorest. On the contrary, historical responsibility for emissions falls predominantly on wealthy countries, particularly the United States and Europe. As such, a uniform carbon price may not be fair or feasible to implement in the near term. Even if implemented at various levels in different countries, carbon pricing would still be effective at reducing emissions.

What are the practical implications of carbon pricing and how to avoid inequalities?

Carbon prices will have inarguable consequences for our everyday lives. They will not only encourage companies and governments to provide a more sustainable system for society, but they would also encourage individuals towards more environmentally-friendly choices, lowering the ecological footprint both at collective and individual level.

As different societal groups dispose of different financial means, carbon pricing must be fair also for disadvantaged groups, especially lower-income earners. For example, if everyone is required to pay extra for their heating, money is likely to be ‘redistributed’ from lower-income households to higher-income households, as an additional cost of €100 represents a much larger share of their household budget.

While this is a valid concern and one of the most common arguments against carbon pricing, these policies do not need to be regressive. In fact, revenue-recycling is an essential component to ensure a ‘progressive’ measure that actually reduces costs for low-income households. Revenue from carbon pricing can be employed to promote equity, cut other pre-existing distortionary taxes or invest in the ecological transition. For example, a measure may involve at first redistributing revenue to lower-income households and then investing in low-carbon projects, or cutting distortionary taxes to improve competitiveness at first and then targeting transfers to the most vulnerable households. The optimal solution will depend in practice on the macroeconomic context and preferences of the government in place. In any case, carbon pricing shows clear potential to be a progressive, fiscally-neutral and even welfare-enhancing tool.

Concluding remark: Can this economic tool drive needed societal change alone?

While there is an inarguable need for price mechanisms to promote clean investment and innovation as well as guide consumption, our societies are also guided by the values that citizens carry in their daily lives. The current Covid-19 crisis has fundamentally altered our way of living in a short period of time. As a result, many people have begun to reconsider their values and priorities, with many placing more weight on aspects of wellbeing such as health and nature. The Covid crisis provides a clear opportunity for us to implement significant changes to the way our society works, reflecting the importance of these values. Citizens are overwhelmingly supportive of government action to this end and are prepared to continue with changes in their own lifestyles to help address the climate emergency. As such, this is a unique opportunity to implement carbon pricing and transition to low carbon economies in order to prioritise the wellbeing of current and future generations.

Progress along the next years and decades will see both technologies develop and individuals shift their behaviors, thus fading the environmental externalities of high-carbon activities. In a future state of the world, the importance of carbon pricing in guiding our societies could diminish and societal values take on a more defining role. By continuing to embrace societal well-being alongside, or even above, economic goals, this future world state will be only better aligned with our shared values through avoiding the disastrous consequences of climate change.

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Comment from our editors:

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