The way forward for carbon pricing

The European Union and other countries are moving forward with higher carbon pricing to fight climate change—but many design issues and operational challenges must be overcome to reach a carbon price that is both effectively high and politically feasible.

This blog reports on a seminar in the Political Economy of European Climate Action series, hosted by the European Studies Centre of St. Antony’s College Oxford, on April 26, 2021, which discussed the current options under consideration.

The panel included Ian Parry, IMF Senior Climate Specialist; Michael Mehling, Deputy Director of MIT Centre for Energy and Environmental Research and Professor of Practice, Strathclyde University Law School; Franziska Funke (discussant), Environmental Change Institute, Oxford, and Technical University Berlin; and was chaired by Daniel Hardy, EuPEP, Oxford. Click here for the podcast of this session.

Ian Parry began by reminding the audience why higher carbon pricing is so crucial. The last window for meeting the central goal of the Paris Agreement – to keep global warming below 2 degrees Celsius—is about to close. The only way to achieve this now is to cut global emissions 30-60 percent below 2030’s projected level. But countries’ pledges for emissions cuts by 2030 add up to only half of the needed reduction (and no mechanism exists to enforce even these pledges).

The most direct, comprehensive, and easy-to-apply weapon to stop emissions would be to raise the price of carbon to levels that deter society from using it (in power, industry, transport, buildings, and other sectors). Carbon taxes are a better economic instrument for raising prices than are trading systems (give more certainty, generate fiscal revenue, are easy to administer) but trading systems can be designed to generate similar effects and may be more socially acceptable—as in much of Europe.

Momentum is growing for carbon pricing, with more than 60 schemes in place around the world, and major initiatives in China, Germany, and Canada in 2021. While this means that prices must rise, most of the burden will be on coal (with expected price increases of 146 percent on average, on a $50 tax—though with wide differences across countries). The average impact on petrol (gasoline) prices will be much less—an 11 percent rise. Countries’ pledges imply a widely varying array of price increases; for instance, China would need only a $25 price hike to deliver on its pledge.

Besides its role in capping global warming, higher carbon pricing would bring domestic benefits: the domestic environmental gains (e.g., to health from lower pollution) would more than offset the economic costs in all countries (with Russia, China and India gaining the most), and governments would benefit from extra revenue of ½ to 3 percent GDP on a $50 tax.

Parry summarized the large body of literature on how to raise carbon prices least disruptively: (i) pre-announce a gradual path of price increases… (ii) that covers as broad a range of sectors as possible… and (iii) use the revenue from charging higher carbon prices productively, so society sees value-for-money. Governments will also need supporting policies—to protect against loss of industrial competitiveness, funnel public investment to support low-carbon activity (e.g., public charging station for electric cars), and ensure the transition is perceived as just, by compensating the poorest and worst-affected. An increase in average sectoral prices could be avoided, if preferred, by bringing in a fee-bate system (with a sliding scale of higher prices on above-average carbon users to lower prices on low-carbon users).

A main problem with national carbon pricing efforts is that countries moving quickly to raise carbon prices would lose international competitiveness relative to laggard countries. A cooperative international strategy could avoid this. The IMF is recommending that G20 countries (i.e., large emitters) agree on an international carbon price floor. Such an agreement would prevent countries from free-riding, and could be designed to accommodate different price floors across countries with different starting conditions (notably, lower for developing countries).

Michael Mehling picked up from this global picture to discuss in more detail where Europe stands at the moment. Since there is little momentum towards a cooperative international agreement, the EU has announced that it will go ahead unilaterally with its own carbon pricing strategy, protecting its trade competitiveness by a Carbon Border Adjustment Mechanism (CBAM). A legislative proposal for the CBAM is expected by July 2021, and it is intended to be operational by 2023.

A border carbon adjustment would level the playing field for trade by offsetting price differentials on imports and possibly also exports, mainly through a tax on imported products and potentially an exemption or rebate on European exports. Releveling the playing field would not only help preserve the competitiveness of EU producers but would ensure EU emissions reduction efforts are not negated by European consumers’ switching to high-carbon imports from countries with lower carbon prices. It would thus address a substantial loophole in the UNFCCC’s international emissions accounting framework, which counts only territorial emissions—meaning that countries can meet their emissions-containment commitments while continuing to import ‘dirty’ goods: for instance, China exports 25-30 percent of its emissions, and Switzerland and Sweden import products responsible for more emissions than they generate nationally.

The 2023 deadline is ambitious. Mehling explained the complex design elements that will need to be pinned down—posing difficult challenges, both technical and political. Decisions to be made include: the coverage of the CBAM (imports, exports, or both? geographic scope? sectoral scope? type of emissions?); how to determine the embedded emissions (using actual data or default proxies such as average producer emissions?); and how to calculate the adjustment (e.g., taking into account carbon taxes already paid by trading partners?) Related decisions have to be taken regarding the use of revenue from the CBAM (which is projected to amount to between 5 and 14 billion euros), and the institutions/processes needed to implement the CBAM.

Mehling described how the EU might tackle this intricate matrix of choices. There are trade-offs between the technically/environmentally best solutions and the simplest, most politically amenable solutions. The ‘Most Probable’ Scenario is that the CBAM will apply to imports of basic materials and electricity only (excluding developing-country imports), be calculated on average EU or global carbon intensities of production, and give its revenue to the EU budget. A ‘Play It Safe’ Scenario would apply the CBAM only to basic imports, count only direct emissions, and use more forgiving prices. A more ambitious ‘Go-Getter’ Scenario would apply the CBAM to more complex imports and to exports, count also indirect emissions, and use actual emissions intensities.

An important consideration is whether the CBAM will be consistent with World Trade Organization (WTO) commitments. A CBAM which subsidizes exports and distinguishes between countries because of their policies is more likely to run afoul of the WTO’s non-discrimination principle. The EU will also have to prepare itself for internal disputes, depending on what sectors are covered, and for international backlash. For instance, the US is reportedly considering its own border adjustment if the EU goes ahead.

Franziska Funke agreed that both the CBAM and the international carbon-price floor would be effective instruments for pursuing emissions reduction. However, she saw a damaging risk that emissions containment would be delayed, given the likelihood of protracted struggle to make either of the two politically feasible. She emphasized the need to work also on a Plan B for raising carbon prices.

Two challenges in particular should be tackled without further delay. The first is to extend the EU Emissions Trading Scheme (ETS) to sectors excluded until now. Notably, food production accounts for 26 percent of global emissions—which means that progress must be made in decarbonizing agriculture, despite the inherent difficulties (a strong farming lobby, small and diverse producers, fear of losing competitiveness, etc.) Moreover, livestock—which accounts for 45 percent of agricultural emissions—has additional problems: it is not clear how to stop cattle producing methane! These problems signal the need to tackle agricultural emissions not only from the production side, but also by reducing demand: Funke advocates imposing consumption taxes on meat (for the same rationale as fuel taxes).

The second challenge that should not be postponed is to strengthen citizens’ support for higher carbon prices. There is evidence (for instance in the gilets jaunes protests) of widespread aversion to carbon taxes, probably due to lack of understanding of the benefits and high visibility of the costs, but also because of fairness concerns and skepticism of the role being played by the state. It is possible that expanded use of the ETS to raise carbon prices would run into less resistance, because its immediate impact is on the wholesale level and thus less visible.

Under either a tax or ETS framework, revenue recycling is likely to be key to citizens’ acceptance. Revenue could be recycled either through green spending, or through direct payment back to citizens. Green spending has the benefit of directly furthering national environmental goals, but tends to satisfy mainly those already supportive of climate action, those with trust in government, and the well-to-do. Redistribution of revenues, through fee-and-dividend schemes, or targeted transfers to low-income and other affected groups, is more likely to respond to citizens’ preference for cushioning the impact—the need for which will become more pressing as carbon prices rise.

The offline discussion considered the likely carbon pricing strategies of the US and the UK. Biden’s climate plan does not include carbon pricing, but it is conceivable that the US could use the threat of a border adjustment as a talking point with China. In the UK, the temptation to enhance trade competition with lower carbon prices than the EU will for now be dampened not only by the promise of CBAM but also by the UK’s commitment to leadership in the COP process and the G7 over the coming year. Commentators were skeptical that technical issues in the CBAM can be resolved satisfactorily (e.g., what would prevent China making a single province ‘clean’ and sourcing all its exports from there?). Given the multi-faceted difficulties to be resolved, the attractions of a simpler cooperative international carbon-price floor might eventually begin to look less utopian—though it would face its own challenges of design and enforcement. There was also wide agreement on the urgency of greening agriculture and making higher carbon prices tolerable to the public.

Adrienne Cheasty (Academic Visitor, St Antony's College, Oxford)