When it comes to tackling climate change, carbon pricing is perhaps the most widely discussed solution. Summarized below are points key to understanding the theory and practice of carbon pricing.
Climate change is caused by an economic externality - the failure to price the costs of emitting greenhouse gases (GHGs) and thereby contributing to climate change.
"Internalizing the externality," e.g. by pricing carbon emissions, is the conventional economic response to climate change. In principle, the right “price” being placed on GHG emissions would result in the “economically efficient” level of climate change (if there is such a thing).
There are many ways to price carbon, both explicitly and implicitly. Carbon prices can be explicitly set as in a carbon tax, derived through the workings of market-mechanisms, or based on the Social Cost of Carbon. They can also be implicit, e.g. buried in the cost of electricity (a Renewable Portfolio Standard) or the cost of new vehicles (a Fuel Economy Standard).
All kinds of carbon pricing initiatives are underway around the world, and the "coverage" of carbon pricing has grown substantially over time
To get a sense for the implications of carbon pricing, a $100/ton (of CO2) carbon price is equivalent to a $1/gallon increase gasoline prices. Although estimates range widely, a $30-50/ton carbon price would be needed to significantly influence electricity decision-making, and a $100-300/ton carbon price would be needed to significantly influence transportation sector decision-making.
Overall, the level at which carbon is being priced around the world tends to be well below the levels that would substantially accelerate a low-carbon transition.
Only the idea of the "Social Cost of Carbon" reflects an attempt to actually quantify the "economic externality" of climate change. But even SCC estimates are based on highly simplified Integrated Assessment Models, and range very widely depending on the assumptions being used to calculate them.
Most carbon pricing based on the Social Cost of Carbon (SCC) adopts a “risk-neutral” approach to the SCC. Given that climate change represents a one-time and largely irreversible human experiment, a risk-averse approach to the SCC makes a lot more sense. Carbon prices today are generally far below what a risk-averse SCC estimate would suggest.
A key challenge to meaningful carbon pricing is political opposition to increasing energy and other costs. Explicit carbon pricing at levels likely to influence economic decision-making have proven very difficult to implement. Much higher levels of implicit carbon pricing (even up to $800/ton) have been possible since, being largely invisible, they don’t generate the same political opposition.
While carbon pricing will continue to expand geographically, there is currently little reason to assume that much higher carbon prices will become politically palatable than they are now. Some observers are coming to the conclusion that no matter how desirable as a matter of economic theory, meaningful carbon pricing may prove impossible in accelerating the low carbon transition. Carbon pricing is not the climate change "silver bullet" economists have been suggesting for many years.
Some observers have suggested that international agreements aimed at mitigating climate change would be a lot more successful if they focused on coordinating international carbon pricing, rather than on trying to agree on quantitative emissions reduction targets.
Discussions of carbon pricing have reached a fever pitch, but will carbon pricing significantly affect business decision-making, from fossil fuels development to consumer choices?
Carbon pricing in its various forms has been on the policy table for many years, and in some cases implicit carbon prices (e.g. RPS requirements) have gotten high (e.g. >$100/ton). But most explicit carbon pricing efforts have yielded carbon prices too low to make much of a difference. To have a big impact on energy decision-making carbon prices have to be predictably substantial, and considerably higher in the transportation sector than in the electric sector.
- Will prices be high enough to make a difference? How high is that?
- Will prices be certain enough over time to be accounted for in decisions?
- Will prices be left to markets to set, and what does that imply?
Carbon pricing is spreading across the world, as demonstrated by annual reports mapping out the latest regions to impose some kind of carbon price. But the existence of a carbon price isn’t the issue – it’s whether that carbon price if having an impact on decision-making and emissions.
The great majority (virtually all) of the world’s carbon pricing initiatives to date have had little if any material impact on fossil fuel use trajectories. It’s generally accepted that a $30-50/ton price (1-5 cents/kWh depending on fuel source) in the electricity sector would have a significant impact on energy mix, but that it would take more than $100/ton price ($1/gallon) price to have a significant impact on oil consumption in the transportation sector. Most carbon prices we’ve seen to date are far below these levels.