The argument for a carbon price

We are paying a price for burning fossil fuels and emitting greenhouse gases.

Some of the consequences of climate change are already visible today, but the most severe consequences will hit us in the years and decades to come:¹

These consequences include the negative economic impacts of climate change through its effects on people’s livelihoods, and the damage to infrastructure through rising sea levels, thawing permafrost, and extreme weather events. They pose a large threat to the life of animals and ecosystems on our planet and include the destruction of coral reefs, forest fires, the loss of ice shields, and the expansion of deserts. They include an increase in extreme weather events, like heat waves, droughts, floods, and storms. And especially for the world’s poorest people they pose a threat to their lives, as they increase the risk of hunger and food insecurity.

Climate change isn’t the only negative consequence of burning fossil fuels. The air pollution that is caused by burning fossil fuels kills an estimated 3.6 million people in countries around the world every year; this is 6-times the annual death toll of all murders, war deaths, and terrorist attacks combined.²

This is the price we are already paying for burning fossil fuels.

The International Monetary Fund (IMF) estimates the sum of these costs in a major study that they update regularly. The title of the study is ‘How Large Are Global Fossil Fuel Subsidies?’ and in the study’s latest issue the researchers estimate them to amount to US-$ 5.2 trillion.³ This is equivalent to 6.5% of global GDP.

As the study’s title makes clear, the IMF sees the sum of damage done by fossil fuels as a subsidy. That might be surprising at first, but it makes sense if you think about it. A good is subsidized when consumers and producers of that good do not have to pay the full cost for it. This can either be an explicit subsidy, for example when governments pay for the school education of the country’s children, or it can be an implicit subsidy, when producers and consumers cause damage, but do not have to pay a monetary price for it.⁴

You find examples of both types of subsidies in your own life. If you pay for you and your neighbour’s dinner then you are explicitly subsidizing them. If your neighbour crashes into your car and you do not charge him for the damage he caused, you are implicitly subsidizing them.

Fossil fuels are subsidized in both ways. They are explicitly subsidized in many places, and they are implicitly subsidized everywhere, as the consumers and producers of fossil fuels do not have to pay the monetary cost for the damage they cause.

Ending the subsidies to fossil fuels would mean to put a monetary price on them that corresponds to the damage they do. Since the alternatives to fossil fuels are both cleaner and safer this would allow the world to make massive progress according to the IMF study: Ending these subsidies and pricing them into the cost that producers and consumers have to pay for fossil fuels would substantially decrease global carbon emissions and save the lives of people who would otherwise be killed by air pollution.⁵

The damage caused by burning fossil fuels is a textbook example of what economists call an externality: Putting a monetary price on carbon emissions makes it possible to internalize the costs of the negative impact on our health, the environment, and future generations.⁶

This means that we do not have the option to not pay a price

It is a mistake to think that it is possible to not pay for emitting carbon. As we have just seen, we are already paying a price.

This is the economists’ argument for putting an explicit monetary price on carbon emissions.

What would change if we put a monetary price on carbon?

There are two ways in which a carbon price can be implemented: a carbon tax or a ‘cap and trade’ system:⁷

• In a ‘cap and trade’ system the carbon price changes over time. A maximum level of pollution (a ‘cap’) is defined and manufacturers need licenses to emit carbon. How expensive these licenses are is determined by a trading system. The price of a license increases as emissions approach the cap.
• A carbon tax is simply a levy that is applied to all goods and services which lead to carbon emissions in their production.

In both systems the price of any product increases with the amount of carbon emitted in the production of it. The result is that products with a low carbon footprint (like taking the train or solar energy) do not get more expensive, while goods that do create a lot of emissions (like a flight or coal energy) do get more expensive.

This helps us reduce emissions and pollution in two ways: it makes carbon-intensive goods much more expensive, meaning consumers will opt for cheaper low-carbon alternatives when they are available; and in markets where they’re not available yet producers will be incentivised to develop low-carbon alternatives.

Carbon pricing changes the relative prices between carbon-intensive and low-carbon products and this changes consumption choices towards a low-carbon lifestyle: Carbon prices make it more likely that we rely on low-carbon electricity rather than fossil fuels; that we take the bicycle rather than the car; that we buy the smaller car rather than the bigger one; that we buy electric vehicles rather than gas-powered ones; that we eat chicken rather than beef; or that we organize a video conference rather than an event that is a flight away.

Both of the intended consequences – transition to and innovation of alternative low-carbon technologies – increase with the carbon price. The incentive for consumers and entrepreneurs is to reduce their emissions whenever doing so costs them less than paying the carbon price.

Because access to energy often constitutes a large share of the budget of poorer families, successful carbon pricing policies include support for those households to offset the increased cost of energy.⁸

In the case of a carbon tax, the government revenue can be used to finance this support for poorer households and it can also be used to pay for additional measures that slow down climate change and support environmental regeneration: including reforestation, more walkable and cyclable cities, or research and development for renewable energy and low-carbon technologies.

With a carbon price one can establish a mechanism that ensures that those who are causing emissions are those who pay for the countermeasures that benefit society and the environment.

A carbon price allows us to make two decisions

Levying a monetary price on emissions allows us to choose our answer to two important questions: Who should pay the price for carbon emissions? How much do we want them to pay for emitting greenhouse gases?

Who should pay the price for emitting greenhouse gases?

At the most fundamental level the argument for carbon pricing is the hard truth that we have to pay a price for carbon emissions. What we can decide is who pays for them.

The status quo in a society without carbon pricing could not be more brutal:

• The people who live in high-income countries – those who enjoy the best living conditions in human history – are those who will be least affected by climate change, yet they are the ones with the highest emissions.
• The people who will be most affected by the negative consequences of a hotter planet are those that have contributed the least to climate change: the poorest people in the world – who are at risk of increasing food insecurity and do not have the resources to adapt to changes as rapidly – and the generations that come after us.

Without a monetary price on carbon it is those who have the lowest emissions that pay the most.

With carbon pricing we make sure that those who cause emissions also pay for them.

Because emissions rise with income, a carbon price ensures that it will be the rich who pay most.⁹ For the very rich it is the case that a few consumption choices – flights, large cars, meat – are responsible for the bulk of their emissions.¹⁰ Carbon pricing is a policy targeted to address these consumption choices, it makes carbon-intensive goods less affordable and ‘degrows’ the consumption of those goods.

How much do we make people pay for emitting greenhouse gases?

The second decision that we can influence with a price on carbon is: How much do we want to pay for fossil fuels?

If we continue emitting high volumes of greenhouse gases we will cause severe climate change and eventually have to pay a high price from the damages. Several studies find that if we don’t achieve a reduction in emissions now, economic growth would be much lower in the decades ahead (and that surely wouldn’t be our main concern in such a future).¹¹

Levying a fee on carbon emissions can be a key policy to bring down emissions quickly so that we avoid large costs in the future.

In the past many macroeconomists considered the need to cut emissions as a drag on the economy that lowers economic growth. This idea, that decarbonisation of our economies conflicts with economic growth, is still shared by many.¹²

But this is no longer the mainstream view. The latest annual IMF report estimates that policies, including carbon pricing, that mitigate climate change actually increase economic growth over the coming decades.¹³ This means that there is no trade-off between fighting climate change and economic growth. Fighting climate change is a way to achieve more growth.¹⁴

From the responses to my recent writing on the need of growth for ending poverty I saw that some people have not caught up with this. Fighting climate change is not just compatible with fighting poverty, the two goals — to reduce emissions and to increase economic growth — actually strengthen each other.

It is very good news that fighting climate change is expected to increase growth over the coming decades, but the benefits to climate mitigation are larger than just additional growth: it also means a modernisation of key infrastructure, faster innovation, the protection of the biosphere on our planet, and the major health benefits of reduced air pollution caused by burning fossil fuels, including millions of lives saved.

Taking both the costs and benefits into account makes a very clear argument for climate action now. Putting a price on carbon to build a low-carbon world is an investment for a much better future.

For once even economists agree

Economists are not known for agreeing much with one another. But regarding the challenge of how to reduce greenhouse gas emissions there is more agreement among economists than in perhaps any other big policy question.

What is particularly encouraging is that this is a policy that is supported by both left- and right-leaning economists. That left-leaning economists are in favour of a tax that will mostly be paid for by richer people is not surprising. It is perhaps more surprising that many right-leaning economists – who are generally in favor of a small state with only minimal taxes – are also in favor. Economists on the conservative side of the spectrum, such as Greg Mankiw, advocate strongly for a carbon tax and widespread support for carbon taxes of economists across the political spectrum is documented in many relevant surveys.¹⁵

An alternative to a carbon price that many governments pursue is to rely on specific guidelines, but doing this well is an incredibly difficult task. A government with the goal to reduce emissions can try to regulate each specific sector and decide which types of production and consumption should be reduced or forbidden. But the planner who is tasked with doing this needs to have an enormous knowledge of all kinds of technologies, their carbon footprint, their cost, the possible alternatives, and their future potential. The carbon price is such an effective alternative to the central planner, because it doesn’t require a central authority to have enormous knowledge. Instead it incentivizes everyone to reduce carbon emissions – since they are incentivized to save money – and thereby distributes the task of reducing emissions to everyone – every producer, every investor, every consumer. Instead of one central agency, it incentivizes billions of people to search for ways to reduce their costs and thereby to find millions of solutions to reduce their emissions.

Another aspect that is convincing even to those who favour a small state is that if you want to have any public spending at all – and very few want a state that is so small that neither roads nor the police are publicly funded – you have to raise state revenue somewhere. The argument then is that if you have to have some taxes, it’s better to tax something that harms people rather than something that we want to encourage, like work. There are big losers from a carbon price – the fossil fuel industry – but for citizens, the overall taxes do not have to increase: the carbon price is government revenue so that it can reduce taxes elsewhere. It is actually the other way around: the implicit subsidies to fossil fuels are costly and thereby increase taxes for everyone – as we have seen, the IMF estimates that the lack of carbon pricing means that governments lose 3.8% of GDP and this loss either means greater public debt or it has to be made up by all of us paying higher taxes.

Poorer households spend a larger share of their income on energy so that a carbon price would hit these households hardest. It is possible to avoid this consequence by making the poorest households benefit from the spending that the carbon tax allows. The famous call for a carbon tax signed by a large number of leading economists at econstatement.org has this goal. "To maximize the fairness and political viability of a rising carbon tax, all the revenue should be returned directly to U.S. citizens through equal lump-sum rebates. The majority of American families, including the most vulnerable, will benefit financially by receiving more in ‘carbon dividends’ than they pay in increased energy prices."

What is stopping us?

The world did make a start on carbon pricing. 78 different jurisdictions have implemented a carbon price and this year (2021) a price will be paid on 22% of the world’s carbon emissions.¹⁶ 17 years ago a price was paid on much less than 1% of all emissions.

But the carbon price is low in many places and the figures just cited mean that there is no monetary price on three-quarters of emissions.

Given all the arguments above, why is effective carbon pricing not implemented in many more places?

A big reason is of course that those that will lose out from carbon pricing – the fossil fuel industry – rally against them.

But it is also the case that carbon pricing is not very popular among voters. Study after study finds that a key reason for this is that many do not believe that a price on carbon is actually effective in reducing emissions.¹⁷ While it is the effectiveness of carbon prices that makes them popular among experts, it is the perceived ineffectiveness that makes them unpopular among non-experts.

But it is also the case that people change their mind about carbon prices when they learn that they do actually work.¹⁸ After the Swiss population rejected a carbon price in a referendum, a group of researchers – Carattini et al (2017)¹⁹ – ran a study to investigate what could have made the proposal more popular. They found that “the effectiveness of energy taxes is not an established fact for the general public” and their study showed that the most important successful argument in favour of the tax is information on the expected effectiveness in reducing emissions.

It shouldn’t be surprising that the communication of successful strategies is of such great importance. Many of us care a lot about climate change – people around the world consistently view it as one of the largest challenges that humanity faces – and at the same time many feel hopeless that we can actually do anything about it. Showing that there is a way forward is key for the successful fight against climate change.

Empirical evidence: Does a price on carbon reduce carbon emissions?

Back in 1991 Sweden was one of the first countries in the world to implement a carbon tax. Over time the carbon tax was gradually increased, but it still mainly affects the transport sector (around 90 percent of the revenues from the carbon tax come from the consumption of gasoline and motor diesel).²⁰

The researcher Julius Andersson studied whether the carbon price worked as intended by studying its impact on emissions from the transport sector.²¹

He finds that “CO₂ emissions from transport declined almost 11 percent in an average year, with 6 percent from the carbon tax alone.” A very strong effect.

How did prosperity and emissions change in Sweden over this period? Average incomes in Sweden – GDP per capita – increased by 52% since the year before the tax was introduced, and emissions declined by 29%.²²

Sweden’s emissions are still far from where they need to be, but the direction of change – growing prosperity, but declining emissions – is right.

And Sweden is not the only country that reduced emissions while growing the economy, as the chart shows.²³ Shown in the chart are consumption-based CO₂ emissions, which means that they account for the carbon emissions caused by products that were consumed within the country but which were produced elsewhere.

Carbon pricing is not the only reason emissions are falling in these countries. As we just saw, the paper on Sweden attributes about half of the decline to the carbon tax. Other reasons include technological progress (such as rising efficiency and cheaper renewables), declining demand for energy, and other regulations (for example, on air pollution).

Like all policies that are based on a price mechanism, the level of the price matters. If it is too low it won’t have much of an effect. This is what Felix Pretis (2020) has found for the carbon tax in British Columbia.²⁴

But in places that have a substantial carbon price, they can play an important role in reducing emissions, as a number of studies have shown.

In a recent global study, researchers Best, Burke, and Jotzo (2020) analysed 142 countries and found that those that have a carbon price do, as one would expect, have lower CO₂ emissions than those who do not.²⁵

Germany too reduced emissions while becoming richer. The research by Petrick and Wagner (2014) showed how EU-wide carbon pricing contributed to this achievement.²⁶

Countries in the European Union have established a cap-and-trade system called the EU Emission Trading Scheme (EU ETS). Recent research by Bayer and Akin showed that this system of carbon pricing has been effective in reducing emissions.²⁷

Lastly, let’s look at the motherland of fossil-fuel-powered industrialization: the chart shows the sources of power production in the UK over the last century.

Electricity production in the UK has been dominated by coal since its early days; as soon as the light bulb was invented, the UK had its first coal power plant, the Holborn Viaduct power station in London. But this changed in recent decades, and especially rapidly after the UK introduced two carbon price systems.

The UK was already part of the EU ETS, but went even further in 2013 when the country implemented the ‘carbon price floor’: a top-up carbon tax to the European system.

In the decade before the tax was introduced one third of electricity in the UK came from coal, the worst of power sources. Since then the carbon tax “has led to an unprecedented reduction in coal generation” according to the research of Castagneto et al (2019).²⁸ In the years following the policy change, the share of electricity generated from coal declined to just 2%.²⁹

As the share of electricity from fossil fuel sources declined, the carbon intensity of electricity production more than halved and carbon emissions from power generation have fallen by two-thirds in the UK!

The Law of Demand – if the price of something goes up, consumption goes down – also holds in this case. Places that have implemented a substantial carbon price are achieving the intended effect, the consumption of carbon-intensive products declines and emissions fall.

Click to open interactive version

Conclusion

What’s frustrating about the challenge of climate change is not that we have no options, but that we do not take the options we have.

The reason our societies are powered by fossil fuels is that they provided energy at the cheapest monetary price. If we want to transition away from fossil fuels and build a world that is powered by their alternatives we can rely on the price mechanism as well.

What makes carbon pricing so powerful is that it is a policy that changes the entire system. No decision about any carbon-intensive activity escapes its influence: it changes the choices of consumers, producers, investors, entrepreneurs and innovators in all relevant sectors at once.

I want to make clear that I do not believe that carbon pricing can be the one policy change that will end climate change.³⁰ But the theory and evidence is clear that carbon prices work as intended and if we are able to end climate change in this century I would be surprised if we achieve this without putting a price on carbon. In other words, I don’t think this is sufficient, but I do think it would be a key step towards a better future.

Our challenge is big. We need to build a new world that still solves the problems that fossil fuels solve today. Carbon-intensive goods and services are often in high demand today, because they are important for people. They have the unfortunate by-product of carbon emissions, but they solve other problems for us and everyone around us. Key to making the transition to a low-carbon future will be to innovate and scale-up alternatives. Carbon prices are useful for this transition because they give everyone an incentive to get there, especially in those sectors where alternatives do exist.

And in those areas where low-carbon alternatives do not yet exist, support for research and development will be key. Because these two policies are working towards the same goal they complement each other, a higher price on carbon provides an incentive to increase R&D.

We do have options, and understanding them is not exactly rocket science. Consumption goes down, when prices go up. If we want to reduce carbon emissions we should not be paying people to burn fossil-fuels. We should end subsidies.

What is hard, is to win the necessary political support for pricing carbon. The article linked below draws the political lessons from places that were successful in establishing carbon prices.

I believe that putting a price on carbon is one of the most important goals to fight for in our lifetime. The current world is not sustainable and it is just not right that the richest have the highest emissions, while those who emit the least – the poorest and those who come after us – pay the highest price. Carbon pricing addresses the current injustice where we are allowing the richest to privately enjoy the gains from fossil fuels, while they pass off the costs to everyone else.

If we are serious about decarbonizing the global economy – and building the low-carbon future – we should make the fight for a monetary price on carbon central to our efforts over the years ahead.

If you want to think through the counterarguments to pricing carbon, here is a list of references to get you started with:

• One of the most widely discussed recent articles on the topic is The Trouble with Carbon Pricing authored by Leah Stokes and Matto Mildenberger. As I emphasized above, the authors’ main point is that while carbon prices make economic and environmental sense, it is difficult to get the political support that they need to be free of loopholes and to be high enough to make a difference. They also argue that it would be wrong to believe that no other policy is needed to bring emissions to zero. I largely agree with the authors. Carbon taxes cannot be the only solution – they emphasise clean energy standards, I’d emphasise public R&D – but I disagree that this means we should not make it our political goal to put a price on carbon. I think they should be part of a big package of successful climate policy tools – carbon prices are one tool in our hands and we shouldn’t weaken ourselves by throwing away solutions that we do have.
• Ramez Naam wrote this very good Twitter thread on why carbon taxes are a good policy, but why he believes that subsidies for specific technologies can be even better in some cases.
• Rosenbloom et al (2020) discuss the weaknesses of carbon pricing and offer their own alternative, which they call “sustainability transition policy”,  a “mix of contextually and politically sensitive policies that simultaneously drive low-carbon innovation and the decline of fossil fuels”.
• Goulder et al. (2016) argue that implementing a closely related policy – a clean energy standard (CES) – can be more cost-effective than a carbon price.
• Lawrence H. Goulder, Marc A. C. Hafstead, Roberton C. Williams III (2016) – General Equilibrium Impacts of a Federal Clean Energy Standard. In the American Economic Journal: Economic Policy. VOL. 8, NO. 2, MAY 2016. (pp. 186-218).

Max Roser (2021) - “The argument for a carbon price” Published online at OurWorldinData.org. Retrieved from: 'https://ourworldindata.org/carbon-price' [Online Resource]

@article{owid-carbon-price,
    author = {Max Roser},
    title = {The argument for a carbon price},
    journal = {Our World in Data},
    year = {2021},
    note = {https://ourworldindata.org/carbon-price}
}

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