Carbon tax could be the answer to climate change

Each discipline views the threat of climate change from a different vantage point. Economics sees it as a massive global externality, one whose sources are global and whose reach spans the Earth but also stretches into the distant future.

Unlike many other global externalities, climate change has a simple solution: make people pay for the harm they cause. For any policy to be effective, it must raise the market price of carbon dioxide and other greenhouse gas emissions. Putting a price on emissions corrects for the underpricing of the externality in the marketplace.

Prices can be raised by putting a regulatory tradable limit on the amount of allowable emissions (“cap and trade”) or by levying a tax on carbon emissions (a “carbon tax”). Both of these price signals would create incentives for changed behaviour.

A central lesson of economic history is the power of incentives. To slow climate change, everyone must have an incentive to replace their current fossil-fuel-driven consumption with low-carbon activities — millions of firms and billions of people spending trillions of dollars. The most effective incentive for change is a high price for carbon. Raising the price of carbon will achieve four goals. First, it will provide signals to consumers about which goods are carbon-intensive and should, therefore, be used more sparingly.

Second, it will provide signals to producers about which inputs are carbon-intensive (such as coal and oil) and which use less or no carbon (such as natural gas or wind power), thereby inducing firms to move to low-carbon technologies.

Third, it will give market incentives for inventors and innovators and investment bankers to invent, fund, develop, and introduce new low-carbon products and processes.

Finally, a carbon price will economise on the information that is required to undertake all these tasks.

However, we have learned that raising the price of carbon in one country or one region will not be sufficient to slow global warming, and surely one country implementing a Green New Deal or other ambitious proposals will not attain the goals of limiting temperature change to 1.5 or 2 degrees Celsius if some free ride on the actions of others.

As a means of projecting carbon pricing into the international space, I have proposed a “climate club.” The notion is that nations can overcome the syndrome of free-riding if they adopt the club model rather than voluntary arrangements such as the Kyoto Protocol and the Paris Agreement on climate change. A climate club is an agreement by participating countries to under-take harmonised emissions-reduction policies, but the central new feature is that nations would be penalised if they did not meet their obligations.

The club proposed here centres on an “international target carbon price” that is the focal provision of the agreement. Under this plan, countries would agree to implement policies that produce a minimum domestic carbon price of, say, $50 per tonne of carbon dioxide. One important feature of the carbon club is that it organises policies around a target carbon price rather than emissions reductions (emissions limits being the approach of the Paris Agreement and the Kyoto Protocol). One reason for focusing on prices rather than quantities is the structure of the costs and benefits. However, the more important reason, emphasised by Martin Weitzman, involves the low dimensionality of the decision process for prices.

The international community is a long way from adopting a climate club or an analogous arrangement that will slow the ominous march of climate change. Indeed, most discussions are still focused on the doomed voluntary model.

Science Focus