How to design a carbon pricing scheme

Recent energy price shocks emphasize the need to transition away from fossil fuels to address the climate crisis and reduce dependence on insecure energy sources. Ideally, a central component of mitigation strategies is a carbon price that increases incrementally over time—complemented by other mitigation policies to address specific sectoral issues.

A comprehensive carbon price promotes a full range of behavioral responses to reduce energy use and shift to cleaner fuels across sectors, firms and households. Carbon pricing can be implemented through a carbon tax, that is, a charge on the carbon content of fossil fuels or through the Emissions Trading System (ETS) requiring firms to earn allowances for their emissions. In the latter case, the government controls the supply of allowances and market transactions in allowances determine the price of emissions. As documented by the World Bank (2022), carbon pricing schemes are already operating in 45 countries and others are considering one (see Figure 1). Economic analysis is needed to guide the design of these schemes (Oswald and Stern 2019); In this column we discuss these issues, drawing from a recent paper (Parry et al. 2022).

Figure 1 Global national or regional carbon pricing schemes, 2022

formula: Parry and others (2022) and World Bank (2022).
Comment: The EU ETS includes Iceland, Liechtenstein and Norway. Prices are emission-weighted averages within national, sub-national and, if applicable, EU level schemes. Currently, China’s system takes the form of a tradable emission intensity standard with no fixed cap on emissions. The pricing standard is the carbon price times emissions divided by GDP.

In addition to accelerating decarbonisation, carbon pricing can also have significant financial and economic benefits. For example, a $50 carbon price in 2030 would reduce CO2 Emissions in individual Group of Twenty (G20) countries are about 15-25% below baseline levels.1 This will raise annual revenue by around 0.5-2% of GDP. These revenues can be particularly attractive in countries where revenue collection from a wide range of financial instruments is hampered by widespread informality. And the economic cost of a $50 carbon price (mainly the annual cost of using cleaner but more expensive technologies) is manageable – about 0.1% to 0.6% of GDP. In fact, the domestic environmental co-benefits of carbon pricing, particularly reductions in local air pollution mortality, significantly exceed mitigation costs in many cases – even before accounting for climate benefits (see Figure 2).

Figure 2 A $50 carbon price, economic costs and domestic environmental co-benefits from 2030

formula: Parry and others (2022).
Disagree: Domestic environmental co-benefits mainly include reductions in local air pollution mortality and road congestion and accident externalities.

Comparing carbon tax and ETS

In their purest form, ETS provide certainty on emissions with a carbon price determined by market factors, as opposed to a carbon tax. Certainty on emissions is attractive if policymakers want to meet future emissions targets. But the resulting price uncertainty may weaken incentives for private investment in clean technologies such as renewable plants with high upfront costs and long-range emissions reductions.

In practice, however, both taxes and ETS may precariously balance emissions and prices, at least to some extent. In most carbon tax schemes, tax rates are fixed and adjusted according to progress towards emission targets, while ETS may include price stabilization mechanisms such as price floors. The latter mechanisms also improve the compatibility of the ETS with overlapping instruments such as energy efficiency and renewables policies – otherwise, under a fixed emissions cap, these measures would lower allowance prices without affecting emissions.

In principle, a carbon price should cover CO2 From the power, industry, transport and building sectors, which account for most of the emissions. In reality, pricing out electricity and industry is the immediate priority. For example, these sectors account for about 60% to 90% of potential emissions reductions under a comprehensive carbon price by 2030 in G20 countries.

Carbon taxes are generally under the purview of the Ministry of Finance and are easy to administer. They can be integrated with existing road fuel taxes and extended to other processed petroleum products, coal and natural gas, or to fiscal measures applied ‘upstream’ when the fuel is extracted or imported. ETS, which are usually under the Ministry of the Environment, are generally applied ‘downstream’ to large emitters in the power and industrial sectors, although they can be applied ‘midstream’ to transport and building energy supply companies (as they are in California and Germany). The ETS requires new powers to monitor downstream emissions and trading markets although these may not be effective where there is limited institutional capacity or where allowance trading markets are concentrated and subject to manipulation.

Much is at stake in terms of economic efficiency and political economy in how potential carbon pricing revenues are used. Productive use of revenues – such as reducing taxes on work effort or financing public investment – ​​can stimulate economic activity, counteract the harmful effects of high energy prices, and potentially garner political support from households. Most carbon tax schemes use revenue for this general purpose.

ETSs can raise similar financial benefits if allowances are auctioned, although especially in the early stages allowances are often given as ‘free allocations’ to extract support from affected industries. Where allowances are auctioned, revenue is earmarked for environmental expenditure.

As with all taxes, implementing a carbon tax can be politically challenging. However, their acceptance can be enhanced through revenue recycling, stronger support for vulnerable groups, and inclusive and comprehensive communication strategies that include consultation with key stakeholders.

Income allocation has important implications for impact on households. Carbon tax revenues can be recycled in ways that make overall reforms distributionally neutral or progressive, for example, combining general tax cuts with some targeted relief for low-income households. Thus for most countries, such reforms can be designed as pro-poor, pro-equality as well as pro-climate. In contrast, an ETS does not provide the same opportunity if allowances are freely allocated or if revenues are earmarked for environmental spending.

Competition and ‘carbon leakage’ concerns drive carbon pricing for policymakers, particularly about the implications of higher energy costs for trade-exposed industries such as steel, aluminum and cement. For carbon taxes, some countries have exempted certain industries or fuels with a gradual phaseout. For ETS, free allowance has been widely used. Both approaches, however, come with potential financial, economic and environmental costs and are much less efficient than the alternatives, especially at high levels of decarbonisation. A more robust measure, currently receiving much attention, is Border Carbon Adjustments (BCAs) which impose charges for embodied carbon on imports, which can be offset by rebates for embodied carbon among domestic exporters. BCAs linked to domestic carbon taxes are probably somewhat easier to square with WTO requirements than BCAs linked to ETS, especially for export exemptions. However, these legal aspects have not yet been tested in practice.

For a wide range of emission sources beyond fossil fuel CO2, carbon taxes – or variants of them – may be more practical instruments than ETS. For example, fees for methane emissions from coal, gas and oil extraction could be integrated into existing tax systems for these industries, potentially in a revenue-neutral way to address competition concerns. In agriculture, where there is existing capacity to administer business taxes or support programs, pricing can also be applied to methane from livestock based on farm outputs and inputs (for example, herd type and feed) and default emission factors. The forestry sector is potentially suitable for a fee-and-rebate (‘fibate’) system, where fees paid by more carbon-intensive firms are used to subsidize less intensive firms.

At the international level, agreements on minimum carbon prices (‘floors’) can address concerns about unilateral mitigation actions, including competition and policy uncertainty in other countries. Price floor requirements can be easily met through carbon taxes since they represent fixed prices. But ETSs can be moved by either underpinning domestic ETSs with floor prices or setting caps to create expected domestic emissions prices (as they are under federal pricing requirements in Canada). The principle of international equity implicit in the Paris Agreement (that developed countries reduce emissions faster), requires price adjustment mechanisms to differentiate requirements by level of development, with higher prices in developed countries than in developing countries.

In conclusion, designing and implementing policy packages that ensure a just transition by reducing emissions, ideally with carbon pricing at their core, will be key to achieving climate targets and, ultimately, the Paris Agreement.

Policymakers will choose between and among carbon pricing instruments depending on their varied national circumstances. Although carbon taxes have many practical advantages, policymakers may prefer the ETS for other reasons – for example, if mitigation policy is delegated to the Ministry of the Environment or taxes face strict constitutional barriers (for example, unanimity rather than a simple majority in the EU). In some ways ETS can be designed to replicate tax incentives (eg through price floors and allowance auctions). In other cases, countries may choose to administer ETSs for energy while using tax schemes that build on existing fiscal regimes for a wide range of emission sources. Table 1 provides a summary of the issues policymakers need to consider in designing carbon taxes and ETSs.

Table No. 1 A brief comparison of carbon tax and ETS

formula. Parry et al. (2022).
Disagree: Green indicates an advantage of the device; Orange indicates no advantage or disadvantage; Red indicates a problem with the device.

reference

Oswald, A and N Stern (2019), “Why are economists dismissing the world on climate change?”, VoxEU.org, 17 September.

Parry, I, S Black, and K Zhunusova (2022), “Carbon Tax or Emissions Trading System? Instrument Choice and Design”, IMF Staff Discussion Note.

World Bank (2022), Carbon pricing status and trends 2022.

Endnote

1 Quantitative results here are from Parry et al. (2022).

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