Does carbon pricing work? Thinking about economics and the environment by Scott Nyquist

If there is one thing on which economists can agree, it is that the price signal works. That is, the price of an item—whether it is pizza or pollution—influences demand for it. Crudely, the higher the price, the lower the demand. For example, in western Europe, where the price of gas is generally double that of the United States, you don’t see a ton of minivans.

This well-understood dynamic is one reason why many people, from across a wide swathe of the political spectrum, believe that economic incentives and market mechanisms, such as the price signal, should be used to promote desired environmental outcomes. The list of things on which Greenpeace and ExxonMobil agree is short, but they do agree on the value of carbon pricing.

But what if it doesn’t work?? A recent article by Stanford’s Jeffrey Ball argued that “carbon pricing isn't cutting it.” Carbon prices have been imposed in two ways, either through a tax or through a trading mechanism. Some form of carbon price exists in 45 countries, including the European Union, a dozen or so American states, a couple of Canadian provinces, and soon China. Global revenues reached $33 billion in 2017. Even so, notes Ball, greenhouse-gas (GHG) emissions keep rising; clearly, the price signal has not proved all that influential.

Be careful what you legislate for

The price signal is an incentive—a high price discourages consumption. There are, of course, other kinds of economic incentives. For example, in 2007, a bill with bipartisan support passed the US Congress to encourage the use of biofuels in transportation. The goal was to help US farmers, promote energy independence by diversifying transport-related energy sources, and in the process to curb car-related GHG emissions. Around the same time, the EU mandated the use of biofuels for 10 percent of transport as a way to lower the carbon footprint of the sector.

Since then, US palm oil imports have risen more than 50 percent, to about 1.5 million tons; these have generally replaced soy, which was instead being blended into transport fuels. In addition, production and imports of biofuels have surged. In Europe, palm oil imports, which are used predominantly for transport, have reached 6.5 million tons.

In the end, these well-intentioned laws ended up showcasing an even more important law—that of unintended consequences.  In an excellent piece of reportage, environmental writer Abrahm Lustgarten went to Indonesia, travelling through once-verdant tropical rain forests now converted into palm oil plantations, created in large part to fulfill the requirements of US and European legislation. The net result: more GHG emissions, because the vanished forests had been carbon sinks and the conversion to palm-oil plantations damaged the carbon-rich peatland soils characteristic of many of the areas from which palm oil is produced (the EU is moving toward banning the import of palm oil for transport biofuels). In a sense, the market was again at work. Required to use more biofuels, carmakers naturally turned to the cheapest source—and that turned out to be palm oil.

In the case of carbon pricing, there have been two major problems. First, there have been too many exceptions. Prices have typically been imposed only on the power sector, which accounts for a minority of GHG emissions, and even then, big users were often exempted, for reasons of competitiveness. And second, the price has usually been set too low. For a price to change behavior, it has to be high enough to make a difference; think again of European versus American gas prices. To put it another way, it needs to hurt, at least a little; otherwise, why bother to change? Policymakers, understandably, don’t like dishing pain. Moreover, there are concerns that a carbon tax, if it is not recycled in some way, would be regressive, hurting those on the lower end of the economic ladder while the rich simply shrug and pay up. That has certainly been a major factor in the ongoing “yellow vest” protests in France (see photo above) against higher fuel taxes, which are a form of carbon price.

In the G-20 nations, which account for the vast majority of the global economy, more than 80 percent of non-road emissions are unpriced. According to the World Bank, almost half of all forms of carbon prices are at less than $10 per ton of CO2; only three percent were at the $40 to $80 level the Bank considers necessarily to meet global GHG emissions targets. It is interesting that when companies and institutions apply a “shadow price” to their own emissions, they set them rather higher than the norm. Only on this basis, they know, does the price signal send a clear message.  

Success stories

No one really disputes that trading systems for leaded gas, sulphur dioxide and nitrous oxide successfully cut emissions at lower-than-expected costs. In each case, the cap was stringent, coverage was broad, the rules were clear, and flexibility was encouraged. (Allowing participants to “bank” allowances,” for example, enabled them to hedge and also smoothed out the market). And yes, there were profits to be made, which some people find distasteful, but is in fact an intrinsic part of any market.

In another instance, the use of tradable “catch shares” or “rights-based fishing” has helped restore fisheries all over the United States. Overfishing is down 60 percent in federal waters compared to 2000; the idea is beginning to catch on, in Australia, Belize, Chile, and Denmark, among other places. The way it works is that experts define the maximum catch; on that basis, fishery managers set a limit. The “total allowable catch” is then divided (via a “share” or “quota”) among the fishermen. They can catch up to their maximum however and whenever they wish. This is a better, more flexible approach than the traditional way, which was for everyone to race out to sea to catch as much as possible as fast as possible. Some fishing seasons lasted only a few days. As the health of the fisheries improve, the shares also grow plumper. With a stake in the long-term sustainability of the oceans, fishermen have an incentive to work more carefully, with fewer discarded fish.

Such rights-based systems, says the National Academy of Sciences, could restore most global fisheries in as little as 10 years, and stocks could double by 2050. In short, it turns out that optimizing the economic value of the fish is good for the oceans. Along the same lines, California jurisdictions have demonstrated that trading water rights can help to successfully manage groundwater.

The big “if”

Incentives are intended to change behavior, and they do. But if they are designed to do stupid things, then stupid things will happen. For example, communities in the American West have actually encouraged home-building in fire-prone areas, even after they have been hit by fire once. Federal flood insurance  subsidizes people to build, and re-build, in vulnerable places.

 So, is the market a help or a hindrance in environmental management? In a sense, that’s not the right question. The market is a fact of life, and the foundation of the global economy; market-oriented policies like carbon taxes and trading systems are tools that can help to harness its power.  They are not the only ones that can be useful, of course. Traditional command-and-control or standards-based regulations also have their place. The point is that any tool  needs to be wielded correctly to shape the desired outcomes.

If carbon pricing isn’t working, look to the practice, not the principle. 

All views are mine and not those of McKinsey & Company.