The Political Economy of Carbon Pricing

By the end of 2015, the concentration of CO2 in the atmosphere had reached 405 parts per million (Tans and Keeling, 2016). This level, a 40% increase from the pre-industrial era, is the consequence of the techno-economic system chosen since the Industrial Revolution. Yet, if we want a 50% chance of keeping the rise in Global Mean Temperatures below 2°C and avoid the most dramatic effects of climate change, global 2050 emissions levels must be 40 to 70% lower than in 2010 and global 2100 emissions levels must be near zero or below (IPCC, 2014)1. To reach this objective in a timely and cost-efficient way, policymakers need a workable strategy. Economists have argued that this strategy should include a credible carbon pricing mechanism. However, we recognize that carbon pricing has been at best a very limited part of any climate change strategy.2 At the end of 2015, carbon pricing covered only 12% of global GHGs (World Bank, 2015) and in most jurisdictions where they existed, they were modest in their coverage and/or level. As a result, the world emissions-weighted price of carbon is currently around US$ 0.74/tCO2e, falling a long way short of what is required to internalize the environmental externality arising from GHG emissions.3 The US EPA figures for 2015 ranged from a low of US$12 62/t CO2 depending on the discount rate.4 Reasons for the weakness of carbon pricing regimes abound. The most salient ones, however, are political. Pricing carbon imposes costs on some producers and all energy consumers that triggers opposition. Producers are concerned about decreased profits and capital losses, although some of them often benefitted from massive windfall gains from the free allocation of emissions allowances in emissions trading schemes and hence did not oppose them; consumers worry about higher retail energy prices, especially in liberalized electricity markets where wholesale and retail prices are more sensitive to carbon prices (Pollitt, 2012). Policy makers are, in turn, reluctant to introduce explicit carbon taxes or charges and favour less visible policy tools such as efficiency standards. Given recent developments one may be tempted to think that some of these political barriers have been overcome. Between 2010 and 2015, the share of covered GHGs increased from 5% to 12% and some of the newly created price signals will push average carbon prices up. However, a careful analysis of these developments calls for more cautious conclusions. Progress toward comprehensive carbon pricing requires that we look at the economy-wide coverage and the resulting average price. The emissions-weighted (or effective) price of carbon (ECP), measured by the ratio of the total economy-wide carbon price revenue divided by total GHG emissions, is a better metric to assess progress on carbon pricing. The figure below provides such a metric for selected jurisdictions over the period 19902012. The figure gives rise to two major observations. First, all jurisdictions except for Sweden and Finland had modest effective carbon prices. Given the Scandinavian high share of zero carbon power (hydro, nuclear, biomass) and the widespread high willingness to tax petroleum in transport use, this is hardly surprising. Moreover, if the World effective price of carbon is any guide, the current global willingness to pay for carbon emissions remains quite low. Hence, if anything, the ability of jurisdictions to price carbon continues to look constrained. That constraint on effective prices of carbon induces a coverage-price tradeoff: a higher coverage could only be introduced at the cost of a lower price (or viceversa). This is particularly apparent in the initial stages of introduction of carbon pricing schemes. For instance, Norway managed to introduce a relatively high price (US$28.5/tCO2e) at the cost of a lower, yet not insignificant, coverage (32.5%); Japan on the other hand achieved broad coverage (69%) by 2012 but at a low carbon price (0.91US$/tCO2e), although where Emissions Trading Schemes have been introduced, they typically have much broader coverage and higher prices (at least initially). Second, initial constraints on pricing persist over time. Hence no jurisdiction (except Sweden) showed a G.G. Dolphin and M.G. Pollitt are with the University of Cambridge Judge Business School (G.G. Dolphin:gd396@ cam.ac.uk; M.G. Pollitt: mgp20@cam.ac.uk) D.M. Newbery is with the Faculty of Economics, University of Cambridge (dmgn@cam.ac.uk)