Tuesday, January 5, 2021

Carbon Pricing and Innovation in a World of Political Constraints

Executive Summary:
Workshop Purpose
- In March 2020, a workshop of academic and policy experts was convened including economists, political scientists, energy innovation scholars and policy practitioners, seeking to synthesize collective expertise and academic research and to reflect on the role of carbon pricing and innovation in climate policy.
- Participants discussed the experience with carbon pricing around the world and the way forward for carbon pricing as a climate policy tool, including political feasibility, economic efficiency, and interaction and integration with other policy mechanisms. The workshop emphasized in particular the importance of political economy considerations on the design, implementation, and durability of climate policies.

Main Points of Discussion
- Carbon pricing has been an important pillar of climate policy discussions, facing no shortage of support from economists and policymakers favoring cost-effective reductions in carbon pollution. To date, around 15% of global carbon emissions are subject to carbon prices, most well under $50/tCO₂.
- Real-world experience with carbon pricing policies is mixed. In Sweden and British Columbia, carbon taxes have led to some emissions reductions, while many other places have low and ineffectual prices. Jurisdictions like Australia and Ontario, Canada have also rolled back policies. Broad-scale experience in California, the Northeast and mid-Atlantic (RGGI) states, and the EU has shown that carbon pricing systems should be seen in the context of wider climate policies and can be a source of revenues for other policy objectives.
- Key criteria for climate policy design are environmental efficacy, cost-effectiveness, and political feasibility as well as durability over time and the interaction of carbon pricing with broader climate, environmental, economic and social policies and political priorities.
- Political challenges in the form of wavering public support and interest group pressures can handicap carbon price policies as prices rise and benefits are perceived as diffuse. Research indicates this is particularly true in nations with higher income inequality.
- Carbon prices supported by complementary innovation and industrial policies can bring down technology and compliance costs and can potentially be sequenced to build political coalitions for more expansive climate policy over time.

Key Recommendations
- Well implemented carbon pricing policies are a potentially important tool in the climate policy toolkit. However, carbon pricing cannot stand alone. Politically feasible carbon pricing policies are not sufficient to drive emissions reductions or innovation at the scale and pace necessary.
- Carbon pricing should be implemented as part of a comprehensive suite of climate policies, such as clean energy standards, low or no-carbon transportation projects, government procurement and subsidy for market adoption of emerging technologies, and direct support for clean energy research, development, demonstration, and deployment (RDD&D).
- Using revenues from carbon pricing for clean energy RDD&D, public infrastructure projects, public procurement or subsidy, and alleviating distributional burdens associated with climate policy, may further decarbonization goals and increase public support.
Carbon pricing can be most directly implemented through a carbon tax or cap-and-trade system. Tax instruments provide greater price certainty; quantity instruments, like cap-and-trade, provide greater emissions certainty. Under a carbon tax, the carbon price remains stable, while emissions can vary depending upon the degree to which emitters choose to pay the tax versus reducing emissions. Carbon prices are often designed to increase over time—a feature that may increase their efficacy while undermining their popularity. With cap-and-trade programs, the emissions level is set by the cap, while the price can vary depending upon the supply and demand for allowances. In practice, quantity and price instruments can be hybridized to achieve some of the benefits of both approaches. California’s cap-and-trade system, for example, includes price floors and ceilings to limit price uncertainties.

Other cap-and-trade design considerations concern carbon “leakage”—the potential for carbon pricing in one jurisdiction or sector to lead to increases in emissions in other jurisdictions or sectors—and other trade implications, emissions hotspots, linkage to other systems, and whether or not to allow carbon offsets. All these decisions need to weigh a number of competing environmental, economic, and political priorities.

The Social Cost of Carbon
One metric often combined—and all-too-often confused—with conversations around carbon pricing is the social cost of carbon (SCC). The SCC, technically the “SC-CO2,” is typically defined as the marginal social damage, or cost, of one additional ton of carbon dioxide (CO2) being emitted into the atmosphere. It plays an important role in shaping policy decisions across the world, providing a metric to measure the economic harm of climate impacts, and to thereby calculate the benefit of regulatory or policy action. To calculate the SCC, researchers estimate the current and future CO2 or broader GHG emissions impacts on the economy, earth systems, and human welfare. Computing the SCC combines modeling of complex economic, behavioral, and geophysical systems.

Social cost of carbon calculations have a long and storied history. Yale economist Bill Nordhaus was one early pioneer. He shared the Nobel Prize in economics for his efforts leading to the calculation of the SCC. His calibrations have been famously conservative, leading to an SCC of around $40/ton of CO2 (tCO2) emitted today, a number similar to that calculated by the Obama Administration’s Interagency Working Group for the Social Cost of Carbon. Recent work applying the same fundamental benefit-cost model has led to SCC estimates of at least $100/tCO2, sometimes $200/tCO2 and above, typically driven by updated climate damage and discount rate assumptions. Most unknowns and unknowables result in still higher SCC estimates. The same goes for other extensions such as more disaggregated climate damage functions, and heterogeneity within and across countries, which result in estimates of around $400/tCO2.
The Obama Administration’s establishment of a $40/tCO2 SCC has helped shape a number of regulatory decisions targeting GHG emissions across the country, for example in Colorado. Meanwhile, the Trump Administration moved to undervalue the SCC by changing key assumptions—excluding the consideration of international climate change impacts, and placing less weight on future impacts—with the expressed goal of reducing the SCC to help it justify its deregulatory climate agenda. It is also worth noting that other national governments use much larger SCC estimates. German government guidance, for example, presents SCC estimates of around $200/tCO2 and almost $800/tCO2, the latter reflecting a zero percent rate of pure time preference.
Carbon Pricing as a Decarbonization Tool
A carbon price can either be economy-wide or sectoral. The EU Emissions Trading System (EU ETS), for example, applies only to large emitters, including in the electricity, aviation, and several other industry sectors, covering approximately 50% of the EU’s CO2 emissions. British Columbia’s carbon tax applies broadly to the purchase and use of fossil fuels across sectors and covers approximately 70% of provincial GHG emissions. California’s ETS covers around 85% of the state’s GHG emissions. Globally, meanwhile, only around 15% of CO2 emissions are subject to carbon prices, most well under the $40-80/tCO2 range that the High-Level Commission on Carbon Prices says are necessary to meet the Paris Agreement targets.

Overall, large-scale cross-country analyses show how carbon pricing can help reduce emissions. Isolating the effects of carbon pricing is difficult, given the confounding effect of other policies, including support for clean energy and other mitigation approaches. Some evidence suggests carbon pricing can be effective at driving fuel switching from coal to natural gas, but this substitution is far from ideal in terms of deep decarbonization. Other studies have shown modest cuts in carbon emissions from carbon pricing.

Ultimately, carbon pricing, by and large, has not resulted in significant decarbonization at the low price levels and narrow sectoral applications implemented to date. This low price is likely due to the political economy of carbon pricing, in which distributional losers lobby to keep prices low, for example through overallocation of allowances. High income inequality can result in an unequal carbon tax burden unless complementary policies assist low income households. This threat of public backlash likely inclines policymakers toward a modest carbon price, or no price at all. Like with many climate policies, the costs associated with a carbon price are often narrowly felt and opposed by organized special interests; benefits, on the other hand, are often distant and diffuse.
Lessons Learned from Around the World
The cases below provide some insight into other countries’ experiences with the policy, which speak to these and other policy design questions.

Sweden’s Carbon Tax
Sweden currently has the highest carbon tax in the world, helping drive national decarbonization efforts. Implemented in 1991, the initial $30 per ton carbon tax was paired with a reduction in fuel taxes and exemptions for energy-intensive, trade-exposed industries (e.g. pulp-and-paper, mining, and industrial horticulture). These design choices helped garner broad political support. Sweden’s tax increased gradually over time to around $130/ton and exemptions for covered industries were gradually reduced and then fully eliminated in 2018. As an EU member state, Sweden adjusted its policy to align with the EU Emissions Trading System (EU ETS) introduced in 2005, with sectors covered by EU ETS (electricity and most industrial emissions) no longer facing Sweden’s (much higher) tax. Today, 95% of carbon emissions in Sweden are either covered by the tax or by the EU ETS, and the majority of carbon tax revenues come from the transportation sector. Revenues are not earmarked for specific climate-related projects and instead fund the general budget, which, in turn, funds a variety of public transport, energy efficiency, and other projects.

Research estimates that the Swedish carbon tax, in conjunction with the country’s Value Added Tax, are responsible for an 11% reduction of transportation emissions since the early 90s.25 The Swedish Environmental Protection Agency estimates that the full suite of carbon taxation policy has resulted in a 26% reduction in domestic CO2 emissions over the same period.26 Additionally, there is no evidence that the Swedish carbon tax has had any negative effect on GDP. Hence there is evidence that “decoupling” is taking place: Sweden’s GDP increased while carbon emissions decreased.

Beyond emissions reductions and economic impact, the distributional effects of Sweden’s carbon tax should also be of great interest to policymakers. Research indicates that rising inequality does make a carbon tax more regressive as it places a higher economic burden on low-income segments of the population, who spend a larger percentage of their income on energy, primarily on transportation fuels. When Sweden’s carbon tax was enacted, disposable income, and thus the carbon tax burden was largely proportional to incomes, possibly even progressive. However, since the 1990s, income inequality has steadily grown, and the carbon tax has become more regressive.28 These lessons indicate that carbon pricing will be more regressive in countries with high income inequality and higher per capita carbon emissions such as Japan, Germany, Canada, Australia, and the United States.

The European Union Emissions Trading System (EU ETS)
Established in 2005, the European Union Emissions Trading System (EU ETS) --is the world’s largest carbon pricing program, covering around 50% of the EU’s CO2 and around 45% its GHG emissions.29 The program limits emissions from over 11,000 large energy-using entities, primarily power plants and large industrial emitters. It was expanded to cover intra-European aviation in 2012. In 2018, the annual reduction rate in allowances was increased to 2.2%, in an attempt to meet 2030 targets.

Unlike the Swedish carbon tax, the earlier phases of the EU ETS presented a challenge to long-term research and development (R&D) investments. Initially low prices and generous allowances did little to spur renewable and clean energy investments, and may even have worked against them.31 Research indicates that more stringent subsequent ETS phases helped spur clean energy innovation but were only marginally responsible for firms adopting lower or no-emission technologies.

Emissions covered by the EU ETS have fallen as planned and will be 21% below 2005 levels by 2020. By 2030, GHG emissions are predicted to be 43% below 2005 levels.33 A policy mix of long-term emissions reduction targets, sectoral efficiency programs, clean energy targets, R&D support, and deployment policies have all played important roles in driving decarbonization across the EU.34 Chief among them was a massive scale-up in renewable energy deployment, led by policies such as the German feed-in tariff.35 Revenue certainty provided by feed-in tariffs has enabled projects to be financed with high debt shares, which combined with low interest rates over the past decade, has made renewable energy financing, and consequently, renewable energy generation, in Europe relatively cheap.

Workshop Report, December 2020
Workshop organized by Jesse D. Jenkins, Leah Stokes, and Gernot Wagner, held virtually on March 19-20, 2020
Suggested citation:
Jenkins, Jesse D., Leah Stokes, and Gernot Wagner (Eds). 2020. “Carbon Pricing and Innovation in a World of Political Constraints.” Workshop Report.

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