Climate change is a problem of the ‘commons’. The atmosphere is shared between countries and while a carbon dioxide-abating country incurs the full cost, it receives only a fraction of the benefits. As with any public good, the self-interested response is to ‘free ride’ in the hope others will foot the bill.
The famous Kyoto negotiations in 1997 tried to create a global cap-and-trade system, whereby a limit on emissions was set at a global level following which individual countries would commit to cutting emissions to varying degrees to meet that cap. The result was a patchwork of weak and unenforceable commitments.
Nations have since stumbled to find a replacement without success. Although the 2015 UN Conference of the Parties (COP21) meeting in Paris received the usual victory statements, the agreement was seen by some as a step back from Kyoto.
There was no longer any serious discussion of a common commitment to reduce emissions through a global cap. Countries merely agreed to non-binding, non-enforceable, incomparable ‘intended nationally determined contributions’ (INDCs).
According to Dr Stephen Stoft, co-editor of the 2017 book Global Carbon Pricing, establishing a global minimum carbon price as a starting point would give the negotiations a much better chance of success.
The price is right?
Establishing what that carbon price should be is not straightforward though. From an economic efficiency perspective, the price ought to match the social cost of carbon (SCC), the marginal damage caused by one extra tonne of emissions.
One way forward could be for countries to agree to price carbon emissions at least as high as a global floor
While estimates of the SCC are uncertain, this is no excuse for prevarication. “One way forward could be for countries to agree to price carbon emissions at least as high as a global floor. Others would be free to set a higher price,” says Steve Waygood, Aviva Investors’ chief responsible investment officer.
Carbon pricing schemes have been growing both in number and ambition. According to the World Bank, as of April 2020 there were 61 initiatives – 31 emissions trading schemes and 30 carbon taxes.1 However, those covered just 22 percent of global emissions.
Worse still, the size of levy on taxed emissions is inadequate. According to Germany’s statistics office, global CO2 emissions reached a record 38 billion tonnes in 2019, with G20 states responsible for around 80 per cent.2
Theoretically, countries or trading blocs could be given leeway to determine how to price emissions, whether via taxation, a cap-and trade system or a combination of the two. Most economists believe taxation is the cleanest, most readily comparable, and optimal method.
For the system to work, the thorniest issue would be the need for richer nations to transfer money to poorer ones. Luca Taschini, associate professorial research fellow at the London School of Economics’ Grantham Research Institute, says that as well as the carrot of transfer payments to induce developing countries to set a minimum carbon price, a stick would be needed to discipline free riders and prevent carbon leakage.
Estimates of the potential for carbon leakage vary wildly. An analysis of 25 studies suggested countries risked giving up between five and 25 per cent of their total emissions reductions due to companies moving high-carbon production elsewhere.3 To avoid this, Taschini says the obvious stick to use would be tariffs on the imports of countries that refused to join the club.
This explains why the EU in July said it planned to introduce a carbon border levy by 2026. By holding products such as imported steel, aluminium, fertiliser and cement responsible for their GHG emissions the same way domestically produced products are, the aim is to maintain the bloc’s competitiveness, prevent carbon leakage, and encourage others to match the EU’s ambition.
One of the most frequent arguments against carbon taxation is that it is regressive, with poorer members of society hit hardest. However, since taxes would be levied and retained at the national level, there is nothing to prevent countries redistributing those tax receipts progressively.
The world’s ongoing failure to price carbon has led to a mishmash of command-and-control policies
Ultimately, the world’s ongoing failure to price carbon has led to a mishmash of command-and-control policies that come at a high cost and are of questionable benefit.
In many instances, with politicians unwilling to grasp the nettle, the problem is being outsourced to the private sector. While not denying the private sector has a vital role to play, Waygood says it needs a carbon price to perform this function efficiently.
As Waygood says: “We have the world's biggest market failure in climate change, and this will go on until we start to price at least a significant chunk of worldwide carbon emissions more appropriately. While no one would suggest we immediately stop driving, flying, or using steel, the sooner we admit these activities come with a cost, the better.”