Pretty well every economist you talk to will agree; if you want to reduce pollution, carbon or otherwise, the most cost-effective way to do so is with a price on the emissions of that which you seek to reduce. They’ll also tell you that, under some basic assumptions, the cost-effectiveness result holds whether you impose that price through a tax or by fixing allowable quantities of emissions, distributing the rights to emit, and making them tradeable – so-called cap-and-trade regimes. This is taught in most first year economics classes, and you will test it under every conceivable permutation and combination of assumptions if you take an environmental economics class. It truly is economics 101.
Carbon pricing mechanisms generate cost-effective reductions because they make emissions (or emissions reductions) valuable. If you are facing a carbon tax, you can reduce your tax bill by reducing emissions either through changes in actions or changes in technology. The same is true for a cap-and-trade program, although in that case you might be earning revenue from the sale of unused permits or avoiding the need to purchase them. Regardless, the price on emissions creates a decentralized economic incentive to reduce pollution. We’ve known this since Pigou in 1924 – Pigou suggested that the government could impose “extraordinary restraints – most obviously taxes,” to reduce pollution.
The reason why carbon pricing is not a panacea also goes all the way back to Pigou, if not earlier: stringency matters. Carbon pricing is cost-effective because it provides people and firms who are affected by the price an incentive to change behaviour or implement new technology if those changes reduce emissions at a cost less than the carbon price. That’s great, but no one is going to spend $50 to save $25. In other words, carbon pricing is cost-effective, but not necessarily effective. Effectiveness is a matter of the level of the price and how broadly it’s applied, not the fact that there is one.
If you’re worried about climate change, your first concern should be effective policy (by how much will this reduce emissions?) and not cost-effectiveness (could the same emissions reductions have been generated at lower total cost to society?). If you believe the International Energy Agency (IEA)’s 2012 World Energy Outlook, to stabilize global GHG concentrations at or about 450ppm, we’re going to need effective policies, and quickly. By 2035, the IEA models suggest that we’ll need the equivalent of a global carbon price of $120/tonne, along with some complementary regulations. With the exception of implicit prices on carbon on some emissions in Sweden, Japan, and Germany (see yesterday’s OECD report for details), no carbon pricing policy in place today comes close to that type of stringency. Put another way, despite all the good things about BC’s carbon tax (and it got some laudatory words in the OECD report yesterday), it’s barely stringent enough to fit into the IEA’s 450ppm path and it’s not likely to be stringent enough to see BC’s emissions decrease between now and 2020 (see Table 17).
Your second order concern should likely be political feasibility, and in particular you should ask whether more stringent regulations are more feasible than a stringent price-based policy. If that’s true, then your regulation will lead to more expensive emissions reductions, but the total benefits to society of a stringent regulation could easily outweigh a weak carbon price. It’s possible, but by no means guaranteed, that more cost-effective policies will be more politically feasible. If your condition for GHG policy is that you must impose the same price on all sectors of the economy because you want to be cost-effective, that rules out higher prices on some sectors where deep emissions reductions are possible, or lower prices in more politically sensitive areas to ensure you get a policy in place at all. Policies are also most cost-effective when the costs are transparent, but when you see the NRDC campaigning against Keystone XL by telling Americans that their gas prices might go up, you know just how politically palatable a transparent price at the pump will be. If you want a policy that will actually reduce emissions, it has to be implemented and kept in place by people who face elections every 4 years or less. You might not like it, but that’s a reality.
So, can we all talk a little more about stringency and political feasibility and a little less about prices vs. regulations?