Is carbon pricing equitable?

Global warming has long been considered a problem of equity. Back in the 80s, when large-scale policy research on climate change began, it was clear what the origin of the problem was - the carbon emissions of the rich - and where the impacts would manifest the most - the poor countries in the tropics. Forty years later, this proposition is not only unchanged, but also enriched by the massive research conducted during these decades. The “uneven distributional issues” mentioned in the Intergovernmental Panel on Climate Change (IPCC) report cover a variety of areas that include economic impacts, unbalanced resources availability, ethical concerns, future generations’ opportunities. This article focuses on the economic impacts.

Why is carbon pricing so important?

Without additional adaptation efforts, unmitigated warming is expected to reshape the global economy by reducing average global incomes roughly 23% by 2100 and widening global income inequality, relative to scenarios without climate change . The increasing media attention to the dangers of global warming has led to a democratization of climate change. Unfortunately, this has hardly translated into actions because climate change appears too big and too far: it is difficult to distinguish between causes and effects, as well as the accountability of responsibility for the diverse emissions. The reason for inaction has an ethical root: immediacy. Human beings are inclined to respond more decisively to immediate and tangible threats but tend to exhibit avoidance behaviors toward future threats – regardless of their gravity.

For example, the immediate impacts of COVID-19 have activated political actions while the lack of immediate effects of climate change has induced many governments to second clean energy to economic concerns.

Enriching climate change actions with an immediacy element is therefore essential: economic agents must be confronted with the consequences of their choices while they take a decision. As part of a broader spectrum of initiatives, carbon pricing can help to address this issue because it adopts market mechanisms to pass the cost of emitting on to emitters, monetizing the cost of emissions. Also, carbon pricing addresses the tragedy of the commons: greenhouse gas emissions carry many external economic costs (i.e. damage to crops, loss of property from flooding) but individual economic agents bear only a minor portion of them, while obtaining full benefit of fossil fuel consumption.

As a consequence, they make decisions that are privately justifiable but socially catastrophic.

To avoid this, some authors have introduced the concept of “universal property” – a property that is not strictly public nor private but held inalienably by all individuals.

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What are the reasons for carbon pricing?

In the short term, carbon pricing offers the economic agents an incentive to select the most cost-effective way to reduce emissions. In the long term, the expectation of growing carbon prices encourages innovation as a solution to reduce the costs of cutting emissions. There is evidence that the European Union's Emissions Trading System (EU ETS) for carbon emissions has increased patenting activity in low-carbon technologies. Additionally, the inclusion of carbon pricing in the policy mix can assure that emission reduction targets are achieved. If a government decides that the Paris goal requires it to cut emissions by 80% over 30 years, it could establish a cap that declines at a constant rate of 5.22%/year during this period. The price of carbon permits would be determined by the demand side as the supply declines predictably.

 What distributional issues does carbon pricing generate?

Carbon pricing has been under scrutiny for decades and its wide-scale adoption encounters several barriers, among which:

• Carbon leakage - one of the most relevant critiques concerns industrial competitiveness due to pricing differentials between jurisdictions. Even though the global average price of carbon is below 10 USD /tCO2e, some countries have imposed higher carbon prices. Sweden has set the highest carbon tax in the world at 119 USD/tCO2e (Worldbank.org 2020) while other countries, for example Turkey, have imposed no policy at all. Therefore, countries with carbon prices are competing with countries with lower (or no) carbon prices, thus incentivizing businesses to relocate their production to jurisdictions with laxer emission constraints (i.e. carbon leakage). This occurrence undermines the original goal – to reduce carbon emissions - leading to a lose-lose scenario, with a loss of competitiveness without any environmental gain. Nonetheless, the real experience shows that to date there is little evidence that carbon pricing has resulted in the relocation of the production of goods and services to other countries.

• Trading opportunities - the existence of several carbon pricing systems generates “distortions” in international competition. Different prices in different markets mean that countries with low carbon pricing have a competitive advantage compared to countries with higher prices: products in the former market would be cheaper compared to those in the latter. The solution to these distortions would be a global carbon pricing system that allows a single carbon price that is set and traded on an equal economic basis. Unfortunately, without an international agreement there is no uniform world carbon price. In reality, a uniform international price allocates the world’s residual carbon space based on the countries’ capabilities to pay: developed countries would inevitably be able to purchase more than developing ones. This approach is incompatible with the UNFCCC declaration that countries will reduce emissions according to their common but differentiated responsibilities and respective capacities, which implies that higher-income countries do more, not less, to curb emissions.

• A regressive system – assuming a transition to a low-emission energy system, the short-term effect would be a price increase (also of non-energy products); for example, the adoption of RES in Germany generated significant costs for electricity consumers. This effect has a proportionally greater impact on developing countries – with a larger share of poor households - because they have a stronger dependence on energy-intensive factors and a higher energy to labor cost ratio. On a broader scale, evidence shows that even in the United States, the incidence of carbon pricing is regressive: higher fuel prices hit lower-income households harder than upper-income households as a percentage of their incomes. In absolute terms, high-income households pay more than low and middle-income individuals but, in relative terms, they indeed pay less.

To avoid such distributional issues, a tax on carbon should be coupled with an equal per-person dividend, which leads to a net transfer from individuals with above-average carbon footprints to individuals with below-average ones.

This results in a decrease of vertical inequality where:

• Upper-income individuals show the highest carbon footprints and pay more than they get back;

• Lower-income individuals show the smallest carbon footprints and receive more than they pay;

• Mid-income individuals achieve a net zero game.

So what?

An urgent inversion trend in global GHG emissions is required to achieve the 1.5°C target and avoid the consequences of a 2°C (or higher) scenario. Combined with regulations and public investments, carbon pricing can be a key enabler for a sustainable low-carbon economy transition. Carbon pricing alone is not sufficient to face the climate crisis: it is the efficiencies, innovations and investments that will make the real difference, ensuring long-term sustainable growth. The net distributional impact of carbon pricing depends on the distribution of equal per-person carbon dividends. This approach is equitable because it protects real incomes for low- and mid-income households, regardless of the future prices of carbon, and strengthens the postulate that the gifts of nature are a universal property, belonging to all in equal measure.