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date: 22 September 2021

Carbon Taxesfree

Carbon Taxesfree

  • Jorge H. GarcíaJorge H. GarcíaSchool of Management, University of The Andes
  •  and Thomas SternerThomas SternerDepartment of Economics, University of Gothenburg

Summary

Economists argue that carbon taxation (and more generally carbon pricing) is the single most powerful way to combat climate change. Since this is so controversial, we need to explain it better, and to be precise, the efficiency gains are largest when the costs of abatement are strongly heterogeneous. This is often—but not always—the case. When it is not, standards can fill much the same role.

To internalize the climate externality, economic efficiency calls for a global carbon tax (or price) that is equal to the global damage or the so-called social cost of carbon. However, equity considerations as well as existing geographical and sectoral differences in the effectiveness of carbon taxation at reducing emissions, suggest earlier implementation of relatively high taxation levels in some sectors or countries—for instance, among richer economies followed by a more gradual phase-in among low-income countries.

The number of national and subnational carbon pricing policies that have been implemented around the world during the first years following the Paris Agreement of 2015 is significant. By 2020, these programs covered 22% of global emissions with an average carbon price (weighted by the share of emissions covered) of USD15/tCO2 and a maximum price of USD120/tCO2. The share of emissions covered by carbon pricing as well as carbon prices themselves are expected to consistently rise throughout the decade 2021–2030 and beyond. Many experts agree that the social cost of carbon is in the range USD40–100/tCO2.

Anti-climate lobbying, public opposition, and lack of understanding of the instrument are among the key challenges faced by carbon taxation. Opportunities for further expansion of carbon taxation lie in increased climate awareness, the communicative resources governments have to help citizens understand the logic behind carbon taxation, and earmarking of carbon tax revenues to address issues that are important to the public such as fairness.

Subjects

  • Environmental Economics

Climate Change and the Urgent Need for Carbon Pricing

The concentration of carbon dioxide (CO2) in the atmosphere will have increased by more than 50% by 2022: When compared with pre-industrial levels from 1750 to 2019, the concentration of CO2 rose, on average, from 278 ppm to 412 ppm. This dramatic change in the chemistry of the Earth’s atmosphere has been caused, first and foremost, by the burning of fossil fuels but also by land-use change. As a result, the average global temperature has increased by about 1 degree Celsius (°C) since the industrial revolution and some of the consequences of the observed warming are already apparent, including the melting of the Arctic ice sheet, sea level rise, and the increased frequency of extreme weather events such as heat waves droughts (Intergovernmental Panel on Climate Change, 2014). Scientists have warned about the dire consequences of further warming and have stressed time and again the need to dramatically reduce carbon emissions over the next few decades. A special Intergovernmental Panel on Climate Change (IPCC) report explains that there would be a significant difference in impacts when warming is limited to 1.5 °C—only 0.5 °C more than the current level—as opposed to 2 °C by 2100 (Intergovernmental Panel on Climate Change, 2018).

The principle of anthropogenic climate change is well established, but how does economics conceptualize the problem of climate change and its potential solutions? Economists describe climate change as a negative externality; in fact, the biggest negative externality humanity has experienced, or more broadly, as a failure of the free market to maximize social welfare. Negative externalities are the negative (nonmarket) side effects of production or consumption, where the associated costs are not borne by the agents that cause environmental damage. Consider, for instance, an individual who drives a gasoline-powered car to work every day. This individual and, arguably the individual’s family, benefit from its convenience but they will, in turn, emit CO2 into the atmosphere. About half of the emitted CO2 molecules will be absorbed by oceans and land plants and trees, but the other half will remain in the atmosphere for decades and around a quarter will remain for a thousand years. Even if only in a slight way, these molecules will drive global temperatures upward and will thereby impose an environmental cost on millions in the present and future generations. Without intending to, the individual is harming others.

If the same individual were to bear the cost of the harms done to others, for example, through a carbon tax, they would probably limit the use of their car or look for a less carbon-intensive alternative, like a bicycle, electric car, or public-transport bus or train. A carbon tax is a surcharge which emitters, whether they are individuals or companies, pay per the unit of carbon (C), or, more commonly, of CO2 emitted into the atmosphere. By levying a cost on emissions, a carbon tax can reduce total emissions and help to correct the climate change externality. Many economists believe that a carbon tax is the best policy instrument for tackling climate change and discusses the key challenges and opportunities involved in carbon tax design and implementation. Others believe strongly that it is preferable to use emission caps that are tradable. Our position is that either will work—or some combination. The decisive factor is that the price emitters have to pay is sufficiently high to incentivize the very ambitious abatement measures needed.

Efficiency: A Carbon Tax

The idea that free markets benefit society dates back to Adam Smith’s Wealth of Nations (1776, p. 17). The most famous sentence in Smith’s book epitomizes the spirit of modern economics: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” Thus, Smith was one of the first to point out that market exchange between two parties is voluntary and undertaken for a mutual benefit. Because individuals act as both consumers and producers of different goods and services, a wide range of social needs will be met, with everyone winning. A crucial implication of this laissez-faire argument is that the government will not have to intervene in the economy in order to maximize social welfare. In fact, competition in the marketplace would ensure that resources are efficiently allocated, in particular in comparison with alternative ways of organizing the economy (Arrow & Debreu, 1954). Efficiency in economics is associated with Pareto optimality—that is, where the economic situation of one individual can be improved only if the economic situation of another individual is worsened. This theory has been very popular with many businessmen and policymakers, but one must take care to read the fine print before embracing it.1

In certain circumstances, a free market’s efficient allocation of resources may fail. Externalities, in particular, are an important and pervasive type of market failure. A positive externality occurs when a consumption or production activity generates benefits that do not exclusively accrue to the consumer or the producer but also to other agent(s) in society. A negative externality occurs when a consumption or production activity generates costs that are not exclusively borne by the agent. Market exchange fails to account for the costs imposed on third parties and leads to an activity level that is higher than what is socially desirable. Such is the case with the use of fossil fuels. Self-interest leads individuals to use inexpensive but CO2-intensive cars which aggravate global warming (note that climate change may be interpreted as the result from a positive externality: CO2 abatement benefits third parties and thus total abatement will be lower than what is socially desirable).

The first account of what is known as externality has been attributed to the renowned economist Alfred Marshall (see Boudreaux & Meiners, 2019). In his description of the firm in Principles of Economics (1890), Marshall introduced the concept of external economies, as opposed to internal economies. External economies are factors originating beyond the firm that increase its productivity, such as technological spillovers. Marshall’s favorite pupil, Arthur Cecile Pigou, delved deeper into these ideas and, most importantly, Marshall and Sidgwick’s analyses of laissez-faire’s failure to deliver maximum social welfare (Keynes, 1924; Sidgwick, 1901). In The Economics of Welfare, Pigou (1920) developed the concept of externality. He distinguished between (marginal net) social and private products and noted how a divergence, as he called it, between the two may arise in competitive markets.

Pigou’s example of the smoky industrial factory is still used today to teach the concept of externality in economics faculties all over the world. In The Economics of Welfare Pigou gave an example that is less well known but better suited to the case of climate change. “It is true, in like manner, of resources devoted to afforestation, since the beneficial effect on climate often extends beyond the borders of the estates owned by the person responsible for the forest” (Pigou, 1920, p. 160). In 1920, Pigou had already characterized a local climate externality; 100 years later, the suitability of his example for global climate change is obvious, not least because of the key role conserving and expanding forests plays in limiting global warming. Externalities are central to economic theory and help us understand why humans, though intelligent, still proceed to destroy their own habitat.

Climate change and its main cause, an economic system based on fossil fuels, became established as a scientific fact in climatology and atmospheric sciences in the 1960s and 1970s (Le Treut et al., 2007).2 The (natural and human-enhanced) greenhouse gas (GHG) effect, which occurs when gases in the Earth’s atmosphere like water vapor (H2O) and CO2 trap the Sun’s heat, satisfies the two main conditions of a “public good,” a concept which economists came up with in the 1950s (Samuelson, 1954), namely, its consumption is nonexcludable and nonrivalrous. Unlike private goods, such as bread and coffee, which are only consumed by one individual (the main concern of Adam Smith), all individuals consume the same level of the public good. Once CO2 is in the Earth’s atmosphere, no economic agent can escape from the GHG effect. Furthermore, the effect of CO2 emissions on a given agent does not reduce its effect on any other agent. To begin with, economists were mostly talking about the provision of public goods like national defense, public health, and primary education, and the theory was only applied to climate change in the 1990s (Nordhaus, 2005).3 Because CO2 perfectly mixes with the air in the atmosphere and accumulates there, the climate externality has far-reaching effects in space and time.

A simple model captures some of the features of climate change as a negative externality and the properties of corrective taxation à la Pigou. The model consists of two periods, (t=1,2), which accounts for the short-term and long-term impacts of CO2 emissions, and Keconomic agents or firms (k=1,,K), which may emit CO2 as a by-product of production or consumptions in period 1. One may think of 2100 or 2120 as marking the end of period 1 and the beginning of period 2—most stabilization scenarios of CO2 concentrations in the atmosphere and most climate policy scenarios are set for 2100. Agent ks emissions are given byek. Agent ks profits directly depend on these emissions and are represented by function Πkek, with Πk'>0and Πk''<0. Total emissions in period 1 are given by e1=kek. Society as a whole bears the costs of an increased concentration of CO2 in the atmosphere through its negative impacts on the climate. All individuals alive in periods 1 and 2, denoted by i and j,respectively, experience the climate externality. Global climate damages in periods 1 and 2 are thus given by the sum of individual damages, that is, D1=iD1ie1 and D2=jD2jαe1with Dt',Dt''>0. Because the GHG effect is a public good, all individuals experience the same contemporaneous level of emissions concentrations in the atmosphere, although damages across individuals may vary. The rate of decay of emissions across the two periods is αϵ01.

With δ representing an intergenerational discount factor, social welfare can be expressed as Wek=kKΠkekiD1ikekδD2αkek. Social welfare maximization leads to the following K first-order conditions, ek:Πk'=D1'+δαD2' for all i. These conditions state that it is socially optimal for firms to emit CO2 in period 1 to the point where their marginal benefits from emissions equal marginal climate damages. Marginal climate damages consist of two elements: period 1 marginal damages plus period 2 marginal damages, discounted by the rate of decay of emissions and the intergenerational discount factor. If the marginal benefits of emissions are higher than the associated marginal climate damages, society as a whole can improve its welfare by reducing its emission levels. If, on the other hand, the marginal benefits of emissions are lower than marginal damages, society as whole can improve its welfare by increasing its emission levels.

Economic agents may affect the welfare of others without the latter’s consent or without a mediating transaction. When deciding on emission levels in a laissez-faire economy, profit-maximizing firms may not consider the social costs associated with climate change. The private optimality conditions in this model are given by ek0:Πk'=0 for all i. One sees that there is a clear divergence between the (marginal net) private benefit from emissions and the (marginal net) social benefit from emissions. The latter is larger than the former (Πk'>Πk'D1'δαD2'), and private agents emit more CO2 than what is socially optimal or ek0>ek (which implies higher than total emissions or e10>e1). In order to close the gap between what is privately optimal and what is socially desirable, Pigou called for state intervention. Pigou argued that the state should introduce an “extraordinary restraint” (to use Smith’s term), in the form of a tax on the activity that produced the “uncharged disservice.” It is important to realize that this was an extraordinary insight at a time when economists spent most of their time arguing against often irrational state regulation and in favor of a free market. When economic agent k faces emission tax T, the agents’ profit function is given by ΠkekTek and the associated first-order condition is Πk'=T. It is easy to see that when the emissions tax is made equal to marginal climate damage, that is,

(1) T = i I D 1 i ' + δα j J D 2 j '

the divergence between (marginal net) private and social benefits vanishes. In fact, under optimal taxation the same first-order conditions characterize both social and private decisions on emissions levels. A Pigouvian fee is an emissions tax that is equal to marginal social damage (Baumol & Oates, 1988). A carbon tax, as opposed to a uniform emissions standard, enables different levels of emissions across different agents. Agents with higher marginal benefits of emissions may decide to emit more CO2 and pay a higher tax bill than those whose marginal benefits are relatively low. This degree of flexibility leads to economic efficiency, a key example frequently mentioned is climate where emissions come from many different sources. We must explain carefully how flexibility saves resources and leads to efficient resource allocation. This is particularly the case when the marginal costs of abatement vary very significantly between polluters and or when technical progress is rapid and can reduce these costs drastically that market-based instruments imply big gains in efficiency (see, e.g., Sterner & Coria, 2012).

We have built our model explicitly to highlight the static efficiency properties of carbon pricing. However, equally important is the dynamic efficiency of carbon taxation, whereby economic agents face a continuous incentive to reduce their carbon tax bill. When the climate externality is internalized through carbon pricing, all relative prices in the economy adjust to it, with carbon-intensive goods and services being more expensive than ones which are less carbon-intensive, thus providing strong incentives to reduce emissions. A carbon tax turns market exchange into an activity based on a mutuality of benefits which takes into account the costs imposed upon third parties.4 Under the Pigouvian solution, those harmed by CO2 emissions do not have to be compensated to arrive at an efficient allocation of resources. Total tax revenues are given by Te1. T is, strictly speaking, a global carbon tax (e.g., Thalmann, 2012). If a significant share of global emissions were to be left out of such a taxing scheme, or were to be taxed at a lower rate, total emissions would be larger than what is economically efficient. There are, of course, a number of issues associated with the implementation of a global carbon tax, a subject that is addressed later in the section “Carbon Taxes in Practice.” In addition to static and dynamic efficiency, Baranzini et al. (2017) present the following characteristics of carbon pricing: (a) it represents the most effective mechanism to limit energy consumption and the rebound effect (as energy savings from efficiency can be offset by increased use); (b) there is a global carbon price to avoid emission leakage or spillovers between countries; (c) regulators have relatively low administrative costs and less information needs as emitters decide the level of reduction; (d) it changes the behaviors of those consumers whose consumption decisions do not take into account environmental considerations or who do not have enough information despite taking them into account.

An alternative but less direct way to price carbon is through the implementation of what is known as a cap-and-trade policy. In these programs, authorities create “rights to emit CO2” consistent with a preestablished cap on emissions (Dales, 1968). These rights or permits are allocated to different emitters and emissions trading is allowed. Supply and demand will then determine the carbon price and permits will wind up in the hands of the agents who derive the largest marginal private benefit from emissions (or the lowest marginal cost of abatement). Unless emission rights are auctioned in a cap-and-trade program, they will yield no revenue for governments. In theory, a carbon tax that leads to a given amount of total emissions should be equal to the carbon price that emerges from a cap-and-trade program that is created with this total amount of emission rights (Montgomery, 1972). However, because regulators cannot accurately gauge the technologies available to the regulated community (i.e., Πkek), the emissions levels achieved by a (given) carbon tax are uncertain. Conversely, in an emissions trading system (ETS), although emissions levels are clearly defined by the cap set by regulators, the carbon price that emerges from economic interactions is uncertain. The choice of a price instrument versus a quantity instrument will depend on the relative welfare costs, once certainty has been resolved—a price instrument tends to be preferable to a quantity instrument when the marginal benefits of emissions (or marginal abatement costs) are steeper and the marginal damages of emissions (or marginal abatement benefits) are flatter and vice versa (Mideksa & Weitzman, 2019; Weitzman, 1974).

Some studies suggest that, for the climate change case, Weitzman’s framework favors a price instrument (see, e.g., Hoel & Karp, 2002; Newell & Pizer, 2003). To the extent that climate damage depends on atmospheric concentrations of CO2, marginal damages of emissions tend to be flat. Beyond the emissions cap and how it may evolve over time, there are a number of policy parameters that ought to be decided when designing an ETS. They include the definition, number, duration, and temporal and spatial validity of the permits as well as the method for their allocation (e.g., Cramton & Kerr, 2002; Goulder & Schein, 2013). These decisions are crucial, partly because permits involve the transfer of essential property rights and, potentially, some substantial transfers of wealth (Sterner & Coria, 2012). It has been argued that an ETS is costlier to administer than a carbon tax since on top of the monitoring costs involved in both schemes, in an ETS the regulator needs to keep a registry of trades and ownership of allowances (e.g., Aldy & Stavins, 2012; Goulder & Schein, 2013). Applying either system upstream on fossil fuel supplies as opposed to final emitters may considerably reduce the number of agents to be regulated and the associated monitoring and administration costs (Aldy et al., 2010).

There are many aspects to consider in the choice between permits and taxes, and in practice no instrument seems to be clearly superior to the other along all relevant criteria in policy choice, including political feasibility, burden sharing, and even efficiency (Goulder & Parry, 2008). For instance, although carbon tax revenues could be used to reduce preexisting distortionary taxes such as income taxes, a cap-and-trade policy with free allocation of allowances may be more politically feasible (Goulder, Hafstead, et al., 2019). As discussed in detail in the section “The Political Economy of Carbon Taxes,” political feasibility, which will vary between countries and sectors affected as well as changing over time, is perhaps the most important factor among those discussed in this article. For the practical goal of dealing with the climate as effectively as possible, the most important consideration is to choose whichever system will give the strongest incentive for abatement. This is normally also the system with the highest carbon price.

The Size of Carbon Taxes: Efficiency, Cost-Effectiveness, and Equity

Most economists agree that a tax (or more generally a price) on CO2 is the single most powerful way to combat climate change. However, estimating the optimal tax level on CO2 is far from easy, and it has been the subject of debate in both the academic and policymaking spheres. The marginal damage caused by a (metric) ton of CO2 emitted at a given point in time (e.g., year 2020) is known as the social cost of carbon (SCC). In terms of our simple two-period model, GlobalSCC=D1'+δαD2' and the optimal tax T=GlobalSCC. It turns out that calculating the global SCC is fairly complex. There are a number of key factors. One of these is the rate of discount and another is the level of climate damages created by climate change (and possibly the co-benefits of abatement).

The estimation of a parameter that has stirred up a lot of controversy in the field of climate change is the intergenerational discount rate, from which the discount factorδ is calculated: δ=1/1+rt where t is the timespan in which discounting takes place. In climate change economics, the concept of discounting builds on Ramsey’s study of well-being across generations (Ramsey, 1928). In this approach (e.g., Cline, 1992; Nordhaus, 1994; Stern, 2007), there are at least two arguments for discounting: First, that society, like an individual, may be impatient and thus value present consumption more than future consumption (ρ represents this “pure time preference”). Second, that if future generations are expected to be richer, a unit of consumption may have a higher value for the present generation than for future ones (η accounts for social value judgments about the distribution of income among generations and g represents the economic growth per capita). Ramsey’s simple social discount rate is given by equation (2). More complicated versions also include risk, prudence, and many other factors which also include recent work trying to resolve various normative arguments, for example, Drupp et al. (2018) and Millner (2020).

(2) r = ρ + ηg

In climate change, discounting takes place over long periods of time and the discount rates used in the evaluation of a private project may result in fairly small discount factors δ, or a low weight given to the welfare of future generations. A (constant) 5% annual discount rate leads to a discount factor of 7×103, 5.8×105and 2.5×1011 in time frames of 100, 200, and 500 years. Two annual discount rates (r) which have influenced the debates about climate economics are Nordhaus’s 4.3% (Nordhaus, 1994) and Stern’s 1.4%(Stern, 2007)—both assume (η,g)=1%1.3 but they differ in the pure time preference used ρ=3%,1.3%. Although the former calls for a relatively slow transition to a low carbon economy, the latter demands immediate and strong mitigation actions.

Hoel and Sterner (2007) and Sterner and Persson (2008) suggest that future climate damages may be larger than initially considered by both Nordhaus (1994) and Stern (2007). The reason is that (nonmarket) environmental assets will be scarcer in the future and changes in their availability will have a relatively strong impact on the welfare of future generations. Another way of expressing this is that different sectors have different growth rates and thus should have individual discount rates (or relative price factor corrections) (Drupp & Hänsel, 2021). The authors find that immediate action may be justified even when using Nordhaus’s relative high discount rates. On the other hand, although the use of exponential discounting is a common practice in private projects, there are doubts about applying it to the evaluation of social projects that entail intergenerational costs and benefits. In such cases, the use of the declining social discount rate has been recommended. Ethical concerns (Brown, 2013; Stern & Taylor, 2007) and uncertainty about the value of future economic variables (Arrow et al., 2014; Weitzman, 2001) may justify the use of lower rates.

Climate damages are an equally important and equally difficult area since we do not know the exact position of, say, thresholds in the climate system, nor do we have good valuation of all the co-benefits (for instance for health) of reducing the combustion of fossil fuels (Howard & Sterner, 2017; Parry et al., 2015). The uncertainty about damages might even be considered as preventing us from credibly assessing the social cost of carbon or the optimal abatement path (Pindyck, 2013). Cost-effectiveness could then be an alternative. If we set targets, we can price carbon to achieve those targets even if we do not know the exact SCC.

Basing itself on a series of integrated assessment models (IAMs) which place the economy and the natural environment into a single framework, a U.S. government panel estimated the SCC to be equal to $12, $42, and $62 per ton of CO2 emitted in 2020 for annual discount rates of 5%, 3%, and 2.5%, respectively (Interagency Working Group on Social Cost of Carbon, 2013)—this panel was established during the Obama administration (see Bento et al., 2018). Using an asset pricing model, Lemoine (2021) finds that uncertainty about the consumption losses due to warming considerably increases the SCC. Analyzing results from an expert survey, Pindyck (2019) finds that the average SCC is higher than the above-mentioned estimates and may lie in a range of $80–$100/tCO2. Some studies that use the first IAM (i.e., the DICE Model, Nordhaus, 2017) estimate the SCC as $31/tCO2 for 2015 and predict that the real SCC will grow at 3% per year up to 2050. In 2017 the High-Level Commission on Carbon Prices concluded the explicit carbon-price level consistent with achieving the Paris temperature target is at least $40–$80/tCO2 by 2020 and should increase by 25% by 2030. Recently, Hänsel et al (2020) adjusted the DICE model—in particular, they used a new calibration of the carbon cycle, updated climate damage estimates, and the median of a recent survey of expert views on intergenerational equity and report an SCC of as much as $200/tCO2 (see also van der Ploeg et al., 2020). Another key finding of the study is that a rapid decarbonization of the economy will allow us to stay well below 2 degrees of warming as opposed to the 3.5 or 4 degrees that Nordhaus’s analysis leads to.

A number of studies address issues related to uncertainty, irreversibility, and learning in climate change (e.g., García & Torvanger, 2019; Gerlagh & Liski, 2018; Kelly & Tan, 2015). To the extent that society is assumed to be risk averse and since it is difficult to gauge the future effects of climate change, the usual approach is to aim for lower emission levels—and higher corrective taxes—in the initial periods. Although learning (about actual future climate damage) may call for a policy of “wait and see” and therefore lower carbon abatement initially, there is also the possibility that climate change may be irreversible due to the difficulty of scaling down the concentration of atmospheric carbon which accumulated in the past or to the existence of tipping points even if scaling down is possible, which may pull policymakers in the opposite direction. Numerical simulations show that when there are tipping points or regime shifts, the optimal carbon tax schedule considerably increases (Lemoine & Traeger, 2014, 2016). Heal and Schlenker (2020) recently noted that the Pigouvian solution does not take into account that fossil fuels are an exhaustible resource. They thus believe that Hotelling’s framework (Hotelling, 1931) may offer a better method for estimating taxes on fossil fuels. Because a carbon tax may lead to substitution of fossil fuels across periods and may extend the period of extraction, it would be less effective at reducing emission. Daniel et al. (2019) treat atmospheric CO2 as an asset and use financial methods to calibrate optimal paths for carbon prices. Unlike most economic models of climate change, this study reports a relatively high optimal price in early periods that is expected to fall over time as the insurance value of mitigation declines and low-carbon technologies become cheaper. Aaheim (2010) finds a similar result using a deterministic model where society optimizes toward a stationary state where the concentrations of GHGs in the atmosphere are stabilized.

Even if a consensus were reached on the size of the global SCC, and therefore on the order of magnitude of the carbon tax and its path, equity issues would still play a role in determining the extent to which different nations may undertake climate mitigation (Chichilnisky & Heal, 1994). The industrialized economies have not only been responsible for higher atmospheric CO2 concentrations than the nonindustrialized ones but, partly because of the economic benefits of intensive energy use, they are also better prepared to deal with current and future climate change impacts. While a global carbon price is required for economic efficiency, temporary exceptions may be made in the name of fairness and feasibility. This would basically imply that rich countries move faster to decarbonization by having a somewhat higher carbon tax than the global SCC while low-income countries would have more time to introduce high taxes.5 In principle this could mean that India for instance would have a lower tax than the United States or European Union (EU). In addition to political feasibility, there are numerous other ways of defending or explaining such a departure from the strict efficiency requirement of having the same tax everywhere. The most important of these is simply equity. A dollar has much higher utility to a poor person than to a rich person. If there were a system of international monetary transfers from rich to poor countries that fully internalized the equity issues, then one could have the same tax level—but that is not the case.

Since its creation in 1992, the United Nations Framework Convention on Climate Change (UNFCC), whose ultimate objective is to stabilize GHG concentrations “at a level that would prevent dangerous anthropogenic (human induced) interference with the climate system” (United Nations, 1992, p. 9), has been guided by the principles of equity and common but differentiated responsibilities. In fact, these principles seem to be a necessary condition, if any broad international agreement is to work. The UNFCC’s Paris Agreement of 2015, which is the most comprehensive global pact on climate change up to now, rests on what are known as nationally determined contributions (NDCs) (United Nations, 2015, p. 4). The signatory countries have submitted their national NDCs to the UNFCC, with the overall aim that warming will not rise more than 1.5–2°C above pre-industrial levels, although there is no certainty that this goal will be met in current conditions. The Paris target is consistent with the stabilization of CO2 concentrations in the atmosphere at a range of 430–450 ppm. Additional considerations may include the strong polluting character of many substitutes for fossil fuel in a low-income country such as peat, dung, leaves, and so on.

In practice, countries and regions usually set carbon tax rates and paths with the aim of reaching a given emissions target by a certain date, as happens with the NDCs. The priority of this approach is (national) cost-effectiveness rather than (global) efficiency (and it thus avoids some of the controversies about the estimation and practical use of the global SCC). As suggested earlier, the emissions targets of lower-income countries are generally less ambitious, since they may prioritize other non-climate development objectives (Bataille et al., 2018). The countries in this group also require lower tax rates than the wealthier ones to reach a given target (High-Level Commission on Carbon Prices, 2017). The International Monetary Fund (IMF) (2019) reports that while a tax as high $35/tCO2 may be sufficient for China to meet its NDC (peak CO2 emissions latest by 2030), a tax of $70/tCO2 may fall short in the case of Canada (20% below 2005 by 2030). Using a similar approach, Kaufman et al. (2020) have made a simulation of carbon price schedules that would enable the United States to reach a net-zero goal in 2040, 2050, and 2060. As the share of global emissions covered by carbon pricing schemes have rapidly increased in recent years (see next section), there has been a renewed interest in a global carbon tax and the associated political-economy implications of such a scheme (see Carattini et al., 2019; Nordhaus, 2015; Weitzman, 2014).

Carbon Taxes in Practice

The Nordic region has been a leader in carbon tax implementation. Finland was the first country in the world to implement a carbon tax in 1990, wherever other Scandinavian countries followed in 1991 and 1992. Now, 30 years later these countries still have some of the world’s highest carbon taxes (World Bank, 2020), with Sweden an obvious outlier in view of a carbon tax of $125/tCO2 in 2020. This tax is also applied quite broadly although there is often misunderstanding about it. It is true there were historically numerous exceptions to the tax. Most of these have been abolished except for heavy industry that is part of the (EU Emission Trading System, or EU ETS). This heavy industry now accounts for a large share of Swedish emissions, which makes it look like the tax coverage is low. This is, however, explained by two factors. First, Sweden has a large share of companies that are part of the ETS. Second, there has been “tax base erosion” among other sources. For instance, in heating, there is practically no use of fossil fuels anymore—precisely because the tax level is so high! It is a long-term tax which has increased over time and gradually led to a situation where economic growth is less and less dependent on CO2 emissions. In the 1990–2017 period, the country’s gross domestic product (GDP) grew at annual rate of 2.2% (i.e., +78%), while it achieved significant CO2 emission reductions (−26%) (Government of Sweden, 2020).

Economic efficiency calls for a single carbon price across and within countries, but in practice carbon taxes often vary in accordance with the type and use of fossil fuels. Finland’s 2020 carbon taxes lie within a range of $60–$70/tCO2, whereas Norway’s carbon tax on the oil and gas sector is $60/tCO2. With a carbon price of $25/tCO2, Denmark seems to have lagged behind its regional neighbors although in reality it is linked to one of the most comprehensive policies for renewable energy in the world.

For ease of implementation, the carbon tax is generally imposed on fossil fuels and varied in accordance with their carbon content. It is worth noting that it is common practice to impose carbon taxes upstream on a very limited number of sources. This simplifies implementation considerably particularly in a country without fossil production: It is then just the imports of coal, oil, or gas that need to be taxed. Consider the case of Tanzania, for example, which has no domestic oil production but imports via the port in Mombasa, Kenya. There is thus just one point where the fuel enters the country, and it is therefore easy to collect the tax on the fuel quantities imported. Carbon taxes are therefore not prone to tax evasion (in this kind of environment). In fact, this may be an advantage compared to other taxes, in economies with a large informal sector or where tax evasion is common. The implementation costs of carbon taxes are indeed quite low (except perhaps in countries that produce fossil fuels) which may be a reason why developing countries rely so much on fuel taxes for fiscal purposes (Sterner, 2007; Sterner et al., 2020). Note, however, that emissions from land-use change, including deforestation and agriculture, are difficult to monitor and measure and may be more difficult to handle using a price mechanism (e.g., Kerr et al., 2017).

In Sweden, as in most countries located in middle and high latitudes, the heating of buildings in cold weather accounts for an important share of final energy consumption. Since the 1990s, fossil fuels have been phased out in the country’s district heating system and today it relies almost solely on renewable energy sources (Svensk Fjärrvärme, 2015). The transport and service sectors have also achieved considerable emission reductions—gasoline taxes are among the highest in the OECD countries (CCC). In order to keep its industrial sector competitive, industries enjoyed a lower carbon tax rate than the rest of the economy for several years, but the tax rate increased over time and eventually converged to the general tax rate (Åkerfeldt & Hammar, 2015; Criqui et al., 2019). There has been a clear negative trend in industrial CO2 emissions since the mid-1990s (Government of Sweden, 2019). Using data from the transport sector in Sweden, Andersson (2019) is, if not the first, one of the first econometric studies to report a significant and large causal effect of carbon taxes on emissions.6

Figure 1. Development of the Swedish CO2 tax for different areas of use. From 2008, industry usage outside the EU ETS is shown.

Sources: Criqui et al. (2019); Government of Sweden (2019).

The World Bank monitors existing and emerging carbon pricing initiatives around the world (World Bank, 2020). These include both carbon tax schemes and ETS at the subnational, national, and regional levels. In 2004, only eight carbon tax schemes had been implemented, all in Northern Europe. In 2005, to reaffirm Europe’s leadership on climate change since the 1990s, the EU introduced the first international emissions trading program EU ETS. Currently covering about 45% of the EU’s GHGs, it is still the largest carbon pricing scheme in the world and a cornerstone of the EU’s climate mitigation policy: In 2020 the EU ETS allowance price was about $20/tCO2. Recently, Bayer and Aklin (2020) found that, despite relatively low allowance prices, the EU ETS was responsible for a reduction of about 3.8% of total EU-wide emissions. Calel and Dechezleprêtre (2016) report that during the first five years of operation, the EU ETS had a strong impact on low-carbon patenting among the regulated firms. Unlike an emission tax, the carbon price that emerges from an ETS may be highly uncertain, as shown by the time series of EU ETS allowance prices. Carbon price uncertainty may delay or hinder investments in abatement technologies and some economists have questioned the alleged cost effectiveness of ETSs (Aldy & Armitage, 2020).

In 2007, Alberta, the Canadian province with the largest greenhouse emissions, became the first jurisdiction outside Europe to formally levy a tax on carbon. New Zealand implemented an ETS in 2008 that has gradually included more sectors of its economy, including forestry and agriculture. By 2011, a total of 21 national, subnational, and regional carbon pricing schemes had been implemented around the world: 18 carbon tax schemes and 3 ETS. In 2020, a total of 60 carbon pricing schemes have been reported, with an almost equal number of the two types of pricing programs. In 2019, South Africa was the first country in Africa to put a price on carbon. Currently, there are expectations of the eventual implementation of an ETS in China. Compared to the situation only a few years ago, these are very encouraging signs. In 2020, pricing programs covered 22% of global emissions and the average carbon price (weighted by the share of emissions covered) in this subset of programs equals $15/tCO2 (this implies a global average carbon tax of about $3/tCO2)

Table 1. The Current State of Carbon Pricing by Continent

Region

Carbon Tax

No. of Initiatives

ETS

No. of Initiatives

Level ($/tonCO2)

Allowance Price ($/tonCO2)

Europe

33.84

17

24.46

2

North America

18.08

7

15.20

11

Africa

7.07

1

0

Latin America and Caribbean

3.87

5

1

Asia

2.65

2

8.55

13

Oceania

0

17.53

1

Total

32

28

Note: The table shows the average regional carbon tax and the average ETS allowance prices (weighted by the share of emissions covered by each initiative) as well as the number of each initiative in each region (due to missing values, 50 of a total of 60 reported initiatives were used in the calculations of carbon tax and allowance price levels).

Source: World Bank (2020).

Table 1 shows the current state of carbon pricing by continent, with Europe leading in terms of price levels, followed by Oceania and North America. These are below what many experts regard as a conservative SCC of $40–$100/tCO2 (see section “The Size of Carbon Taxes: Efficiency, Cost-Effectiveness, and Equity”) and are expected to rise in the future. Similar to the case of Sweden (see fig. 1), most schemes start with a low carbon tax which increases over time according to, in some cases, a predefined tax schedule. Note that these figures should be treated as approximate and read with caution for several reasons. Exchange rates are one of the more obvious—in real terms, the differences in carbon price levels between developing countries and developed ones are smaller than shown in table 1.7 But note that there is an overestimation of carbon taxes because there are hidden subsidies (negative taxes) mainly in the coal- and oil-producing countries. There are also underestimations since some taxes are effectively carbon taxes but have other names. Gas taxes in Europe are several hundred dollars per ton,8 but often people say they have other motivations (such as fiscal, congestion, road building), and hence this total tax is not included in the averages above. But we believe the emissions just react to the price (or tax) irrespective of the “motivation.”

The Political Economy of Carbon Taxes

One of the defining features of the climate externality is its long-term nature. Although some groups in the current generation will bear the costs of climate mitigation, and others will profit from it, many of the associated benefits will only unfold in the future. The most important barrier for the implementation of carbon pricing measures that would be consistent with the breadth and depth of the climate mitigation problem—universal emissions coverage and prices pegged to the global SCC—continues to be their political feasibility. Opposition to or support for carbon taxation is often related to tax incidence, the manner in which the tax burden is divided among different actors. In some countries, certain interest groups and the general public may strongly oppose these reforms and, in some circumstances, work together to overturn them. Studies of public acceptance indicate that it will be higher when revenue recycling returns tax revenues to affected households as well as firms, and when governments use communication strategies to explain the actual nature and impact of carbon taxation to the public (Carattini, Carvalho, et al., 2018; Klenert et al., 2018).

British Columbia’s carbon tax was implemented in 2008 and was the first comprehensive tax in North America. It covers GHG emissions generated by the combustion of all fossil fuels used in the province, which correspond to 70%–75% of total emissions. It makes use of a revenue-neutrality scheme, which means that tax revenues are used to reduce other taxes or make direct transfers (Murray & Rivers, 2015). The price was initially low, but it rose to $30.17/tCO2 in 2020 (World Bank, 2020). A number of studies have shown that this scheme reduced carbon emissions by 5%–15% during the first five years of existence. The tax caused the loss of jobs in the brown sectors of the economy but created new jobs in the green sectors, with a small but positive increase in overall employment (Yamazaki, 2017).

With the exception of some initiatives on a state and regional level, like California´s cap-and-trade program, the United States, the second largest emitter of GHGs after China, has struggled to put a price on carbon. A recent study shows that lobbies which represent the opponents of climate change reforms spent about $2 billion between 2000 and 2016 to block the passing of such laws by the U.S. Congress (Brulle, 2018). Sectors like coal, oil and gas, and transport account for the bulk of these expenditures, which dwarf those by environmental organizations and renewable energy corporations—Downie (2017) studied a major ETS proposal in the United States in 2009 (the Waxman-Markey bill) and found that opposition to the bill by electric utilities companies was not universal, but, rather, it depended on reliance on fossil fuels. Currently it is no exaggeration to say that the Trump administration was overtly an expression of fossil interests. This is an important issue, with multiple underlying factors. One of the more unsavory ones is that powerful big-industry vested interests spend huge resources on lobbying. In addition to this, many oil and gas operations in the United States are quite small scale, so-called mom and pop companies, with strong popular support among broad layers of the population. A third factor is that employments are linked to these industries. Finally, in the United States (as opposed to many other countries), there may be quite strong distributional factors. IMF (2019) found that a carbon tax in the United States would be regressive.9 The supply of electricity which strongly relies on fossil fuels accounts for a relatively large share of household expenditures of the poor. In 2017, only six months after a change in government, the United States announced its withdrawal from the Paris Agreement. In recent years, fracking has made large reserves of natural gas available in the United States, and many coal-fired power plants have been converted to gas and thus helped the country to reduce its emissions. In a study on the impacts of carbon taxation in the United States, Castellanos and Heutel (2019) report that although the impact on coal mining and the oil and gas sector is significant, the effect in aggregate unemployment is low.

The public’s attitude toward taxation and state intervention is quite different in Europe. A number of studies argue that European industries have adopted a more proregulatory approach than American ones in response to the demands on climate action of their societies (e.g., Meckling, 2019).10 The EU is still the world’s third largest emitter of GHGs, but its emissions have shown a clear negative trend since 2010. The implementation of the Swedish carbon tax, a pioneer in the field, owed much to some special characteristics of the country, which has long had high taxes. In the 1970s, marginal income taxes reached 90%, but as a major tax reform in 1990/1991 showed, lowering them later became a major concern. In a similar manner, other progressive taxes on wealth, inheritance, and property were reduced or abolished—these reforms are an example of what is known as the double dividend of environmental taxation, whereby the revenues from environmental taxation are used to lower taxes which many think are unfair (Goulder et al., 1999). Given that situation, the carbon tax was not perceived a big problem: Instead, it was regarded as part of the solution. Sweden has no fossil fuel resources or companies which mine fossil fuels, and thus no anti-climate lobbying. The situation was seemingly different in France where the government met fierce resistance as it tried to raise the carbon tax quickly at the same time that it reduced wealth taxes (Criqui et al., 2019; Jonsson et al., 2020).

It should be noted that the French case of the yellow vests (a grass-roots protest movement that began in 2018) should be seen as representative of the ramifications of carbon tax implementation in general. Often the implementation of a carbon tax goes smoothly enough. In the case of France, it was the fast elevation of the tax that was the issue, and the reaction among the public to the fact that it was implemented at the same time as a big cut in wealth taxes and was therefore perceived as an inverse Robin Hood tax taking from the ordinary citizens to give to the wealthy. French politicians do not seem to have followed best practice for implementing environmental fiscal reforms (Carattini, Carvalho, et al., 2018). France currently actually does have one of the highest carbon taxes in the world (World Bank, 2020), and hence it is not fair to view the yellow vest protests as being a sign of the French population strictly being against carbon taxation in any form. It is interesting to compare to Sweden where an even higher tax has been readily accepted by the population perhaps because the tax was raised more gradually and taking into account many issues such as the fear of industries moving abroad (which motivated temporary lowering of the tax for a number of years) (Criqui et al., 2019).

When household expenditures on carbon-intensive goods and services represent an important share of the budget of low-income families, carbon taxes may be regressive (vertical inequity). However, this problem may be solved by the implementation of transfer programs (see, e.g., Cronin et al., 2019, for an example from the United States). These findings are consistent with Metcalf (2009), who describes a carbon tax scheme for the United States that is not only effective at reducing emissions but also neutral in terms of revenue and distribution. Cronin et al. (2019), however, state that horizontal equity concerns may be more difficult to deal with (families with the same income but different levels of energy consumption). In their analysis of five tax schemes in the developed world, Klener et al. (2018) list the implementation of the following recycling mechanisms: tax cuts for firms, transfers to affected firms, transfers aimed at hard-hit households, and progressive and other tax cuts for households. Taxes can be directly refunded as subsidies for abatement as proposed by Hagem et al. (2020).

Slovenia was the first Eastern European country to implement a carbon tax, in 1997 (Andersen, 2019). The scheme initially included a number of exemptions that have been eliminated over the years, in line with the norms of the EU (Carl & Fedor, 2016; World Bank, 2016). Due to subsequent increases, the tax rate reached $20.15/tCO2 in 2020. Some of the revenues from the tax have been invested in green subsidies and carbon mitigation projects (Marten & van Dender, 2019). In 2012, Japan implemented a carbon tax scheme that covered about 70% of its GHG emissions (World Bank, 2014). The initial tax rate seems particularly low (about $2.75/tCO2), although we should bear in mind the relatively high prices of energy in Japan (Kojima & Asawaka, 2021). A computable general equilibrium (CGE) model indicates that Japan’s carbon tax can be part of a broader strategy of tax reform aimed at reducing distortionary taxes and stimulating economic growth (Takeda & Arimura, 2021).

A number of recent studies analyze the factors which influence public support for carbon taxation in developed countries (e.g., Carattini, Carvalho, et al., 2018; Kallbekken et al., 2013). Among them, they find the following determinants: (a) its perceived impact on personal finances, (b) its perceived effectiveness at reducing emissions, and (c) fairness concerns. Evidence from our own ongoing studies show that support for carbon taxation increases when tax revenues are used to reduce the impact of the instrument on the poor to strengthen the protection of the environment, for example, by investing in research and development on green energy. The literature also stresses that the perception of carbon taxes on the part of individuals and voters is often biased, especially because they tend to underestimate their effectiveness and their impact on their personal finances and the poor (e.g., Carattini, Carvalho, et al., 2018; Douenne & Fabre, 2019; Kallbekken et al., 2013). Evidence from laboratory experiments (Cherry et al., 2014) and comparisons with other environmental pricing schemes (Andersson & Nässén, 2016; Carattini, Baranzini, et al., 2018; Schuitema et al., 2010) indicate that when individuals have experienced the effects of this instrument, their perception is more realistic and they are more willing to accept it. Carbon tax trials offer the possibility of increasing public acceptance, but they may be unfeasible in many contexts. However, providing the general public with information about the real impacts and personal benefits of a given carbon tax package can be useful when the public does not have a direct experience of its effects (Carattini et al., 2017). Some studies also suggest that rebranding a carbon tax as a fee (Kallbekken et al., 2011) or a contribution to climate change (Baranzini & Carattini, 2017) may boost acceptance.

Ever since China surpassed the United States as the world’s biggest emitter of GHGs in 2006, its emissions have continued to rise and they are now nearly twice those of the United States and more than three times those of the EU. However, as part of its NDC to the 2015 Paris Agreement, China has pledged to peak its emissions by 2030. Since this pledge is backed by the Communist Party, which rules the country with an iron hand, China is more likely to comply with it than a number of democratic governments subject to electoral cycles. Furthermore. President Xi Jinping recently announced that China will be climate neutral by 2060 (at the United Nations General Assembly in September 2020). China is about to implement a national ETS that will cover its power sector (see, e.g., Goulder, Long, et al., 2019). It is the world’s largest consumer of coal, which accounts for 66% of its electricity generation. One study estimates that, to meet its mitigation commitments, its carbon price would need to be less than $25/tCO2 (IMF, 2019). The same study shows that a carbon tax would be progressive, which would also be the case for such a tax in India, the fourth largest CO2 emitter. See Carattini et al. (2019) for an evaluation (based on a CGE model simulations) of a carbon tax in India.

A recent study found that, for countries with per capita incomes lower than $15,000 per year (at PPP-adjusted 2011 U.S. dollars), carbon pricing is, on average, progressive (Dorband et al., 2019). This result is consistent with an earlier survey of transport fuel taxes in more than 20 countries, which found that, in low-income countries, fuel taxes were progressive (Sterner, 2012). From the standpoint of fairness, this suggests that carbon pricing may face less public opposition in the developing world than in the developed world. In reality, however, public opinion may be based on mistaken ideas or a lack of knowledge about the actual impact of climate policy. In most developing countries, many are too absorbed in the struggle for daily survival to even think about these issues. The governments of developing countries suffer from a constant financial stress and struggle to meet the basic needs of their inhabitants. This, along with the progressive nature of carbon taxation in these contexts, makes this instrument rather attractive. Colombia implemented one of the first carbon taxes in Latin America in 2016, only a few months after it had signed a peace agreement that ended the oldest and one of the bloodiest internal conflicts in the Western Hemisphere. The carbon tax was part of a major tax reform but drew little public attention—currently, the tax stands at $5 and covers about 20% of total emissions. Seventy percent of the carbon tax revenue was to be used to implement the peace agreement, 5% for the national parks system and the remaining 25% on general environmental protection (Romeret al., 2018; Sabogal & Puerto, 2019). Companies can reduce their tax burdens by buying certified carbon credits from conservation and restoration projects—about 55% of Colombia’s CO2 emissions come from Agriculture, Forestry, and Other Land Use (AFOLU). It should be noted that information on the actual use of tax revenues and on the implemented offset projects had not been made publically available by 2020.

In 2019, South Africa became the first country in Africa to put a price on carbon. With an initial tax rate of $7/tCO2, the scheme covers all fossil fuels for the industrial, energy, building, and transportation sectors. During the initial phases of the scheme, however, a relatively large proportion of emissions has remained tax-free (Nong, 2020; World Bank, 2020). In 2014, Chile became the first country in South America to introduce a carbon tax as part of a broader fiscal reform that also included taxes on local air pollutants. The tax level was initially set at $5/tCO2e. The scheme includes a provision for offsets which allows companies to meet their obligations by buying reductions from third parties in the country (World Bank, 2017, 2020).

Carbon Leakage

Climate governance has an important strategic dimension. Although all countries benefit from the services provided by the Earth’s atmosphere, individual countries or groups of countries may have minor incentives to undertake climate mitigation actions. The main reason is that the costs of unilateral mitigation actions exclusively accrue to proactive countries, while the benefits are enjoyed by all countries and regions. Furthermore, unilateral mitigation actions may lead to carbon leakage. Carbon leakage occurs when efforts to reduce emissions by one country or group of countries affect market prices, thereby providing incentives to third parties to increase their fossil fuel exploitation or usage (Hoel, 1994). If carbon leakage offsets or more than offsets unilateral mitigation (e.g., Babiker, 2005), strategies that minimize its negative effects ought to be considered (e.g., Böhringer et al., 2017). The possible presence of carbon leakage highlights the importance of coordination in climate policy at the regional and global levels, for example, through a global accord such as the Paris Agreement. As mentioned earlier, a key feature of a global carbon tax is that it would prevent the leakage of emissions.

In a review of the literature on this subject, Branger and Quirion (2014) conclude that while ex ante simulation exercises and CGE models suggest that leakage may be in the 5%–20% range, ex post econometric evaluations find no statistically significant evidence of leakage. The latter result also applies to the forestry sector, which has received little attention in studies of carbon leakage (e.g., Andam et al., 2008; Carranza et al., 2014). A number of simulation studies show that cross-border adjustments (e.g., a customs duty on carbon-intensive products paid by the importer) may deal with the problem of leakage whenever it has been identified as a potential problem (e.g., Elliot et al., 2010; Fischer & Fox, 2012). By 2020, however, there have been hardly any cases where this instrument has been used in practice. It is also important to note that economic theory suggests that that there are conditions under which carbon leakage may be negative in the industrial sector (Baylis et al., 2014) and also in the forest sector (García et al., 2018).

The Way Forward

Economists overwhelmingly agree that carbon taxation (or more generally carbon pricing) is the best policy to deal with climate change, since it internalizes the externality from emitting carbon and therefore forces the polluter to pay for polluting. By contrast, noneconomists often favor sectorial or regional policies, like dates for peaking, detailed phase-out plans, technology standards, and so on. Both groups agree on the usefulness of subsidies for new technology such as solar power. The problem with implementing regulatory policies at a scale that would be sufficiently massive is that they might remove some sources of demand for fossil fuels—and thus lower prices of petrol, gas, heating oil, and so forth. This in turn will stimulate a new demand. The only policy that deals with climate change effectively at the systemic level is a change in prices—since this is the only policy that will deal with new technologies, products, and industries that use fossil fuels or products and thus lead to new emissions and, more so, when the use of such fuels is promoted by the national policy of some countries.

In 2020, a total of 60 carbon pricing schemes have been reported around, with an almost equal number of the two types of pricing programs, namely, carbon taxes and ETS. These programs covered 22% of global emissions with an average carbon price (weighted by the share of emissions covered) of $15/tCO2 and a maximum price of $120/tCO2. The share of emissions covered by carbon pricing as well as carbon prices themselves are expected to consistently rise throughout the decade 2021–2030 and beyond. The pace at which these two key variables grow in the future will largely determine whether the world will meet the Paris Agreement target to stay below two degrees of warming by 2100.

Despite a widespread clamor for effective climate policies, it seems that few taxes of a sufficiently high level have been imposed so far. We do not know if the current pandemic and other global developments will make it easier or more difficult to improve climate policy. We have already mentioned that the fossil-fuel lobby is one obvious reason for this shortfall, as are the lobbies from heavy energy-using sectors. Ironically, their opponents in the environmental movement also share some responsibility when they oppose pricing which they see as capitalist decoy that is not a true climate policy. They may be motivated by legitimate concerns about employment, transitional costs, and distributional injustices; however, they sometimes fail to understand the nature of this market mechanism. There is a widespread concern that taxation unfairly punishes the poor and/or that taxes do not work the way economists say they do, namely, as a way to incentivize the behavior of consumers and make it more environmentally friendly. This is an area where more research is needed first to identify cases when the critique may be correct and, second, when it is not correct, to find new ways of communicating the benefits of carbon pricing.

We do believe there are ways to solve this dilemma. A crucial starting point for designing effective and publicly acceptable policies is to understand the public’s perception of carbon taxes and other climate policies. At the current time, it is difficult for policymakers and governments to design climate policies that are acceptable to the public, since many citizens still believe that carbon taxation is a mere excuse to boost government revenues. This has been aggravated on the one hand by actual increases in inequality and on the other hand by a recent worldwide surge of polarization and populism. Research on the public acceptability of public policy suggests that more efforts are needed to help the public understand the benefits of market-based policies, but this of course also entails actually listening to popular complaints about many issues including deepening inequalities.

Acknowledgments

The authors are grateful to Marcela García, James Weiskopf, and Petter Wikström for research and editorial assistance and to two anonymous referees for many thoughtful and thorough comments and suggestions.

Further Reading

  • Environment for Development. (n.d.). Emission pricing for development. Efdinitiative.org. EFD.
  • High-Level Commission on Carbon Prices. (2017). Report of the high-level commission on carbon prices. World Bank.
  • Interagency Working Group on Social Cost of Carbon. (2013). Technical update of the social cost of carbon for regulatory impact analysis (Technical support document). U.S. Government.
  • International Monetary Fund. (2019, May). Fiscal policies for Paris climate strategies: From principle to practice (IMF Policy Paper). IMF.
  • Sterner, T., Carson, R. T., Hafstead, M., Howard, P., Carlsson Jagers, S., Köhlin, G., Parry, I., Rafaty, R., Somanatan, E., Steckel, J. C., Whittington, D., Alpizar, F., Ambec, S., Aravena, C., Bonilla, J., Daniels, R. C., Garcia, J., Harring, N., Kacker, K., . . . Wang, M. (2020). Funding inclusive green transitions through greenhouse gas pricing. CES-IFO Forum: A Quarterly Journal on Economic Trends in the Federal Republic of Germany, 18(1), 3–8.
  • World Bank. (2020). State and trends of carbon pricing 2020. World Bank.

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Notes

  • 1. It is important to acknowledge that Adam Smith had a broader understanding of individual and social behavior (Smith, 1790) and recognized some of the limitations of markets (Norman, 2018). Because markets can lead to an unequal allocation of resources among the population, he recognized a role for government in smoothing out these differences.

  • 2. The natural greenhouse gas effect was discovered and described in the 19th century (Tyndall, 1861). Callendar (1938) first estimated the impact of increasing atmospheric CO2 on the planet’s temperature, but doubts remained about the actual impact of human activity on atmospheric CO2. In the 1950s, David Keeling developed a technique to measure the levels of CO2 in the atmosphere and later discovered that the concentration of this gas was indeed rising year after year (Keeling et al., 1976). This discovery was crucial in alerting the scientific community to climate change and the later development of global climate models (Le Treut et al., 2007).

  • 3. One may consider the natural greenhouse effect as a public good and the human-enhanced greenhouse effect, or climate change, as a public “bad.”

  • 4. Although economists tend to focus on the static and dynamic efficiency properties of carbon taxation, those who focus on environmental law often see it as an application of the polluter-pays principle.

  • 5. In national discussions of climate change, there can be a tendency to favor mitigation policies based on the local SCC rather than the global one (e.g., Fraas et al., 2016). It is clear that this is neither efficient, since it does not consider the damages done to other countries, nor equitable, because the damages caused by climate change are not evenly spread across different countries (Revesz et al., 2017).

  • 6. The number of ex post evaluations (especially peer-reviewed ones) of carbon taxation’s effectiveness at reducing emissions is rather limited. Some are mentioned in Baranzini and Carattini (2014): one, which compares data from Denmark, Finland, Sweden, the Netherlands, and Norway (Lin & Li, 2019) Baranzini finds that Finland was the only country which registered a significant fall in the growth rate of per capita CO2 emissions (1.7%) and argues that tax exemptions to energy-intensive sectors are likely to be responsible for the minimal effect in most countries. Bruvon and Larsen (2004) report that Norway’s carbon tax led to a 2.3% reduction in emissions in the 1990s, and argue that if the country hadn’t exempted certain sectors, it might have been more effective. Other studies have measured the price elasticity of fuel demand to project the impact of carbon taxation. Baranzini and Carattini (2014) report that in Denmark, Norway, and Sweden all energy inputs except natural gas and electricity had an elasticity of between −0.42 and −0.62 for energy/carbon taxes (Enevoldsen et al., 2007); Brons et al. (2008) find that the price elasticity of gasoline demand is −0.34 in the short term and −0.84 in the long term and that, in general, price elasticity grows over time. Andersson (2019) notes that, in Sweden, the tax elasticity of the demand for gasoline is three times larger than the elasticity of its price, so the calculations of reductions which use price elasticity may underestimate the effect of the carbon tax while ignoring the replacement of carbon fuels with cleaner ones.

  • 7. Table 1 shows that carbon taxes in Europe are 8.7 times higher than carbon taxes in Latin America. Using purchasing parity power parities (2019), these difference drops to 4.6 times.

  • 8. Netherlands gas tax €0.79/l or $3.53 per gallon (October 2020). This corresponds to almost $400/tCO2—which is thus the effective tax on using gasoline in cars in the Netherlands. Fuel taxes existed long before climate change came to the fore in international forums, but few researchers and politicians have regarded them as climate mitigation instruments (Sterner, 2007).

  • 9. Hassett et al. (2009) report that carbon taxes in the US may be more regressive when annual income is used as a measure of economic welfare than when proxies for lifetime income are used.

  • 10. Meckling et al. (2017) report that low-carbon leaders such as California and the European Union have helped build economic interest groups in support of decarbonization before the introduction or scaling-up of carbon pricing initiatives.