Resistance is futile. Higher carbon prices needed to guide the transition to carbon neutral growth

carbon-ratesKurt van Dender, Tax and Environment Unit, OECD Centre for Tax Policy and Administration

Limiting the cost to societies of climate change and reducing the risk of catastrophic impacts requires deep cuts in greenhouse gas emissions. The agreement reached in Paris during the 21st session of the Conference of Parties in December 2015 (the COP21 Paris Agreement), which will enter into force on 4 November, aims to limit average temperature increases to well below 2 degrees Celsius. The agreement is clear on what is required to attain this goal, namely evolve towards zero net greenhouse gas emissions in the second half of this century. A different way of stating the challenge is to say that burning all currently known fossil fuel reserves exceeds the amount that can be burned while limiting temperature increases to 2 degrees Celsius by a factor of three.

Comprehensive efforts to transform the energy base of our economies are urgently needed. Further delay will only reduce the chances of success and will drive up the cost of the transition by allowing more investment in fossil fuel assets that ultimately will become stranded. Intensifying efforts now will not only limit the cost – it will also maximise the potential for economies to shift to a carbon neutral growth path and thrive.

Shifting to a low carbon path of economic development requires adopting policies that cut carbon at the lowest possible cost and that incite businesses and households to find new ways to produce and consume in a carbon neutral way. Carbon prices are indispensable to accomplish this goal. They can be aligned with the cost of damages resulting from emissions, and it can then be left to the ingenuity of consumers and suppliers of goods, services and infrastructure (both public and private) to reduce emissions as they see fit. There is no need for politicians to figure out precisely how to cut emissions – these decisions are left to the agents best placed to do so, and who have an interest in keeping abatement costs as low as possible. Pricing greenhouse gas emissions is not the alpha and omega of climate policy, but it is an indispensable component. If emissions needed to be cut just a little bit, perhaps some countries might choose options for political expedience rather than for cost-effectiveness. This, however, becomes less tenable when the goal is to become carbon neutral.

So how are prices currently being used to mitigate greenhouse gas emissions? The recent OECD report Effective Carbon Rates – Pricing CO2 through taxes and emissions trading systems answers this question for CO2 emissions from energy use, covering 41 OECD and G20 countries which represent 80% of global energy use and of the associated CO2 emissions. Effective carbon rates include price signals resulting from emissions trading systems and from carbon taxes, but also from specific taxes on energy use, notably excise taxes. These three components all increase the price of CO2 emissions compared to other spending items, so they capture the economically relevant contribution of tax and emissions trading policies to the cost of emitting CO2.

The results are stark: carbon pricing policies are falling a long way short of living up to their potential. Most emissions across the 41 countries are not priced at all; 90% are priced at less than EUR 30 per tonne of CO2, a conservative estimate of the costs resulting from a tonne of CO2 emissions. High effective carbon rates occur mostly in the road transport sector, because of the higher excise taxes on motor fuels. In addition to cutting CO2 emissions, motor fuel taxes can help curb air pollution and congestion, among others, so that high rates are justified. Outside road transport, rates are usually below EUR 30 (only 4% of emissions across all countries face a price of EUR 30 or more), which is very hard to justify, now and especially going forward. Rates differ strongly across countries, and it is worth noting that the 10 countries with the highest effective carbon rates represent 5% of the 41 countries’ carbon emissions, whereas the 10 countries with the lowest rates – which include several large countries – account for 77% of emissions. Finally, as is well known from other OECD work, in several countries there are ‘negative carbon taxes’ in the form of fossil fuel support, only some of which are captured in the effective carbon rates.

Why have governments up to now been reluctant to do the obvious, namely increase effective carbon rates? One reason is that the increasing awareness of the urgency of climate action has not translated into political momentum everywhere. The Paris Agreement and subsequent initiatives can do much to change this situation. A second reason is that potentially adverse effects of higher energy prices on poorer households render them a difficult political proposition. Here, the adage applies that there are better ways of delivering support to poorer households than via energy prices. And if higher taxes were levied, there is evidence that only part of the revenue – between a quarter to a third – would be needed to compensate poorer households.

Concerns about reduced competitiveness of businesses are a third reason behind the reluctance to raise carbon rates. However, the available ex post evidence finds no adverse impacts of prevailing carbon rates on competitiveness. Of course, these rates are low, but nevertheless it is apparent that businesses can adapt to gradually increasing carbon prices. And if the climate challenge is taken seriously, the only way to stay competitive in the long run is to adapt to ultimately very high carbon rates and a carbon neutral way of operating. This will require phasing out some activities but firms can adapt and thrive. Strong public commitment to a rising carbon price path will help them do so, not least by establishing an environment in which investments in long-lived carbon neutral assets can be made with confidence. Arguing for low carbon prices on competitiveness grounds increasingly involves fighting a rearguard action.

The Paris Agreement has raised support for carbon pricing, crystallised for example in the Carbon Pricing Leadership Coalition, and there is concrete action in several countries. We need to seize these opportunities to move to comprehensive carbon pricing at meaningful levels.

Useful links

OECD work on tax and the environment

OECD work on climate and carbon: aligning prices and policies

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