Dealing with climate change mitigation requires the implementation of a wide array of policies and instruments. Carbon pricing, considered a cost-efficient instrument to achieve mitigation objectives, continues to receive increasing attention. Although there is clarity of what carbon pricing means in theory, there is less understanding of what it means in practice. This, in my view, generates some confusion when policymakers are assessing whether to implement a carbon pricing policy or a carbon pricing instrument (CPI).
Carbon pricing is a policy that imposes a price on carbon emissions. This has also been referred to as an implicit carbon price. A carbon pricing instrument, on the other hand, is a policy vehicle, implemented through a legal and institutional infrastructure, that can deliver a price on carbon emissions on specific sectors or entities. This has also been referred to as an explicit carbon price.
The distinction between these two concepts is relevant since the first, and obvious, carbon pricing policy to be implemented is the elimination of fuel and energy subsidies. While this can have an immense impact on carbon emissions reductions, it does not require the development of infrastructure to support a policy instrument . That is, it does not require a CPI to deliver an explicit carbon price.
It is valuable to also note that the definition of CPI suggests that a carbon price ‘can’ deliver. The carbon price itself (or tax rate) is not intrinsic to the policy instrument. A jurisdiction could decide on a very low (even zero) carbon price, while developing a carbon pricing instrument infrastructure to be able to deliver it. In short, the CPI is a lever, while the price is how far we are willing to pull it.
The decision to implement a carbon pricing policy, then, involves at least three distinct but related questions.
1. Should a jurisdiction implement a carbon pricing policy? Answering this question, should initially involve eliminating wasteful and contradictory fuel and energy subsidies; and may even require reviewing pricing land use change and forest clearing, as well as other pertinent policies, such as, for example, carbon pricing in public investment decisions or incentivizing internal carbon pricing within companies. These are all carbon pricing policies, but do not require a carbon pricing instrument. They are in short, policies that implement an implicit carbon price.
2. Should jurisdictions implement a CPI? If yes, at which price or tax rate? A jurisdiction may decide to complement its carbon pricing policy by implementing an explicit carbon price, that is with the development of a CPI. Associated with this choice is the need to determine the most adequate price level (or tax rate) to fulfill environmental policy objectives and limit economic impacts and income distribution effects. However, many policymakers conflate the choice of implementing the carbon pricing instrument with the level or rate at which the price is set, and immediately evaluate the ‘optimum’ or most effective price level. This is not necessary. The choice of developing a CPI does not immediately mean implementing the highest price or tax. In fact, many jurisdictions have started with low price levels and then increased it, after assessing how the instrument was working, for example, Sweden and British Columbia.
Across the world, different jurisdictions have implemented different CPIs and have applied very different carbon prices; for example, Chile, Argentina, Colombia and Mexico have carbon prices at or below US$5 a ton, while Sweden has a tax rate of €110 per ton, and California a price of US$16 per ton in its emissions trading scheme (ETS) program (auction reserve price). It is the price level that has environmental and economic impacts, not the mere existence of a CPI.
Once policymakers realize that the development of a CPI does not necessarily mean very high prices, emphasis should be taken away from assessing the impact of CPIs with sophisticated modelling techniques, such as GCE models. These are only necessary if the intention is to set a very high price at the outset. Furthermore, many jurisdictions simply do not have the capacity or information to develop these types of analytical models. Before evaluating the right price, and therefore the full impact, the immediate question is whether a jurisdiction can develop the institutional infrastructure to deliver a CPI that can generate an explicit carbon price.
3. Which CPI should a jurisdiction adopt? Generally, te literature refers to a binary choice between a carbon tax and an ETS, however, within this binary choice there are a range of, what I will refer to as, macro-design choices which change the nature, object, outcome, and above all, the viability of the CPI. For example, a tax on fuels or emissions have considerably different institutional arrangements, although they are both taxes; while an ETS with no trading and emission permits acquired at the government’s minimum auction price is essentially a tax (as was the case of the ETS in California until recently).
In this context, I identify at least five features of CPIs that are not only key design choices but have considerable economic, institutional and, above all, political economy consequences. In short, these design choices change the nature and outcome of the policy instrument. These are: (1) the choice between a tax or an ETS; (2) the choice of emissions or fuels as the base; (3) the choice of CO2 or GHG as the contaminant; (4) what to do with the revenue, and; finally, (5) whether to have complementary market features such as offsets and emissions trading in secondary markets. We will discuss these choices in an upcoming blog post.
Carbon pricing and carbon pricing instruments are distinct and have different implications. Clarity on what is meant is useful for policymakers to understand the consequences of the choices available to them. Moreover, despite the general perception the choice on which CPI to implement is much broader, it is not exclusively tax vis-à-vis ETS, in fact there are at least five macro-design features that imply different technical and institutional requirements, that focus on different types of emitters and sectors, and which will have different results and impacts. Understanding the full range of alternatives will provide policymakers with more tools to implement a carbon pricing strategy more consistent with their national contexts and political realities.
