What's the right price for carbon?

The Paris Agreement on Climate Change is a historic diplomatic achievement. Climate change is a global problem. Many believed that global problem solving would prove elusive: the benefits of cutting emissions arise globally while the costs of doing so are borne nationally, so national self-interest would prevent a meaningful agreement. Paris proves otherwise—creating a commonality of purpose at the global level.

At the core of the agreement are the country-level emission reduction pledges and timetables that were submitted by 186 countries. The agreement also establishes procedures for updating and evaluating progress in meeting these national commitments. Governments will be under considerable public pressure to deliver. How can they make it work? As we argue in our new paper, the crucial thing is to price energy right.

Getting prices right

According to IMF estimates, energy prices undercharged the true costs of fossil fuel energy use—the supply costs and the damage that energy consumption inflicts on people and the environment—by a total of $5.3 trillion (or 6½ percent of Global GDP) in 2015. This estimate of global energy subsidies gives an order of magnitude of the unpriced costs that energy consumption imposes on the economy and environment. Global warming only accounts for around 25 percent of the global subsidies. The other 75 percent of the subsidies include health impacts from exposure to outdoor air pollution, and also undercharging for the local side effects (e.g., congestion) of motor vehicles, energy supply costs, and general consumption taxes. And the benefits from reducing these impacts by reforming energy prices arise, by and large, in the country doing the reform. The good news is that this also means that getting energy prices right at the national level is largely justified in terms of simple national self-interest.

Pricing carbon is part of getting prices right

The heart of the matter is that firms and households are not charged for the environmental consequences of their emissions, most importantly carbon dioxide (CO2) caused by burning fossil fuels. So establishing a proper charge for these emissions is critical.

Pricing carbon is the way forward. The price mechanism engages the full power of human ingenuity in exploring all possible margins for mitigation: reducing energy consumption; shifting from dirtier to cleaner ways of generating energy; and, last but not least, encouraging innovation and technological change.

And, in our view, taxation is generally the best way to implement carbon pricing. Ideally, this means extending fuel excises (well established in most countries, and among the easiest of taxes to administer) to include carbon charges and applying similar charges to other petroleum products, coal, and natural gas. The revenues can be used to boost the economy through, for example, cutting taxes on labor and capital that deter work effort and investment, which in turn helps to offset the drag on the economy from higher energy prices.

If instead governments use emissions trading systems, these should be designed to look like taxes by auctioning allowances to raise revenue, and including price floors and ceilings. A robust, predictable emission price provides the critical signal for redirecting technological change to low-emission investments. Although the Paris mitigation pledges typically specify emissions targets, it makes more sense to meet these on average over time (with predictable prices) than rigidly meeting them year-to-year (with unpredictable prices). At the IMF, we are assessing the different types of pricing paths that countries will need to do just this.

Right now, about 40 national and over 20 sub-national governments have adopted some form of carbon pricing. This is very welcome, but it only scratches the surface of the problem. These schemes cover about 12 percent of global emissions (though this will double when China prices industrial emissions in 2017) and typically with modest prices (around $10 per ton or less). Countries need to transition to greater coverage of emissions, and to prices that are better aligned with their mitigation commitments.

As pricing systems continue to proliferate at the national level, at some point it will make sense for countries to enhance these efforts through international coordination. A natural way to do this would be through carbon price floor arrangements (analogous, for example, to tax minima for excises and value added taxes in the European Union). These can provide some protection against competitiveness impacts and allow individual countries, if they wish, to set prices higher than the floor.

New technologies

Renewables and other forms of “green technology” are getting a lot of attention from the media. Techno-optimists trumpet a new industrial revolution and governments need to support the invention and development of cleaner technologies. However, in order for these new technologies to be created and widely disseminated, firms have to be rewarded for adopting them—this is the bottom line. The most effective way to do that is to price carbon right. In the absence of such incentives, relying on technological progress to solve climate change looks a lot like banking on miracles.

To follow through on the success of the Paris Agreement we need to get energy prices right and start moving now.