Advanced Review
Carbon pricing in climate policy:
seven reasons, complementary
instruments, and political
economy considerations
Andrea Baranzini,
1
Jeroen C. J. M. van den Bergh ,
2,3,4
*
Stefano Carattini,
5
Richard B. Howarth,
6
Emilio Padilla
7
and Jordi Roca
8
Edited by Stéphane Hallegatte, Domain Editor, and Mike Hulme, Editor-in-Chief
Carbon pricing is a recurrent theme in debates on climate policy. Discarded at the
2009 COP in Copenhagen, it remained part of deliberations for a climate agreement in
subsequent years. As there is still much misunderstanding about the many reasons to
implement a global carbon price, ideological resistance against it prospers. Here, we
present the main arguments for carbon pricing, to stimulate a fair and well-informed
discussion about it. These include considerations that have received little attention so
far. We stress that a main reason to use carbon pricing is environmental effectiveness
at a relatively low cost, which in turn contributes to enhance social and political accept-
ability of climate policy. This includes the property that corrected prices stimulate
rapid environmental innovations. These arguments are underappreciated in the public
debate, where pricing is frequently downplayed and the erroneous view that innova-
tion policies are sufficient is widespread. Carbon pricing and technology policies are,
though, largely complementary and thus are both needed for effective climate policy.
We also comment on the complementarity of other instruments to carbon pricing. We
further discuss distributional consequences of carbon pricing and present suggestions
on how to address these. Other political economy issues that receive attention are
lobbying, co-benefits, international policy coordination, motivational crowding
in/out, and long-term commitment. The overview ends with reflections on imple-
menting a global carbon price, whether through a carbon tax or emissions trading.
The discussion goes beyond traditional arguments from environmental economics
by including relevant insights from energy research and innovation studies
as well.
© 2017 The Authors. WIREs Climate Change published by Wiley Periodicals, Inc.
How to cite this article:
WIREs Clim Change 2017, 8:e462. doi: 10.1002/wcc.462
*Correspondence to: jeroen.bergh@uab.es
1
Haute Ecole de Gestion Genève, University of Applied Sciences
Western Switzerland (HES-SO), Delémont, Switzerland
2
Institute of Environmental Science and Technology, Universitat
Autònoma de Barcelona, Barcelona, Spain
3
ICREA, Barcelona, Spain
4
Institute of Environmental Studies & Faculty of Economics and
Business Administration, VU University Amsterdam, Amsterdam,
Netherlands
5
Yale School of Forestry & Environmental Studies and Grantham
Research Institute on climate change and the environment and
Centre for Climate Change Economics and Policy, London School
of Economics and Political Science (LSE), London, UK
6
Environmental Studies Program, Dartmouth College, Hanover,
NH, USA
7
Department of Applied Economics, Universitat Autònoma de Bar-
celona, Barcelona, Spain
8
Department of Economics, Faculty of Economics and Business,
University of Barcelona, Barcelona, Spain
Conflict of interest: The authors have declared no conflicts of inter-
est for this article.
Volume 8, July/August 2017 1of17
© 2017 The Authors.
WIREs Climate Change
published by Wiley Periodicals, Inc.
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and distribution in
any medium, provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.
Published in Climate change, Volume 8, Issue 4, pp. 1-17, 2017, which should be cited to refer to this
work. DOI : 10.1002/wcc.462
INTRODUCTION
I
n the aftermath of COP21 in Paris, countries will
have to turn pledges into effective policies, to guar-
antee that their promises about reduction of green-
house gas (GHG) emissions are actually achieved. It
is easy to underestimate this challenge. We will argue
that to achieve the Paris targets, the use of the instru-
ment of carbon pricing is essential, even though not
sufficient. All alternative options are likely to lead to
inadequate and overly costly abatement activities.
Imprudent policy design could have extremely far
reaching consequences, not least because of the real
chance of dangero us climate change.
However, many observers are critical of car-
bon pricing, often without being well informed
about its unique advantages. Research suggests that
resistance to innovative environmental policy—
whether by citizens, firms, NGOs, or politicians —
may be driven by lack of knowledge about how it
exactly functions and which impacts it generates.
1
Ex post, that is, based on experience with imple-
mented new policies, perceptions may dramatically
change so that social–political acceptability
increases.
2,3
Hence, imperfect information is an
important obstacle to the implementation of carbon
pricing, particularly as it allows political-ideological
motivations to dominate.
Here, we argue that the main reason for car-
bon pricing is to achieve environmental goals at a
reasonable cost, relatively low to t hat of other
instruments. We provide m any reasons for this,
going beyond traditional static arguments about
cost-effectiveness from environmental economics,
by including relevant insights from energy research
and innovation studies. Admittedly, many main-
stream economic accounts of carbon or environ-
mental pricing provide a more limited and
technical perspective that often is not very accessi-
ble to noneconomists. Our paper offers a broader
treatment that includes additional considerations,
reflects a more heterodox and critical perspective
on carbon pricing, and adopts a more multidiscipli-
nary angle. We further briefl y address some core
political economy issues associated with carbon
pricing, that is, reasons for why widespread imple-
mentation of such an instrument is not observed in
reality.
4
This involves attention for distributional
equity, lobbying, co-benefits, international coordi-
nation of policy, and motivational crowding in/out.
While most arguments we consider have received
ample attention in the literature, a comprehensive
and synthetic tr eatment is m issing. By summariz ing
all main arguments in favor of carbon pricing, this
paper therefore fills a gap. It offers an accessible
and nontechnical synopsis of the need for carbon
pricing in a post-Paris world. This hopefully contri-
butes to the debate on carbon pricing improving in
quality and having more impact on political
decision-making.
GENERAL IMPLICATIONS OF
CLIMATE CHANGE
CHARACTERISTICS FOR POLICY
INSTRUMENTS
Climate change possesses several characteristics that
must be accounted for in the formulation of climate
policies to guarantee their effectiveness. Sources of
anthropogenic GHG emissions are diverse and cover
all economic sectors. Emissions arise principally from
the combustion of fossil fuels, in very distinct activ-
ities, including resource extraction, production, con-
sumption, transport, and waste management
activities. This explains the heterogeneity of the many
abatement options and associated costs. The GHG
emissions accumulate in the atmosphere with resi-
dence times stretching from decades to millennia.
Therefore, abatement incentives should last through
time and be dyn amic, that is, responsive to economic
and technological change. The location of GHG
emissions does not affect climate change as GHGs
mix uniformly in the atmosphere. Hence, a reduction
of emissions has the same global effect independently
of the distribution of abatement efforts across space.
Mitigating climate change lacks a simple end-of-pipe
solution. Even though carbon capture and storage
technologies may be part of the solution, these apply
especially to large point sources and thus cannot pro-
vide an overall answer. Indeed, combating climate
change represents such an immense and immediate
challenge that relying on the promise of one option
would be very risky. Instead, many options are
required, including altering the composition of
demand (using less energy), structural change in the
composition of the economy (dirty vs cleaner sectors
and products, and different input mixes in produc-
tion), low-carbon transport, more energy-efficient
technologies, and low-carbon (notably renewable)
energy sources. Finally, particularly challenging for
international negotiations is that abatement activities
are generally costly and contribute to a global public
good, meaning that others can benefit from them
without undertaking any effort. This motivates the
need to coordinate actions by countries and polluters
to avoid free riding and international carbon leakage.
Worldwide consistent policies are required to ensure
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cost-effectiveness of total abatement, fair economic
competition between countries, and limited trans-
boundary displacement of emissions.
We will argue that carbon pricing supported by
a climate agreement is able to respond to these char-
acteristics of climate change. This becomes clear by
considering seven unique advantages of it, as
explained in the next section.
SEVEN ARGUMENTS FOR GLOBAL
CARBON PRICING
Carbon pricing affects emissions by penalizing energy
sources in proportion to their carbon content. It is
easily applicable to emissions coming from energy
use, but can be extended to emissions arising from
land use changes and other sources. In what follows
we present the most important arguments in favor of
carbon pricing.
Argument 1: As Carbon Pricing Alters Relative
Prices, Firms and Consumers Automatically
Internalize Global Warming Effects
Carbon pricing changes relative prices of all goods
and services in accordance with the Polluter Pays
Principle. As a consequence, when making deci-
sions that cause GHG emissions, firms, consumers,
and investors consider not just their private costs
and benefits, but also the social costs associated
with (direct and indirect) emissions generated in
every phase of the p roduct life cycle, from resource
to waste. The entire economy then becomes less
carbon intensive, since all consumers and produ-
cers will adjust their decisions to prices corrected
for the climate externality. To obtain t he same
result with nonprice instruments would require
that the regulator possesses all relevant informa-
tion about emissions and abatement options to
control in detail all polluting processes and beha-
viors. This would evidently be extremely diffi cult
and imply a huge c ost of governance.
Carbon pricing means that the prices of fos-
sil energy fuels will adequately reflect the carbon
content of these fuels. As a result, industries that
use more carbon-intense fuels will face higher
input costs and thus ask higher output prices from
their customers. In turn, sectors using these out-
puts as inputs will also see their output prices go
up. Finally , consume rs buying products or services
from the latter sectors will confront higher prices
as well. As all these agents are motivated to pur-
chase the cheaper input, product or service, a shift
will occur to options with relatively low direct
and indirect emissions. In other words, with a
fairly simple carbon-pricing policy on fossil fuels
each price in the economy will be corrected so as
to reflectinsomewaytheoverallCO
2
emissions
effect of the associated good or service. This
means that no economic decision escapes the regu-
latory effect of carbon pricing—it is a systemic
solution. This does not mean carbon pricing is the
complete and only solution: as discussed in the
More Than Carbon Pricing section, complemen-
tary instruments are needed, because of informa-
tional failures and bounded rationality, among
others.
Argument 2: Carbon Pricing Accounts for
Heterogeneity of Emitters, Which Reduces
the Overall Abatement Cost
Compared to other types of instruments, carbon pri-
cing can address the vast heterogeneity of GHG
emitters, thus helping to minimize the cost of pollu-
tion control. Heterogeneity m ight result from firms
producing diverse goods or having distinct technolo-
gies, and th us different emissions per un it of output,
which translates into unequal marginal costs of pol-
lution abatement. Under p erfect information and
substantive rationality, all polluters should choose
that level of emissions abatement for which the
associated marginal cost equals the carbon p rice.
Hence, with a carbon price signal, the marginal
abatement costs would becom e eq ual among all pol-
luters, implying that a given level of abatement i s
met at least global cost. No other instrument than
pricing is able to realize the same outcome. Since
polluters show inertia or are not always perfectly
aware of available abatement technologies and asso-
ciated costs, one should expect the global cost to
not reach the exact lowest level. Nevertheless,
empirical research suggests that relian ce on nonp rice
policy instruments often leads to considerably
higher abatement costs.
5,6
The reason is that such
instruments are less effective in covering diverse
sources of emissions. For example, it is impossible
to implement technical standards for the millions of
technologies and products worldwide, and moreo-
ver update these frequently to account for nonsto p
technical innovation. To illustrate, t wo studies
show, using different models, that a fuel economy
standard for cars results in considerably higher costs
of reducing CO
2
emissions than fuel taxes.
7,8
Note
that older empirical studies found the abatement
costs of uniform standards to be up to a factor
22 higher than th ose of pricing instruments.
9
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Argument 3: Carbon Pricing Provides a
Continuous Incentive for Adoption and
Innovation of Carbon-Efficient Technologies
Carbon pricing contributes to so-called dynamic effi-
ciency as it stimulates innovation and adoption of
technologies emitting less carbon. By increasing the
cost of carbon-emitting technologies and activities,
carbon pricing provides a financial incentive for con-
sumers and producers to invest in technologies redu-
cing emissions. This not only encourages more
adoption of existing low-carbon technologies, but
also indirectly promotes the development of new
ones. Empirical evidence suggests a positive relation-
ship between higher energy prices and the develop-
ment of more energy-efficient technologies.
10
Compared with emission or technology-based stan-
dards, carbon pricing provides a continuous and
stronger economic incentive for adoption of, and
R&D on, improved abatement technologies. Econo-
metric studies find that under stable energy prices,
innovations generally reduce consumer prices, while
after oil price hikes, they tend to make equipment
more energy efficient.
11
This suggests that carbon pri-
cing is an essential element of a policy package aimed
at redirecting technical change towards the cleaner
goods and ways of production. Further support for
this comes from a comprehensive theoretical
analysis.
12
Examining the effect of the European carbon
market (EU-ETS) on innovation, one study finds that
carbon pricing is responsible for a 10% increase in
clean innovation (measured by patents), in spite of
the relatively low prices experienced so far.
13
Another study provides additional evidence on the
innovation effects of EU-ETS.
14
Both confirm the
results of an earlier patent-based study that energy
prices have the largest inducement effect on energy-
related innovations.
15
A third study analyses 3412
firm-level patent data from 80 countries for the car
industry between 1965 and 2005, concluding that
firms tend to innovate more in clean technologies
when they face higher tax-inclusive fuel prices.
16
Corrected prices are essential to rapid innova-
tion in the right direction, as relative prices steer
innovation opportunities and associated investments.
This aspect is underappreciated in many discussions
about technological change and climate change,
where pricing is downplayed as if innovation/diffu-
sion subsidies and other innovation policies, such as
information provision or stimulating cooperation
between innovators, were sufficient. To fully appreci-
ate the subtlety of this point, it should be recognized
that rather than current carbon or energy prices,
expectations about future prices are relevant.
17
Of
course, a high carbon price today acts as a signal for
the near and more distant future, so that it will con-
tribute to stimulating investments and R&D with the
aim to reduce dependence on high carbon energy in
all sectors of the economy.
Argument 4: Carbon Pricing Represents the
Most Effective Way to Limit Energy/Carbon
Rebound
The issue of energy rebound and how carbon pricing
could mitigate it has received little attention in the
public debate on carbon pricing. One reason may be
that this argument was neglected by previous com-
prehensive reviews of environmental policy analy-
sis.
18,19
In line with this, rebound has so far not been
considered a standard criterion in environmental pol-
icy analysis.
Rebound denotes that energy conservation,
including through adoption of more energy-efficient
technologies, can indirectly create additional energy
uses and associated emissions. Hence, the net conser-
vation effect will be lower than the initial energy
savings—or even negative in some cases, known as
Jevons paradox. Rebound involves diffusion of tech-
nologies as well as various economic mechanisms.
Technological advances and improvements in energy
efficiency tend to lead to a direct reduction in energy
consumption. However, given the improved effi-
ciency, the energy services—for instance, traveling by
car—become cheaper, which stimulates more inten-
sive use of these services. Moreover, mon ey saved
due to more energy efficiency will increase spending
on other goods and services, and hence associated
energy use and emissions.
20
Compared to other policy instruments, oppor-
tunities for such rebound effect are limited if carbon
pricing is in place, because it is a systems approach
that reduces rebound consistently across all carbon-
intensive goods and technologies.
21
Such pricing
would discourage money savings due to energy con-
servation to be spent on energy-intensive goods and
services, as the latter will have a higher price due to
carbon pricing. Empirical evidence sugg ests that such
‘re-spending rebound’ is non-negligible and deserves
serious attention in policy design.
22
Furthermore, in
many cases, carbon pricing can reduce absolute
rebound due to the direct rebound or intensity effect,
because it may partially compensate the fall in the
user (fuel) cost due to implementing more energy-
efficient technologies (as in transport
23
). In these cir-
cumstances, the direct rebound effect on dema nd, in
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absolute terms, will be lower than in a situation with-
out carbon prices as then initial demand is higher.
Carbon pricing will further ensure that consu-
mers automatically, without even realizing, make a
trade-off between the individual benefits of new or
higher energy consumption due to rebound and
related climate change damages.
24
Indeed, carbon
pricing will mainly discourage rebound associated
with a price correction for environmental dama ge
costs exceeding direct individual benefits of the
respective consumption decision.
Argument 5: Global Carbon Pricing Curtails
Emissions Leakage Between Countries
An international carbon price covering all countries
and sectors would ensure that there are no emission
leakages or spillovers, that is, increases in carbon diox-
ide emissions in some countries as a result of emissions
reduction in others.
25,26
The mechanisms through
which this occurs are relocation of pollution-intensive
industries and shifts in comparative advantages that
alter international trade patterns, both driven by rela-
tive cost increases in countries with stricter regulations.
Although some empirical studies suggest modest com-
petitiveness effects of distinct environmental/climate
policies, this will not necessarily be the case under sce-
narios with stricter but differentiated national policies,
conceivable under the Paris climate agreement.
27
With
a global carbon price, relative prices for all carbon-
intensive products will be consistent among all coun-
tries worldwide, guaranteeing the absence of carbon
leakage.
Obtaining such an ideal situation with no leak-
age would require effectively addressing the incen-
tives to free ride. Various ideas have been put
forward on how to overcome free riding in interna-
tional negotiations.
28–33
In the absence of a global
agreement to implement a carbon price, unilateral cli-
mate policies by individual countries (or regions)
confront two main problems: loss of international
competiveness, which discourages political support
for a stringent unilateral climate policy; and carbon
leakage, which reduces the effectiveness of any uni-
lateral policy. Once a country applies carbon pricing
on its domestic goods, it could in principle also apply
it to imported goods, through a carbon-motivated
border tax adjustment or requirements of acquisition
of emission permits by importers when the policy is a
cap-and-trade system.
34
This would level the playing
field in the sense that comparative disadvantages due
to carbon pricing would be reduced or even annulled.
Several studies discuss technical aspects of carbon-
motivated border tax adjustments, and on how they
can be made consistent with World Trade Organization
(WTO) rules.
35–38
In PE issue 4 in the section on Political
Economy Issues,wewilldiscussthepoliticaleconomy
aspects of free riding and possible strategies to overcome
it, to achieve international coordination of climate policy,
or even an effective climate agreement.
Argument 6: Carbon Pricing Decentralizes
Policy, Reducing Regulators’ Need for
Information
Carbon pricing is consistent with flexibility and
autonomy of choice, allowing emitters to freely
change their behavior to reduce their costs. They can
opt for emitting and paying any charges or taxes
associated with emissions, or for undertaking a vari-
ety of activities, immediately or after relevant invest-
ments, to abate emissions. Carbon pricing thus
means decentralization of policy, with associated low
information needs and administrative costs. In addi-
tion, carbon pricing implies low transactions costs
for firms, as, unlike eco-labeling, it requires no sepa-
rate life cycle analysis to account for all carbon diox-
ide emissions of products and services. Instead, firms
will integrate carbon prices in existing cost-
accounting systems of their products and services.
Argument 7: Carbon Pricing Takes into
Account that in Making Purchasing
Decisions, most Consumers are more
Influenced by Prices than by Environmental
Concerns
Even if one is environmentally conscious, it is impos-
sible to perfectly know which goods to buy and in
what amounts to achieve environmental goals. It is,
moreover, unthinkable that one can voluntarily con-
tribute to all public goods in the world.
39
Even
though many people would like to contribute at a
personal cost to a more responsible use of the natural
environment, such cooperative behavior frequently
depends on the perception of what others will do.
40
The fact that an individual action alone has a negligi-
ble impact tends to discourage most people to under-
take these voluntary actions. Moreover, many
consumers are not particularly environmentally con-
scious in their purchase behavior, being sensitive to
personally salient concerns, notably financial consid-
erations, when making purchasing decisions. An
effective climate policy has to reach out to this group.
Carbon pricing is capable of doing this as it naturally
intervenes in a core element of markets, namely
prices of goods and services. It does so without the
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