A Practical Guide to the Economics of Carbon Pricing

Canadian economists, politicians and even environmentalists are lining up enthusiastically behind pricing carbon as the solution to controlling greenhouse gas emissions in this country. Pricing carbon (or, more accurately, pricing carbon dioxide) is not just a fashionable policy approach; it is the most efficient way we have to ration emissions, as it allows emitters — businesses and consumers — to make the most rational decisions about where it makes economic sense to curtail carbon and where it does not. Painfully costly command-and-control reductions make little sense in Canada, given our marginal contribution to global emissions. When practiced globally, a carbon price deals with Canadian emitters as fairly as it does others. However, a beneficial outcome is not guaranteed: certain rules must be observed in order for carbon pricing to have its intended effect of achieving the optimal balance between emission reduction and economic growth. First and foremost, carbon pricing only works in the absence of any other emission regulations. If pricing is layered on top of an emission-regulating regime already in place (such as emission caps or feed-in-tariff programs), it will not only fail to produce the desired effects in terms of emission rationing, it will have distortionary effects that cause disproportionate damage in the economy. Carbon taxes are meant to replace all other climate-related regulation, while the revenue from the taxes should not be funnelled into substitute goods, like renewable power (pricing lets the market decide which of those substitutes are worth funding) but returned directly to taxpayers. The price of carbon is set according to what is known as the “social cost of carbon” — the quantified value of the impact that an emitted tonne of carbon today will have on humans in the future (adjusted to present value). That cost is not limitless; there is a point at which the cost of abating a tonne of carbon outweighs the cost of the impact that same tonne will have in the future (and some of that impact may be positive, not necessarily negative). Therefore, another important rule for creating a proper carbon-pricing system is to be as careful as possible in estimating the social cost of carbon. Estimates are all we have, and they vary wildly, from negative — meaning any carbon price is too high — to hundreds of dollars per tonne. Minor adjustments to the calculation’s inputs, such as the discount rate used and fluctuating estimates about climate sensitivity, produce dramatically different estimates. The social cost of carbon must be set with extreme prudence in order to set a reasonable carbon price. Whatever the carbon price, it will necessarily detract some degree from economic growth. But when a carbon tax is added in the presence of other taxes, such as income, sales and corporate taxes, its effect will be even more harmful, due to the compounded burden on economic activity. As a result, whatever the social cost of carbon is determined to be, the carbon price must be discounted below it by the marginal cost of public funds (MCPF) — that is, the economic cost of the government raising an additional dollar of tax, on top of what is already being raised. This varies by province, but estimates suggest that in Canada, the optimal carbon tax should be about half of the estimated social cost of carbon. Finally, it needs to be remembered that carbon pricing works because it is a marketbased policy: it works with market forces, not against them. But that means the policy maker needs to let the market play its role. Choosing the price means the market will set the quantity, and vice-versa. In response to a well-designed carbon price, the market may only reduce emissions a little, especially in the short term. Policy makers need to resist the temptation to reintroduce command-and-control rules and arbitrary quantity targets, which will simply unravel the gains from adopting the policy in the first place. There may be many reasons to recommend carbon pricing as climate policy, but if it is implemented without diligently abiding by the principles that make it work, it will not work as planned, and the harm to the Canadian economy could well outweigh the benefits created by reducing our country’s already negligible level of global CO2 emissions.