Carbon Markets and Beyond: The Limited Role of Prices and Taxes in Climate and Development Policy

The climate policy debate has advanced from science to economics, with a growing focus on creating carbon markets and getting the prices right. This is necessary but far from sufficient for an effective and equitable response to the climate challenge. While market-oriented forces such as the IMF and the World Bank have focused almost exclusively on carbon markets, others, such as the Human Development Report and the Stern Review, have emphasized the need for complementary, non-market climate initiatives to promote energy conservation and above all, to create and adopt new low-carbon technologies. The equity implications of market-based policies depend on the price elasticity of demand. When demand is elastic (i.e. the elasticity is large in absolute value), as in the case of industrial energy use, price incentives are quite effective and distributional impacts are minimized. On the other hand, when demand is inelastic (i.e. the price elasticity is close to zero), as in the case of transportation fuel use, price incentives are less effective, worsening income inequality but doing little to change in energy use and carbon emissions. Thus non-market policy instruments are particularly important in sectors with inelastic demand for energy, such as transportation. Price incentives alone cannot be relied on to spark the creation of new low-carbon technologies. Many technologies display “learning curve” effects, starting out with high unit costs and becoming cheaper as they are used more widely. Wind power, which is now commercially viable, only became affordable as a result of decades of government subsidies and research support. The same will be true of other low-carbon energy technologies, which will be needed for a sustainable solution to the climate problem. Policy debate has focused on the need for a globally harmonized price for carbon. This is not required by economic theory; in an unequal world, the logic of market economics implies that richer countries should, in effect, have a higher price for carbon. It appears likely, nonetheless, that a consistent global price will eventually be adopted. This will make the benefit of reducing carbon emissions loom larger in lower-income countries. As a result, a wider range of carbon-reducing technologies will be profitable in developing countries, creating opportunities for “leapfrogging” beyond the technologies in use in high-income countries – thereby helping to launch a new, green path to development.