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The following is an excerpt from Energy Innovation's book Designing Climate Solutions: A Policy Guide for Low-Carbon Energy by Hal Harvey, with Robbie Orvis and Jeffrey Rissman.
The most obvious pitfall in carbon pricing, worldwide, has been inadequate ambition in setting targets for emission reductions. In the effort to find the balance between environmental stringency and cost containment, policymakers have leaned toward keeping costs low. The social cost of carbon, representing the damage caused by carbon emissions, can be thought of as a reasonable target price.
In practice, very few carbon pricing efforts have even approached, much less surpassed, the social cost of carbon . This is not due only to policy challenges, of course: A fortunate side note in carbon pricing programs is that it has been very cheap to hit targets.
For many years, the notion of any carbon pricing at all seemed like a pipe dream. In the 1990s, the elegantly named Tax Waste, Not Work and other efforts promoted the concept but with no concrete success. In 2005, the European Union’s Emissions Trading System (EU ETS) began operation, and it remains the largest system in the world, covering about 1.8 billion tons of annual carbon emissions. Not long after, in 2009, a group of northeastern U.S. states came together to form the Regional Greenhouse Gas Initiative (RGGI) to cover the region’s electric power plants. In 2007, California began planning its carbon cap program, which launched in 2013, linked with the Canadian province of Quebec in 2014, and was extended through 2030 in 2017.
Existing carbon prices are lower than needed to meet Paris targets
A comprehensive survey by the World Bank finds that about 40 nations and two dozen sub-national jurisdictions have established a price on carbon. These instruments currently cover about 12% of global greenhouse gas emissions. Roughly two-thirds of the coverage, about 8% of global emissions, is under a carbon cap, and about 4% is subject to a carbon tax. A particularly anticipated development is the expansion of China’s pilot projects, which should cover more than 1.2 billion tons of emissions. China’s national cap-and-trade program is expected to launch in 2018.
Aggregating all the world’s current carbon prices into a curve also shows the amount of CO2 tons covered. The width of each segment of the stair-step line shows the amount of covered emissions, and its height indicates the price.
But for a tiny slice of emissions in Nordic countries, nearly the entirety of the globe’s carbon pricing falls well below the U.S. EPA’s social cost of carbon, about $41 per ton. This also highlights the recommendation of the High-Level Commission on Carbon Prices that countries aim for carbon prices of $40–$80 per ton in 2020 in order to meet the emission reductions agreed to in the Paris Agreement.
Although the EU ETS has become an accepted part of doing business in Europe, it stands as a cautionary tale about the potential for a very large bank of allowances to accumulate and cause persistently low allowance prices (the program has no auction price floor). The price has varied from €3 to €10 since 2011, standing at €7 per European Union Allowance as of October 2017.
The onset of the financial crisis in late 2008 caused a fall in emissions due to reduced economic activity. Other renewable energy and energy efficiency policies also drove emissions down. The result was an oversupply of allowances that reached more than 2 billion tons in 2013, at the start of the program’s third compliance period. Policymakers are tackling the problem by taking some allowances out of future caps and delaying some auctions. Meanwhile, political barriers have impeded adoption of a price floor.
Carbon taxes have been most robustly used in Nordic countries, where prices range from about $25 per ton in Denmark to roughly $50 per ton in Norway and Finland and $130 per ton in Sweden. These Nordic countries have mostly used new government revenue to lower taxes on labor. Japan greatly expanded the emissions covered by a carbon tax when it introduced one in 2012, but at less than $2 per ton it provides a weak incentive. Canada’s new commitments around carbon pricing should be a game changer in stringency for taxes, with a carbon price of $10 in 2018 and increasing to $50 in 2022.
Adjusting cap levels helped solve RGGI allowance over-allocation
RGGI covers the electricity sector CO2 emissions in nine eastern American states. A key highlight is the program’s early embrace of auctioning as the main method of distributing allowances. RGGI was the first program to fully auction allowances, illustrating the economic benefits that can be created by smart investment of auction revenue.
Revenue generated by RGGI has funded energy efficiency improvements, which have created an array of economic benefits, starting with consumer savings of more than $618 million, and spending of extra disposable income from energy efficiency and local clean energy investments has generated more than $2.9 billion in additional economic growth. Public health benefits worth $5.7 billion are estimated to have come from reductions in fine particles and smog-causing emission, which are co-benefits of lowered carbon emissions.
Time and again, modeling in advance of cap setting has resulted in business- as-usual emissions that are higher than the real-world result, and RGGI is an example of the problems with using this approach. As a result of basing allowances on a forecast emission scenario, RGGI has wrestled with over-allocation. Despite the governance challenges in a linked system, RGGI has been regularly tightened to deal with this oversupply. In addition to the cap adjustments discussed later, RGGI has established a regular four-year program review and recalibration process.
In 2005, when the cap was set, natural gas prices were high and rising, as were emissions. The intent of the states was to set the cap at the expected levels in 2009, keep it flat for five years (when emissions were otherwise expected to continue to grow), and then decrease it by 2% per year through 2019. It was a surprise when gas prices fell precipitously in the intervening years, displacing a great deal of coal and causing emissions to fall far below the cap before the program had even launched.
RGGI was more than 50 million tons oversupplied from the outset. By 2012, emissions had fallen to about 90 million tons, about half the level of the 180-million-ton cap. Participating states made two adjustments to the cap in response to the oversupply of permits. First, they lowered the cap to account for the misjudgment of underlying technological trends; modelers had not anticipated the decline of coal with the emergence of natural gas as a cheaper alternative. In a second adjustment, the states lowered caps by 140 million tons to account for excess allowances sold and banked from 2009 to 2013.
In 2017, the program completed another review, tightening the post-2020 cap, which had previously been set to flatten. Under new commitments, the cap will provide an additional 30% reduction in emissions by the year 2030 relative to 2020 levels. As part of this adjustment, the Regional Greenhouse Gas Initiative will also undertake another adjustment for banking.
The price floor included in the initiative has saved the program’s allowance price from completely collapsing. By 2017, the price floor had reached $2.15 per ton, with an escalation rate of 2.5% per year. Thus, the price floor ensured the program provided some revenue, although it did not truly solve the problem of over-allocation. At such low prices, it costs little to purchase allowances as a hedge against future higher prices.
RGGI includes a soft price ceiling by allowing a set of reserved allowances to be released if the price hits certain levels: $4 in 2014, $6 in 2015, $8 in 2016, and $10 in 2017, rising by 2.5% each year thereafter. Prices have remained low, however, peaking at $7.50 per ton at the December 2015 auction. However, in light of the low soft price ceiling, some release of reserve allowances has happened.
In sum, RGGI demonstrates how policymakers can adapt to oversupply, why auctioning of allowances is important, and the value of having a price floor at auction. However, the program suffers from limited coverage (it covers only the power sector), failure to address leakage (it does not cover imported electricity), and an overly weak price collar.
Carbon pricing is not a silver bullet - but it is important to solving climate change
Carbon pricing is not a silver bullet to achieve the deep emission reductions needed to meet the two-degree target . Rather, it is one important part of a package of policies.
The steadily increasing adoption of carbon pricing attests to the positive real-world experience so far. There have been no major breakdowns or market disruptions that might have led to a loss of confidence in the approach. The policy has proven to be an attractive source of revenue. Economists and public finance experts universally agree there are efficiencies to raising funds through charges on pollution or other socially harmful activities. For regulators, carbon pricing has somewhat lower informational demands, providing a cross-sector tool to achieve cost-effective reductions above and beyond other policies.
The major limitation so far is that policymakers have been overly cautious. Taxes have been too modest and caps too generous, evidence of the substantial political hurdles and the limits of state-of-the-art economic and technology forecasting. Our suggestion to focus on proper design instead of whether to use a tax or a cap aims to move the dialogue past clashes of worldviews to practical design considerations.
Design of either can be simple or complex, and they have similar enforcement requirements. Each can be structured to counter its weakness through hybridization. Carbon pricing policy should embody scientifically grounded emission targets while using proven mechanisms to keep prices within reasonable bounds. If chosen, carbon taxes should be quantity-adjusted, with prices ratcheting up if emission impacts fail to materialize as expected.
