Part I: The basics
By Brendan Frank, Canada’s Ecofiscal Commission
Climate policy can be complicated—especially if you’re talking to economists. Carbon pricing? Complementary policies? Marginal abatement costs? Let’s unpack some of this jargon in the simplest ways possible.
What’s the problem?
Negative externalities occur when someone’s actions impose costs on others. For example, consuming energy creates pollution, which has costs. Health impacts from air pollution and increased impacts of climate change are two good examples. But when someone drives their car, heats their home, or otherwise consumes energy, they don’t pay those costs; society does. These costs to society are negative externalities. This is a problem. It means that we don’t have the right incentives to avoid those costs because we don’t bear them personally.
Fortunately, we have policy solutions to environmental externality problems.
The basics of carbon pricing
Carbon pricing is a policy that imposes a charge on emitting carbon dioxide and other greenhouse gases. It fixes the externality problem by making anyone who emits carbon pay for the damages that result from their emissions.
There are two main ways to implement carbon pricing:
- A carbon tax is a flat charge to emit a tonne of carbon. The more carbon you emit, the more you pay. That creates incentives to switch to practices or technologies that produce fewer emissions.
- A cap-and-trade system places a limit on the total emissions in the economy (the “cap”). Businesses covered by the system receive permits for the right to pollute, which they can buy and sell to one another (the “trade”). They can buy permits from other polluters instead of reducing their emissions, or they can reduce their emissions and sell any permits they don’t need for a profit. Again, that creates an incentive to reduce emissions.
One of the biggest advantages of carbon pricing is cost-effectiveness. In the context of climate policy, cost-effectiveness means reducing a given amount of emissions in the least expensive way possible. Carbon pricing is cost-effective because it uses the power of markets. It lets people and businesses decide for themselves where, when and how to reduce emissions. The alternative to carbon pricing is regulation that tell people and businesses where, when, or how to reduce emissions, and by how much. Carbon pricing lets the market decide what is cost-effective, unlike prescriptive regulations.
Other climate policies and when they make sense
Carbon pricing is the most cost-effective way to reduce emissions, but it can’t do it all. That means additional policies to reduce emissions can sometimes make sense. We call these non-pricing policies.
Non-pricing policies can support research and development or provide additional information to consumers on issues like energy efficiency. Or they might apply to emissions that are challenging to measure and price, like methane emissions in the oil and gas sector. It’s hard to measure the methane leaks from gas wells and pipelines, so carbon pricing won’t work. Complementary policies might also lead to other, additional benefits. For instance, phasing out coal can reduce asthma attacks and sick days, which reduces health care costs.
But not all non-pricing policies (e.g., regulations or subsidies) are cost-effective. Some may reduce emissions at high cost. If a non-pricing climate policy is cost-effective, we call it a complementary policy. Truly complementary policies do something a carbon price can’t and do it at the lowest possible cost.
But there’s more than one way to think about costs. Next week in part II of this post, we’ll talk about costs and policy design.
