Three economic principles

The first economic principle is that having less of something (greenhouse gas emissions in this case) almost certainly requires an increase in the price of those activities that cause it. This is because a price increase for emitting activities encourages both increases in efficiency (a reduction in emissions for a given amount of the activity) and also frugality (reduced engagement in the activity) (Daly 2007). Critically, increasing the efficiency of an activity without a corresponding increase in the price makes engaging in the activity cheaper, which encourages more of the activity. As a result, efficiency gains without an increase in the price of an activity may not lead to emissions reductions.

The second economic principle is that incorporating the costs associated with climate change into the price emitters pay for their emissions (i.e., through an additional price on emissions) would be expected to increase overall economic well-being. This is because economic well-being is maximized when individual decision-makers (the entity choosing to emit in this case) pay all costs and receive all benefits associated with the activity.

Currently, the societal consequences of climate change are distributed across the entire population, including future generations. As a result, potentially significant economic costs associated with greenhouse gas emissions (i.e., the societal costs of climate damage) are shifted away from those who choose to emit. Instead, the people who endure the consequences of climate change pay those costs. This constitutes an economically harmful subsidy that emitters receive from the broader society. Incorporating the costs of climate damage into the price paid by emitters would reduce that subsidy and therefore bring net economic benefits.

The third economic principle related to emissions pricing is that market mechanisms are generally the most economically efficient way to reduce emissions. This means that a price-based approach can be expected to result in the greatest amount of emissions reduction for the least cost or, equivalently, the most emissions reduction for a given cost. An important caveat to this basic conclusion is that it applies when the externality constitutes the dominant market failure because the additional market failures involved may be more responsive to non-market based approaches (e.g., regulation).