Pricing greenhouse gas emissions

Adding a price to greenhouse gas emissions is a particularly noteworthy policy option because it would be expected to have a broad-reaching impact on emissions, has received a great deal of attention from the research community, and has been a focus of policy discussions since climate change emerged as a public issue.

Adding a price to emissions addresses the first market failure (the externality) but is insufficient or ineffective at addressing the other market failures. This means that including a price on emissions that accounts for climate damages associated with emitting would likely be insufficient for fully addressing all the relevant market failures that contribute to human-caused climate change (i.e., greenhouse gas emissions).

Furthermore, we cannot quantify precisely the cost of climate damage associated with emitting greenhouse gases because the consequences of climate change are characterized by deep uncertainty, as described above. This means we cannot know the economically optimal price to add to emissions. In practice, adding a price to greenhouse gas emissions will either be too high or too low to maximize economic benefits.

A price that is too high (i.e., that exceeds the cost of climate damage associated with emissions) would sacrifice some economic well-being relative to a lower price because energy prices would be too high. A price that is too low (i.e., that fails to account for the costs of climate damage) would sacrifice some economic well-being relative to a higher price because too much climate damage would occur.

This illustrates part of the risk management challenge of emission pricing. In general, aggressive mitigation could lead to overly high prices for energy and the early retiring of capital equipment whereas weak mitigation increases the changes of economic, social, and environmental harm from avoidable climate change impacts. Risk aversion to climate change implies erring on the side of a price on emissions that is more likely to be too high than too low. Whereas risk aversion to price increases for energy implies erring on a price that may result in excessive climate damage.

Despite these basic economic principles, adding a price on emissions may be insufficient or undesirable. As noted above, the price on emissions will necessarily be too high or too low because we cannot know what the actual damages to the climate system will be from a given amount of the emissions and a price-based approach cannot address the full range of market failures.

Adding a price to greenhouse gas emissions could also have significant distributional consequences (i.e., there would be winners and losers) even while overall economic benefits would be expected to increase. Depending on the specific details of the policy design those distributional consequences could be severe, particularly for heavy emitters or low income families. Furthermore, losses are likely narrowly distributed whereas benefits are broadly distributed. This creates both legitimate questions of fairness and political challenges for climate policy (described below).

Finally, societal values other than maximizing economic efficiency also matter, perhaps more than economic efficiency, in some cases. For example fairness, the role of people in the Earth’s characteristics and functioning, and the impacts on cultural heritage or other species are all questions outside the realm of economic efficiency.

Three basic economic principles suggest that adding a price to greenhouse gas emissions might be a beneficial way to manage climate change risks.

Note, however, that greenhouse gas emissions result, in part, from six separate market failures (Higgins 2010). These include 1) that the cost of climate damages associated with emissions are not included in the price paid by the emitter (i.e., a negative externality is unaccounted for, as described above); 2) split incentives, in which the narrow interests of a decision-maker are maximized when creating much higher costs for someone else (e.g., a landlord’s incentive to minimize capital investment expenses even when doing so ensures that their tenants excess energy expenses will be greater than the landlord’s savings on capital equipment); 3) imperfect information, in which decision-makers do not know or understand their options and the implications of their choices; 4) monopoly power, which limits consumer choices for low-emission alternatives; 5) long-lived (fixed or immobile) factors of production, which locks in less efficient technologies because the  existing capital stock makes emitters less responsive to market signals; and 6) a nonexistent market for climate stability because the private sector simply cannot provide and price public goods such as a stable climate.