By Carlo Cottarelli

As world leaders gather in Copenhagen, climate change is again in the headlines. The science of the issue can get pretty incomprehensible pretty quickly. And the politics are clearly very ugly. Let’s not forget, however, that much of the economics is simple.

It’s an externality, stupid—so price it

Climate change is an “externality” problem. Individuals, firms, and, yes, governments, do not take full account of the harm that others suffer when they emit greenhouse gases. So they emit too much. And the best way to stop them doing this is to charge them a price for the carbon content of what they emit: a “carbon price.”

Admittedly, climate change is a particularly complicated externality. Since the damage will fall largely on future generations, the proper price depends very much on how we value their well-being relative to ours. The importance of such long-lived investments as power-stations, and the heavy sunk costs of investing in new technologies, mean that the carbon prices people expect in the future are even more important than the price now. And the fact that the world’s supply of fossil fuels is ultimately fixed means that the effect of carbon prices on total emissions is not as clear cut as it may seem.

Emission reductions solely by those countries historically responsible for the accumulated stock of emissions will not come close to solving the climate problem (photo: Newscom)

But the basic principle remains—polluters should pay (these and other points made here are elaborated on in an IMF paper on the fiscal implications of climate change).

How much? How? Who?

Not surprisingly, views on the best path of carbon prices differ. But the numbers are often strikingly moderate. Even $60 per ton of carbon—somewhat higher than current prices in the EU emissions trading market,and a fairly realistic starting value for proposed schemes in the United States—would mean only $8 per barrel of oil, hardly noticeable relative to the swings we’ve become used to.

Of course, the point is that this would not be just another swing. It would be permanent. The carbon price would also increase over time, and apply not only to oil but also (importantly) to coal and (ideally) to emissions from deforestation and agriculture. What is underappreciated in the public debate is that the initial steps need not be very scary. Moreover, many countries continue to underprice or even subsidize gasoline, which is almost always found to be a hugely expensive handout to the relatively affluent.

There are several ways to implement a carbon price—tax carbon emissions, issue a fixed quantity of emission rights that can be bought and sold (“cap and trade”) or a bit of both. There are pros and cons of each. For example, rights are all too often given away for free (“grandfathered”) dissipating a source of revenue that could help address the alarming fiscal challenges ahead. What matters most for the climate is that something effective is actually done.

Another key piece of the economics is that the collective costs of reducing emissions are much lower when more countries participate. Here we run up against perhaps the most inconvenient truth of all—emission reductions solely by those countries historically responsible for the accumulated stock of emissions will not come close to solving the climate problem. But the basic economics of externalities tells us that we should be able to find a way of dealing with them such that everyone benefits—by, for instance, a clever allocation of emissions rights across countries.

Balancing the fiscal

There are certainly important developments under way toward carbon pricing. What worries me is the lack of serious debate on such key issues as their proper level, how to compensate those who might genuinely suffer from their imposition, how to ensure efficient linkages between national schemes, and (though I hope my views on this one are clear!) the pros and cons of grandfathering.

No doubt there’s reluctance to talk about raising energy prices at the present time of macroeconomic weakness. But the need for a clear, credible, and broad-based carbon pricing strategy is urgent. There is a risk that, in addressing climate change, we get the balance between tax and spending measures seriously wrong, playing down the role of taxation. Our fiscal problems will become even worse if we use spending measures to make up for failures to properly price carbon. 

For more on this, see our new paper and other articles summarized by IMF Survey online.