By Ian Parry

(Versions in  عربي, 中文, Español and Français)

As we slide into another year of tough economic times, it’s easy to understand why policymakers are preoccupied with the next few weeks. But they also need to be thinking about the longer term issue of leaving the planet in reasonable shape for future generations.

Without serious efforts to reduce greenhouse gases, scientists predict that by the end of this century global temperatures could be 2.5 to 6.0OC higher than a couple of hundred years ago. That could mean more heatwaves, more droughts, higher sea levels, more violent storms—and so on. When you start to think about the potential impact of, say, droughts on the livelihood of farmers, especially in poorer countries… well, you get the point.

While some progress was made in the latest round of United Nations’ climate change negotiations in Durban, South Africa, we saw two major omissions. There was little progress on either carbon pricing or, related, financing for action against climate change. And there was not enough recognition of what economics has to offer to help tackle the problems.

Pricing that carbon: Playing the long game

At the IMF, we’ve been working on the fiscal, financial, and economic challenges of climate change. Two years ago Carlo Cottarelli wrote about the importance of carbon pricing as the sina que non (forgive the Latin) of a coherent mitigation policy.

Carbon pricing policies are easily the most effective instruments for reducing CO2 emissions—the pre-dominant greenhouse gas—and providing incentives for the clean technology investments that are ultimately needed to stabilize the global climate system. Yet over 90 percent of global CO2 emissions are still not covered by pricing schemes.

Carbon pricing would also provide a substantial new revenue source for cash-strapped governments. Pricing US CO2 emissions (currently about 5.5 billion metric tons) at $25 per ton—a level suggested as reasonable in a recent report—could raise in just one decade about the same revenue as the entire aspirational target of the recent United States congressional deficit reduction ‘super committee.’

Of course, carbon pricing is challenging to implement, not least because consumers get hit with higher energy prices and energy intensive firms, such as steel and aluminum producers, become less competitive. And, measures to compensate those affected, especially the most vulnerable, will likely be a factor in effective implementation.

One possibility is to scale back pre-existing energy taxes that become redundant with carbon pricing. In many advanced countries, most, if not all, of the burden of carbon pricing on electricity prices and motorists could be offset by reducing pre-existing excise taxes on electricity consumption and vehicle purchases. Yet this tax change would be far more effective at reducing emissions as, for example, higher fossil fuel prices penalize firms using carbon-intensive fuels and driving.

Another possibility is to adjust the broader fiscal system. In Australia, revenues from planned carbon pricing will be used to substantially increase personal income tax thresholds—in effect, people can earn more before jumping up to the first tax bracket. A further option to deal with lost competitiveness is for carbon-taxing countries to levy fees on imports from non-carbon-taxing countries: so-called border tax adjustments. These adjustments penalize countries that do not price emissions, though they need to be carefully designed, especially to be consistent with international trade obligations.

Climate change finance: Show me the money!

Advanced country governments have also committed to raising $100 billion a year for climate adaptation and mitigation projects in developing countries, but it is far from clear where this money might come from. Earlier this year, the Group of Twenty advanced and emerging economies asked the IMF, along with others, to evaluate the options.

Many domestic revenue sources are up for debate (like taxes on electricity, fuels, income, capital, and even financial transactions). But carbon pricing seems the best bet—it raises this revenue and tackles the climate problem directly. Realistically though, it is difficult to imagine, in the current fiscal environment, governments parting with much revenue from any of these domestic sources.

Carbon charging for international aviation and maritime fuels might be more promising, given that national governments don’t yet have a clear claim on this tax base. (There are all sorts of legal issues with international aviation—but I’m no lawyer, so let me focus on the economics.)

There are clear environmental grounds for such fuel charges: about 3 percent of global CO2 emissions result from flying or shipping, and currently there are no excise taxes analogous to those for motor fuels. There are also broader fiscal grounds for the charges. For example, international passenger tickets are generally not subject to value added taxes.

Charges should be coordinated internationally, and developing countries may need compensation to entice their participation in these charging regimes. Here, there are some promising options: they could keep the revenues they collect from aviation fuel charges or receive rebates for maritime charges in proportion to trade shares.

Insuring against catastrophe

Not to get too gloomy on you, but maybe we also need to start thinking about developing ‘last resort’ technologies like filters for sucking CO2 out of the atmosphere, techniques for deflecting incoming sunlight, and the like. This could come in very handy in the very unlikely event that future warming imperils the planet as we know it. These possible technologies raise all sorts of tough issues.

But the longer policy omissions delay real progress on emissions pricing, the very small possibility of such a catastrophe creeps up just that little bit more.