Carbon Pricing Enters Middle Age
It is difficult to identify another policy tool that has been either more celebrated or dismissed in recent decades as carbon pricing. Long heralded by advocates as a silver bullet to confront climate change, it has increasingly been panned by critics as a political non-starter that distracts from serious climate mitigation. This paper reviews the last half-decade of global climate policy and carbon pricing experience. It examines significant political challenges to pricing adoption in nations including the United States. However, it also demonstrates that carbon pricing can play an increasingly significant role in supporting decarbonization in such cases as the European Union, the United Kingdom, and Canada, part of an ensemble of policies rather than a solo act. Such cases may expand in coming years through stronger links between pricing and trade policy, continued shifting of pricing revenues toward green investment programs, and extension of pricing to short-lived climate pollutants such as methane and hydrofluorocarbons.
It is difficult to identify another climate policy tool that has been either more celebrated or dismissed in recent decades as carbon pricing. Long heralded by advocates as a silver bullet to confront climate change, it has increasingly been panned by critics as a political non-starter that distracts from serious climate mitigation. This paper revisits the question of whether pricing is politically feasible and durable or if we instead need to abandon it in favor of alternative policies to subsidize or regulate the decarbonization necessary to stave off the worst threats of climate change. It concludes that it is premature to declare any iron laws that assure the success or failure of pricing or other climate policy tools globally and that there is a growing need to consider how different types of policies might effectively complement each other rather than rely exclusively on one.
The Case for Pricing—and Political Stumbling Blocks
Much earlier climate policy scholarship assumed that nations would inexorably develop robust carbon pricing regimes that would be integrated into a sustained global assault on carbon emissions. This expectation animated the 1997 Kyoto Protocol, building on early experience with market-based policy tools for sulfur dioxide in the United States and carbon dioxide in Nordic nations. Pricing was embraced by global trade and monetary authorities, as well as platoons of economists of varied ideological stripes. Many carbon pricing advocates deemed regulatory and subsidy policies as second-best alternatives unworthy of serious attention.
In theory, carbon price adoption could drive down fossil fuel consumption, heighten demand for non-carbon energy sources, and propel technological transition to cleaner energy production. It featured a distinct choice between a direct and administratively straightforward tax across fuel types or a cap-and-trade system that fostered bargaining over allowance purchases under a firm emissions cap. Both taxes and trading system auctions generated government revenues that could be used for a range of purposes. The underlying argument behind carbon pricing involved economic efficiency, allowing markets to find the lowest-cost emission reductions to stimulate a complex transformation away from fossil fuels.
In practice, carbon pricing has faced major policy adoption challenges around the world. Climate change is the ultimate wicked problem, necessitating short-term actions that may ameliorate long-term problems; pricing makes direct pain-imposition through increased energy prices salient and potentially combustible. Fossil-fuel interests built coalitions to aggressively oppose carbon pricing and many resulting systems adopted were modest and loaded with exemptions. Carbon taxes could not guarantee specific emission reduction levels while cap-and-trade systems often encountered operational complexity and relied on suspect offset purchases to ease compliance. Equity and fairness considerations often surfaced over policy costs and benefits and no global regime succeeded the flawed Kyoto system to place carbon pricing on firm global footing. Abiding focus on carbon pricing as a presumably dominant climate policy crowded out serious political and scholarly consideration of policy alternatives or complementarity between them.
Durability was also an unexpected problem. Numerous early carbon pricing experiments, from Australia to Ontario, were launched with hoopla and then folded amid political backlash. High-profile 2010 Congressional rejection of cap-and-trade legislation became and remains a global poster child flagging carbon pricing’s political shortcomings. Social scientists drawn from outside economics piled on in opposition, deriding carbon pricing proponents as “out of touch” with political realities and reflecting “out of date thinking.” France’s “yellow vest” protests against proposed carbon tax increases and a pair of rejected Washington State ballot propositions in the 2010s are routinely invoked as cautionary tales against efforts to resuscitate pricing. Implementation issues have also emerged, including California’s ongoing cap-and-trade struggles to secure and retain other American state trading partners, devise a credible approach to offsets, and resolve chronic political brawls over allowance auction revenue usage.
Carbon Pricing Entering Middle Age
The empirical evidence on carbon pricing remains decidedly mixed. There has been no political groundswell to adopt robust carbon pricing regimes in most developed or emerging nations, much less integrate them into a seamless global system. There is no obvious political path for a serious American version of carbon pricing at the national level in the near term. Studies of numerous systems indicate modest annual emission reductions. Any suggestion of an inexorable transition toward a dominant global pricing system that will marginalize other policies while driving substantial decarbonization seems fanciful.
In practice, carbon pricing has faced major policy adoption challenges around the world.
At the same time, carbon pricing has diffused across a growing number of nations and plays an increasingly central decarbonization role in some major contexts, with additional expansion forthcoming. In 2021, 68 pricing systems were operational, annual revenues reached $84 billion, and more than 23 percent of global emissions were covered, all record highs. A 2021 global deal under the Paris Agreement promotes greater cross-border cooperation among emissions trading programs and even China has initiated a modest transition from seven urban pricing pilots into a national system.
Most carbon pricing policies remained limited in scope, imposing prices below $10 (U.S) per ton and laden with exemptions. But a small yet growing set of initiatives outside the United States have pushed well above this level. Some studies indicate more substantial emissions reduction patterns, particularly in cases where relatively high rates have been sustained over time. Such cases loom increasingly large in contemplating additional carbon pricing steps, drawing from real experience rather than theory. In turn, expanding use of micro data by economists indicates that elevated energy prices reduce consumption more aggressively than earlier studies reliant on aggregate data concluded. Four emerging issues suggest that it is premature to relegate carbon pricing to the ashbin of failed policy tools.
Breaking from the Pack. Europe, the United Kingdom, and Canada have shrugged off prolonged carbon pricing and climate policy struggles to establish increasingly robust pricing regimes in recent years. Their political paths and policy design features vary markedly but demonstrate the ability of large, multi-level political systems to find viable political formulas to adopt, sustain, and expand major carbon pricing regimes. They are increasingly well positioned to play central roles in concert with other climate policies.
Europe’s transformation of its Emissions Trading System (ETS) represents a combination of durable political support for carbon pricing with far-reaching management reforms. Once a train wreck of administrative foibles and political accommodations that was widely disparaged by scholarly critics, the ETS has steadily matured and expanded. It features a Market Stability Reserve to withdraw excessive allowances and stabilize the carbon market under a steadily-declining emissions cap. ETS has played a significant but hardly exclusive role in EU emission reduction in covered sectors (electricity, heat generation, and energy-intensive industry) by 37 percent between 2005 and 2021. It is intended to be a central player in the EU’s next stage of climate policy, a 62 percent emissions reduction from 2005 to 2030 in sectors under the ETS umbrella. Planned expansion targets the shipping, building, and road transport sectors. ETS allowance prices increased nearly three-fold during 2021, averaging between 80 and 105 Euros per ton since late 2021. Additional ETS reforms to increase the “policy coherence” between pricing and non-pricing policies as they expand and mature have been proposed. The United Kingdom remains aligned with EU-wide carbon pricing provisions through its own system, relatively unique amid the fallout following Brexit and further demonstrating pricing durability capacity on a continental scale.
In Canada, the political path toward any viable federal climate policy strategy has long been perilous. This reflects strong political divides in a nation with substantial fossil fuel production and deeply-decentralized energy and environmental governance. Nonetheless, Canada adopted the Greenhouse Gas Pollution Pricing Act in 2018, building directly on early provincial carbon pricing policies. The emerging Pan-Canadian Framework required each province and territory to develop carbon pricing systems reaching $50 (Canadian) per ton by 2022. Jurisdictions were offered considerable flexibility in designing their systems, including retention of all funds and control over their use, as long as they cooperated with federal goals. Particularly favorable transition terms were provided to earlier pricing adopters, such as British Columbia and Quebec. Resistant jurisdictions faced a “backstop,” federal carbon tax imposition with direct federal rebate payments to residents. In December 2022, Ottawa announced plans to apply the backstop in three provinces, having found their policies inadequate.
Numerous early carbon pricing experiments, from Australia to Ontario, were launched with hoopla and then folded amid political backlash.
This novel carbon pricing approach has retained support from four of Canada’s five main political parties and from modest public opinion majorities since its inception. Over half of Canadian global trade involves the United States, whose prolonged lack of credible carbon pricing or climate policy gave Canada abundant political cover to dial back its pricing ambitions. Nonetheless, it doubled down in 2020, scheduling annual carbon price increases until reaching $170 per ton by 2030. Numerous political and implementation issues remain, as Ottawa pursues negotiations with provinces and territories over what policies meet federal standards. Thus far, Canada has sustained carbon pricing as a climate policy cornerstone, although effective complementary policies will also be needed if it is to finally begin to honor emission reduction pledges. In 2022, Canada began to develop “carbon contracts for differences,” which would provide energy investors insurance against any future carbon price rate cuts.
Carbon Border Adjustments. Major climate policy differences between trade partners could create significant leakage problems, prompting investment to gravitate toward jurisdictions with easier compliance paths. This could reflect sharp variation in numerous policies, including regulatory standards and energy subsidies, but carbon pricing leakage risks long seemed modest given generally low prices. Nations pursuing carbon pricing at steep rates, however, might be more eager to consider trade equalization steps to protect domestic industrial competitiveness, pressuring climate laggards that have eschewed pricing to keep pace or face consequences.
Economists have studied these asymmetries and asked whether like-minded nations on climate might form “clubs,” applying tariffs on goods imported from countries lacking comparable commitments. This could assume the form of “carbon border adjustment mechanisms” (CBAM), which remained largely theoretical until the EU formally entered this territory after observing the growing void between its pricing policies and those of many of its major trade partners.
The EU’s Green Deal strategy for deep 2030 greenhouse gas emission cuts and mid-century carbon neutrality includes further ETS expansion and CBAM development, designed to thwart leakage and incentivize laggard trade partners to follow suit in reducing emissions. CBAM took initial legislative form in 2021, with plans to coordinate its phase-in with phase-out of remaining free ETS allowances, likely producing additional auction revenue that would further bolster Green Deal investments. In December 2022, the EU announced agreement on the details of the world’s first tax linked to the carbon content of imported goods, followed by April 2023 legislative approval by the EU’s Parliament. CBAM exploration is simultaneously accelerating in Canada and the United Kingdom. In these cases, more robust domestic carbon pricing policies provided impetus to consider global carbon tax applications to imported goods produced without comparable policies.
CBAM development was not well-received by major trade partners such as China, Russia, and Brazil, which maintain modest climate policies alongside high emission-intensity levels in their economies. They also raised a stir in the United States, as the climate-ambitious 117th Congress eschewed carbon pricing to focus on expansive clean energy subsidies that decisively favored American firms and would be hard to measure and compare with carbon prices elsewhere. Nearly forty percent of American imports arrive from nations with carbon prices expected to exceed $50 (U.S.) per ton in 2024 while the US carbon price remains lodged at zero. Growing CBAM interest among major trading partners triggered a flurry of Congressional counter-proposals from members of both parties in 2022-2023, some incorporating carbon pricing to fend off potential tariffs on American exports, assure access to emerging border adjustment clubs, and complement existing policies. Senator Sheldon Whitehouse (D-RI) noted that “There’s a real prospect that Canada, EU, and UK all basically bind together on common carbon border adjustment. If we haven’t joined up with them, we’re just sort of deliberate losers.”
Carbon pricing increasingly plays a largely unanticipated climate policy role, providing funds to cover growing shares of complementary climate program costs.
Political, administrative, and economic uncertainties abound in contemplating potential linkages between trade and climate policy and multi-national club formation. But some form of border adjustment process appears increasingly plausible in a world with ever-deeper carbon pricing and climate policy variation amid growing national support for domestic economic protection measures. Stiff trade penalties for non-complying nations have been a cornerstone of the lone binding and effective global greenhouse gas regime, the Kigali Amendment to the Montreal Protocol on Substances that Deplete the Ozone Layer, in driving aggressive cooling sector transition from hydrofluorocarbons (HFC). These trade provisions were essential in securing bipartisan congressional support for comprehensive American legislation in 2020 and Senate treaty ratification in 2022, with national and global implementation utilizing complementary policy tools buttressed by industry desire to retain access to international markets. Kigali is often taken for granted as a seemingly inevitable and incremental extension of the Montreal Protocol. Instead, Kigali represents an unusually innovative multi-tool and multi-level reinterpretation of Montreal to better address climate challenges as well as provide ozone layer protection. It warrants far greater recognition and deeper study by policy scholars than it has received to date.
Earmarked Revenue Use. Carbon pricing increasingly plays a largely unanticipated climate policy role, providing funds to cover growing shares of complementary climate program costs. Such a hypothecated revenue use strategy is common among taxes on other products that cause harm, such as tobacco and sugar. But similar linkage for carbon pricing was dismissed by many advocates as less efficient than commensurate tax reductions or dividend payments. It was also eschewed by many early carbon taxes that deposited revenues into general funds.
This transition is reflected in global use trends for carbon pricing revenue, which has increasingly shifted support toward related programs including energy efficiency, renewable energy transition, environmental justice, climate adaptation, and energy bill payment assistance. The Regional Greenhouse Gas Initiative (RGGI), a power sector cap-and-trade program involving northeastern American states, pioneered quarterly auctions that return revenue to each participating state. RGGI regularly measures and reports on the ways its auction investments reduce regional emissions and consumer costs. Most revenue has been allocated to a focused suite of programs directly linked to climate considerations in each member state, enabling RGGI to build and sustain an enduring political constituency.
RGGIs revenue model has diffused broadly in the last decade. In 2021, green investments linked to carbon pricing revenue globally exceeded combined expenditures for direct financial payments, tax reductions, and general budget transfers. New or revised carbon pricing programs in such nations as Colombia, Costa Rica, Germany, Ireland, Japan, New Zealand, Portugal, South Korea, and Taiwan and such American states as Pennsylvania, Virginia, and Washington have adopted green earmarking. Europe has pivoted increasingly in this direction with its cap-and-trade auction proceeds. Member states use approximately 80 percent of their portion of ETS-generated revenue for complementary climate purposes while the EU deploys its auction share to support continental energy technology development and transition assistance for lower-income nations. In 2022, ETS expansion included creation of a new Social Climate Fund supported by auction revenue to assist households and small businesses vulnerable to higher energy costs.
Public opinion research demonstrates that earmarking carbon pricing revenue for supplemental climate mitigation resonates with citizens in many nations. This may reflect public perception that this dual purpose for carbon pricing is more likely to prove effective in terms of reducing emissions by directly supporting transitional costs. Earmarking may secure dedicated funding for green investment policies that may be popular but struggle politically to compete for sustained general revenues with health care, education, housing, and other policy areas. This practice reflects linkages maintained in other specialized and enduring taxes, such as gasoline excise taxes for transportation infrastructure and payroll taxes for public pensions, that citizens commonly understand. Similar tax-and-expenditure linkages have proven essential in the remarkable political durability of severance taxes in nearly all American oil and gas production states, historically capable of deflecting threats from oil and gas production firms to exit the state if tax rates are not reduced.
Pricing Short-Lived Climate Pollutants. Policy scholars have largely ignored extension of pricing to short-lived but highly-intensive climate pollutants, which collectively are responsible for nearly half of global warming that has already occurred. Even in the pricing-averse United States, however, energy sector methane fees were adopted by Congress in 2022. These were designed to complement regulatory and subsidy policies and collectively achieve methane reduction goals, essential to adding credibility to President Biden’s Global Methane Pledge leadership with the EU. Fees go into effect in 2024, long before EPA can plausibly approve and implement expanded performance standards through negotiated state implementation plans. Firms with very low, Norway-like methane loss rates are exempt from the fee if states comply fully with federal standards, incentivizing regulatory cooperation after a lost decade of legal combat over standards between industry, states, and federal authorities. In turn, the first major increase in oil and gas royalty rates on federal lands and offshore since the Woodrow Wilson era has also been adopted, featuring the unprecedented inclusion of methane lost through venting, flaring, or negligence. These place pricing upstream near energy production, tapping some of the political advantages long associated with upstream severance or extraction taxes over downstream consumption or excise taxes. Ironically, the United States has emerged as the only G-7 member with a national methane price but no semblance of national carbon price.
Norway pioneered methane taxation decades ago to complement performance standards. These work together to produce the world’s lowest sustained methane loss rates among nations producing oil and gas. New Zealand is establishing a tax for methane, nitrous oxides, and carbon dioxide emissions from agriculture and livestock operations in a sector where subsidies and voluntary programs prevail globally and have demonstrated very modest emissions impact. European border adjustment exploration includes possible levies on methane released from both domestic production and from imported oil and gas, much of which has historically involved nations with very high methane loss rates such as Russia. Growing precision in measuring energy sector methane releases within jurisdictional boundaries via satellite and other methods raises the possibility that nations could credibly factor methane emissions into climate-focused tariffs that reflect the profound cross-national divergence in actual methane loss rates.
The 2022 Inflation Reduction Act (IRA) funds a vast array of clean energy subsidy programs through general revenues, offering an important test of the role this policy tool can play in driving rapid decarbonization.
Methane is not the only short-lived climate pollutant being priced. Five EU nations have adopted HFC taxes to complement Kigali implementation, adding a price signal to phase-down timetables and generating funding to accelerate global transition toward alternative cooling technologies. The EU ETS already addresses perfluorocarbons, a fluorinated greenhouse gas used commonly in aluminum production. The United States is finalizing an auctioning system to allocate declining HFC allowances as set forth in 2020 legislation. This is designed to achieve an 85 percent reduction in HFCs over the next decade, aligning America with Kigali reduction targets by utilizing a version of the very cap-and-trade model it rejected for carbon a decade earlier. Nearly all methane and HFC pricing policies did not exist just five years ago, raising the possibility that pricing diffusion may be politically easier and more rapid for short-lived climate pollutants than long-lived ones such as carbon.
Whither Carbon Pricing?
Question marks remain appropriate in any discussion of the future role of carbon pricing. There is no obvious near-term political path toward a robust carbon pricing regime in the United States or many other countries. In turn, pricing faces additional challenges in the current period of high inflation, political sensitivity to heightened gasoline prices, European efforts to subsidize energy costs and secure near-term oil and gas alternatives to Russian supplies amid war, and a seeming pivot from an era of neoliberalism focused on free trade toward an emerging form of neomercantilism absorbed with national energy production and domestic industry protection.
Calls for non-pricing policy alternatives have proliferated in the last decade, including the American Green New Deal and permutations elsewhere. The 2022 Inflation Reduction Act (IRA) funds a vast array of clean energy subsidy programs through general revenues, offering an important test of the role this policy tool can play in driving rapid decarbonization. Its adoption demonstrates some of the political advantages that this approach may have over pricing, particularly in an American context given deep federal fiscal capacity and strong aversion to numerous forms of taxation. One significant limitation of this landmark legislation was its inability to legislatively incorporate complementary policies such as clean electricity or industry performance standards, intergovernmental land use and permitting reform, or some form of a carbon pricing mechanism to augment the substantial subsidy package. IRA implementation will merit rigorous study to inform our understanding of whether a subsidy-centered policy can achieve deep emission reductions, do so in a cost-effective manner, and provide a model for widespread political diffusion to other affluent nations and those with limited resources. Deeper policy science analysis of clean energy and energy efficiency subsidies and their performance over time emerges as a major priority in coming years.
To date, some regulatory approaches have proven successful in reducing greenhouse gas emissions, such as coal phase-out initiatives. They often raise costs but find stealthier ways to disguise them than pricing, thereby sharing some of the political advantages of subsidies. But their performance is often uneven and limited. Some durable American programs to promote vehicular emission reductions have produced modest transportation sector emission impacts but have proceeded at an uneven pace over decades and have been laden with loopholes facilitating increased vehicle size and horsepower that offset advances in engine efficiency and technology. Similar issues arise in other regulatory areas, such as biofuel mandates and clean electricity portfolio standards, particularly when intended to serve as major decarbonization drivers without effective complementary subsidy or pricing policies. American regulatory programs continue to face considerable political adoption and implementation challenges, reflected in more than three decades of congressional failure to revise air quality legislation to address climate change, limited durability of executive regulatory actions spanning partisan transition in presidencies and governorships, and growing judicial constraints on federal agency reinterpretation of existing laws in the era of West Virginia v. EPA and inevitable successor cases. Emerging 2023 steps by EPA to revisit potential regulatory applications of the Clean Air Act to the transportation and electricity sectors will represent a major test of whether executive-driven regulatory reforms in the American system can prove durable and effectively complement subsidy programs.
The path forward for carbon pricing remains laden with political challenges and uncertainties in terms of its domestic feasibility, durability, climate and economic impacts, and capacity to diffuse broadly.
Then there is carbon pricing, which sustains its slow global evolution from the ideal world of the seminar room into the realm of climate policy practice. It has proven less than what proponents envisioned as a silver bullet but considerably more than what opponents dismiss as a distraction. In some major cases, pricing can play a significant role in supporting decarbonization, but as part of an ensemble of policies rather than a solo act. One can begin to see how pricing fits into a set of evolving cases, including the European Union, the United Kingdom, and Canada. Such cases may expand further through stronger links between pricing and trade policy, continued shifting of pricing revenues toward green investment programs, and extension of pricing to short-lived climate pollutants such as methane and hydrofluorocarbons. The path forward for carbon pricing remains laden with political challenges and uncertainties in terms of its domestic feasibility, durability, climate and economic impacts, and capacity to diffuse broadly. The same remains true for other types of policies that could also contribute to substantial decarbonization. More than a quarter-century after the arrival of the Kyoto Protocol, relatively few nations have achieved significant climate mitigation progress. *The most promising national cases to date are largely clustered in Europe, where some nations have found ways politically to sustain and harmonize pricing with effective complementary policies rather than rely exclusively on any singular policy tool. This pattern is also reflected in some sub-national jurisdictions, such as American states and Canadian provinces. Building on the experience of the most successful cases to date can help illuminate the ways in which well-crafted policies might be sequenced effectively and prove complementary.
Barry Rabe is the Arthur Thurnau Professor of Environmental Policy and the J. Ira and Nicki Harris Family Professor at the Gerald R. Ford School of Public Policy at the University of Michigan. He is a political scientist who examines the political feasibility and durability of climate and environmental policy in federal and multi-level systems of government. He has received four awards recognizing his research from the American Political Science Association and in 2021 received the Distinguished Research Award from the Network of Schools of Public Policy, Affairs, and Administration. Rabe is the author or co-author of six books, including Can We Price Carbon? (MIT Press, 2018), following a Wilson Center fellowship. No external funding was involved in the production of this report.
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About the Author
Arthur Thurnau Professor of Environmental Policy and the J. Ira and Nicki Harris Family Professor at the Gerald R. Ford School of Public Policy at the University of Michigan
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