The traditional response that economists used to give was “put a price on carbon emissions.” But new thinking on the political economy of climate policies and a finer understanding of what transformation those policies are trying to achieve suggest the answer may not be that simple.
The policies that governments can use to move towards a carbon-free world can be split into two buckets. The first bucket contains what most countries have been using so far: fiscal incentives in favor of cleaner cars, subsidies or mandates for renewable energy, energy-efficiency standards on new buildings and cars, or bans on incandescent lighting. The common characteristic of these policies is that they focus on redirecting new investments towards cleaner equipment. They do not affect how people use existing cars or power plants, but they aim at making sure that in the long run, the economy runs on clean capital (i.e. renewable energy, electric cars, efficient buildings).
The second bucket of policies contains economists’ traditional favorite: putting a price on carbon, through carbon taxes or carbon trading schemes. Carbon prices are seen by economists as necessary instruments because they reduce emissions through two levers. First, like instruments in the first bucket, they favor investments in clean capital, by making polluting capital more expensive to use and so, less attractive as investments. Second, carbon prices discourage the owners of existing polluting capital from using it or even push them to discard their polluting assets. For example, owners of polluting cars will possibly drive less and switch to other transport modes because using their cars suddenly becomes too expensive. This leads to larger emission reductions through the early retirement, or reduced use, of existing power plants, cars, and low-efficiency equipment.
But this second lever also imposes a cost on the owners of polluting assets and provokes a sudden drop in the value of these assets. And it may put some people in a difficult situation. For some households with little access to public transport, for example, not using their old gas guzzler car is just not an option. And for a 50-year-old worker in a coal power plant, responding to a carbon tax by changing jobs could be challenging. This situation can be perceived as unfair as it changes the rules of the game over the course of an asset’s lifetime. It is also highly visible and concentrated on the owners of certain assets – from coal power plants and fishing boats to heavy SUVs and homes that are far from jobs – making it obvious for them to oppose the implementation of the tax.
The political economy of acting only on new investments – leaving alone existing assets – could be much easier to navigate. Is it the way to go?
We recently published a paper in the Journal of Environmental Economics and Management that explores the trade-offs between these climate policy instruments. The paper proposes a long-term model that explicitly represents the impact of different instruments on the value of clean and polluting assets. It highlights the challenges with implementing a carbon tax, by showing how it reduces the value of polluting assets, even if the tax has a phase-in period, and leads to the early retirement of polluting assets and a sudden drop in asset value.
In contrast, instruments that influence new investments transform the economic system over time by replacing polluting assets with “green” assets as they reach the end of their lifetime. Because they do not lead to capital underutilization or early retirement, they do not provoke a sudden drop in asset value. While they drive the economy along two different paths in the short-term, the long-term outcome is the same:
The difference is in the transition: instruments focused on investments impose an economic cost that is smoother over time, with smaller short-term costs and larger costs over the medium to long term. They also impose a cost that is more broadly distributed in the full population and is much less concentrated, which makes the implementation much easier in political terms.
What is the catch? Acting only on new investments do less to reduce GHG emissions in the short term and might make very stringent climate targets like the 1.5C degrees target unattainable. Also, designing and implementing a set of independent policies in many sectors may create some inconsistencies across sectors, compared with an optimal, perfectly coordinated solution. There is, therefore, a trade-off between efficiency and political feasibility.
What can we do? Certainly, we should not give up on the implementation of carbon taxes where it is possible. But where it is out of reach, or where a realistic carbon price is too low to do much to reduce emissions, it’s critical to mobilizing other instruments without delaying action. And indeed, we can do two things to achieve our climate objectives in a way that is immediately politically feasible.
First, since the main assets that need to be retired early to achieve a 2C or 1.5C degrees target are the existing coal power plants, and because it will be impossible to avoid a drop in the value of coal mines, we need solutions to reduce the cost of such early decommissioning by helping people and regions that depend on coal mines and coal power plants. Options include classical social protection systems, programs for retraining workers, and public investments in energy and other sectors in affected regions. The European Union Instrument for Pre-Accession Assistance and Structural and Investment Funds provides an example of tools to support regional transitions that can be applied to the decarbonization challenge.
Second, we cannot wait until the rationale of taxing pollution becomes more broadly accepted to start redirecting all new investments toward clean capital. Each year with no incentive toward green investment leads to further accumulation of polluting assets, making the political economy even more difficult and our climate objectives even more distant.
Today, renewable energy is cheaper than coal in many places in the world, all major car manufacturers are working on several electric car models, and cities are starting to switch to electric buses. All of this was achieved with policies focused on new investments, not with carbon taxes. We should immediately implement all available and cost-effective measures to influence investment patterns with tax incentives, regulations, and subsidies, to start reducing the stock of polluting assets as existing assets are retired or replaced. As the economy shifts toward greener technologies and assets, the implementation of further instruments, including a carbon tax, will become easier.
Put simply, an excessive focus on carbon pricing should not become an obstacle to the implementation of sensible climate policies that can build on proven instruments, from construction standards to fiscal incentives.