Carbon Pricing in the Policy Mix
Carbon pricing is powerful, but it does not work in isolation. It operates within a broader landscape of climate and energy policies. Understanding how carbon pricing interacts with other policies is essential for effective design.
Carbon Pricing Is One Tool in the Toolbox
Think of climate policy as a toolbox. Carbon pricing is one of the most important tools, but you also need others:
- Regulations set minimum standards (like vehicle fuel efficiency requirements)
- Subsidies support emerging technologies (like renewable energy tax credits)
- Information programs help consumers make better choices (like energy efficiency labels)
- Public investment builds necessary infrastructure (like electric vehicle charging networks)
- Research funding develops future solutions (like advanced battery technology)
Carbon pricing creates economy-wide incentives for emissions reductions. But it works best when combined with complementary policies that address market failures carbon pricing cannot fix alone.
Why Carbon Pricing Alone Is Not Enough
Carbon pricing is excellent at sending a price signal through the economy. But some barriers to emissions reductions are not price-related:
Information gaps
Consumers may not know how much energy different appliances use. Even with a carbon price, they cannot respond to information they do not have. Energy labels and disclosure requirements help solve this problem.
Split incentives
A landlord who pays for building upgrades is not the one who pays the energy bills. Even with higher energy prices from carbon pricing, the landlord has no incentive to invest. Building codes and tenant protection policies address this gap.
Technology lock-in
Infrastructure lasts for decades. Power plants, buildings, and transportation systems built today will emit for 30 to 50 years. Carbon pricing alone may not be enough to prevent locking in high-emission technologies, especially for long-lived assets.
Innovation spillovers
When one company develops a clean technology, others can learn from it. This means companies under-invest in research because they cannot capture all the benefits. Public R&D funding compensates for this market failure.
Example: Consider electric vehicles. A carbon price makes gasoline more expensive, encouraging EV adoption. But that alone may not be enough if:
- Charging infrastructure is lacking (need public investment)
- Consumers do not trust EV range claims (need information programs)
- Battery technology is not yet good enough (need R&D funding)
- Automakers face no requirements to offer EVs (need vehicle standards)
A comprehensive approach uses carbon pricing alongside these complementary policies.
Three Types of Policy Interactions
When carbon pricing meets other policies, three things can happen:
1. Complementary policies (good)
These policies strengthen each other. For example:
- Energy market reforms that allow cost pass-through help carbon pricing work effectively
- Energy efficiency labeling helps consumers respond to carbon price signals
- Infrastructure investment enables low-carbon alternatives
2. Overlapping policies (potentially inefficient)
These policies duplicate incentives for the same activity. For example:
- A renewable energy subsidy plus carbon pricing both encourage clean power generation
- This may not be harmful, but it means emissions reductions cost more than necessary
- The same reductions could be achieved with carbon pricing alone at lower total cost
3. Countervailing policies (problematic)
These policies work against carbon pricing. For example:
- Fossil fuel subsidies make dirty energy cheaper, offsetting the carbon price signal
- Industry tax breaks for high emitters undermine the incentive to reduce emissions
- These contradictions waste money and reduce effectiveness
Think of policy interactions like driving a car. Carbon pricing is the engine. Complementary policies are the steering wheel and brakes that help you navigate. Overlapping policies are like pressing both the accelerator and brake at once (you get there, but inefficiently). Countervailing policies are like driving with the parking brake on (you work against yourself).
The Role Carbon Pricing Can Play
Different jurisdictions use carbon pricing for different purposes. The role it plays affects how it should be designed.
As a primary driver of emissions reductions
In New Zealand, carbon pricing is meant to be the main tool for meeting climate targets. The ETS covers most of the economy and is designed to deliver significant emission cuts. Other policies play supporting roles.
As a backstop for other policies
In California, the cap-and-trade program largely acts as a safety net. If other policies (like the renewable portfolio standard or low-carbon fuel standard) do not deliver expected reductions, the carbon price rises to fill the gap.
As a revenue-raising tool
In British Columbia, the carbon tax was introduced partly to fund reductions in other taxes. While it also reduces emissions, revenue recycling was a central part of the original design.
As a driver of broader reform
In Colombia, the carbon tax was part of a larger fiscal reform package. It helped diversify the tax base while building capacity for future climate policy.
Understanding what role carbon pricing will play helps determine its design. A carbon price meant to be the primary emissions driver needs higher rates and broader coverage than one serving mainly as a revenue tool.
Managing Policy Interactions
When designing carbon pricing, policymakers should:
1. Map existing policies
Identify all policies that affect emissions in covered sectors. For each, determine whether it is complementary, overlapping, or countervailing.
2. Phase out countervailing policies
Fossil fuel subsidies are the most important example. Removing them before or alongside carbon pricing implementation amplifies the effect and frees up government resources.
3. Coordinate overlapping policies
If multiple policies target the same emissions, consider:
- Which policy is most cost-effective?
- Are there non-climate reasons to keep both?
- Can the policies be better coordinated?
4. Strengthen complementary policies
Identify gaps that carbon pricing cannot address alone. Ensure supporting policies are in place for information, infrastructure, and innovation.
The International Energy Agency estimates that global fossil fuel subsidies exceeded $1 trillion in 2022. These subsidies directly counteract carbon pricing by making dirty energy artificially cheap.
Consider a country that introduces a $20/ton carbon tax on coal but maintains a $15/ton subsidy for coal production. The net effect is only a $5/ton increase in coal costs, far less than the intended price signal.
Countries serious about carbon pricing typically need to reform fossil fuel subsidies first or simultaneously. This can be politically difficult, which is why many carbon pricing advocates see subsidy reform as the essential first step.
The IMF recommends that carbon pricing be implemented alongside:
- Phase-out of producer subsidies
- Reform of consumer subsidies (with protection for vulnerable households)
- Transparent communication about why reform is needed
Sequencing Matters
The order in which policies are introduced can affect their success:
What often works well:
- Build emissions monitoring capacity first
- Reform fossil fuel subsidies
- Introduce carbon pricing
- Ramp up ambition over time
What to avoid:
- Introducing carbon pricing while maintaining large fossil fuel subsidies
- Setting carbon prices so low they are invisible amid other price fluctuations
- Expecting carbon pricing to solve problems it cannot address (like infrastructure gaps)
Coordination Across Levels of Government
Carbon pricing often involves multiple levels of government:
- National governments may set carbon prices or caps
- Subnational governments (states, provinces) may have their own systems
- Local governments implement building codes, transit systems, and land use policies
Effective carbon pricing requires coordination across these levels. Canada, for example, has a federal carbon pricing backstop that applies in provinces without equivalent systems, while allowing provinces flexibility in how they meet the standard.
Looking Ahead
In the next lesson, we will look at the current state of carbon pricing globally, with 75 instruments now operating around the world covering nearly a quarter of global emissions.