Some problems with pricing carbon

Many people now agree that it is vital to make the cost of carbon explicit if we want to reduce greenhouse gas emissions. The FT’s leader on 2nd January 2009 emphasises the importance of a carbon tax.

There is a tendency of commentators glibly to claim that market will respond to carbon price signals, and once we have carbon priced in the economy, then emissions will go down again and we will all be ok. This is dangerous because politicians, and their economist friends, who implement carbon taxes or emission trading schemes, will think that they have done enough thereby. But they will not have.

First, if it is to work, the market needs to know how to price carbon. The FT talks of policies to “capture the true cost of using oil and other carbon-based energy”. To know the “true cost”, we would have to know the cost of the long-term impact of climate change. When you start looking at that you get into pretty demanding philosophical stuff about which generations have the right to what resources and how much, and how we should allocate these benefits across generations. If the true cost is something sufficient to allow a sustainable lifestyle through many generations, then it will be pretty high. Oil prices of USD 140 a barrel did not cut demand much.[1] The true cost of carbon, if applied uniformly across the economy, could easily be over Euro 100. It is politically hard to sell.

In fact, rather than seeking to incorporate the “true cost” of carbon across the economy, it might be more effective to apply different carbon costs to different industrial and domestic activities, exploiting the fact that the demand curve is a curve and not a horizontal line. Application of different carbon costs implies a disaggregation which is the exact opposite of a market-based solution.

Second, there is a question of what behaviour we would like to elicit by the imposition of carbon taxes. One reason for imposing a cost on emissions is that we want people to switch away from carbon intensive products and services and adopt less carbon intensive ones. A carbon tax shifts the supply curve of carbon intensive products and services to a point that a certain number of consumers will change their behaviour and walk to work.

This assumes a certain elasticity of demand and a certain availability of alternatives. The fact is that people like to stick with what they are used to and are ready to pay to avoid hassle. They would rather just pay higher fuel bills than root around looking for suppliers of loft insulation. In short, without a dynamic supply of alternatives, carbon taxes will do nothing more than cause inflation.

The supply of alternatives is anything but dynamic today. If you can get someone to come and replace your single thermostat with a household heating control system, they will probably turn up the wrong day and leave bookshelves covered in plaster and soot. Try cutting a deal to sell back the power from the windmill on your roof into the grid. Look at the marketing of shoes – it is several steps behind marketing of motor vehicles.

So pricing carbon will only work if the industries which supply low carbon services and products are buzzing to jump in once the price is right. They haven’t started.

Finally, price signals only work if we believe in them. Unfortunately like railway signals, price signals can go up and down, according to political will and whim. Supplying and buying alternatives to low-carbon products and services often require making investments with economic lives of many years. If customers and suppliers do not believe that the signals will stay up, they will not respond to them. If politicians were railway signalmen, we would not use trains. When EU politicians talk of putting in limits to carbon prices, that is a very powerful signal … that they don’t really believe in markets after all.

It is easy to talk of leaving the solutions to the market. However, this does not consider sufficiently the inelasticity of demand for carbon intensive products and services, the lack of responsiveness of the supply of alternatives in the market, and the lack of credibility of signals given by policy-makers.


1. A recession did bring down emissions, though, which implies that something other than price signals might be more effecting in cutting emissions.

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