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Carbon pricing in climate policy:

seven reasons, complementary
instruments, and political
economy considerations
Andrea Baranzini,1 Jeroen C. J. M. van den Bergh ,2,3,4* Stefano Carattini,5
Richard B. Howarth,6 Emilio Padilla7 and Jordi Roca8
Edited by Stéphane Hallegatte, Domain Editor, and Mike Hulme, Editor-in-Chief

Carbon pricing is a recurrent theme in debates on climate policy. Discarded at the

2009 COP in Copenhagen, it remained part of deliberations for a climate agreement in
subsequent years. As there is still much misunderstanding about the many reasons to
implement a global carbon price, ideological resistance against it prospers. Here, we
present the main arguments for carbon pricing, to stimulate a fair and well-informed
discussion about it. These include considerations that have received little attention so
far. We stress that a main reason to use carbon pricing is environmental effectiveness
at a relatively low cost, which in turn contributes to enhance social and political accept-
ability of climate policy. This includes the property that corrected prices stimulate
rapid environmental innovations. These arguments are underappreciated in the public
debate, where pricing is frequently downplayed and the erroneous view that innova-
tion policies are sufficient is widespread. Carbon pricing and technology policies are,
though, largely complementary and thus are both needed for effective climate policy.
We also comment on the complementarity of other instruments to carbon pricing. We
further discuss distributional consequences of carbon pricing and present suggestions
on how to address these. Other political economy issues that receive attention are
lobbying, co-benefits, international policy coordination, motivational crowding
in/out, and long-term commitment. The overview ends with reflections on imple-
menting a global carbon price, whether through a carbon tax or emissions trading.
The discussion goes beyond traditional arguments from environmental economics
by including relevant insights from energy research and innovation studies
as well. © 2017 The Authors. WIREs Climate Change published by Wiley Periodicals, Inc.
How to cite this article:
WIREs Clim Change 2017, 8:e462. doi: 10.1002/wcc.462

*Correspondence to: [email protected] Centre for Climate Change Economics and Policy, London School
1
Haute Ecole de Gestion Genève, University of Applied Sciences of Economics and Political Science (LSE), London, UK
Western Switzerland (HES-SO), Delémont, Switzerland 6
Environmental Studies Program, Dartmouth College, Hanover,
2
Institute of Environmental Science and Technology, Universitat NH, USA
Autònoma de Barcelona, Barcelona, Spain 7
3
Department of Applied Economics, Universitat Autònoma de Bar-
ICREA, Barcelona, Spain
celona, Barcelona, Spain
4
Institute of Environmental Studies & Faculty of Economics and 8
Department of Economics, Faculty of Economics and Business,
Business Administration, VU University Amsterdam, Amsterdam,
Netherlands University of Barcelona, Barcelona, Spain
5 Conflict of interest: The authors have declared no conflicts of inter-
Yale School of Forestry & Environmental Studies and Grantham
Research Institute on climate change and the environment and est for this article.

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This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and distribution in
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INTRODUCTION paper therefore fills a gap. It offers an accessible

and nontechnical synopsis of the need for carbon
I n the aftermath of COP21 in Paris, countries will
have to turn pledges into effective policies, to guar-
antee that their promises about reduction of green-
pricing in a post-Paris world. This hopefully contri-
butes to the debate on carbon pricing improving in
quality and having more impact on political
house gas (GHG) emissions are actually achieved. It decision-making.
is easy to underestimate this challenge. We will argue
that to achieve the Paris targets, the use of the instru-
ment of carbon pricing is essential, even though not GENERAL IMPLICATIONS OF
sufficient. All alternative options are likely to lead to
inadequate and overly costly abatement activities. CLIMATE CHANGE
Imprudent policy design could have extremely far CHARACTERISTICS FOR POLICY
reaching consequences, not least because of the real INSTRUMENTS
chance of dangerous climate change.
Climate change possesses several characteristics that
However, many observers are critical of car-
must be accounted for in the formulation of climate
bon pricing, often without being well informed
policies to guarantee their effectiveness. Sources of
about its unique advantages. Research suggests that
anthropogenic GHG emissions are diverse and cover
resistance to innovative environmental policy— all economic sectors. Emissions arise principally from
whether by citizens, firms, NGOs, or politicians— the combustion of fossil fuels, in very distinct activ-
may be driven by lack of knowledge about how it ities, including resource extraction, production, con-
exactly functions and which impacts it generates.1 sumption, transport, and waste management
Ex post, that is, based on experience with imple- activities. This explains the heterogeneity of the many
mented new policies, perceptions may dramatically abatement options and associated costs. The GHG
change so that social–political acceptability emissions accumulate in the atmosphere with resi-
increases.2,3 Hence, imperfect information is an dence times stretching from decades to millennia.
important obstacle to the implementation of carbon Therefore, abatement incentives should last through
pricing, particularly as it allows political-ideological time and be dynamic, that is, responsive to economic
motivations to dominate. and technological change. The location of GHG
Here, we argue that the main reason for car- emissions does not affect climate change as GHGs
bon pricing is to achieve environmental goals at a mix uniformly in the atmosphere. Hence, a reduction
reasonable cost, relatively low to that of other of emissions has the same global effect independently
instruments. We provide many reasons for this, of the distribution of abatement efforts across space.
going beyond traditional static arguments about Mitigating climate change lacks a simple end-of-pipe
cost-effectiveness from environmental economics, solution. Even though carbon capture and storage
by including relevant insights from energy research technologies may be part of the solution, these apply
and innovation studies. Admittedly, many main- especially to large point sources and thus cannot pro-
stream economic accounts of carbon or environ- vide an overall answer. Indeed, combating climate
mental pricing provide a more limited and change represents such an immense and immediate
technical perspective that often is not very accessi- challenge that relying on the promise of one option
ble to noneconomists. Our paper offers a broader would be very risky. Instead, many options are
treatment that includes additional considerations, required, including altering the composition of
reflects a more heterodox and critical perspective demand (using less energy), structural change in the
on carbon pricing, and adopts a more multidiscipli- composition of the economy (dirty vs cleaner sectors
nary angle. We further briefly address some core and products, and different input mixes in produc-
political economy issues associated with carbon tion), low-carbon transport, more energy-efficient
pricing, that is, reasons for why widespread imple- technologies, and low-carbon (notably renewable)
mentation of such an instrument is not observed in energy sources. Finally, particularly challenging for
reality.4 This involves attention for distributional international negotiations is that abatement activities
equity, lobbying, co-benefits, international coordi- are generally costly and contribute to a global public
nation of policy, and motivational crowding in/out. good, meaning that others can benefit from them
While most arguments we consider have received without undertaking any effort. This motivates the
ample attention in the literature, a comprehensive need to coordinate actions by countries and polluters
and synthetic treatment is missing. By summarizing to avoid free riding and international carbon leakage.
all main arguments in favor of carbon pricing, this Worldwide consistent policies are required to ensure

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WIREs Climate Change Carbon pricing in climate policy

cost-effectiveness of total abatement, fair economic will occur to options with relatively low direct
competition between countries, and limited trans- and indirect emissions. In other words, with a
boundary displacement of emissions. fairly simple carbon-pricing policy on fossil fuels
We will argue that carbon pricing supported by each price in the economy will be corrected so as
a climate agreement is able to respond to these char- to reflect in some way the overall CO 2 emissions
acteristics of climate change. This becomes clear by effect of the associated good or service. This
considering seven unique advantages of it, as means that no economic decision escapes the regu-
explained in the next section. latory effect of carbon pricing—it is a systemic
solution. This does not mean carbon pricing is the
complete and only solution: as discussed in the
SEVEN ARGUMENTS FOR GLOBAL More Than Carbon Pricing section, complemen-
CARBON PRICING tary instruments are needed, because of informa-
tional failures and bounded rationality, among
Carbon pricing affects emissions by penalizing energy others.
sources in proportion to their carbon content. It is
easily applicable to emissions coming from energy
use, but can be extended to emissions arising from Argument 2: Carbon Pricing Accounts for
land use changes and other sources. In what follows Heterogeneity of Emitters, Which Reduces
we present the most important arguments in favor of the Overall Abatement Cost
carbon pricing. Compared to other types of instruments, carbon pri-
cing can address the vast heterogeneity of GHG
emitters, thus helping to minimize the cost of pollu-
Argument 1: As Carbon Pricing Alters Relative tion control. Heterogeneity might result from firms
Prices, Firms and Consumers Automatically producing diverse goods or having distinct technolo-
Internalize Global Warming Effects gies, and thus different emissions per unit of output,
Carbon pricing changes relative prices of all goods which translates into unequal marginal costs of pol-
and services in accordance with the Polluter Pays lution abatement. Under perfect information and
Principle. As a consequence, when making deci- substantive rationality, all polluters should choose
sions that cause GHG emissions, firms, consumers, that level of emissions abatement for which the
and investors consider not just their private costs associated marginal cost equals the carbon price.
and benefits, but also the social costs associated Hence, with a carbon price signal, the marginal
with (direct and indirect) emissions generated in abatement costs would become equal among all pol-
every phase of the product life cycle, from resource luters, implying that a given level of abatement is
to waste. The entire economy then becomes less met at least global cost. No other instrument than
carbon intensive, since all consumers and produ- pricing is able to realize the same outcome. Since
cers will adjust their decisions to prices corrected polluters show inertia or are not always perfectly
for the climate externality. To obtain the same aware of available abatement technologies and asso-
result with nonprice instruments would require ciated costs, one should expect the global cost to
that the regulator possesses all relevant informa- not reach the exact lowest level. Nevertheless,
tion about emissions and abatement options to empirical research suggests that reliance on nonprice
control in detail all polluting processes and beha- policy instruments often leads to considerably
viors. This would evidently be extremely difficult higher abatement costs.5,6 The reason is that such
and imply a huge cost of governance. instruments are less effective in covering diverse
Carbon pricing means that the prices of fos- sources of emissions. For example, it is impossible
sil energy fuels will adequately reflect the carbon to implement technical standards for the millions of
content of these fuels. As a result, industries that technologies and products worldwide, and moreo-
use more carbon-intense fuels will face higher ver update these frequently to account for nonstop
input costs and thus ask higher output prices from technical innovation. To illustrate, two studies
their customers. In turn, sectors using these out- show, using different models, that a fuel economy
puts as inputs will also see their output prices go standard for cars results in considerably higher costs
up. Finally, consumers buying products or services of reducing CO2 emissions than fuel taxes.7,8 Note
from the latter sectors will confront higher prices that older empirical studies found the abatement
as well. As all these agents are motivated to pur- costs of uniform standards to be up to a factor
chase the cheaper input, product or service, a shift 22 higher than those of pricing instruments.9

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Argument 3: Carbon Pricing Provides a expectations about future prices are relevant.17 Of
Continuous Incentive for Adoption and course, a high carbon price today acts as a signal for
the near and more distant future, so that it will con-
Innovation of Carbon-Efficient Technologies
tribute to stimulating investments and R&D with the
Carbon pricing contributes to so-called dynamic effi-
aim to reduce dependence on high carbon energy in
ciency as it stimulates innovation and adoption of
all sectors of the economy.
technologies emitting less carbon. By increasing the
cost of carbon-emitting technologies and activities,
carbon pricing provides a financial incentive for con-
sumers and producers to invest in technologies redu- Argument 4: Carbon Pricing Represents the
cing emissions. This not only encourages more Most Effective Way to Limit Energy/Carbon
adoption of existing low-carbon technologies, but Rebound
also indirectly promotes the development of new The issue of energy rebound and how carbon pricing
ones. Empirical evidence suggests a positive relation- could mitigate it has received little attention in the
ship between higher energy prices and the develop- public debate on carbon pricing. One reason may be
ment of more energy-efficient technologies.10 that this argument was neglected by previous com-
Compared with emission or technology-based stan- prehensive reviews of environmental policy analy-
dards, carbon pricing provides a continuous and sis.18,19 In line with this, rebound has so far not been
stronger economic incentive for adoption of, and considered a standard criterion in environmental pol-
R&D on, improved abatement technologies. Econo- icy analysis.
metric studies find that under stable energy prices, Rebound denotes that energy conservation,
innovations generally reduce consumer prices, while including through adoption of more energy-efficient
after oil price hikes, they tend to make equipment technologies, can indirectly create additional energy
more energy efficient.11 This suggests that carbon pri- uses and associated emissions. Hence, the net conser-
cing is an essential element of a policy package aimed vation effect will be lower than the initial energy
at redirecting technical change towards the cleaner savings—or even negative in some cases, known as
goods and ways of production. Further support for Jevons paradox. Rebound involves diffusion of tech-
this comes from a comprehensive theoretical nologies as well as various economic mechanisms.
analysis.12 Technological advances and improvements in energy
Examining the effect of the European carbon efficiency tend to lead to a direct reduction in energy
market (EU-ETS) on innovation, one study finds that consumption. However, given the improved effi-
carbon pricing is responsible for a 10% increase in ciency, the energy services—for instance, traveling by
clean innovation (measured by patents), in spite of car—become cheaper, which stimulates more inten-
the relatively low prices experienced so far.13 sive use of these services. Moreover, money saved
Another study provides additional evidence on the due to more energy efficiency will increase spending
innovation effects of EU-ETS.14 Both confirm the on other goods and services, and hence associated
results of an earlier patent-based study that energy energy use and emissions.20
prices have the largest inducement effect on energy- Compared to other policy instruments, oppor-
related innovations.15 A third study analyses 3412 tunities for such rebound effect are limited if carbon
firm-level patent data from 80 countries for the car pricing is in place, because it is a systems approach
industry between 1965 and 2005, concluding that that reduces rebound consistently across all carbon-
firms tend to innovate more in clean technologies intensive goods and technologies.21 Such pricing
when they face higher tax-inclusive fuel prices.16 would discourage money savings due to energy con-
Corrected prices are essential to rapid innova- servation to be spent on energy-intensive goods and
tion in the right direction, as relative prices steer services, as the latter will have a higher price due to
innovation opportunities and associated investments. carbon pricing. Empirical evidence suggests that such
This aspect is underappreciated in many discussions ‘re-spending rebound’ is non-negligible and deserves
about technological change and climate change, serious attention in policy design.22 Furthermore, in
where pricing is downplayed as if innovation/diffu- many cases, carbon pricing can reduce absolute
sion subsidies and other innovation policies, such as rebound due to the direct rebound or intensity effect,
information provision or stimulating cooperation because it may partially compensate the fall in the
between innovators, were sufficient. To fully appreci- user (fuel) cost due to implementing more energy-
ate the subtlety of this point, it should be recognized efficient technologies (as in transport23). In these cir-
that rather than current carbon or energy prices, cumstances, the direct rebound effect on demand, in

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WIREs Climate Change Carbon pricing in climate policy

absolute terms, will be lower than in a situation with- can be made consistent with World Trade Organization
out carbon prices as then initial demand is higher. (WTO) rules.35–38 In PE issue 4 in the section on Political
Carbon pricing will further ensure that consu- Economy Issues, we will discuss the political economy
mers automatically, without even realizing, make a aspects of free riding and possible strategies to overcome
trade-off between the individual benefits of new or it, to achieve international coordination of climate policy,
higher energy consumption due to rebound and or even an effective climate agreement.
related climate change damages.24 Indeed, carbon
pricing will mainly discourage rebound associated
with a price correction for environmental damage Argument 6: Carbon Pricing Decentralizes
costs exceeding direct individual benefits of the Policy, Reducing Regulators’ Need for
respective consumption decision. Information
Carbon pricing is consistent with flexibility and
autonomy of choice, allowing emitters to freely
Argument 5: Global Carbon Pricing Curtails
change their behavior to reduce their costs. They can
Emissions Leakage Between Countries opt for emitting and paying any charges or taxes
An international carbon price covering all countries associated with emissions, or for undertaking a vari-
and sectors would ensure that there are no emission ety of activities, immediately or after relevant invest-
leakages or spillovers, that is, increases in carbon diox- ments, to abate emissions. Carbon pricing thus
ide emissions in some countries as a result of emissions means decentralization of policy, with associated low
reduction in others.25,26 The mechanisms through information needs and administrative costs. In addi-
which this occurs are relocation of pollution-intensive tion, carbon pricing implies low transactions costs
industries and shifts in comparative advantages that for firms, as, unlike eco-labeling, it requires no sepa-
alter international trade patterns, both driven by rela- rate life cycle analysis to account for all carbon diox-
tive cost increases in countries with stricter regulations. ide emissions of products and services. Instead, firms
Although some empirical studies suggest modest com- will integrate carbon prices in existing cost-
petitiveness effects of distinct environmental/climate accounting systems of their products and services.
policies, this will not necessarily be the case under sce-
narios with stricter but differentiated national policies,
conceivable under the Paris climate agreement.27 With Argument 7: Carbon Pricing Takes into
a global carbon price, relative prices for all carbon- Account that in Making Purchasing
intensive products will be consistent among all coun-
tries worldwide, guaranteeing the absence of carbon
Decisions, most Consumers are more
leakage. Influenced by Prices than by Environmental
Obtaining such an ideal situation with no leak- Concerns
age would require effectively addressing the incen- Even if one is environmentally conscious, it is impos-
tives to free ride. Various ideas have been put sible to perfectly know which goods to buy and in
forward on how to overcome free riding in interna- what amounts to achieve environmental goals. It is,
tional negotiations.28–33 In the absence of a global moreover, unthinkable that one can voluntarily con-
agreement to implement a carbon price, unilateral cli- tribute to all public goods in the world.39 Even
mate policies by individual countries (or regions) though many people would like to contribute at a
confront two main problems: loss of international personal cost to a more responsible use of the natural
competiveness, which discourages political support environment, such cooperative behavior frequently
for a stringent unilateral climate policy; and carbon depends on the perception of what others will do.40
leakage, which reduces the effectiveness of any uni- The fact that an individual action alone has a negligi-
lateral policy. Once a country applies carbon pricing ble impact tends to discourage most people to under-
on its domestic goods, it could in principle also apply take these voluntary actions. Moreover, many
it to imported goods, through a carbon-motivated consumers are not particularly environmentally con-
border tax adjustment or requirements of acquisition scious in their purchase behavior, being sensitive to
of emission permits by importers when the policy is a personally salient concerns, notably financial consid-
cap-and-trade system.34 This would level the playing erations, when making purchasing decisions. An
field in the sense that comparative disadvantages due effective climate policy has to reach out to this group.
to carbon pricing would be reduced or even annulled. Carbon pricing is capable of doing this as it naturally
Several studies discuss technical aspects of carbon- intervenes in a core element of markets, namely
motivated border tax adjustments, and on how they prices of goods and services. It does so without the

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need for people to act altruistically, show voluntary emissions would then be insufficiently discouraged. As
environmentally benign behavior, or have the ability soon as renewables were to become competitive, they
to handle much information about products as in the would likely trigger responses by fossil-fuel markets in
form of eco-labels. This does not deny proenviron- the form of lower fossil-fuel prices, thus making the
mental behavior.41,42 There is no clear evidence, attainment of climate goals more difficult. This type of
though, that voluntary action can overcome very outcome is a special case of what is known as the
large differences in prices between green and dirty Green Paradox.46–49
products/services, nor that it applies to a large group Contrary to carbon pricing, subsidies aimed at
of consumers. Of course, policymakers are encour- stimulating adoption and diffusion of renewable
aged to leverage cooperative behavior when they energy do not target exactly the emission externality
have the opportunity to do so, but this approach can- and moreover generate a burden for public finances.50
not represent the main solution to climate change. Nevertheless, it may be hard to convince the public of
Probably the most relevant voluntary behavior is that how ineffective they may be in changing behavior.
voters choose politicians who will strike a climate Yet, recent evidence in promoting renewables suggests
agreement that supports effective climate policies that the implicit carbon price of subsidies for adopting
in all countries (see PE Issue 4 in the section on solar energy is in the order of magnitude of 550 €/
Political Economy Issues). Once implemented, car- tCO2 for the period 2006–2010 in Germany51 and of
bon pricing does not require proenvironmental 1000 €/tCO2 from 2008 to 2011 in Italy.52 These
behavior. Nevertheless, the evidence available so amounts are considerably higher than any currently
far suggests that, if anything, proenvironmental discussed carbon prices, indicating that a counterfac-
behavior makes carbon pricing more effective, tual world with carbon pricing would for the same
which is all good for climate policy (PE Issue 5 in overall cost have achieved much more carbon dioxide
section on Political Economy Issues). emissions reduction.
In view of informational failures and bounded
rationality, carbon pricing may be supplemented with
MORE THAN CARBON PRICING: mechanisms that aid households and businesses
INNOVATION POLICIES, respond effectively to market signals and incen-
INFORMATION PROVISION, AND tives.53 Bounded rationality involves a broad set of
behavioral features, such as decision heuristics,
OTHER INSTRUMENTS
habits, conformism, imitation, status seeking, inter-
As already hinted at in Argument 3 in the previous temporal choice, effects of information framing, and
section above, as carbon pricing and technology pol- other-regarding preferences. The associated literature
icy are largely complementary mechanisms they on policy design provides especially useful advice
should both form part of a climate policy package. In for information framing, on choice options
the words of Bowen43: ‘Other policies are needed, too, (e.g., presenting a greener product as the default
particularly to promote innovation and appropriate option, or providing information about how many
infrastructure investment, but cannot be relied upon neighbors already purchased it), or on explaining cli-
by themselves to bring about the necessary reductions mate policy to voters (e.g., when framing a tradable
in emissions. Carbon pricing is crucial.’ While carbon permit system, rather than employing the term
pricing can internalize the global warming externality, ‘permits,’ which stresses the interpretation of ‘right
innovation subsidies are needed to internalize the posi- to pollute,’ one might refer to ‘emission penalties’41).
tive, knowledge externalities of innovation, to pro- In addition, information provision to citizens
mote escape from lock in, and to keep promising but and firms about the opportunities to reduce GHG
still expensive options open.44,45 With only carbon emissions would increase the impact of carbon pri-
pricing, there is a risk of a lock in of currently cost- cing.54 Recent research suggests that the price elastic-
effective technologies (e.g., wind energy) while promis- ity of demand may be higher with long-lasting
ing, but more expensive options in early stages of carbon taxes than with temporary price
development may not survive (e.g., certain solar fluctuations.55–58 In view of this, media coverage and
PV technologies). On the other hand, fostering a low- communication campaigns might aim at improving
carbon transition through innovation and/or adop- public understanding of the need for carbon pricing,
tion/diffusion subsidies, that is, without carbon pri- clarifying it is meant to signal carbon-intensive goods
cing, is extremely difficult, given that the emissions and services. Information might further stress it is a
externality would not be internalized. Even when permanent measure, thus limiting uncertainty about
clean technologies develop and become less expensive, future prices for consumers and investors.59

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WIREs Climate Change Carbon pricing in climate policy

The above list of considerations regarding com- climate policy could have similar, undesirable distri-
plementary policies is not exhaustive. Well-tailored butional impacts. In the case of carbon pricing, how-
policies, not necessarily based on prices, are needed ever, regressive impacts are not inevitable. They can
to control emissions from sources other than energy be avoided through appropriate policy design or
production and use, such as land conversion, for- complementary measures. Moreover, when consider-
estry, or landfill emissions. Ideally, pricing nonenergy ing the distributive consequences of carbon pricing, it
sources of GHG emissions would allow lowering is important to compare these to alternative scenar-
even further the cost of climate policy,60 but this may ios, notably business-as-usual (no climate policies)
be relatively hard to do in practice. Another aspect of and climate mitigation policies with alternative, and
complementary policy is removing existing market less effective, instruments. For instance, many studies
imperfections to improve the performance of carbon show that unmitigated climate change impacts would
pricing. For instance, one study compares energy be unequal among countries and that poorest coun-
efficiency standards with carbon pricing through tries will be more affected than richer.62
cap-and-trade and find that the differences get less Paradoxically, carbon pricing provides an
pronounced if there is interaction with existing taxes excellent instrument to address undesirable distribu-
on inputs other than energy and carbon, or if there tional consequences—notably if taking the form of
are preexisting tax distortions, as is common in the carbon taxation, but also of emissions trading, if ini-
case of capital.61 By removing such distortions, car- tial permits are auctioned or sold. The reason is that
bon taxes would become even more effective. it will generate public revenues that can be used to
Finally, not all complementary policies or mea- compensate low-income households, for example,
sures are desirable. To illustrate this, we highlight through tax reductions for low incomes or energy
that the effectiveness of carbon taxes is, contrary to poor households, or lower value-added tax (VAT)
what many believe, not dependent on the use of rev- rates for products serving basic needs.63–65 Progres-
enues for funding ‘environmental projects.’ It is quite sive effects can also be obtained by lump sum redis-
common, though, to hear in public debates the idea tribution, which represents the simplest and
expressed that revenues of environmental taxes administratively less burdensome way of recycling
should always be used for the environment. But this revenues from carbon pricing.66–68
is not supported by insights from environmental eco- Any remaining distributional impacts of carbon
nomics. Carbon taxes are regulatory, not financing pricing have to be compared with those resulting
instruments. Of course, earmarking carbon tax rev- from climate change or other climate policy instru-
enues, or revenues of auctioned emission permits, for ments. For example, technical standards will not nec-
environmental projects or other issues, can be done essarily guarantee an equitable distribution of
to increase the acceptability of carbon pricing, but emissions reductions and associated monetary and
one should always bear in mind that its main objec- welfare costs. In particular, they will also raise costs
tive is altering behavior. In the next section, we and thus prices, but not generate extra public reven-
address the question of acceptability in more detail. ues that could be used to lessen perceived unfair dis-
tributive impacts. In a review of arguments and
empirical studies, one study warns that assessing dis-
POLITICAL ECONOMY ISSUES tributional effects of environmental policy (any
ASSOCIATED WITH CARBON PRICING instrument, not only pricing) is a difficult task, as it
This paper does not aim at addressing exhaustively involves six elements: (1) higher prices of carbon-
the political economy (PE) of carbon pricing. We intensive products, (2) changes in relative returns to
nevertheless briefly discuss six issues, namely distri- factors such as labor, capital, and resources, (3) allo-
butional equity, lobbying, co-benefits, international cation of scarcity rents from a restricted number of
policy coordination, crowding in/out, and long-term tradable permits in the case these are initially freely
commitment. distributed, (4) distribution of the benefits from
improvements in environmental quality, (5) tempo-
rary effects during the transition, and (6) capitaliza-
PE Issue 1: Distributional Consequences of tion of all those effects into prices of property values
Carbon Pricing (land, buildings, and houses).69 A full assessment
Much resistance against carbon pricing is motivated should account for all of them, which clarifies the
by concerns that it will be inequitable, that is, have huge challenge to comprehensively address distribu-
regressive distributional effects in terms of income or tive impacts of policy. It means one should be careful
consumers’ purchasing power. Of course, any serious in quickly judging a particular instrument, like

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carbon pricing, negatively from the angle of equity. It organizations need to stress, though, the benefits of
should further be noted that in the case of climate carbon pricing, and be informed about potential
change, the beneficiaries of reducing emissions are solutions to limit the drawbacks. Following decades
future generations, notably people living in poor of lobbying against carbon pricing, misunderstand-
countries. Hence, carbon pricing can contribute to ings of, and ideological resistance against, this instru-
both intra- and intergenerational equity. ment have permeated the public arena.
A general finding of the literature on acceptabil- Recent developments including the Paris Agree-
ity of climate policy, and in particular of carbon ment seem to have shifted the opinion of many impor-
taxes, is that people tend to have a strong preference tant businesses in favor of carbon pricing. Indeed,
for designs that protect low-income households.70–73 150 companies that report to the Carbon Disclosure
Concern about income inequality is among the main Project (CDP) are using internal carbon pricing as a
reasons why 92% of voters (more than two million tool to internalize carbon dioxide emission costs and
people) in a public ballot held in Switzerland in 2015 drive investments in emissions abatement. Resulting
rejected a proposal for an energy tax to replace the carbon prices range from US$6 to US$89/tCO2 equiva-
national VAT.74 The authors of this study show, lent.83,84 A recent survey realized among more than
using a choice experiment administered at the same 100 executives of large companies around the world
time of the ballot, that acceptability is much higher suggests that support for carbon pricing is strongly on
when a progressive energy tax is proposed, provided the rise.85 Almost half of the executives now declare to
that information on its distributional properties are be in favor of carbon pricing, while another large por-
made salient. tion states to be not against it. Moreover, a significant
When considering redistribution effects of cli- portion of respondents expects future climate negotia-
mate policies, one should realize that a subsidy scheme tions to bring about some form of carbon pricing, and
for adopting renewable energy—not to be confused is ready to prepare for this scenario.
with innovation subsidies as discussed in the More In countries that are credibly pursuing their
Than Carbon Pricing section—may be regressive as commitments to the Paris Agreement, industries
well, namely when it involves a considerable transfer would do well to lobby for instruments, like some
of money to homeowners, notably for installing solar form of carbon pricing, that provide them flexibility
PV panels on roofs. This type of scheme was intro- in choosing the means of abating emissions. Many
duced in a number of countries (e.g., Germany and businesses already realize that carbon pricing is not a
Switzerland) as carbon pricing turned out to be unpop- bad option as it leaves them a free choice between
ular. But, as argued, subsidies do not necessarily per- paying for emitting or abatement, while postponing
form better, neither on (cost-)effectiveness nor on action only makes the cost of achieving a given target
equity. The distributional effect should be carefully higher.86,87 However, because carbon taxes and auc-
analyzed in each specific case as it will depend on the tioning of permits means considerable money transfer
precise design of the subsidy scheme. from enterprises to public administrations, one
should expect many firms to continue lobbying
against carbon pricing.
PE Issue 2: Carbon Pricing and Lobbying
There is evidence that lobbying by energy-intensive
industries contributed to prevent the implementation PE Issue 3: Carbon Pricing and Co-Benefits
of carbon pricing in several countries,75–78 and may Another political economy issue is local co-benefits
have influenced voters’ perceptions about its poten- playing in favor of carbon pricing. Examples of co-
tial drawbacks.79 Even where carbon-pricing schemes benefits are health benefits of clean air due to less
were implemented, energy-intensive industries have local pollution, reduced energy costs due to improved
in many countries through lobbying managed to energy efficiency, or energy security and less depend-
receive a very favorable treatment, resulting in less ence on fossil energy imports due to more variety in
effective policies.77,80,81 energy sources, including renewable energy.88,89
Energy-intensive industries are, however, no Cobenefits also arise from other climate policies.
longer the only actors active in lobbying: we now However, since carbon pricing should be expected to
observe a situation in which ‘green organizations’ be more effective in emissions reduction, as argued in
oppose ‘brown industries.’82 For instance, evidence the Seven Arguments for Global Carbon Pricing sec-
from British Columbia’s carbon tax stresses the tion, its co-benefits are likely to be larger. In this
importance of environmental organizations in suc- respect, we support those who argue that co-benefits
cessfully spreading support for it.2 Environmental can be a reason for countries to implement carbon

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WIREs Climate Change Carbon pricing in climate policy

pricing unilaterally, that is, in the absence of a bind- energy policies already in place (e.g., fossil-fuel taxes
ing climate agreement.90 A relatively high carbon are common in most countries), and requiring rela-
price, up to 63$ per ton of CO2-equivalent in the tively little information (notably compared with an
case of China, could be justified based only on local agreement on climate technology standards).96 Two
co-benefits, that is, without accounting for climate relevant insights should be added to this.97 First,
benefits.91 The authors find that even for the United whereas quantity negotiations involving n countries
States, a carbon price of more than 30$ per ton of imply dealing with an at least n-dimensional coordi-
CO2-equivalent is warranted by local co-benefits. nation problem, focusing on a global carbon price
Since co-benefits can be reaped in the short term and comes down to a much simpler, one-dimensional
be appropriated by the country that implements car- negotiation challenge. Second, a global carbon price
bon pricing, drawing more public attention to them benefits from a self-enforcement mechanism, given
could increase its acceptability.73,92,93 Carbon pricing that incentives are better aligned because the desire to
may not be the best way to reduce local pollution, internalize the climate externality offsets the basic
and other complementary policies precisely targeting urge of countries to bargain for a low national carbon
harmful local pollutants might be preferable. But as price. Such a mechanism is missing in the case of
long as the latter policies are not, or unlikely to be, national mitigation contributions as characterized the
implemented one can count reduction of local pollu- Kyoto protocol and the Paris Agreement.
tion due to climate policy as a relevant cobenefit.

PE Issue 5: Carbon Pricing and

PE Issue 4: Carbon Pricing and Motivational Crowding In/Out
International Policy Coordination Motivational crowding out may arise when financial
The literature offers various suggestions to overcome incentives or punishments undermine intrinsic motiva-
free riding and achieve international coordination of tions to contribute to public goods,98–100 including
carbon pricing. Nordhaus94 proposes a radical solu- environmental policy or public goods issues.101 This
tion to deal with free riding and carbon leakage, tak- has stimulated critiques that (carbon) pricing may be
ing the form of a climate club, the members of which less effective than expected ex ante, because it would
implement significant trade tariffs on imports of non- reduce proenvironmental behavior of some indivi-
complying countries, regardless of the carbon con- duals.102 However, various studies suggest that at the
tent of the traded goods. These would serve as aggregate level carbon taxes are, if anything, more
incentives for nonmembers to join the club. Similarly effective than predicted.55–58 Carbon pricing may actu-
to carbon border tax adjustments, this proposal cre- ally contribute to motivational crowding in.103 At the
ates an incentive for other countries to implement microeconomic level, we are not aware of any occur-
carbon pricing as well. rence of considerable crowding out due to carbon pri-
One proposal builds on the standard idea of a cing. One may wonder why there is so much concern
carbon border tax and, to clarify that it is motivated about motivational crowding out.104–106 Backed by
by environmental concerns and should not be inter- experimental data and a survey among economists, a
preted by nonclub members as a protectionist meas- recent study concludes that a plausible reason is that
ure, suggests to complement it with so-called revenue- certain influential, early publications as the ones men-
recycling offsets.95 This means that while the tariffs tioned above have been interpreted as demonstrating
reduce import demand for the carbon-intensive goods, that crowding out was a general phenomenon, whereas
the associated revenues of the tariffs are uncondition- it only applies to particular settings.107
ally returned to the exporting countries from where
the products subject to the tariff originate. This would
signal that the tariffs are meant to support climate pol- PE Issue 6: Carbon Pricing and Long-Term
icy, and are not a disguised form of protectionism or Commitment
aimed at raising public revenues. An effective climate policy requires that there is long-
Another political economy issue relates to what term commitment for a credible carbon price signal.
type of effective climate policy is easier to negotiate This can be achieved with both options as discussed
globally. A global carbon price would be an ideal in the Two Ways of Implementing Carbon section.
basis for negotiations aimed at worldwide commit- The cap-and-trade system provides a guarantee for
ment as it is easy to agree upon, relatively fair (pend- long-term commitment with policy goals as the sys-
ing on equitable national and international tem, once in place, will assure a carbon price that
redistribution of receipts, see below), consistent with keeps emissions within the cap. If, on the other hand,

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governments pledge to a carbon tax schedule over Carbon Pricing Through a Carbon Tax
time, supported by an international agreement, then There are two possible international carbon tax
commitment is arranged too. One can observe that designs, both of which require an international cli-
carbon tax rates have been kept constant or gradually mate agreement. One is a global carbon tax, the rev-
increased over time in all countries in which they have enues of which would be collected centrally, for
been applied. Likewise, in every later phase of emis- example, through the UNFCCC Secretariat, and sub-
sions trading schemes, increased stringency was sequently redistributed among countries in relation
strived for. This is illustrated by the EU-ETS, which to their demographic weight or other criteria. Despite
has broadened its scope both in term of number of its political difficulty, this alternative has the advan-
countries and of activities covered, and has progres- tage of a single worldwide carbon price. It would,
sively used auctioning instead of free allocation.108 moreover, generate positive international redistribu-
To date, the only meaningful example of policy rever- tive effects given the positive correlation between per
sal is Australia, whereas the ‘carbon club’ of countries capita GHG emissions and per capita income. A
applying increasingly stringent policy is steadily main advantage of a carbon tax is that it generates
increasing in size.77,84 This underpins long-term com- revenues over time that allow complementing it with
mitment regarding a carbon price. redistribution policies to ameliorate any undesired
While credibility of a long-term policy commit- inequitable effects of the tax. In addition, a part of
ment is not easy to achieve, this may improve when the carbon tax revenues might be allocated to inno-
policy reversals are discouraged by introducing com- vation and adoption/diffusion subsidies or to the pro-
mitment devices. To illustrate, the well-known carbon vision of green funds financing environmental
tax of British Columbia was introduced with a com- projects or adaptation measures in poorer countries.
mitment device imposing on the regulator a prede- Public acceptability studies show that using carbon
fined tax escalator (i.e., a set path for future price tax revenues in these ways can often increase their
hikes) and the obligation to reduce revenues from social and political acceptability.1
other taxes (mainly on income) to compensate for car- While a global carbon tax would imply finan-
bon tax revenues. The incentive effect of this was con- cial transfers from rich to poor countries, one should
firmed by a recent review.2 Switzerland has opted for realize that any serious climate policy, price-based or
an automatic carbon tax adjustment system. If emis- not, will require such financial transfers. However, as
sions levels are above an emissions path that has to be carbon taxes as well as carbon markets—through ini-
followed to reach the abatement objective as specified tial sales or auctioning of permits—generate consid-
in the CO2 Act, then the carbon tax rate is automati- erable public revenues, with carbon pricing rich
cally raised. This ensures that carbon tax rates are not countries are more likely to provide financial support
affected by political cycles. Incidentally, one should to poorer countries than with other policy instru-
realize that commitment to any serious climate policy ments (notably quantity regulation or technical stan-
will be difficult and require appropriate design, that dards), as these do not generate public revenues.
is, this problem is not unique to carbon pricing. Absent any transfer, carbon prices should be lower in
poor countries, as the marginal valuation of con-
sumption is higher there, because of diminishing
TWO WAYS OF IMPLEMENTING returns of consumption in utility, and thus the mar-
ginal cost of abatement should also be lower.109
CARBON PRICING GLOBALLY However, as distinct carbon tax levels between coun-
One can achieve a unique worldwide carbon price tries reduce effectiveness, due to carbon leakage (see
using a global carbon tax or a global emissions trad- Argument 5 in the section on Seven Arguments for
ing system. While the first approach sets the carbon Global Carbon Pricing), transfers—which in effect
price directly through an administrative decision, the are motivated by the same argument of different mar-
second sets a cap on emissions and allocates the ginal values of consumption—are preferable.
emission allowances between emitters. Emissions An alternative to a global tax is an interna-
trading then results in a carbon price. Both tional agreement that partially harmonizes national
approaches satisfy the general favorable properties carbon taxes, requiring a minimum common rate.
mentioned in previous sections. In addition, each This would contribute to the cost-effectiveness of the
approach has particular advantages and disadvan- allocation of global abatement efforts among coun-
tages, as discussed below. Hence, there is not an une- tries. In comparison with a genuine global tax, under
quivocally better alternative, which explains why this option redistribution of revenues between coun-
each option has its own advocates. tries would be more complicated. In the near term,

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WIREs Climate Change Carbon pricing in climate policy

measures as discussed in PE Issue 4 in the section on have been developed in North America, Europe, and
Political Economy Issues, namely carbon border tax Asia, forming a fertile basis for integration at a lar-
adjustment or more generally trade sanctions, could ger, global scale. There are already examples of lin-
reduce free riding and promote wide participation kages between emissions trading systems, such as
in an international agreement. As a carbon tax those that exist between California and Quebec.
might be difficult to apply straight away in some As in the case of carbon taxes, some developing
low-income countries, in a preliminary stage, one countries may be reluctant to participate. A possible
could aim for at least a reduction in fossil-fuel subsi- approach is to link the carbon markets of developed
dies equivalent to the increase in prices in developed countries to an emission-reduction-credit (ERC) sys-
countries.110 The avoided expenditures could be tem based on projects reducing emissions in develop-
used to ameliorate any negative distributive impact ing countries, thus exploiting their low-cost
of such policy reform. This might facilitate a broad mitigation opportunities.110 Such a design would
participation of developing countries in a first stage open the door to a truly global carbon pricing system
and their adoption of a harmonized carbon tax in a in these countries. However, an ERC system is still
later stage. very controversial as it faces various problems, such
as assuring ‘additionality’ (abatement that would not
have occurred without carbon pricing) and allowing
Carbon Pricing Through Emissions Trading for perverse, counterproductive effects.111 Problems
An international emissions trading system could also of this kind should be analyzed before ERC can be
take different forms. A truly global market would considered a viable option.112 Current controversies,
cover all emission sources, giving rise to a single car- and ethical-equity considerations, have discouraged
bon price worldwide. This would assure cost- the use of the ERC system in the EU-ETS.108 Similar
effectiveness of emissions abatement at a global level. controversies concern the Californian ETS. A recent
This works as follows. The emissions cap set by the paper113 tackles the question of the acceptability of
regulator would be motivated by an agreed upon international carbon offsets experimentally. Partici-
long-term climate goal (such as maximally 1.5 C or pants face the decision to fund domestic or interna-
2 C global warming). A consistent number of per- tional reforestation programs, knowing that the same
mits is then given, sold or auctioned among the emit- emissions reductions are provided by a local or an
ters from all countries. Global emissions trading international tree, but domestic trees are much more
among emitters then translates the scarcity of permits expensive. Randomized treatments making even
into a global carbon price. This price will be affected more salient the price differential contribute to the
by incomes, demand-price relations for carbon- popularity of international offsets, in particular
intensive goods and services, and technologies in the among individuals with strong environmental prefer-
global economy. This means individual agents do not ences, suggesting that transfers between developed
need to have a long-term vision or goal—this is only and developing countries may be facilitated by stres-
required from the global regulator in order to set an sing the related environmental gains.
adequate cap. The carbon market price will then As with the redistribution of carbon taxes rev-
ensure that all decisions by all economic actors in the enues, setting rules of allocation of allowances
global economy are in line with the long-term among countries and emitters in each country is a
climate goal. major hurdle, because they reflect implicit ethical and
Nevertheless, creating such a global emission political choices. The grandfathering approach used
trading system is very challenging in both political in many programs favors large emitters and penalizes
and institutional terms. An ideal international treaty those who made mitigation efforts before the policy
would fix a global emissions cap and then distribute implementation.114 As a result, there is now broader
allowances between countries, which could trade support for initializing systems through auctioning
them, resulting in a global carbon price. If all coun- permits, also because it improves the efficiency of the
tries distributed their allowances among their firms, a overall tax and permit system, namely by using the
cost-effective international market could be estab- auction revenues to reduce distortionary taxes.115 As
lished. However, similarly to carbon taxes, it would for carbon taxes, distributional concern would play
probably be politically easier to start with distinct in favor of either a redistribution of revenues from
emissions trading systems covering certain countries permit auctions based on the demographic weights of
and regions (like the EU), and integrate these globally countries or the direct allocation of allowances on
in a subsequent stage to ultimately cover all countries per capita basis. Hence, both could be progressive in
and sectors. Indeed, various cap-and-trade systems terms of intercountry distribution and so address one

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of the criticisms to global carbon markets in particu- generally stresses the optimality of carbon pricing in
lar and global carbon pricing in general. terms of maximum welfare or minimal abatement
Emissions trading systems have been criticized costs, our arguments draw attention to the fact that
for their volatility, which may be an important hand- carbon pricing is more effective, at a reasonable cost,
icap for long-term investments, as these depend not in reducing emission than other approaches. This is
only on current prices, but also on expectations especially true when it is combined with some form
about future prices. However, carbon prices in emis- of innovation subsidies. This is not to deny the
sions trading systems do not necessarily have to be importance of the relatively low global abatement
extremely volatile. Price floors and ceilings (so-called cost of carbon pricing compared to other instru-
‘safety valves’) have been proposed to address the ments, but we believe that its high effectiveness in
issue of volatility. The latter comes down to a mixed reducing GHG emissions has been somewhat
system, that is, a combination of tradable permits neglected in many popular accounts, while it should
and a tax,116 thus insuring against unexpectedly high matter equally for political feasibility. We stress that
costs, one may convince firms to comply with, and corrected prices are also essential for environmental
countries to participate in, carbon markets.110 innovation as they affect innovation opportunities.
This is seriously underappreciated in the public
debate on technological change and climate change.
CONCLUSIONS Here, pricing is often downplayed, while the errone-
We have presented seven reasons for using carbon ous view is widespread that to stimulate innovation
pricing in climate policy: and diffusion attention should be focused only on
subsidies, or other innovation policies. But as argued,
1. It changes relative prices to reflect all direct and carbon pricing and innovation policies are predomi-
indirect GHG emissions of products and ser- nantly complementary and hence an effective climate
vices so that firms and consumers will automat- policy mix should include them both.
ically internalize the costs to achieve a given Many countries already have implemented poli-
emissions abatement goal. cies to stimulate climate change mitigation, including
carbon taxes and emissions trading schemes.84,117
2. It minimizes the overall cost of pollution con- Some early examples of carbon taxes and emissions
trol as it accounts for differences (heterogene- trading schemes may have been or seemed relatively
ity) between polluters in terms of abatement ineffective, due mainly to excessive generosity in
opportunities and costs. handling emissions allowances, very low tax rates, or
3. It contributes to dynamic efficiency, because it exemptions. But this does not argue against the pol-
provides continuous incentives for adoption icy instrument. The observed lack of stringency was
and innovation of new technologies that emit mainly due to a lack of effective international coordi-
fewer GHGs. nation of climate policies. Emissions pledges have
4. It is the best instrument to limit energy and car- been at the center of climate negotiations preparing
bon rebound in an effective way. for COP21 in Paris. We believe that negotiating
5. If it were to cover all countries and sectors, it around a single price will become easier as more
would ensure that there are no leakages countries get involved in carbon pricing and an
through international relocation of dirty indus- increasing number of people become well informed
tries and shifts in foreign trade patterns that about its unique advantages.
merely replace GHG emissions from one coun- A concern sometimes raised is that uncertainty
try to another. about the social cost of carbon (SCC), or assessing a
monetary SCC value in the first place, translates into
6. It implies decentralization of policy, with asso- uncertainty about the appropriate value of a carbon
ciated low information needs for regulators. price. While such uncertainty about the SCC indeed
7. It builds on the empirical fact that when mak- exists, support seems to be increasing for the view
ing purchase decisions, most consumers are that it is higher than 100 US$ per ton CO2, as indi-
more influenced by prices than by environmen- cated by recent surveys.118,119 One should realize,
tal concerns. though, that controversy about the SCC value is not
at all a barrier in implementing a carbon price. If
As a result, carbon pricing will be a very effective using cap-and-trade, the cap—set in accordance with
instrument, for a given cost of abatement. While the a political climate or emissions goal like the two-
economic literature on environmental policy centigrade target—will determine the adequate price

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WIREs Climate Change Carbon pricing in climate policy

level. If using a carbon tax, then a rising tax schedule pricing, but to go beyond the Paris agreement. A
has to be applied until the responses by consumers global carbon price would facilitate this, as it would
and producers are in line with the same climate goal. achieve a not overly expensive outcome using an
In other words, the reality of carbon pricing is not effective instrument.
limited by academic controversies on the possibility In view of the seven advantages of carbon pri-
of defining and estimating an optimal level of pollu- cing and the additional considerations, including the
tion. One can defend the necessity of pricing carbon various political economy issues, we should remove
and at the same time be rather skeptical about the ideological barriers against such a critical element of
concept of an optimal carbon price. Since we are an effective climate policy package. Anyone who is
now in a post-Paris world, the trajectory for carbon critical of carbon pricing needs to address these seven
pricing is for the time being determined by the Paris proarguments, and present an alternative policy
goals. However, the national pledges of the Paris cli- approach that guarantees a similar effectiveness in
mate agreement are far from cost-effective, in the reducing GHG emissions against reasonable cost. As
sense that some countries will have much higher mar- we have argued, however, all alternative options are
ginal abatement costs than others, so that the global likely to result in considerably less effective, even
cost to reach the same emissions abatement objective though well intended, ways of regulating emissions
will be unnecessarily excessive. Paris’ pledges are and thus are likely to be unable to avoid dangerous
merely a first step, insufficient by itself, to avoid dan- climate change. We hope to have convinced the
gerous interferences with the climate system. In view reader that among all instruments carbon pricing
of this, our proposal is not to be satisfied with the deserves the most serious attention from researchers,
Paris pledges and just achieve them through carbon politicians, and citizens.

ACKNOWLEDGMENTS
Baranzini and Carattini received financial support from the Swiss Federal Office of Energy, and Carattini addi-
tional support from the Swiss National Science Foundation, grant P2SKP1_165028, and from COST Action
IS1309 ‘Innovations in Climate Governance: Sources, Patterns and Effects’ (INOGOV). Padilla and Roca
acknowledge support from projects ECO2015-67524-R (Ministerio de Economía y Competitividad) and
2014SGR950 (Generalitat de Catalunya). van den Bergh’s research benefited from a María-de-Maeztu
Excellent Unit grant awarded to ICTA-UAB. We are grateful to Alex Bowen and three anonymous reviewers
for useful comments.

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