Why is a carbon price necessary in climate policies?
In the recently concluded COP 15 in Copenhagen, binding agreements could not be reached among the developed and developing nations to cut carbon dioxide emissions. Much expectation were generated before the conference as the US announced that they will cut 17% of 2005 emissions by 2020, while China committed to cut 40-45% of 2005 emissions per GDP capita. However, in any discussion to reduce greenhouse emissions, there is a need to put a price to carbon. Simply put, the higher the target reductions, the higher the price to pay for a tonne of carbon.
Why is a price of carbon necessary, and why has it not been discussed extensively by conference parties? By putting a price to carbon the market failure of a common resource is arrested. The atmosphere and the climate is a common resource, in that no one owns it, no one pays for it, everyone uses it, and no one is ultimately responsible for its upkeep. As such, continued exploitation of the atmosphere resulted in greenhouse warming and a market failure.
Putting a price to carbon arrests this market failure, and sends a signal to consumers and producers alike. For example, suppose a consumer that drives 15000 miles a car that has a fuel efficiency of 30 mpg. Assuming a carbon price of $10, the consumer has to pay $14 to emit the carbon that was produced. This is derived as follows. The consumer uses 15000/30 x 4.2 / 1000 = 2.1 kilolitres of gasoline or 2.1 x 0.74 = 1.55 tonnes. The consumer now needs to pay ~ 1.55 x (60) / (60 + 6) x 10 = $14. The ‘60’ is the molecular weight of 5 carbon atoms (which is approximately what gasoline contains), while ‘6’ is the molecular weight of 6 hydrogen atoms. These are of course approximations since gasoline contains other additives like ethanol and has higher carbon molecules.
Consumers therefore have incentives to be more ‘carbon-conscious’ and reduce emissions. A price on carbon also incentivises researchers to engage in carbon abatement technology research and determines which technologies are presently feasible. For example, $60 a tonne is the approximate cost of capturing carbon emissions from coal plants, which will make the technology feasible for commercial use. Removal of carbon dioxide from the 800+ coal power stations in US will remove 1/3 of total emissions. Further increasing the price of carbon will make other technologies possible for example hydrogen cells, synfuels etc. There will be a sufficiently high price such that a backstop technology becomes feasible to even remove all carbon emissions!
Hence reducing greenhouse emissions is really about setting a price on carbon. A high price of carbon reduces emissions more and vice versa is true. Setting too strict an emission criterion now however will constrain other parts of the economy to grow. This crowds out investment into other parts of the economy, and actually reduces the overall welfare of the population. This is in fact the proposal taken by Al Gore and the Stern Review, which proposes immediate hefty reductions in carbon emissions.
Research has shown that it is actually more beneficial to have a ramp-shaped carbon price into the future. A lower price now is beneficial in that it removes carbon from lower-costs abatement alternative such as re-forestation, renewable energies like wind or solar. The carbon price increases in the future such that as the technology for other more advanced abatements progresses, it becomes cheaper and more economical to implement them instead of the present hefty premium.