Carbon Pricing for Climate Change Mitigation and Financing the SDGs

Challenge

The climate conference in Paris in 2015 was an enormous success. All countries have committed to stabilize global temperature to “well below 2°C” and almost all have put their planned climate protection efforts (INDCs) on the table.

Great challenges remain. The increase in global greenhouse gas emissions will not be stopped through the implementation of the INDCs; emission growth up to 2030 will only slow down, while 2°C stabilization requires decarbonization of the world economy. To render the emission of GHGs unattractive in the future, INDCs have to be backed with substantive instruments. Therefore, it is important to back the often vague intentions of the INDCs with substantive instruments. Putting a price on carbon would be such an instrument. The consequences of historic and current changes in the oil price illustrate of the transformative force of changing relative energy prices.

The implementation of carbon pricing, however, is unlikely to be successful as part of climate change negotiations under the umbrella of the UNFCCC given its consensus decision rules with 195 governments. Other institutions can complement the UNFCCC in this respect. The G20, representing three quarters of the global emissions, would be an appropriate forum to advance carbon pricing as a key tool for climate change mitigation and for generating revenues that can finance the attainment of the Sustainable Development Goals (SDGs).

Proposal

The G20 process in 2016 and 2017 could become an important starting point for reaching new milestones for climate protection after the climate summit in Paris in 2015. The Agreement has laid the foundation for going a major step forward. It is now time for implementation.

Climate change is no longer a purely environmental topic. Both climate change itself with its disastrous impacts, and any action to mitigate its effects, will deeply affect economic processes. Economic development has been based on the consumption of fossil fuels in the past. In order to mitigate climate change, however, it is crucial to decouple economic growth from emissions growth. There is currently an abundant supply of fossil fuels still available in the ground. Coal is especially cheap in comparison to other energy carriers as the resulting emissions can be dumped freely into the atmospheric commons. Carbon pricing is an effective instrument to guide production and investment decisions towards mitigating emissions and can be implemented using a tax, an emissions trading system, or a combination of the two (Edenhofer et al. 2015).

Carbon pricing has three advantages:

1. it triggers economy-wide decarbonization in a cost efficient manner,
2. it generates (domestic) revenues that can be used e.g. for financing the Sustainable Development Goals (SDGs) or reducing other distortionary taxes, and
3. it could become a focal point for international climate policy cooperation focusing on carbon pricing coordination.

Carbon pricing as instrument for climate change mitigation

The 2015 UNFCCC Paris Decisions explicitly recognize carbon pricing by stating “the important role of providing incentives for emission reduction activities, including tools such as domestic policies and carbon pricing” (#137). In addition, the novel and yet to be defined concept of “internationally transferred mitigation outcomes” (Art. 6.3) could, for example, formally prepare the linking of emission trading schemes between different countries.

A carbon price increases the cost of CO₂ emissions and implements the polluter pays principle. In particular, it increases the costs and – if sufficiently high and rising over time – makes carbon-intensive energy carriers unprofitable, in particular coal. In this way, carbon pricing can effectively counteract the global renaissance of coal. The latter is expected to take place, despite the Paris Agreement, in some G20 countries, including Turkey, South Africa and India (Steckel et al. 2015). In the medium to long term, there is no other cost-effective climate protection instrument that could drive coal out of the market worldwide.

Carbon pricing and generation of revenues for financing SDGs

Some G20 countries reject ambitious short-term climate policy and would like to let their emissions grow further before reducing them at a later date. They argue that they have the right to development, which is certainly justified. A closer look, however, reveals that this argument can be refuted. Research undertaken by MCC shows that by appropriately designing carbon pricing and revenue spending climate protection and development can be achieved simultaneously (Jakob et al. 2016), see Figure 1.

The additional revenue from the taxation of CO₂ or the auctioning of emission allowances could remain in the respective countries (Franks et al. 2015). It could be used to lower other distortionary taxes, reduce government debt, compensate poor communities for the additional burden imposed on them through the carbon price, or invest in public infrastructure serving to reach the Sustainable Development Goals. Assuming 36 Gt of global CO₂ emissions in 2015 and a hypothetical price of US$50 per tonne, this would amount to US$1.8 trillion annually or 2.3% of the global GDP. By contrast, the cost of providing universal access to clean water, sanitation and electricity are estimated to incur only US$1 trillion annually (Jakob et al. 2016).

Carbon pricing to facilitate international climate cooperation

Given the many potential veto players (especially countries with large fossil fuels reserves) and the consensus-based process of the UN Framework Convention on Climate, more effective forums are needed to negotiate ambitious carbon prices. The Paris Agreement allows and encourages such negotiations in other multilateral contexts, such as the G20 (Art. 6). What could these negotiations look like? Individual countries would pledge to introduce minimum national carbon prices, either as taxes or as minimum prices in their emissions trading schemes. However, those prices would only come into effect if other countries were likewise implementing high prices. This strategy would allow to mitigate the concern that carbon pricing leads to competitive disadvantages. It would also introduce a sanctioning mechanism if countries were to lower their carbon prices in response to unilateral reductions of carbon prices by some members of the carbon pricing club. With a view to reaching the 2°C target, actual and anticipated emission reductions achieved through carbon pricing would have to be compared with the reduction requirements implied by the long-term goal, and prices be adjusted accordingly. With this strategy, the biggest emitters should ideally take the lead. A country’s national carbon price scheme could also be integrated into it NDC (Nationally Determined Contributions) communicated to the UNFCCC. Moreover, newcomers to the carbon pricing club could be allowed to gradually adapt to a carbon price coalition by increasing their domestic carbon prices over time (converging to the envisioned club level).

Strategic use of climate finance

Carbon prices will only be acceptable in poorer countries if they are (at least party) compensated for the associated costs by richer countries. Therefore, climate finance transfers for mitigation (not for adaptation) to poorer countries could be made under the condition that these accept a minimum price for emissions. One option would be to start with differentiated minimum prices according to country groups that would rise and converge over time.

The US$100 billion of climate finance mobilized through the Paris Agreement could be a main pillar of this strategy. The sums drawn from an international pot such as the Green Climate Fund (GCF) would then have to be linked to carbon pricing levels of a given country. A country with a comparatively high carbon price would receive higher climate finance compensation for its higher mitigation costs. Countries then have an incentive to pursue more ambitious carbon pricing. Conditional transfers would serve to mitigate the incentive problem inherent in the currently voluntary commitment scheme established by the Paris Agreement, since a reduction in the level of ambition would lead to the loss of international support. Donor countries that contribute to the international fund would also benefit from the provision of climate financing because more ambitious emission reductions in the recipient countries achieve greater global climate protection. Each country benefits from the conditionality, as it increases the trust that other countries will pursue ambitious climate protection and as contributions are part of an established, solid system for coordinating ambitious climate policies. Also, each country would retain its domestic revenues from carbon pricing to finance e.g. investments into measures for attaining the SDGs.

However, a system of conditional transfer payments depends on developing countries having the capacity and expertise to introduce carbon taxes. A portion of the promised US$100 billion could be initially used to build these capacities. Concerns about regressive effects of carbon taxes could be mitigated by developing socially responsible and country-specific tax models. The GCF could prefinance tax relief measures and compensation payments to poor communities introducing carbon prices, to avoid regressive effects and to increase social acceptance.

Carbon pricing in the G20 context

The political momentum for implementing carbon pricing as an instrument for climate change mitigation is growing. In the wake of the G7 summit in Elmau in 2015, the German government initiated a Global Carbon Pricing Platform in order to stimulate dialogue on carbon pricing. Comments by leaders of international organizations are also remarkable: Christine Lagarde, managing director of the International Monetary Fund (IMF), has been outspoken in her support for a CO2 tax. The same holds for Jim Yong Kim, the president of the World Bank. Furthermore, under the umbrella of the IMF, World Bank and OECD, the Carbon Pricing Leadership Coalition was launched at the beginning of the negotiations in Paris. This coalition brings together governments such as those of Mexico, Germany, France, Chile and California, along with nearly 90 global businesses and NGOs, to advocate carbon pricing. Financial markets now recognize that climate change may pose a significant risk to the stability of financial systems. Mark Carney, Governor of the Bank of England and Chairman of the G20 Financial Stability Board, proposes carbon pricing as a remedy against this risk.

This places the topic where it belongs. The G20 would be the ideal forum to promote and conduct ​​carbon pricing coordination and thus specify the so far often vague promises of INDCs by putting them into action. Not only are the G20 responsible for about three-quarters of global emissions and launched an initiative to remove fossil subsidies in the past (negative carbon pricing). Above all, China who holds the G20 Presidency in 2016, has announced the introduction of the world’s largest emissions trading scheme in 2017. Pilot projects in several Chinese provinces are already under way. This suggests that even the world’s largest emitter of greenhouse gases would have a strong interest in promoting carbon pricing within the G20. Combined with the German G20 Presidency in 2017, this could generate a strong momentum for action.

Carbon pricing must not only be considered in the narrow context of climate protection, but in the broader context, such as in financing the SDGs adopted by all countries in September 2015. Climate change mitigation will only be implemented if developing countries understand that it will not hinder their development; it needs to be recognized as a success story. After COP21 in Paris, the G20 should seize the chance to write the first chapter of this story.

Edenhofer, O., Jakob, M., Creutzig, F., Flachsland, C., Fuss, S., Kowarsch, M., Lessmann, K., Mattauch, L., Siegmeier, J., Steckel, J.C., 2015. Closing the emission price gap. Global environmental change 31, 132–143.

Franks, M., Edenhofer, O., Lessmann, K. (2015): Why Finance Ministers Favor Carbon Taxes, Even if They Do Not Take Climate Change into Account. doi: 10.1007/s10640-015-9982-1

Jakob, M., Chen, C., Fuss, S., Marxen, A., Rao, N., Edenhofer, E. (2016): Using carbon pricing revenues to finance infrastructure access. World Development, in press

Steckel, J.C., Edenhofer O., Jakob M (2015): Drivers for the renaissance of coal. PNAS 112(29):E3775–E3781.