A market approach to climate change: how and why to regulate global carbon dioxide emissions

08 November 2016

By Julie Phillips and Jonathan Grant

Paris COP21 set a very ambitious target to limit global average temperature change to 1.5 °C. To achieve this target however, current rates of decarbonisation need to be raised significantly.

Michael Pollitt (Cambridge Judge Business School) and Carlo Stagnaro (Italy’s Ministry of Economic Development), spoke at the PwC sponsored Beesley lecture about the necessity of using a market approach to regulate global carbon emissions.

Their central argument was that if we aren’t using market mechanisms to decarbonise the global economy, nothing else will work. When it comes to global pollutants (i.e. CO2), local emissions are irrelevant so it makes more sense to have a widely defined approach than to impose regulations at the individual source level.

There are several ways of using a market approach to carbon regulation. The first is setting a price, such as a tax, and letting the pollution quantity be determined by this price. The second is setting a quantity, such as permits, and then letting the price be determined by the quantity. A third, more unpredictable method which has been observed in the US, is leaving individuals or entities to tackle pollution by suing when damage is caused.

The key to using markets to regulate carbon emissions is being able to optimally spread abatement across sectors and geography. Having emissions trading that is widely defined decreases the cost of abatement, allowing polluters with a lower marginal cost of abatement to trade abatement with polluters that have a higher cost.

Using a market system to regulate carbon emissions is not a new approach. The EU implemented an Emissions Trading System (ETS) that ultimately failed in delivering carbon prices as high as expected. One of the reasons for this was the economic recession in 2008, which pushed down energy consumption and concurrently decreased carbon emissions. The demand for emission permits dropped and with it, the marginal price of carbon emissions.

The difficulty with a market approach to reducing carbon emissions is that we don’t know exactly what the marginal cost of pollution is. This makes it difficult to know how much abatement can be achieved.

Lessons can be learned from past failures and should not detract from the opportunities market based solutions to carbon emissions offer.  Economic incentives encourage organisations to innovate - and the climate challenge is largely one of innovation. For example, half of global research and development in energy is being spent on renewables and currently, 50% of new capacity additions are happening in the renewable area.

Trading schemes like the ETS, as well as other cap & trade schemes and taxation, can be powerful instruments but should not be expected to deliver decarbonisation targets alone. Co-ordinated policies are essential. If they are devised in a competitive, open-to-innovation environment, they have the potential to further drive up rates of decarbonisation. Only through combining market approaches and enabling policies do we have a chance at fulfilling Paris agreements and limiting the temperature rise to 1.5 °C.

Julie Phillips and Jonathan Grant
Tel: 07802 658786 or 07841 567014

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