Why we need a higher price of carbon now

Emissions of carbon dioxide and other greenhouse gases are increasingly priced around the globe. Yet, the price tends to be far too low to adequately reflect the social cost of carbon. Currently, the emission of a tonne of carbon dioxide is priced at c.$50 in the EU, but around $10 in most other countries. And in the United States, there isn’t even a national carbon emissions market in place. Yet, the consensus at the moment is that the cost of a tonne of carbon emissions should be around $50 to $100 and rise to about $250 to $300 by 2030. 

Industry lobbies hard to keep the price of carbon as low as possible in order to be able to continue running plants that would become uneconomical at higher prices or to be able to sell oil and gas at higher prices. A higher price of carbon would inevitably reduce demand for fossil fuels and thus lower the price of oil and gas. Yet, that is exactly what we need to do. 

We need to make inefficient plants uneconomical and reduce the demand for oil to create incentives to switch to more efficient ways of generating power and producing goods. That is what capitalism and markets are all about. Price all the costs of an economic activity adequately, so the best technologies and most productive companies survive, and the inefficient producers go under. It is Schumpeter’s creative destruction in action and by not pricing carbon emissions adequately, we are effectively reducing the ability of markets and capitalism to do what they do best.

In a sense, people who are advocating against pricing carbon and in favour of keeping oil and gas companies alive at all costs act like the socialist governments of Soviet Russia. These inefficient companies dabbling in outdated and uncompetitive technologies can survive for a long time this way. But the longer we wait, the more likely it will become that eventually, the price of carbon will have to rise dramatically in a very short time. 

The UN PRI has termed this scenario the inevitable policy response. The basic idea is that we have a certain amount of time to change our economy to adapt to climate change. The longer we wait for that adaptation, the faster we will have to change it because climate change is not going to wait for us. And if we wait too long, the changes will have to be so drastic and large that they will create a large shock to the system. 

If you want to know what this shock could look like, you just have to go back to the oil crisis of 1974. Back then, oil was cheap (about $3.30/bbl.) and the economies of all industrialised countries depended heavily on cheap imports from the Middle East. Then all of a sudden, the oil price rose significantly to c. $11/bbl. as an externality (in that case the geopolitical tensions between Israel and the Arab World) got priced. Given how much oil was consumed globally, the price increase in oil in 1974 amounted to a shock in the order of 3.5% of global GDP. The result was a severe recession in the United States and Western Europe an inflation shock and the beginning of the stagflation of the 1970s after the central banks mismanaged the situation. Furthermore, it created an intense rivalry between workers and business owners as both parties tried to keep as much of the reduced profits to themselves. This rivalry escalated more and more over time, leading to the strike waves of the late 1970s and early 1980s in the UK and many European countries.

Now compare this scenario with the costs of an inevitable policy response. Let’s start with an optimistic scenario where the global economy does not produce more carbon emissions every year, but that emissions stay at 2019 levels of 36.4 gigatons. Let’s also assume that the price for carbon emissions stays level at current prices until 2029. Then in 2030, prices suddenly adjust upwards to $75/bbl. everywhere around the globe. Jean Pisani-Ferry from the Peterson Institute estimates that in this scenario the cost of the price shock to carbon would create additional costs of 3.1% of global GDP. If prices rise to $100 per tonne of CO2, the costs would increase to 4.1% of GDP and by my calculations, an increase to the above-mentioned $300 per tonne of CO2 would cost the world economy 12.1% of GDP. And that is only the direct cost of higher emissions prices, not the secondary costs from businesses going into bankruptcy and people losing their jobs, etc.

Thus, just a small increase in carbon prices in 2030 would create a global economic shock similar to the 1974 oil crisis. A more realistic price shock would create a global economic shock similar in size or even larger than the pandemic last year.

The countries with the highest price for carbon emissions today would be the winners because their economies would have adjusted to the higher price of this commodity and thus experience a smaller shock. Countries with no or very low carbon prices would bear the brunt of the economic losses. 

But it doesn’t even have to come to that. It is the year 2021 after all. We still have ten years during which we can gradually increase the price of carbon. If you increase the price linearly over time, the 4% shock to GDP in 2030 gets distributed to about 0.4% every year during this decade. Clearly, this will reduce economic growth during this decade and means that we are facing a decade of slow growth ahead. But it would avoid another disaster both in terms of environmental impacts and in terms of economic impacts. If only politicians and business leaders were able to plan a decade ahead instead of the next election or the next annual results, we could avoid a catastrophe in the making.