Editing IPCC:AR6/SR15/Chapter-4 (section)

==== 4.4.5.2 Carbon pricing: necessity and constraints ====

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Economic literature has long argued that climate and energy policy grounded only in regulation, standards and public funding of R&amp;D is at risk of being influenced by political and administrative arbitrariness, which could raise the costs of implementation. This literature has argued that it may be more efficient to make these costs explicit through carbon taxes and carbon trading, securing the abatement of emissions in places and sectors where it is cheapest (IPCC, 1995, 2001; Gupta et al., 2007; Somanathan et al., 2014) <sup>[[#fn:r1361|1361]]</sup> .

In a frictionless world, a uniform world carbon price could minimize the social costs of the low-carbon transition by equating the marginal costs of abatement across all sources of emissions. This implies that investors will be able to make the right choices under perfect foresight and that domestic and international compensatory transfers offset the adverse distributional impacts of higher energy prices and their consequences on economic activity. In the absence of such transfers, carbon prices would have to be differentiated by jurisdiction (Chichilnisky and Heal, 2000; Sheeran, 2006; Böhringer et al., 2009; Böhringer and Alexeeva-Talebi, 2013) <sup>[[#fn:r1362|1362]]</sup> . This differentiation could in turn raise concerns of distortions in international competition (Hourcade et al., 2001; Stavins et al., 2014) <sup>[[#fn:r1363|1363]]</sup> .

Obstacles to enforcing a uniform world carbon price in the short run would not necessarily crowd out explicit national carbon pricing, for three reasons. First, a uniform carbon price would limit an emissions rebound resulting from a higher consumption of energy services enabled by efficiency gains, if energy prices do not change (Greening et al., 2000; Fleurbaey and Hammond, 2004; Sorrell et al., 2009; Guivarch and Hallegatte, 2011; Chitnis and Sorrell, 2015; Freire-González, 2017) <sup>[[#fn:r1364|1364]]</sup> . Second, it could hedge against the arbitrariness of regulatory policies. Third, ‘revenue neutral’ recycling, at a constant share of taxes on GDP, into lowering some existing taxes would compensate for at least part of the propagation effect of higher energy costs (Stiglitz et al., 2017) <sup>[[#fn:r1365|1365]]</sup> . The substitution by carbon taxes of taxes that cause distortions on the economy can counteract the regressive effect of higher energy prices. For example, offsetting increased carbon prices with lower labour taxes can potentially decrease labour costs (without affecting salaries), enhance employment and reduce the attractiveness of informal economic activity (Goulder, 2013) <sup>[[#fn:r1366|1366]]</sup> .

The conditions under which an economic gain along with climate benefit (a ‘double dividend’) can be expected are well documented (Goulder, 1995; Bovenberg, 1999; Mooij, 2000) <sup>[[#fn:r1367|1367]]</sup> . In the context of OECD countries, the literature examines how carbon taxation could substitute for other taxes to fund the social security system (Combet, 2013) <sup>[[#fn:r1368|1368]]</sup> . The same general principles apply for countries that are building their social welfare system, such as China (Li and Wang, 2012) <sup>[[#fn:r1369|1369]]</sup> or Brazil (La Rovere et al., 2017a) <sup>[[#fn:r1370|1370]]</sup> , but an optimal recycling scheme could differ based on the structure of the economy (Lefèvre et al., 2018) <sup>[[#fn:r1371|1371]]</sup> .

In every country the design of carbon pricing policy implies a balance between incentivizing low-carbon behaviour and mitigating the adverse distributional consequences of higher energy prices (Combet et al., 2010) <sup>[[#fn:r1372|1372]]</sup> . Carbon taxes can offset these effects if their revenues are redistributed through rebates to poor households. Other options include the reduction of value-added taxes for basic products or direct benefit transfers to enable poverty reduction (see Winkler et al. (2017) <sup>[[#fn:r1373|1373]]</sup> for South Africa and Grottera et al. (2016) <sup>[[#fn:r1374|1374]]</sup> for Brazil). This is possible because higher-income households pay more in absolute terms, even though their carbon tax burden is a relatively smaller share of their income (Arze del Granado et al., 2012) <sup>[[#fn:r1375|1375]]</sup> .

Ultimately, the pace of increase of carbon prices would depend on the pace at which they can be embedded in a consistent set of fiscal and social policies. This is specifically critical in the context of the 1.5°C limit (Michaelowa et al., 2018) <sup>[[#fn:r1376|1376]]</sup> . This is why, after a quarter century of academic debate and experimentation (see IPCC WGIII reports since the SAR), a gap persists with respect to ‘switching carbon prices’ needed to trigger rapid changes. In 2016, only 15% of global emissions are covered by carbon pricing, three-quarters of which with prices below 10 USD tCO <sub>2</sub> <sup>−</sup> <sup>1</sup> (World Bank, 2016) <sup>[[#fn:r1377|1377]]</sup> . This is too low to outweigh the ‘noise’ from the volatility of oil markets (in the range of 100 USD tCO <sub>2</sub> <sup>−</sup> <sup>1</sup> over the past decade), of other price dynamics (interest rates, currency exchange rates and real estate prices) and of regulatory policies in energy, transportation and industry. For example, the dynamics of mobility depend upon a trade-off between housing prices and transportation costs in which the price of real estate and the inert endowments in public transport play as important a role as liquid fuel prices (Lampin et al., 2013) <sup>[[#fn:r1378|1378]]</sup> .

These considerations apply to attempts to secure a minimum price in carbon trading systems (Wood and Jotzo, 2011; Fell et al., 2012; Fuss et al., 2018) <sup>[[#fn:r1379|1379]]</sup> and to the reduction of fossil fuel subsidies. Estimated at 650 billion USD in 2015 (Coady et al., 2017) <sup>[[#fn:r1380|1380]]</sup> , these subsidies represent 25–30% of government expenditures in forty (mostly developing) countries (IEA, 2014b) <sup>[[#fn:r1381|1381]]</sup> . Reducing these subsidies would contribute to reaching 1.5°C-consistent pathways, but raises similar issues as carbon pricing around long-term benefits and short-term costs (Jakob et al., 2015; Zeng and Chen, 2016) <sup>[[#fn:r1382|1382]]</sup> , as well as social impacts.

Explicit carbon prices remain a necessary condition of ambitious climate policies, and some authors highlight the potential benefit brought by coordination among groups of countries (Weischer et al., 2012; Hermwille et al., 2017; Keohane et al., 2017) <sup>[[#fn:r1383|1383]]</sup> . They could take the form of carbon pricing corridors (Bhattacharya et al., 2015) <sup>[[#fn:r1384|1384]]</sup> . They are a necessary ‘lubricant’ through fiscal reforms or direct compensating transfers to accommodate the general equilibrium effects of higher energy prices but may not suffice to trigger the low-carbon transition because of a persistent ‘implementation gap’ between the aspirational carbon prices and those that can practically be enforced. When systemic changes, such as those needed for 1.5°C-consistent pathways, are at play on many dimensions of development, price levels ‘depend on the path and the path depends on political decisions’ (Drèze and Stern, 1990) <sup>[[#fn:r1385|1385]]</sup> .

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