Policy responses for mitigation

The first half of this Review has considered the evidence on the economic impacts of climate change itself, and the economics of stabilising greenhouses in the atmosphere. Parts IV, V and VI now look at the policy response.

The first essential element of climate change policy is carbon pricing. Greenhouse gases are, in economic terms, an externality: those who produce greenhouse gas do not face the full consequences of the costs of their actions themselves. Putting an appropriate price on carbon, through taxes, trading or regulation, means that people pay the full social cost of their actions. This will lead individuals and businesses to switch away from high-carbon goods and services, and to invest in low-carbon alternatives.

But the presence of a range of other market failures and barriers mean that carbon pricing alone is not sufficient. Technology policy, the second element of a climate change strategy, is vital to bring forward the range of low-carbon and high-efficiency technologies that will be needed to make deep emissions cuts. Research and development, demonstration, and market support policies can all help to drive innovation, and motivate a response by the private sector.

Policies to remove the barriers to behavioural change are a third critical element. Opportunities for cost-effective mitigation options are not always taken up, because of a lack of information, the complexity of the choices available, or the upfront cost. Policies on regulation, information and financing are therefore important. And a shared understanding of the nature of climate change and its consequences should be fostered through evidence, education, persuasion and discussion.

The credibility of policies is key; this will need to be built over time. In the transitional period, it is important for governments to consider how to avoid the risks that long- lived investments may be made in high-carbon infrastructure.

Part IV is structured as follows:

• Chapter 14 looks at the principles of carbon pricing policies, focusing particularly on the difference between taxation and trading approaches.

• Chapter 15 considers the practical application of carbon pricing, including the importance of credibility and good policy design, and the applicability of policies to different sectors.

• Chapter 16 discusses the motivation for, and design of, technology policies.

• Chapter 17 looks at policies aimed at removing barriers to action, particularly in relation to the take-up of opportunities for energy efficiency, and at how policies can help to change preferences and behaviour.

14 Harnessing Markets for Mitigation – the role of taxation and trading

Key Messages • Agreeing a quantitative global stabilisation target range for the stock of greenhouse gases (GHGs) in the atmosphere is an important and useful foundation for overall policy. It is an efficient way to control the risk of catastrophic climate change in the long term. Short term policies to achieve emissions reductions will need to be consistent with this long-term stabilisation goal.

• In the short term, using price-driven instruments (through tax or trading) will allow flexibility in how, where and when emission reductions are made, providing opportunities and incentives to keep down the cost of mitigation. The price signal should reflect the marginal damage caused by emissions, and rise over time to reflect the increasing damages as the stock of GHGs grows. For efficiency, it should be common across sectors and countries.

• In theory, taxes or tradable quotas could establish this common price signal across countries and sectors. There can also be a role for regulation in setting an implicit price where market-based mechanisms alone prove ineffective. In practice, tradable quota systems – such as the EU"s emissions-trading scheme – may be the most straightforward way of establishing a common price signal across countries. To promote cost-effectiveness, they also need flexibility in the timing of emissions reductions.

• Both taxes and tradable quotas have the potential to raise public revenues. In the case of tradable quotas, this will occur only if some firms pay for allowances (through an auction or sale). Over time, there are good economic reasons for moving towards greater use of auctioning, though the transition must be carefully managed to ensure a robust revenue base.

• The global distributional impact of climate-change policy is also critical. Issues of equity are likely to be central to securing agreement on the way forward. Under the existing Kyoto protocol, participating developed countries have agreed binding commitments to reduce emissions. Within such a system, company-level trading schemes such as the EU ETS, which allow emission reductions to be made in the most cost-effective location – either within the EU, or elsewhere – can then drive financial flows between countries and promote, in an equitable way, accelerated mitigation in developing countries.

• At the national – or regional – level, governments will want to choose a policy framework that is suited to their specific circumstances. Tax policy, tradable quotas and regulation can all play a role. In practice, some administrations are likely to place greater emphasis on trading, others on taxation and possibly some on regulation.

14.1 Introduction This chapter focuses on the first and key element of a mitigation strategy – how best to ensure GHG emissions are priced to reflect the damage they cause.

This chapter focuses on the principles of policy and, in particular, on the efficiency, equity and public finance implications of tax and tradable quotas. Chapter 15 follows with a detailed discussion of the practical issues associated with the implementation of tax and trading schemes.