The Promise and Problems of Pricing Carbon: Theory and Experience

In a modern economy, nearly all aspects of economic activity affect greenhouse gas – in particular, carbon dioxide (CO₂) – emissions, and hence the global climate.  To be effective, climate change policy must affect decisions regarding these activities.  This can be done in one of three ways:  (1) mandate businesses and individuals to change their behavior regarding technology choice and emissions; (2) subsidize businesses and individuals to invest in and use lower-emitting goods and services; or (3) price the greenhouse gas externality, so that decisions take account of this external cost.

By internalizing the externalities associated with CO₂ emissions, carbon pricing can promote cost-effective abatement, deliver powerful innovation incentives, and ameliorate rather than exacerbate government fiscal problems.  By pricing CO₂ emissions (or, equivalently, by pricing the carbon content of the three fossil fuels – coal, petroleum, and natural gas), governments defer to private firms and individuals to find and exploit the lowest cost ways to reduce emissions and invest in the development of new technologies, processes, and ideas that could further mitigate emissions.  A range of policy instruments can facilitate carbon pricing, including carbon taxes, cap-and-trade, emission reduction credits, clean energy standards, and fossil fuel subsidy reduction. 

Some of these instruments have been used with success in other environmental domains, as well as for pricing CO₂ emissions.  The U.S. sulfur dioxide (SO₂) cap-and-trade program cut U.S. power plant SO₂ emissions more than 50 percent after 1990, and resulted in compliance costs one half of what they would have been under conventional regulatory mandates (Carlson, Burtaw, Cropper, and Palmer, 2000).  The success of the SO₂ allowance trading program motivated the design and implementation of the European Union’s Emission Trading Scheme (EU ETS), the world’s largest cap-and-trade program, focused on cutting CO₂ emissions from power plants and large manufacturing facilities throughout Europe (Ellerman and Buchner, 2007).  The U.S. lead phase-down of gasoline in the 1980s, by reducing the lead content per gallon of fuel, served as an early, effective example of a tradable performance standard (Stavins, 2003).  These positive experiences provide motivation for considering market-based instruments as potential approaches to mitigating greenhouse gas emissions.