The HEC Research Centre for Grand Challenges held a Practice and Research Seminar on 16th March 2023. Duncan Pollard and Sébastien Houde debated our current corporate and economic approaches to climate change. They concluded that our current market-based solutions have come to an important junction. Here they explain how we got to where we are, their challenges, and what be done to improve upon them.
For more than forty years, economists have argued in favor of market-based instruments, namely carbon pricing, to address climate change. In the nineties, the first cost-benefit analysis of the climate problem[1] recommended a small but steadily increasing global carbon tax, the economic dream. Fast forward to 2023, 23% of world greenhouse gas (GHG) emissions are covered by some carbon pricing schemes with a price ranging from 0.50 to 138 USD/tCO2eq.[2] It is tremendous progress. Europe has certainly been a leader in demonstrating that a comprehensive broad-based carbon pricing scheme could succeed in achieving emission reductions across multiple international jurisdictions. The first phases of the EU Emission Trading System (ETS) certainly had hiccups but overall the scheme delivered emission reductions at modest, or in fact even positive in some cases, economic costs.[3] More importantly, the EU-ETS was a large-scale natural experiment that delivered crucial lessons about the promises and pitfalls of carbon pricing.
The EU-ETS can play an important role in helping European countries achieve their net-zero targets. The main advantage of this policy instrument is that the overall quantity of emissions is capped. Regulators can then adjust the cap over time so that the net quantity of GHGs is zero by a certain date. The main disadvantage of this approach is that regulators do not know the equilibrium carbon price under a certain cap. Regulators, firms, and consumers are averse to large carbon prices, but also to volatility. Mechanisms have thus been put in place to avoid large variations and cap the maximum price, so-called price ceiling mechanisms. In practice, this means that if the net zero target becomes difficult to attain, the price signal will be muted, which will make it even more difficult to steer the economy toward net-zero. For Europe, the question about the feasibility of net-zero is thus directly linked to the political acceptability of letting the EU-ETS prices reach high level.
For other jurisdictions, especially among the largest world emitters, such as the United States and China, the question is more fundamental. Will market-based instruments play a central role at all in steering those economies toward deep decarbonization? The coordinated adoption of broad-based carbon pricing schemes seems unlikely. The political momentum has lost steam. If those countries are serious about achieving net-zero by 2050, they will have to rely on a collection of micro-climate policies, some of which might be market-based instruments. But the economist’s dream of sending a clear price signal to all corners of the economy by having GHGs priced is rapidly fading away. There is a myriad of reasons that explain how we got there. As an environmental economist, let me repent about our sins.
Carbon pricing is regressive. Lower-income households allocate a larger share of their income to energy services. The pass-through of carbon prices on energy prices thus represents a larger burden on them relative to richer households. For emerging economies, it would also be unfair to constrain their growth due to carbon pricing whereas today’s major economies have enjoyed a century-long growth propelled by fossil fuels with little constraints on how much they should burn. Carbon price regressivity is a serious problem, but one with a plethora of solutions. The failure of environmental economists is not in our lack of solutions. It is that we did not take regressivity as seriously as economic efficiency. We are now playing catch-up. This is only recently that our work on climate policy design has accounted for citizens’ views and understanding.[4]
Carbon pricing is complex. Whether it takes the form of a tax or a cap-and-trade, multijurisdictional carbon pricing schemes are a feast for lawyers, political scientists, and lobbyists. This also means that they bring substantial risks related to compliance and enforcement. The EU-ETS is a case-in-point. A little design mishap with respect to the treatment of the VAT on inter-country permit trading led to a multi-billion fraud. As of today, the amount of this fraud could even be larger than the economic value of the emission reductions achieved since the inception of the EU-ETS.[5] Sunk costs and lessons learned! Some might say. For detractors of market-based instruments, this is a proof of the excess of the market. Questions related to compliance and enforcement are also economic ones. Environmental economists are keen on working out beautiful theoretical model where profit maximizing firms interact with each other. The role of weak institutions and potential nefarious actors taking advantages of institutional weaknesses are, however, rarely part of our formal analysis. In practice, those forces are important and can lead to large welfare losses.
Moving forward, arguing that firms’ and households’ voluntary actions could lead to a net zero world is simply naïve. Arguing that carbon pricing is the only solution is, however, equally naïve. The lack of pollical accessibility due to the perceived regressivity, combined with political complexity makes it unlikely that we will be able to deploy such a solution in time and at the right scale.
Corporate engagement on climate change only got going around 1999/2001. That period saw the formation of WWF Climate Savers, the launch of the Greenhouse Gas Protocol, and the creation of the Climate Disclosure Project (Now CDP). From then on, awareness and pressure to tackle climate change gradually built, but it was only from 2015 onwards that the emphasis of corporate efforts shifted from energy savings (with consequent GHG savings) to GHG reductions as a primary outcome.
2018 was a turning point. The IPCC brought out its 1.5° report and it was immediately clear that a 1.5° limit was completely different to the previously de-facto 2° limit. For those companies who had been making serious efforts on energy and GHG reduction for a decade or so, this was a serious undertaking. It meant halving emissions by 2030; halving again by 2040; keeping going to 2050, and finally compensating for those really hard to abate emissions by removing CO2 from the atmosphere. Thus the idea of Net Zero got traction.
Companies have embraced ‘Net-Zero’ enthusiastically. By putting significant efforts into removing carbon from the atmosphere, primarily through tree planting and soil management. Or by promoting carbon capture & storage and hydrogen as a primary fuel source. All these measures avoid difficult decisions about existing business models and their suitability for a world living beyond its means.
In parallel to Net Zero we have seen the uptake of the Science-Based Targets Initiative (SBTi) as a solution. Initially championed by a few from 2015 onwards, after 2019 the uptake of SBTi became almost exponential. But this is where it all gets a bit murky. The SBTi does not provide enough public information to understand the impact that can be expected by companies that it has assessed as meeting its standard. This is made worse by the combination of different start dates, science models and emission scopes. There is also a paucity of real data on scope 3 emissions, especially in land use. As someone close to the process remarked to me a few years ago, science-based targets should rather be named speculation-based targets. Its not clear then what impact the SBTi efforts are having.
It is clear that there are very serious efforts being made across the corporate world, and many well-intentioned efforts, and yet it feels like Net Zero and Science Based Targets have become an elaborate charade. The reality is that many multinational companies still rely upon incomplete data, models and assumptions. And existing business models.
Living on a finite planet does mean that eventually we need an economic model that does not depend upon perpetual growth. At some point reducing energy consumption (at least in the global minority of wealthy countries) and non-beneficial production will be needed to limit damaging heating. The IPCC has recently included reduced energy consumption in its AR6 report, mentioning degrowth in the main report, even if the term was not used in the summary for policy makers. It’s easy to write that the solution is a change to the economic system such that we are less dependent upon growth and ever-increasing energy consumption. But that is politically unacceptable for the global minority that determine the course of the global economy, even if it may be democratically acceptable for the global majority. So for the foreseeable future we are stuck with current business models linked to todays economic models. What seems more realistic is for a different simpler solution to emerge. Such as eliminating fossil fuels. This would deliver more immediate impact and is easier for Governments, consumers and investors to understand.
Duncan Pollard, Sébastien Houde
[1] See the work of William Nordhaus, 2019 Nobel laureate in economics, with the DICE model. Nordhaus, William D. Managing the global commons: the economics of climate change. Vol. 31. Cambridge, MA: MIT press, 1994.
[2] World Bank’ Carbon Pricing Dashboard: https://carbonpricingdashboard.worldbank.org/
[3] Martin, Ralf, Mirabelle Muûls, and Ulrich J. Wagner. “The impact of the European Union Emissions Trading Scheme on regulated firms: what is the evidence after ten years?.” Review of environmental economics and policy (2016).
[4] Dechezleprêtre, Antoine, Adrien Fabre, Tobias Kruse, Bluebery Planterose, Ana Sanchez Chico, and Stefanie Stantcheva. Fighting climate change: International attitudes toward climate policies. No. w30265. National Bureau of Economic Research, 2022.
[5] Betz, Regina, Axel Michaelowa, Paula Castro, Raphaela Kotsch, Michael Mehling, Katharina Michaelowa, and Andrea Baranzini. The Carbon Market Challenge: Preventing Abuse Through Effective Governance. Cambridge University Press, 2022.
One Response
What a great article !