Oil prices have gone down in recent weeks from the peak reached in mid-summer, but they are still much higher than at the beginning of the decade. With high oil and coal prices, there are stronger incentives to use less fossil fuels. Alternative energies become financially more attractive. These developments can bring about reductions in greenhouse emissions and contribute to mitigate climate change. But it all can go away if the price of oil comes down substantially. So we could seize the opportunity of high oil and coal prices to lock-in these incentive effects on climate change mitigation. This could be achieved by introducing an internationally harmonized floor to the user cost of emitting carbon by using oil and coal. To implement this floor, a variable carbon levy could be enacted by a group of participating countries. The levy would kick in if and when the price of oil and coal were to fall below a pre-agreed threshold. No additional costs would be imposed on anyone above those already being paid now. And this would create certainty to guide consumers and investors in their behavior and resource allocations towards less greenhouse gases emitting activities
The remaining of this post elaborates on this idea. First, it explains why policies to reduce emissions are likely to result in increases in the cost of emitting ? and why this is actually efficient and desirable from an economic and environmental point of view. Second, it discusses the recent increase in the price of oil in light of estimates of the impact that climate change mitigation policies would have on the price of oil. Third, and finally, it outlines and justifies a proposal for a floor to the user cost of emitting carbon by using oil at $90 per barrel, concluding with a series of questions and issues that would merit further discussion and reflection.
With Effective Mitigation Policies, Greenhouse Gas Emissions Are Likely to ? and Should ? Become More Costly
Helping the world face the climate challenge in an efficient and equitable way is one of the top priorities for the United Nations as often underlined by Secretary General Ban Ki-moon. Earlier this year in Bali and in late August at Accra, parties to the UN Framework Convention on Climate Change (UNFCC) moved forward the negotiations towards a strengthened and effective climate change deal. Much of the details remain under negotiation. But the parties to the UNFCC recognized in Bali that deep cuts in greenhouse gases global emissions will be required to stabilize our climate.
There are several ways of imposing a reduction in emissions. At the national level, command-and-control policies (technology standards, quotas, and other quantity constraints) are commonly used to control pollution. Market-based instruments, relying either on tradable permits or taxation, are also used, even though more sparingly. In the context of climate change mitigation, the policy debate has focused mostly on market-based instruments. In the end, climate change mitigation policy will probably encompass a portfolio of measures, but any effective outcome will have to result in lower and more costly greenhouse gases emissions.
An increase in the cost of emitting is also desirable. Currently, activities that result in greenhouse gases emissions are undertaken without taking into account the depletion of our planet’s ability to absorb these emissions. As this capacity is depleted, the concentration of greenhouse gases in the atmosphere goes up and our planet’s climate changes. We are imposing the costs of climate change on the world’s current and future generations, but nobody is yet paying for them.
From a normative point of view, these social costs of emitting greenhouse gases need to be added to the current costs of economic activities that result in emissions. Therefore, there is broad agreement in the policy community discussing climate change that ?carbon? and carbon equivalent heat trapping gases should have a ?price? emitters pay so that the full social costs are taken into account in the various economic activities that result in emissions. When we drive our cars or use our air conditioners, the price we pay for gasoline or electricity should reflect the cost of our emissions.
Pricing carbon will ensure that the structure of incentives for various economic activities reflects the damage that we do to our planet when we emit greenhouse gases, which will make investments to adopt and develop alternative, carbon-free sources of energy, much more attractive. When we switch to wind or solar energy, what we pay relative to fossil fuel based energy should reflect the fact that these new alternative sources of energy will help reduce the pace of global warming.
In particular, the cost of using oil and other fossil fuels, the use of which is responsible for about 65 percent of total greenhouse gases emissions, will likely go up with strong mitigation policies of the type currently being discussed. Given that today’s economies are heavily dependent on oil, coal and natural gas for transportation and producing energy (electricity, heating), the impact on the likely increase in the cost of using fossil fuels due to measures to reduce greenhouse gases emissions has been a source of political and economic concerns.
But the world has been handed an unprecedented opportunity to assuage these concerns. The price of oil and coal exploded since 2000. The average price of barrel of oil in 2000 was about $35 while during the first half of 2008 it reached $125 (in today’s prices). It has gone down lately, hovering around $100 (still two and half to three times more, in real terms, than in 2000). Similarly, the price of a metric ton of coal increased from an average of $34 in 2000 to $118 in the first half of 2008 (again, in today’s prices). The world is now paying for oil and coal much more than would have been the case if even the most ambitious climate change mitigation policies had been put in place.
The increase in oil and coal prices is providing the type of incentives to curb emissions that climate change policy is intended to achieve. People and firms are adjusting to the new reality of high oil prices by curbing demand ? except where subsidies keep the domestic prices from changing in line with the international price. Alternative sources of energy are becoming more attractive financially. Of course, the increase in prices has been challenging for many oil-importing countries. But it is important to bear in mind that, as noted, effective mitigation policies to reduce emissions would likely lead to increases in the price of using oil, a situation to which these countries and the world community are now adjusting.
Therefore, there is now a unique opportunity to address climate change. We have so far failed to be ambitious enough, perhaps in part because of the concerns with potential increases in the cost of using oil and coal. But we can now turn things around. We can use the increase in the price of oil and other fossil fuels as an opportunity to drive climate change mitigation policy forward. We can do it in a way that locks-in the incentives to change behavior and invest in new carbon-free technologies without actually increasing anybody’s cost over what we are already paying.
But How Much Should Greenhouse Gas Emissions Cost ? and How Does This Compare with the Recent Increase in Oil Prices?
Estimates of the optimal carbon ?price? (that is, the price that would capture the marginal social costs associated with climate change damages) have had a broad range. In part, this reflects the underlying uncertainty on the scale and timing of the long-term catastrophic outcomes of climate change. The wide range also depends on assumptions about long-term economic growth, technical progress, the extent present well-being is valued more than the distant future (time preference), and geographical as well as sectoral coverage.
A truly ambitious climate change mitigation policy in line with the EU and G8 long term mitigation goals has been estimated to require a carbon price in the $150-$350 range a ton (in 2008 prices) for the beginning of the next decade. Divide by 3.7 if referring to carbon dioxide rather than carbon. Efficiency would require a global ?price? covering all carbon. Equity and political feasibility will require a more differentiated approach. This ?price? would rise slowly over time.
An explicit carbon ?price? would add to the actual price of oil. The burning of a barrel of oil leads to an emission of about 0.12 tons of carbon. So if a carbon ?price? in the range of what is estimated for meaningful reductions were to be implemented in the first years of this decade, it would come on top of the carbon cost already implicit in the price of crude at that time.
But, as noted, the price of crude oil, along with coal, exploded since 2000, rising more than three-fold in real terms. So this increase in the price of oil to about $120 has an effect similar to a carbon ?price? of about $700 a ton imposed in the year 2000 when the oil price was about $35 a barrel (again, all in 2008 prices). If crude oil and close substitutes were the only causes of global warming, the increase in the oil price over the last few years could be expected to solve much of the carbon pricing problem over the next decade at least, assuming the price stays at the levels reached in the first half of 2008.
There are, of course, other sources of global warming such as methane released in agriculture and changes in net emissions due to deforestation. A high price of oil and coal is also not as efficient in dealing with the carbon problem as a direct price of carbon. Importantly, there is no guarantee that the alternatives to fossil fuels that will be sought do not themselves contribute to emissions ? for example, the impact of biofuels on greenhouse gases emissions is now being reassessed. Carbon capture and storage technology for coal fired power plants will not be encouraged just by a high price for coal: what matters in that context is the actual price of carbon itself. Nonetheless it is clear that the barrel of oil at $120 or so with equivalent pricing for coal and other close substitutes, including natural gas, would have long term effects on carbon emissions in many sectors equivalent to a very high carbon tax added to the oil at $35 a barrel of some years ago. This would help steer the world economy on to a much more sustainable low carbon growth path.
Seizing the Oil Price Opportunity: Committing to Locking-in the Incentives to Mitigate Greenhouse Gases Emissions by Adopting a Price Floor to the User Cost of Oil
Thus, the current level of oil prices offers the world economy an unprecedented opportunity to deal with the climate change challenge. The price of oil has gone down substantially since the peak reached in July of this year, but it is still more than three times ? in real terms ? what it was in 2000. So primary energy prices remain high today, which means that we could lock-in a substantial carbon price incentive without actually increasing anybody’s cost over what they are already paying (except in countries where there are massive energy subsidies).
We could lock-in this price incentive simply by making a credible and therefore legally binding commitment to introduce an internationally harmonized floor to the user cost of carbon. This floor could be supported in the form of a variable carbon levy to be enacted by participating countries. The levies would kick in if and when the price of oil were to fall below, say, $90 a barrel, and they should then also be applied to coal.
Why $90 a barrel? A $90 price already represents a cost increase of about $450 per ton of carbon compared to the year 2000, a higher implicit carbon ?price? than that estimated by many ambitious mitigation models. The $90 oil price at which the carbon pricing measures would kick in reflects a personal assessment of political feasibility.
Initially not all countries would participate, and putting a floor on the cost of carbon at this high level would reduce the pace at which it will have to be increased later. Note that no actual levy would be needed unless the price of crude fell below $90. The levy would be variable so as to put a floor under the user cost ?as if? the cost of oil always remained at $90 a barrel. The carbon levy would then rise slowly over time irrespective of the oil price. The rate of increase could be revised every 5 years by a small amount in light of new information about technology and other factors. In a decade or so we would have an ?unconditional? carbon tax, which is the long-run objective.
Such a policy commitment would still allow room for some short term decline in the cost of oil and relief for consumers and industries, but it would ?lock in? a cost of carbon that would encourage the reduction of its use and greatly encourage new ?clean? technologies such as solar, wind and truly environment friendly biofuels from lignocellulosics, for example, as well carbon capture and storage technologies. No matter what actually happens to the price of oil, a steady rising floor price, or more correctly, user cost on which investors can rely and which consumers know is permanent, would be an extremely powerful instrument to help steer the world economy on to a sustainable growth path.
One particular important and interesting sub-topic for further work relates to the international distributional consequences of the type of policy proposal here. Note that the fact that not all countries would immediately participate does not pose a big political or trade problem, since the initial variable carbon levy would be very small. It would grow over time, but over time a much wider participation would become politically more feasible. One very important point is that it would not be able to unleash the kind of substantial financial flows from the private sector to developing countries that have hoped for in the context of international cap-and-trade schemes. But it must be realized that very high fossil fuel prices if they persist will act as tariffs making quotas worthless and therefore clearly undermining the potential for such resource flows: the ?caps? will not be the binding constraint if energy prices are very high. Over time revenues from the growing carbon levy can be used for development purposes.
Many details would have to be worked out, of course. How could one extend this user cost floor to other sources of carbon? What would countries do with eventual revenues? How many countries would participate and when? How to treat existing differences in gasoline taxes? How could such an approach best work in tandem with some sectoral cap-and-trade schemes? The figures would have to be firmed up.
Today’s high primary energy prices constitute an unprecedented opportunity to introduce the durable price incentive signal that could revolutionize the nature of our growth and do so without incurring the prohibitive short term internal and international political costs that were preventing such a move in the past. It is an opportunity we should not miss.
Photo © UNDP
