Efficient pricing of past and future CO2

Curated by Derek Lemoine (University of Arizona),
edited by Adrian von Jagow (E-axes Forum)

Economists have long called for pricing carbon emissions, ideally at the price that matches the social costs it inflicts. Such a tax was first discussed 100 years ago by Arthur Pigou. One obstacle to its wide-spread implementation has been lack of information about the present and future costs of emitted carbon. Carbon taxes and cap-and-trade schemes already fail at efficiently pricing present costs. And both impose a price only on additional CO2, not on already emitted carbon.

Derek Lemoine (2022), in his NBER working paper “Informationally Efficient Climate Policy: Designing Markets to Measure and Price Externalities,” analyzes a novel market-based instrument that simultaneously measures and controls climate damages. Information about damages is dispersed among agents: a regulator publishes the aggregate costs to output, while emitters privately measure climate impacts in their own sectors. At the time of emission, emitters must post a deposit in exchange for a tradeable “carbon share” but receive regular refunds from the regulator. Like a bond, shares are traded at the price of expected refunds, which are by construction smaller than the value of the deposit, and which vary inversely with traders’ expectations of the regulator’s future damage measurements.

Emitters now have two options to maximize their revenue: they can emit and receive a share (which they can sell), or they can reduce emissions and avoid the deposit.  And shareholders subsequently also have two options: they can do nothing and receive refunds, or they can pay to remove a unit of carbon from the atmosphere in order to recover a carbon share’s original deposit and retire the share. When traders’ private information about climate damages becomes more pessimistic, they depress the carbon share’s market price. This makes emitting less attractive because the value of a newly created share falls, and it makes carbon removal more attractive because the opportunity cost of retiring a carbon share falls.

Using markets to improve estimates of climate damages

The “carbon share” facility combines ideas from environmental economics and the literature studying financial markets’ ability to efficiently aggregate dispersed information.

William J. Baumol (1972), in “On Taxation and the Control of Externalities,” stressed the obstacles to pricing the social cost of externalities and the impossibility of implementing the ideal emission tax from a central planner’s point of view. Likewise, Martin L Weitzman (1974), in “Prices vs. Quantities,” emphasized that only emitters know about their costs to reduce emissions, and have no self-interested reason to share the knowledge with the regulator. Sanford Grossman (1976) in “On the Efficiency of Competitive Stock Markets Where Trades Have Diverse Information,” showed that markets, through prices, can aggregate and thus reveal the piecemeal information possessed by competitive traders.

Political frameworks for efficient pricing

Information requirements have not been the only obstacle to setting Pigouvian taxes. Political arrangements have arguably been the strongest factor. Recent research argues that practical solutions to truly Pigouvian taxation exist. Given the uncertainty and non-linearity of the climate response to emissions, they must price not only future but past carbon emissions, too.

Ottmar Edenhofer et al. (2021), in “Pigou in the 21st Century,” highlight that second-best solutions to the tax rate can be Pigouvian in theory, but they are hampered in reality by uncertainty over the social cost of carbon, distributional concerns, and fragmented government. While most existing carbon taxes reflect the compromise of competing interest groups, efforts to realize true Pigou taxes are gaining momentum.

Johannes Bednar et al. (2019), comment “On the financial viability of negative emissions.” Amid concerns about the feasibility of Paris-aligned emission trajectories, the role of negative emission technologies (NETs) must be reconsidered, they argue. NETs should be understood as a tool to hedge against an uncertain future climate. This implies sooner deployment of NETs to understand their true potential. As the scale of subsidies needed to remove carbon remains unknown, the authors call for alternative tools “enabling transfers from present polluters to future negative emissions.”

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