Lighting the Way: Toward a Sustainable Energy Future

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  • 4.3 The importance of market signals

    Although few specific policy recommendations can be ventured at an international level, certain policies are likely to have widespread applicability. Efficiency standards and building codes have been implemented cost-effectively in many industrialized countries. The knowledge gained there can be emulated and improved upon to help moderate energy demand growth in rapidly industrializing economies. Subsidies that distort energy markets, particularly when they do so in ways that favor increased fossil-fuel consumption, should be reduced and reformed; instead energy prices should reflect, to the maximum extent feasible, environmental and other externalities.

    The point is critical: without market incentives to prompt different behaviors and investment decisions, policies that focus solely or primarily on voluntary reductions in greenhouse gas emissions and technology R&D are unlikely to promote change on a scale commensurate with the environmental challenge at hand. Opinions vary as to the level of price signals that are warranted, but many experts believe that a price on the order of US$100–150 per ton of carbon equivalent emissions (in other widely used units, US$27–41 per ton of carbon dioxide equivalent emissions) may be necessary to overcome current cost differentials for many low- and non-carbon technologies and to stimulate the large-scale changes that will be required to eventually stabilize atmospheric concentrations of greenhouse gases. The two policy options that are most frequently proposed to address climate concerns are energy or carbon taxes and cap-and-trade programs; important features of each approach are discussed in Box 4.1.

    It is important here to emphasize, however, that establishing in every market that there eventually will be an emissions price—in the range of US$100–150 per avoided metric ton of carbon equivalent (US$27–41 per ton of carbon dioxide equivalent)—is more important than establishing exactly the number of years in which such a transition will occur. For many countries, pragmatic considerations are likely to argue for a phased and multi-pronged approach, wherein an initial carbon price signal is gradually increased over time and complemented by other policies to address remaining market barriers and accelerate the commercialization of more efficient, lower-carbon technologies. Complementary policies, such as appliance and building standards and air pollution control requirements, can likewise be introduced slowly but inexorably. By making resistance from entrenched stakeholders begin to appear futile, this approach can effectively stimulate innovation and reduce transition costs. In sum, given that the world’s energy infrastructure includes many long-lived, capital-intensive assets, it would be extremely expensive and probably infeasible to transform that infrastructure overnight. But for precisely the same reason, policies that allow for continued expansion of carbon-intensive energy systems are also unwise and—as climate-related policies are introduced—will also prove costly. Thus, the process of initiating change must begin soon.

    Box 4.1 Reducing emissions:

    Taxes vs. cap-and-trade programs Carbon taxes and cap-and-trade programs are the two market-based regulatory options most often advanced for limiting greenhouse gas emissions. Both options are well-suited to situations where there are a large number and variety of emissions sources that must be regulated and where the opportunities for mitigation are similarly diverse and characterized by a wide range of costs. Indeed, the salient argument in favor of either approach is precisely that they rely on market forces to produce emissions reductions at the lowest marginal cost and without relying on policymakers to identify the optimal set of technology pathways.

    The carbon tax recommended by neoclassical theory is one that accurately reflects the environmental damage or ‘externality ’ associated with each ton of emissions and that therefore produces the socially optimal level of emissions. That is, society as a whole will spend only as much to reduce emissions as those reductions are worth in terms of avoided damages. A carbon tax would have the effect of raising prices on fossil fuels in proportion to their carbon content and—assuming properly functioning markets—should stimulate users of fossil fuels to reduce their consumption wherever it is cheaper to do so than to pay tax.a The cost of a tax policy is transparent and known in advance. What is not known in advance is how much emissions abatement will occur in response since this depends on the cost and magnitude of mitigation opportunities available throughout the economy. Another noteworthy feature of a carbon tax is that it generates revenues for the government that could be used for other socially productive purposes.

    Monetizing the environmental damages associated with carbon emissions is a necessary, albeit difficult, first step. Even where this is done, however, there is abundant evidence to suggest that markets will respond only imperfectly to a carbon price signal. For reasons discussed in Chapter 3, cost-effective energy- efficiency opportunities are routinely overlooked by large corporations and individual consumers alike, and new technologies often face barriers to entry that are not strictly a function of cost. Carbon or energy taxes have proved politically unpalatable in some countries— notably the United States—though they have been accepted more readily elsewhere.

    A carbon cap-and-trade system functions, in many ways, like a tax. The recent experience of the European Union, which has created a market for carbon with values in the realm of US$100 per ton through a cap-and-trade-type program for large industrial emitters of carbon dioxide, provides a useful, realworld example of how this approach can work in practice. In principle, the mechanism is simple: government requires that each ton of emissions be accompanied by a permit and then constrains the quantity of permits available to emitters. As with a tax, this approach effectively raises the price of fossil fuels and—provided permits can be freely traded—stimulates the lowest cost emissions reductions. In addition, some cap-and-trade programs provide for ‘offset credits ’ to stimulate mitigation activities in sectors not covered by the cap. Companies will use permits only when the cost of doing so is lower than the cost of avoiding emissions. Like a tax, a cap-and-trade program can generate revenues if government chooses to auction permits, although past programs of this type have typically allocated most permits for free to regulated entities.b

    The key difference between the two approaches is that, under a tax, costs are known but final emissions are not. By contrast, under a cap-and-trade program, final emissions are known (assuming requirements are enforced, they are determined by the cap) and costs are uncertain. In theory, a tax could be adjusted to achieve a desired emissions goal. Similarly, it is possible to design a cap-and-trade system that improves price certainty by building in a ‘safety valve ’—essentially a promise that government will sell additional permits and allow emissions to rise above the cap if the market price of permits exceeds a certain threshold. The latter approach may be attractive in situations where political considerations favor a cap-andtrade approach but there are also significant concerns about cost and competitiveness.

    a Additional provisions might be necessary under a tax-based system to recognize emissions avoided by carbon capture and sequestration. A tax rebate, for example, might be used to accommodate this form of mitigation.

    b Giving permits for free to regulated entities may seem to ‘mask ’ the cost impacts of a cap-and-trade program, but in practice both policies will raise energy prices and generate revenues. In a cap-and-trade program with a free allocation those revenues simply go to the recipients of permits, rather than to the public treasury.