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A policy framework for achieving negative emissions

Summary:
Economists’ recommended policies for dealing with climate change have an Achilles’ heel that could flare up within a few decades.  If we are to limit warming to internationally agreed-upon targets such as 1.5 or 2 degrees Celsius, global emissions need to not just to be zeroed out over the next decades but to become negative (e.g. Clarke et al. 2014, Rogelj et al. 2015, 2018, Hilaire et al. 2019, Realmonte et al. 2019).  If that happens, the world will actually be pulling more carbon out of the air than it puts in, for instance by chemically separating carbon from ambient air (‘direct air capture’).  But economists’ favourite policies cannot make negative emissions happen without massive government spending.  Fortunately, it doesn’t have to be this way. Economists almost

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Economists’ recommended policies for dealing with climate change have an Achilles’ heel that could flare up within a few decades.  If we are to limit warming to internationally agreed-upon targets such as 1.5 or 2 degrees Celsius, global emissions need to not just to be zeroed out over the next decades but to become negative (e.g. Clarke et al. 2014, Rogelj et al. 2015, 2018, Hilaire et al. 2019, Realmonte et al. 2019).  If that happens, the world will actually be pulling more carbon out of the air than it puts in, for instance by chemically separating carbon from ambient air (‘direct air capture’).  But economists’ favourite policies cannot make negative emissions happen without massive government spending.  Fortunately, it doesn’t have to be this way.

Economists almost universally recommend pricing carbon emissions as the most effective way of limiting climate change (e.g. Metcalf 2009, Klenert and Hepburn 2018, van der Ploeg and Rezai 2018, Metcalf 2019, Schlögl and Schmidt 2020, Stavins 2020). They suggest that this price be implemented as a carbon tax (as in British Columbia) or via a market for tradable emission permits (as in the EU Emission Trading System and several US states).  By increasing the cost of emissions from zero, carbon prices incentivise firms and consumers to substitute towards lower-emission inputs and products, to adopt existing ways of reducing emissions, and to develop new ways of reducing emissions.

But carbon emission taxes or caps cannot induce total emissions to be negative.  Once total emissions are zeroed out, these policies do not impose costs on firms or consumers and thus provide no incentive to undertake additional carbon removal.  Directly subsidising carbon removal (in effect, allowing a negative carbon price) would overcome this limitation, but the scale of the required subsidy could be enormous, exceeding even the share of US output spent on defence (Bednar et al. 2019).  The ideal policy framework would not depend on maintaining such a high level of government spending.

Can a market-based policy incentivise negative emissions without requiring government spending?  In a new paper, I propose a new type of policy called ‘carbon shares’ that does exactly as well as conventional carbon pricing policies in efficiently limiting emissions and raising revenue, but goes further in also efficiently incentivising negative emissions (Lemoine 2021a).  Further, whereas standard policies require substantial information on the part of the government to figure out the proper tax or cap on emissions (Gollier 2021, Lemoine 2021), this new policy requires only simpler calculations that could be updated annually in a similar way to GDP and inflation estimates.

Under this policy, each emitter must post a bond per unit of carbon and in return receives an asset, called a carbon share, attached to the unit of carbon.  The emitter can choose whether to retain or sell its carbon share.  Initially, the face value of the carbon share is the bond.  In each subsequent period, the regulator pays a dividend to the holder of the share and deducts both that dividend and a damage charge from the face value of the share.  If the owner of a share ever removes the unit of carbon attached to it, then the owner receives the remaining face value and the share is retired.  No revenue needs to be raised from taxpayers when the bond is set properly. Instead, revenue is generated for public coffers through the damage charges.  

A carbon share is an option to recover the remaining face value, with the strike price being the cost of carbon removal and dividends paid in the meantime.  This option is valuable.  This policy therefore converts past emissions into a valuable asset that investors want to own, whether or not the original emitter continues to exist.  That valuable asset is financed by the bond posted at the time of emission, but as I will discuss shortly, that bond does not distort emission incentives.

I show that the optimal policy sets the initial bond equal to the worst possible damage that current emissions could impose over time (i.e. the worst-case ‘social cost of carbon’) and sets each period's damage charge equal to the damage incurred in the same period.  The dividends return the difference between an updated estimate of the worst-case damages and the previous estimate.  The shareholder thus receives substantial dividends if climate change turns out to impose small costs and few dividends if climate damages turn out to be large.  Shareholders remove their carbon in order to recover the stream of future damage charges that would otherwise be lost to the regulator.  They therefore weigh the cost of carbon removal against the expected remaining harm from leaving that unit of carbon in the atmosphere, as required for first-best carbon removal.  We have priced the decision to leave carbon in the atmosphere!

And we have not lost the price on emissions so heavily focused on by traditional economic analyses.  Emitters pay the worst-case social cost of carbon, but they receive a valuable asset in return.  I solve for the value of this asset and find that emitters’ net outlays are equal to expected damages from additional carbon over all future time (the expected ‘social cost of carbon’), as required for first-best emissions.

Carbon shares can be seen as a dynamic deposit-refund scheme, with the bond being the deposit and the refund varying annually based on whether realised damages were as bad as they could have been.  Because the refunds are typically only partial refunds, emitters are incentivised to reduce emissions in order to avoid putting down the deposit in the first place.  And rather than bet on future refunds, shareholders can recover whatever is left of their deposit by paying to remove carbon.  

The damage charge is the critical variable that policymakers need to set each period.  Importantly, it is much easier to calculate this variable than to calculate the optimal emission tax or cap.  Calculating the optimal emission tax or cap requires projecting the many possibilities for damages from additional carbon emissions in all future years (Gollier 2021, Lemoine 2021b).  In contrast, the carbon share policy's damage charges can be grounded in whatever losses were realised this year.  A policymaker could combine the estimated costs of realised weather events with attribution studies of how climate change altered the weather events' probability in order to determine this year’s damage charge.  These damage estimates could be calculated and released regularly, similarly to GDP and inflation estimates.

I quantitatively assess the benefits of the proposed policy within a conventional economic model of climate change.  I find that the bond need be only double what the year 2015 emission tax would have been in order to be able to fund the ex post optimal series of charges in over 95% of possible cases.  Moreover, by enabling negative emissions, the carbon share policy provides 10% more value in expectation than does an emission tax or cap policy.

Two additional benefits to the carbon share policy are hard to quantify but could be especially important in practice.  First, by establishing a larger market for carbon removal technologies, this policy should accelerate those technologies' development.  If climate damages do end up warranting negative emissions, then innovators should receive a strong signal in the form of high damage charges in advance of those technologies being needed.  By directing innovation, the carbon share policy offers additional insurance against worst-case outcomes.   

Second, the public sector has to date borne both the burden of projecting future climate change damages for emission price calculations and the risk of paying for carbon removal should negative emissions become desirable.  The proposed policy disperses this burden and risk throughout the private sector.  Markets would perform price discovery, with futures and options markets emerging for future damage charges.  Such markets would coordinate expectations throughout the economy and thereby facilitate lending for new removal technologies and installations.  Firms and investors would have an incentive to become educated about future climate risks and to fund new monitoring and modelling systems.  And these investments could in turn mitigate political risk, as improved knowledge of climate impacts may enable more durable and informed climate policy.

The world is still struggling to zero out emissions – or even to reduce emissions at all.  Negative emissions will not happen soon.  It may seem that implementing carbon shares can wait.  However, waiting until we can achieve negative emissions is too late.  It is critical to implement carbon shares early, while we are still emitting the carbon that we may want to eventually remove.  This new policy offers a better tool than the ones policymakers are currently developing and economists are advocating, but that tool works only if today’s policymakers have the foresight to use it now, in preparation for a possible future with negative emissions. 

References

Bednar, J, M Obersteiner and F Wagner (2019), “On the Financial Viability of Negative Emissions”, Nature Communications, 10(1): 1783.

Clarke, L, K Jiang, K Akimoto, et al. (2014), “Assessing Transformation Pathways”, in Climate Change 2014: Mitigation of Climate Change. Contribution of Working Group III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change, Cambridge University Press. 

Gollier, C (2021), “Efficient carbon pricing under uncertainty”, VoxEU.org, 6 April. 

Hilaire, J, J C Minx, M W Callaghan, J Edmonds, G Luderer, G F Nemet, J Rogelj and M del Mar Zamora (2019), “Negative Emissions and International Climate Goals---Learning from and about Mitigation Scenarios”, Climatic Change, 157(2): 189–219. 

Klenert, D and C Hepburn (2018), “Making carbon pricing work for citizens”, VoxEU.org, 31 July. 

Lemoine, D (2021a), “Incentivizing Negative Emissions Through Carbon Shares”, CEPR Discussion Paper 16039.

Lemoine, D (2021b), “Estimating the economic impact of climate change from weather variation”, VoxEU.org, 9 July. 

Metcalf, G E (2009), “Market-Based Policy Options to Control US Greenhouse Gas Emissions”, Journal of Economic Perspectives, 23(2): 5–27.

Metcalf, G E (2019), Paying for Pollution: Why a Carbon Tax Is Good for America, New York: Oxford University Press.

Realmonte, G, L Drouet, A Gambhir, J Glynn, A Hawkes, A C. Köberle and M Tavoni (2019), “An Inter-Model Assessment of the Role of Direct Air Capture in Deep Mitigation Pathways”, Nature Communications, 10(1): 1–12.

Rogelj, J, G Luderer, R C Pietzcker, E Kriegler, M Schaeffer, V Krey, and K Riahi, (2015), “Energy System Transformations for Limiting End-of-Century Warming to below 1.5 °C”, Nature Climate Change, 5(6): 519–27.

Rogelj, J, D Shindell, K Jiang, S Fifita, P Forster, V Ginzburg, C Handa, H Kheshgi, S Kobayashi, E Kriegler, L Mundaca, R Séférian, M V Vilariño (2018), “Mitigation Pathways Compatible with 1.5ºC in the Context of Sustainable Development,” in Global Warming of 1.5°C, An IPCC Special Report on the Impacts of Global Warming of 1.5°C above Pre-Industrial Levels and Related Global Greenhouse Gas Emission Pathways, in the Context of Strengthening the Global Response to the Threat of Climate Change, Sustainable Development, and Efforts to Eradicate Poverty.

Schlögl R and C Schmidt (2020), “Making the European Green Deal really work”, VoxEU.org, 23 November.

Stavins, R N (2020), “The Future of US Carbon-Pricing Policy”, Environmental and Energy Policy and the Economy, 1(January): 8–64.

Van der Ploeg, R and A Rezai (2018), “How to deal with climate change deniers: Price carbon!”, VoxEU.org, 5 January.

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