How to price carbon in good times … and bad!

Abstract

Emissions trading systems and carbon taxes are two market-based policy instruments for responding to the climate change externality. This article focuses on the relationship between the design of these carbon pricing instruments and business cycle fluctuations. In particular, whether and how these instruments should respond to business cycles is a topical policy question. To answer it, the article brings together the relevant empirical and theoretical results from the academic literature. It finds that building responsiveness into the design of carbon pricing instruments can reduce the burden of regulation by distributing it more evenly over time. Specifically, relative to a fixed cap emissions trading system, this can be achieved by relaxing the cap during economic expansions and tightening it during recessions. Similarly, a carbon tax regime in which the tax is higher during expansions, and lower during recessions, is likely to improve welfare compared to a cyclically unresponsive tax. In practice, a mechanism which renders real-world carbon pricing instruments responsive is a challenging task. The article provides an overview of the trade-offs involved by focusing on the broad classes of mechanisms explored in the literature. The choice of responsiveness-inducing mechanism must crucially consider country characteristics such as the properties of fluctuations in the country's GDP and emissions, any relevant political economy concerns and its institutional background.

Overcoming public resistance to carbon taxes

“…Note that this may imply renouncing to allowing the carbon tax rate to fluctuate depending on the business cycle, although this type of flexibility might be welfare improving (cf. Doda, 2016).…”

Institutional Change and Environment: Lessons from the European Emission Trading System

“…Now, given the difficulty of implementing these instruments in practice, his analysis focused on the so-called "pure" instruments. In recent years and within the framework of climate policy, contributions focused on the analysis and improvement of carbon pricing instruments have gained special interest [48]. Thus, some studies raise intensity objectives, so that the policy decisions are conditioned to observable economic indicators [49][50][51][52][53].…”

A price on warming with a supply chain directed market

“…Policymakers and researchers are concerned about an ETS's ability to flex in response to economic shocks [48]. Doda [49] wrote, "A well-designed system can prevent prices from falling too low during a recession and so maintain the abatement incentive, or from overshooting in a boom and excessively constraining production by regulated firms precisely when they are at their most productive. " Such flexibility seems unnecessary in general.…”