As recent events have shown, putting a price on carbon is no easy task. A host of issues must be addressed to ensure the viability of a comprehensive climate bill, including competitiveness and leakage concerns. Competitiveness questions primarily concern the impact that a carbon pricing policy has on industry output, employment, and profits. Leakage concerns tend to reflect two main components, the first being the desire to keep firms (and hence jobs) from shifting production to countries with less stringent carbon pricing policies. The second is the desire to prevent negative impacts on the environmental integrity of a cap-and-trade program that would result from carbon emissions increasing abroad from this shift in production.
There are two primary tools for dealing with these issues: output-based rebates and a border carbon adjustment. While the general idea of either is fairly simple, how effective each is at preventing adverse competitiveness and leakage impacts is not as straightforward. Fortunately, there are a number of researchers around the world examining these policies and their interplay with the cap-and-trade policies that could develop in the coming years around the world.
RFF recently gathered researchers from the United States, Canada, the EU, and Japan who are currently studying these policies. The goal was to provide a forum for discussing research results and for exploring some further topics for consideration. With the conference spanning several days, many issues were covered but in the course of the dialogue a few interesting themes cropped up:
Allocation design has important economic consequences. Not a surprise right? Of course, but for some more specifics, it was generally found that full auctioning is the most efficient way of allocating permits provided revenues are used to lower distortionary tax rates (here ignoring the political feasibility of full auctioning). Grandfathering was generally found to be the least efficient approach.
Output-based rebates help to mitigate short-run adverse impacts of a carbon pricing policy. The idea here is that setting a price on carbon is going to have the most adverse impacts at the inception of the policy because it is more difficult for firms to adjust production processes to reflect this new higher-cost reality. By establishing output-based rebates you can help mitigate some of the early shock to industrial output that could occur in the U.S. at the start of the program.
Time horizons matter for assessing the impacts of carbon pricing policies. In the near term the effects are likely to be more severe than the medium and long term, as firms change production processes and new technologies are developed.
Emissions leakage can occur from two main sources. The first is through the direct reallocation of production abroad. The second occurs when a country that is large enough to influence the world price of an energy commodity enacts a policy that will lower demand for the fuel in question. Here the lower demand that results from the carbon pricing policy lowers the world price and, as a result, raises the quantity demanded abroad.
And effectively dealing with these two different sources of emissions leakage requires two different approaches. To deal with firms leaving the country, some form of output-based rebating or a border carbon adjustment is necessary. In order to deal with the increase in emissions that could result from lower world fuel prices, the only real way to effectively deal with that is to get the world on board in establishing carbon prices.
Find a full summary of the workshop here.
