This chapter sheds light on the role of carbon pricing as a key decarbonisation policy. It provides a general estimate of how strongly carbon prices reduce emissions. In addition, the chapter describes two practical examples of significant increases in effective carbon rates that were soon followed by a strong decline in emissions: First, the carbon price support in the United Kingdom, then the increase in emission permit prices in the European Union Emissions Trading System between 2018 and 2019.
Effective Carbon Rates 2021
Pricing Carbon Emissions through Taxes and Emissions Trading
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OECD Series on Carbon Pricing and Energy Taxation
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2. Carbon pricing works
Abstract
Carbon pricing is a very effective decarbonisation policy. Carbon prices make low- and zero- carbon energy more competitive compared to high-carbon alternatives, and reduce emissions. Carbon prices encourage emitters to find and use economical ways of cutting emissions. By increasing the price of high-carbon energy, carbon prices reduce demand for carbon-intensive fuels (Arlinghaus (2015[7]); Martin et al. (2016[8]). In addition, strong commitment to carbon prices creates certainty for investors that it pays to invest in the use of available zero- and low-carbon technologies and the development of new ones.
Using OECD (2013[3]; 2016[2]) data, Sen and Vollebergh (2018[9]) estimate that a EUR 1 increase in the effective carbon rate leads to a 0.73% reduction in emissions over time. This means that, for a country that starts from no carbon price at all, the introduction of a carbon tax of EUR 10 per tonne of CO2 on its entire energy base would be expected reduce emissions by an estimated 7.3%.1
One practical example is the carbon price support in the United Kingdom, which increased effective carbon rates in the electricity sector from EUR 7 per tonne CO2 to more than EUR 36 between 2012 and 2018. Emissions in the electricity sector in the country fell by 73% in the same period (UK Department for Business, 2020[10]), showing a strong response of UK utilities to higher effective carbon rates.2 The higher carbon rates in the electricity sector made it profitable for utilities to replace coal with natural gas, which is about half as emission-intensive as coal per unit of energy, and zero-carbon renewables. Overall CO2-emissions in the United Kingdom decreased by 27% of which 24 percentage points were due to cleaner electricity generation (UK Department for Business, 2020[11]).
Another practical example concerns the European Union Emissions Trading System (EU ETS). From 2018 to 2019, permit prices in the EU ETS increased by EUR 8.90 per tonne CO2, from about EUR 16 to EUR 25 (ICAP, 2020[12]). At the same time, overall emissions in the EU ETS decreased by 8.9% (Marcu et al., 2020[13]), illustrating a significant short-term response of emitters covered by the EU ETS to higher permit prices.3 The emission decrease was particularly strong for the electricity generation sector with 13.9% (Marcu et al., 2020[13]). Owners of power plants have to buy emission permits for all emissions of their plants. In the industry sector, where the vast majority of emission permits is allocated to facilities for free, emissions fell by 1.8% (Marcu et al., 2020[13]). Free permit allocation implies that the effective average carbon rate that accounts for free allocation, and which is decisive for the ranking of investment projects with similar outputs but different carbon-intensities, is substantially lower than the effective marginal carbon rate that does not take the amount of free allocation into account (see Box 4.1 for a more in-depth explanation).
References
[1] Arlinghaus, J. (2015), “Impacts of Carbon Prices on Indicators of Competitiveness: A Review of Empirical Findings”, OECD Environment Working Papers, No. 87, OECD Publishing, Paris, http://dx.doi.org/10.1787/5js37p21grzq-en.
[8] ICAP (2020), International Carbon Action Partnership (ICAP) - ETS Prices, https://icapcarbonaction.com/en/ets-prices (accessed on 13 October 2020).
[9] Marcu, A. et al. (2020), 2020 State of the EU ETS Report, ERCST, Wegener Center, BloombergNEF and Ecoact.
[2] Martin, R., M. Muûls and U. Wagner (2016), “The Impact of the European Union Emissions Trading Scheme on Regulated Firms: What Is the Evidence after Ten Years?”, Review of Environmental Economics and Policy, Vol. 10/1, pp. 129-148, http://dx.doi.org/10.1093/reep/rev016.
[4] OECD (2016), Effective Carbon Rates: Pricing CO2 through Taxes and Emissions Trading Systems, OECD Publishing, Paris, https://dx.doi.org/10.1787/9789264260115-en.
[3] OECD (2013), Taxing Energy Use: A Graphical Analysis, OECD Publishing, Paris, https://dx.doi.org/10.1787/9789264183933-en.
[10] Perino, G., R. Ritz and A. van Benthem (2019), “Understanding Overlapping Policies: Internal Carbon Leakage and the Punctured Waterbed”, NBER Working Paper Series, No. 25643, NBER, Cambridge, http://www.nber.org/papers/w25643.ack (accessed on 11 April 2019).
[5] Sen, S. and H. Vollebergh (2018), “The effectiveness of taxing the carbon content of energy consumption”, Journal of Environmental Economics and Management, Vol. 92, pp. 74-99, http://dx.doi.org/10.1016/J.JEEM.2018.08.017.
[7] UK Department for Business, E. (2020), Digest of UK Energy Statistics (DUKES) 2020, UK Department for Business, Energy & Industrial Strategy, https://www.gov.uk/government/statistics/digest-of-uk-energy-statistics-dukes-2020 (accessed on 13 October 2020).
[6] UK Department for Business, E. (2020), Updated energy and emissions projections: 2018 - Projections of greenhouse gas emissions and energy demand from 2018 to 2035., UK Department for Business, Energy & Industrial Strategy, https://www.gov.uk/government/publications/updated-energy-and-emissions-projections-2018 (accessed on 13 October 2020).
Notes
← 1. The new tax will increase the price of carbon-intensive fuel, but at a level of EUR 10 per tonne of CO2 the overall price increase is moderate. For example, heating oil prices will increase by about 4%, assuming that the country also levies a standard VAT rate of 15% on energy products and that pre-tax heating fuel prices correspond to average levels in the EU 28 as of 26 November 2018.
← 2. While the higher effective carbon rates reduced emissions in the United Kingdom, some of these additional emission reductions may have been counteracted by an increase in emissions in other countries that are part of the European Union Emissions Trading System (EU ETS). However, limited transmission capacity between the United Kingdom´s and the European Mainland´s electricity grids puts a limit on simultaneous shifts of carbon emissions from the United Kingdom to other countries in the EU ETS. The additional emission cuts in the United Kingdom may thus have rather increased the intake of emission permits into the Market Stability Reserve (MSR) of the EU ETS than increased emissions outside the United Kingdom. For a detailed analysis of how policies accompanying the EU ETS affect emissions over time see Perino et al. (2019[30]).
← 3. This recent example from the EU ETS illustrates the effectiveness of carbon pricing by considering the carbon price elasticity, i.e. how much do emissions change, when the carbon price increases. The mechanisms that underlie the observation of an increase in carbon prices and a corresponding decline in emissions are complex. Annex A makes a short attempt to reveal some important mechanisms behind the increase of permit prices and reduction of emissions.