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[REFLEXIONS] The challenges of decarbonizing the global economy

04 Jun. 2023
According to the latest IPCC report, greenhouse gas emissions between 2010 and 2019 represent 80% of the "carbon budget" that humanity still has left before exceeding the 1.5°C target set by the Paris Agreement. In order to preserve this budget, we need to transform the global economy and change consumption behaviors that are the most damaging to climate. But decarbonizing technologies and processes does not come without a price tag. So what measures should be put in place to encourage private-sector players to invest in the technologies needed to decarbonize the global economy?
[REFLEXIONS] The challenges of decarbonizing the global economy

From carbon tax ... 

The question of how to remedy the negative externalities associated with pollution is not a new one. As early as 1920, British economist Arthur Cecil Pigou proposed the implementation of a tax designed to align the interests of polluters with those of the community. This tax, proportional to pollution, is intended to be equivalent to the damage caused to third parties. Its revenues can be used to compensate stakeholders or to finance the state budget. The Pigouvian tax encourages polluters to invest in reducing the pollution they cause. It also impacts the selling price of the products that cause pollution, sending a price signal to consumers. 

It is this very reasoning that justifies the introduction of taxes on tobacco or alcohol, with the aim of reducing demand while financing prevention policies. In France, the idea of a tax on fossil fuels proportional to emissions was rejected twice, in 2000 and 2010, before finally being adopted in 2014. The price of a tonne of CO2, the yardstick against which all greenhouse gas emissions are measured, will gradually rise from €7 when it was first introduced to €44.60 today.

... to carbon markets 

In fact, instead of assessing the long-term economic impact of greenhouse gas emissions, the approach is to set a price for the CO2 needed to achieve a given emissions target. Much has been written about estimating such a price, but in reality, it is often the market that sets it. 

As early as the 1997 Kyoto Protocol, the idea of an emissions trading scheme emerged. The principle is simple: emitters exceeding a critical size sufficient to absorb the associated administrative costs must buy as many "pollution permits" - the famous carbon quotas - as they emit greenhouse gases. As a result, governments no longer need to set a price: all they need to do is set a maximum quantity of admissible emissions. This has the advantage of providing an economic model for technologies that contribute to decarbonization. 

As Nicolas Mottis, Professor at Ecole Polytechnique - IP Paris, points out, "putting a price on carbon is a powerful incentive for innovation. This price acts as a penalty, making comparatively profitable renewable or energy storage technologies, which are crucial to the energy transition."   

In principle, therefore, these markets send a price signal to consumers and manufacturers, so that they can collectively find a way to comply with a CO2 emissions limit. The total number of allowances is gradually reduced from year to year, to give industries with long-term expenditure commitments time to adapt, without destabilizing the economy.  As Ekaterina Ghosh, a student in the Economics for Smart Cities and Climate Policy master's program at Ecole Polytechnique (IP Paris) points out, "this system has the advantage of enabling states to plan the decarbonization trajectory of their economy".

Carbon markets around the world 

According to a note by I4CE (Institute for Climate Economics), on April 1, 2020, "44 countries and 31 provinces or cities representing 60% of global GDP had an explicit carbon price (carbon tax or allowance market)".  

In Europe, the European Emission Trading System (EU-ETS) has been in place since 2005 and is gradually being extended. While prices, at around ten euros per tonne until early 2017, struggled to send out a strong signal, a market reform followed by the Covid and energy crises caused prices to rise above €100 in February 2023. This volatility creates uncertainty for the industry, which needs to make long-term investments. In addition, global carbon prices, whether derived from markets or taxes, show huge geographical disparity, from a few dollars to the €100 peak reached on the EU-ETS.  

In addition to the permits issued by various jurisdictions to industry, a number of systems enable companies and individuals to finance projects to reduce CO2 emissions, and generate carbon credits that can be traded, either voluntarily or on a compulsory basis. Organizations such as the Gold Standard Foundation audit and certify emissions reductions achieved by both for-profit and not-for-profit projects, by connecting them with companies likely to finance them, in line with the Clean Development Mechanism framework set out in the Kyoto Protocol.

Challenges and limits  

One of the challenges facing the carbon economy is data accuracy and reliability (this problem is addressed in the article on green finance). Ekaterina Ghosh points out: "The current trend is to impose carbon reporting obligations on a growing number of economic players, who will be demanding reliable data not only on their own activities, but also on those of their suppliers and subcontractors (indirect impacts). This will require new collaborative methods and new tools".  

As far as quota systems are concerned, while they provide theoretically optimal financial incentives, they do raise a number of practical questions. They can encourage companies to relocate their production, weakening the economies of the countries that set up these quotas. This is why the European Union allocates free quotas to the most polluting industries, to protect them from unfair competition from non-European companies. This preserves the incentive to reduce emissions, but removes the price signal sent to the consumer. Adopted in December 2022, a "border adjustment scheme" should soon enable imported products to be taxed according to their carbon content, and taxes on exports to be reduced, so that free quotas can eventually be genuinely abolished. Philippe Drobinski, professor at Ecole Polytechnique - IP Paris and director of the Energy4Climate Interdisciplinary Center of Institut Polytechnique de Paris - says: "This is an appropriate response, which addresses distortions of competition and acts in favor of transition, even if it is unfortunate that it only concerns certain sectors for the time being."  

Putting a price on carbon, whether through a tax or tradable allowances, is not without raising questions of social justice, such as those raised by the yellow vests: when consumers are captive, is it fair to make them pay a tax? Also, if we take the example of emissions offsetting through tree plantations, beyond the controversies over the effectiveness of the process, isn't this equivalent to monopolizing low-cost lands in developing countries for the benefit of the airline industry in developed countries? 

These schemes alone are therefore not enough, and require effective international coordination. The carbon accounting standards used are also essential to ensure a real impact. Together with many other initiatives, such as subsidies, research funding, regulations and standards, they can contribute to the energy transition and its financing.

Energy transition, carbon tax and markets, green finance, civil society involvement, climate action is multifaceted. Find out more about these themes during the REFLEXIONS conference which will take place on June 9 on the campus of Institut Polytechnique de Paris.