Compensating for the cost of carbon pricing emphasizes the benefits of substitution

by Sebastian Wehrle (reFUEL team member)

In recent weeks and months, a lively debate has evolved on the pros and cons of carbon pricing, be it through cap & trade schemes or taxation. While some are questioning whether carbon pricing is reducing GHG emissions effectively, an impressive agglomeration of renowned economists recently reiterated the idea of combining carbon pricing with compensating payments, something that was also advocated in a joint contribution from Johannes Schmidt, Mathias Kirchner and myself.

The effect of carbon pricing is to raise the cost of emission intense activities, such as driving your petrol-guzzler to work or starting up your gas furnace to have a warm and cozy home. Yet, raising the cost of such essential activities would consume a substantial part of the income, in particular of low-income households. The “yellow vests” in France have demonstrated potential impacts of such policies. Thus, economists suggest compensating households for higher cost through payments financed from the proceeds of pricing carbon emissions.

But what is the point of first making something more expensive to purchase and then handing over the required additional money? Wouldn’t that be highly ineffective?

Indeed, Evgeny Slutsky thought about such issues more than 100 years ago. In 1915 he published a cornerstone of modern consumer theory. The Slutsky equation decomposes the effect of a change in a good’s price on demand for this good into a substitution effect and an income effect. The former arises due to changes in relative prices, while the latter reflect the fact that the same income buys fewer goods when price increases. 

In the case of energy and thus emission intense activities, substitution is indeed often rather difficult. Many people depend on their car to commute to work; frequently tenants have no other option than using the pre-installed, emission intense system for heating their homes. Thus, the short-run substitution effect is, quite likely, limited. To be effective at the level of households, carbon pricing would thus have to work through the income effect. Yet, this effect is (hopefully) largely eliminated by compensation payments. So how can carbon pricing be effective?

The important point here is that such a policy does not aim at reducing final energy consumption. Rather it aims at reducing greenhouse gas emissions. And doing so is not limited to households, but also affects producers.

In the short term, carbon pricing works by providing incentives for substitution, mostly on the supply side. For instance, electricity systems nowadays frequently have significant fossil spare capacity as renewable generators keep being added to these systems. Typically, the most emission intense coal or lignite-fired generators have the lowest cost, while less polluting natural gas-fired units are more costly to dispatch. A sufficiently high carbon price can reverse cost-based dispatch in such a system. Besides, the additional cost from carbon pricing will only be partly passed through to consumers.

Even more importantly, a credible carbon price also provides long-run incentives for investment on the supply side and for durable consumer goods on the demand side. When companies decide on investment options, a carbon price changes future revenues in the favor of low emitting technologies. This also helps to avoid lock-in effects arising from continued investment in emission intense technologies with long life times.

In addition, credible carbon pricing also increases the potential gains from innovating low or no emission products, either through raising final demand, e.g. because an innovation enables cost-saving substitution at the level of final consumers, or potential revenues, e.g. because an innovation allows saving costs of production.

Carbon pricing can go a long way even without reducing energy consumption from final consumers. This, however, does not mean that carbon pricing is a panacea. There are good reasons for combining carbon pricing with other, reinforcing polices that foster low or no carbon innovations. Ultimately, we will need to find a sensible mix of policies to mitigate climate change. Carbon pricing is one of them.