Why a carbon tax cannot be the only solution to climate change
Economics has always had a fairly straightforward solution to climate change: a carbon tax. If you raise the price of carbon to its socially optimal level, the story goes, carbon emissions will reduce to their socially optimal level. This implies that, from a public policy point of view, we don’t need to overthink climate policy too much. Get the price of carbon right and markets will work their magic and bring carbon emissions down.
And yet climate policy in practice has taken a far more complex path. Many countries do use carbon taxes, but they do so alongside subsidies and state investment, alongside regulations and bans. Governments are now spending huge amounts of money on tackling climate change, placing strict regulations on businesses and telling households they will have to switch away from petrol cars and gas boilers.
Why do countries choose all this complexity when a simple carbon tax might suffice? Is it because climate policy makers lack insight, or politicians lack the will to impose carbon taxes? Or is it because carbon taxes are not, on their own, the right solution?
I think it’s primarily the latter. Carbon taxes can and must play an important role in our journey to net zero, but they will not be enough — not even nearly enough — on their own. As I will set out, climate change is too complex, too fundamental and too politically sensitive an issue to be tackled solely by carbon taxes.
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There are four reasons why I think carbon taxes can’t solve climate change on their own, which I’ll address in turn:
1. The socially optimal level of carbon emissions is (net) zero — we need to eliminate, not reduce, our carbon emissions
2. Net zero requires systemic changes — such as decarbonising and hugely expanding our electricity supply — that are beyond the means of individual tax-paying businesses and households to make alone
3. Carbon taxes may have a limited effect on changing behaviour, because they tend to target price inelastic goods (such as regular fuel purchases) rather than key decisions (such as purchasing cars or heating systems)
4. Carbon taxes seem to be far too politically unpopular to be a climate policy we can rely on
But before I dive into the downsides, let me quickly set out the rationale and the case *for* carbon taxes.
Why do economists propose carbon taxes? Well, carbon emissions are a textbook example of a negative externality. That is, they impose costs on everyone (by warming the planet and changing the climate) which are not paid by the person who emits the carbon. The solution to such externalities is simple: put a tax on carbon emissions, so that the price people pay to emit carbon equals the damage it causes to society.
This concept — known as a Pigouvian Tax — is one of the most elegant and widely endorsed concepts in economics. Aside from its simplicity, its main theoretical appeal is that it should let markets find the most cost effective way to reduce carbon emissions to their “socially optimal” level. Where people can reduce emissions for less than the cost of the tax, they will do so. Where abatement is more costly than the tax, they will keep emitting and pay the tax. There is no doubt it is a good concept: it works to some extent for carbon, and is effective at tackling many social challenges, like air pollution and traffic congestion. We should do more Pigouvian taxes!
And carbon taxes are helpful in many situations. Making petrol and diesel more expensive does improve the financial case for people to buy electric vehicles or ditch their cars altogether. Likewise, raising the price of natural gas would make switching to a heat pump or other low carbon heating system more attractive. As someone who works on expanding the use of heat pumps in the UK, introducing a carbon tax on natural gas would help — but it wouldn’t solve the problem on its own, as I’ll go on to explain.
Carbon taxes will play an especially important role in the hardest to decarbonise areas, such as flying and eating meat. For most aspects of net zero — electricity, transport, heating and so on — there is no question of asking people to consume less; rather, it is about replacing fossil fuel technologies with ones powered by clean energy sources. But for flights, meat, perhaps some industrial processes, we may never develop technology which allows a perfect substitute. In such cases, we will need to use up some of our carbon offset credits — the “net” bit of net zero — if we have them. But alongside that, we will also need to reduce demand — and taxes are probably the best way to do this. So it’s likely we will be able to fly and eat meat in future, but that we’ll have to pay for it and use the proceeds to properly offset the carbon.
Carbon taxes *are* useful and important. We will need them. But my argument is that they’re not enough on their own. Let’s get into the limits of carbon taxes.
1. The socially optimal level of carbon emissions is (net) zero
The logic of carbon taxes is that they reduce carbon emissions to their “socially optimal level”. That means the point at which the cost of extra carbon emissions — the damage they cause to the climate — is equal to the cost of reducing them.
The problem is that, if you follow the climate science, the right level of carbon emissions is (net) zero. Carbon taxes are good at reducing emissions a bit, but it’s much harder to tax something all the way down to zero. You either have to raise the level of the tax to very high levels (see section 4 on political challenges), or you have to make the very hardest bits of abatement quite cheap. Getting to zero via taxes alone would be quite difficult.
One possible counter argument here is to claim net zero is not the right target. Some economists might weigh the costs of climate change against other costs, while discounting the future, and conclude that a certain amount of carbon emissions above zero is desirable. I’m not going to get into a full defence of net zero here — I’m an economist, not a climate scientist — but I think this is one of those occasions where economists need to defer to specialists in other fields (there are of course situations where the reverse is true). Their advice is that we need to reduce emissions to zero as quickly as possible, and the UK and many other countries have quite rightly signed up to follow that advice.
There is also an argument that carbon taxes can interplay with the net bit of net zero. Rather than driving emissions to absolute zero, which would be hard, you can set the tax equal to the marginal cost of removing carbon from the atmosphere — so you still reach net zero, while drawing on the cheapest available ways to do it. I think this would be a very good place to reach by 2050. Net zero will mean having some residual emissions (mainly from meat, aviation and a few other very hard to abate sectors) and we will need to remove carbon to offset them.
The problem is that, on the way to 2050, carbon offsets are much less useful, possibly even damaging. Our ability to remove carbon from the atmosphere is likely to be very limited, even by 2050, so we need to use it as a last resort for very hard to abate emissions. For many sectors — electricity, transport, heat, much of industry — we just need to focus on reducing emissions. Allowing companies or countries to offset instead of reducing emissions in these sectors is likely to delay the action we need now — and ultimately make the transition to net zero more difficult and risky. Carbon taxes and offsets are part of the solution to net zero and will play a big role once we’ve got there, but they can’t get us there alone.
2. Net zero requires systemic changes that are hard for individuals
The basic pathway to reducing carbon emissions over the next decade is roughly this: we need to switch our electricity grid from using fossil fuels to using renewables and nuclear; and then we need to switch our transport, heat and industrial processes from using fossil fuels to using this newly clean electricity. To do this, we need to both decarbonise and massively expand our electricity grid at the same time — all the electric vehicles, heat pumps and electric furnaces will probably more than double our electricity demand. That means vastly expanding both our electricity supply and the grids that move that electricity, it means tackling complex issues like storage and grid balancing, it means dealing with big changes in pricing and the flexibility of electricity use. In short, it is extraordinarily complex — and this is just part of the journey to net zero.
Relying on a carbon tax as your sole lever would mean relying on individual firms and people — and the market — to find the optimal solution. Markets clearly have a critical role to play in net zero, but there are obvious coordination problems here. It is very hard for individual companies to combine to make this whole system work.
Let me give an example from my own little area of expertise: heating. Suppose we put a big carbon tax on natural gas, and as a result many people switch over to heat pumps or (more problematically) direct electric heating. This results in a big surge in electricity demand locally. Can the local electricity grid take this sudden extra load? If not, it could mean blackouts. Likewise, the local gas grid will suddenly have very few users — will the company that owns it survive? And even if it does, how would we deal with the sudden drop in use of this gas network? And this is before we even get onto the question of how the heating industry copes with the switch from gas to electric heating. It’s unlikely to be able to retool production lines and retrain workers so quickly — which will probably lead to supply shortages and massively increased prices of low carbon heating.
All of these challenges — and I’m really only flagging the top level issues, there are many more when you get into the detail — can be tackled with long term coordination. If you treat this transition as a 10 or 20 year process, if you signal direction to everyone in the industry and help them make the switch together, it is a manageable (if challenging) process. This is what the mainstream approach to climate policy looks like. If you leave it solely to individuals and the market, the chance of coordination failures — and of ultimately deciding the whole net zero thing is too difficult — is much greater.
3. Carbon taxes may have a limited effect on behaviour change
As all economists know, price effects work. If you make something (such as carbon emissions) more expensive, people consume less of it. But as all economists also know, the power of price effects varies depending on the price elasticity of different goods. And petrol and natural gas are both examples of price inelastic consumer goods — when the price rises, people only reduce consumption a bit. Why? Because if you already have a petrol car or a gas boiler, you can’t easily switch to an alternative fuel in the short term, and you probably need to keep travelling and heating your home. Carbon taxes generally apply to the price of fossil fuels — and so raising them has a relatively modest impact on their use in the short term.
The time when people’s behaviour can change is when they come to buy a new car or heating system. If they choose to switch to an electric vehicle (or even better an e-bike!) or a heat pump, that has a huge impact on fossil fuel use. Unfortunately, people tend to weight ongoing running costs (i.e., the cost of fuel) less than the upfront cost of new goods — because we discount the future. So putting a tax on the purchase price of petrol cars or gas boilers is likely to have more influence, pound for pound, on people’s carbon emissions than putting one on fuel. A carbon tax does the latter.
All of this was pointed out in Eric Lonergan and Corinne Sawers’ excellent book Supercharge Me, which made the case that if you want a quick, popular transition to net zero, you need to make green choices much more attractive rather than relying solely on carbon taxes.
4. Carbon taxes seem politically unpopular
This isn’t an economic argument, but it’s impossible to ignore: politicians seem very nervous about carbon taxes, particularly on consumers.
Many countries subsidise rather than tax fossil fuels, and attempts to remove these subsidies are often associated with widespread protests. In the UK, protests over a fuel duty escalator nearly brought the country to a halt in 2000 and briefly shook Tony Blair’s government. Natural gas for home heating is exempt from carbon taxes because of concerns about fuel poverty. Applying carbon taxes to these fuels seems to be genuinely politically risky.
This is particularly problematic if you want to raise carbon taxes to the kind of levels needed to drive emissions to net zero (as I set out in section 1). And it also creates a risk over time — even if we succeeded in getting an appropriate carbon tax to cover the whole economy, there is still a risk that future governments repeal it, in the hope of short term political gain.
On one level, this is frustrating — petrol and natural gas should face appropriate carbon taxes, and politicians would ideally be braver, more future-facing and less willing to use these taxes to score political points. But it is also a reality that is hard to see changing. Relying solely on carbon taxes would be a highly risky approach politically, and is another reason why we need other measures besides carbon taxes.
To summarise: this is not an argument against carbon taxes. Carbon taxes are good, important and useful. It is an argument against relying solely on carbon taxes, for a host of reasons. Effective climate policy needs a mix of approaches — including incentives, investment, regulation and long term planning — alongside taxes. Broadly speaking, this is exactly how climate policy looks in the UK and elsewhere. But it would be nice if, every time a difficult policy choice on climate change emerges, we had fewer people saying: “just do a carbon tax instead”. It’s really not that simple.
