Is Climate Neutrality Possible Based on Carbon Pricing?

Questions & Answers

Interview with Prof. Dr. Sebastian Rausch

Professor Sebastian Rausch, head of the ZEW Research Department “Environmental and Resource Economics, Environmental Management”, in an interview on greenhouse gas emissions in market-based systems.

Fighting climate change is an enormous challenge. To avert potentially catastrophic global warming the EU intends to become climate neutral by 2050. Among other measures, carbon pricing is anticipated to play a key role. In this interview, Professor Sebastian Rausch explains how greenhouse gas emissions can be reduced in market economies.

Prof. Dr. Sebastian Rausch explains in an interview how greenhouse gas emissions can be reduced in market-based systems.

What is the potential impact of carbon pricing?

In market economies, prices have important coordinating and incentive functions. Prices provide information about scarcity and the value of goods and services. In the same way as any price, a carbon price has the potential to influence economic behaviour and guide decision-making. Carbon prices remind economic actors that the atmosphere is a scarce commodity, and they influence market behaviour accordingly.

How well does the current European Emissions Trading System (ETS) function?

Seen solely from the perspective of emissions reductions, the ETS has been a success story to date. The objectives set for reducing emission have been met and the cost burden for firms has stayed relatively small. From a long-term perspective, however, low certificate prices have been a target of criticism. To date, price levels have not been high enough to stimulate innovation and investment, which are necessary to meet long-term objectives. In the second trading phase, for example, prices remained quite low over many years. As a result, reforms were implemented to increase certificate prices. The current phase includes a Market Stability Reserve that uses a rules-based approach to keep the volume of emissions certificates within a predetermined range. This mechanism will need to be further developed in the future. Clearly, an emissions trading system must be able to respond to changing market conditions while also offering reliable price signals and a sound basis for long-term planning.

What is the aim of the carbon border adjustment?

Free trade between countries can thwart the effectiveness of ambitious climate policy if measures are only implemented in certain countries or regions. If the EU proceeds with climate protection and levies a high carbon price on European firms, in the long term, these firms will shift production to locations where emissions cost nothing. For this reason, the EU is considering underpinning its climate protection policy through a carbon border adjustment. The idea is that the EU could soon impose a carbon tax on the importation of certain goods to its economic area, specifically targeting importation from countries with less stringent climate policy standards.

Does introducing a border adjustment of this kind entail any problems?

On the one hand, a border adjustment only combats one part of the ‘carbon leakage’ problem that results from companies shifting their production of carbon-intensive goods abroad. Another shift in emissions occurs through changes in prices and the demand for fossil fuels in the global energy markets. If a large region reduces its demand for oil, gas, and coal, this lowers prices in global markets. Lower prices make it cheaper for other countries to burn fossil fuels. The resultant rise in foreign emissions may eat up any reductions in domestic emissions. Another problem is that a carbon border adjustment must include a consideration of the differences in CO2 prices between different countries that already have carbon pricing. Otherwise, there is the risk of assigning different prices to imported and domestic emissions. Differences of this kind would create disincentives for foreign firms while also distorting competition. A fundamental problem is that a carbon border adjustment would only reflect national differences in carbon pricing. As we know, climate policy is much more wide-ranging: even an optimally designed border adjustment mechanism would be incapable of levelling distortions to competition that might result from regulatory interventions, such as standards for renewable energy in the power sector.