Dr Baran Doda explains the findings of his latest report, ‘How to price carbon in good times… and bad’ published  by the Grantham Research Institute on Climate Change and the Environment at London School of Economics and Political Science. The report was  sponsored by the Global Green Growth Institute. 

As the world economy slowly recovers from one of the longest and most severe global slowdowns in history, interest in how economic fluctuations interact with climate change policy is growing.

This interest comes off the back of a recession that exposed the shortcomings of existing carbon pricing instruments – namely, their inability to respond to economic shocks.

A prominent example is the response of the carbon price in the European Union emissions trading system (EU ETS), which fell dramatically following the 2008 financial crisis, partly as a result of a reduced demand for emissions permits. The price has since remained too low due to a lack of responsiveness in the system, providing little incentive for companies to reduce emissions.

The EU ETS was designed with little regard for the potentially disruptive effects of business cycles on prices, especially during downswings in economic activity. So when the price of carbon in the EU ETS plummeted in the recession, regulators were unable to do much. Today the price of carbon remains low and shows no sign of recovering any time soon, severely undermining the effectiveness and credibility of the system.

The European Union has so far removed 900 million emissions permits temporarily from the EU ETS – a process known as backloading – in response to the lower demand. However, this action was only taken after more than a year of negotiation among policy-makers and politicians, and arrived several years after the onset of the recession.

So how should carbon be priced around the world to maintain appropriate emissions reductions incentives in good times and in bad?

Creating responsive systems

Crucially, carbon pricing instruments should be responsive. Cap-and-trade systems in which the ‘cap’ moves together with the level of economic activity can improve climate change policy by allowing higher greenhouse gas emissions during times of economic expansions and lower emissions during recessions. Regulation allowing greater emissions in years of above normal economic growth need not affect overall climate change mitigation, since the increase is compensated for in years of below normal economic growth.

This trade-off is possible over an extended period of business cycles, when there are both booms and recessions, because climate change damages are related to the stock of accumulated emissions in the atmosphere, rather than how much is emitted each year.

Retrofitting old systems

These recommendations do not just apply to systems that are yet to be designed and implemented. Existing carbon pricing instruments designed with a fixed ‘cap’ or tax rate could be retrofitted to respond to economic shocks. When combined with an appropriately selected long-term target, responsive carbon pricing schemes provide better incentives to reduce emissions in times of boom and bust alike.

The findings of the report fall in line with a recent proposal to establish a market stability reserve for the EU ETS.

Furthermore, new emissions trading systems being set up around the world – such as one due to be launched in South Korea shortly, and pilots in six regions of China – should incorporate lessons learned from the problems experienced by the EU ETS.

While retrofitting is always an option, building the responsiveness mechanism into the system from the start is preferable to adding it on at a later date. Retrofitting can create uncertainty about the system’s core design features, undermining its credibility and the predictability of outcomes.

Reducing carbon price volatility

Raising and lowering the ‘cap’ within a cap-and-trade system according to economic conditions could also reduce volatility in the price of carbon, provided the rules implementing responsiveness are well designed.

Moreover, it is important that regulation applies to as large a group of emitters as possible, ideally to the world as a whole. Broader coverage reduces the inefficiencies arising from different carbon prices by pooling the volatile and imperfectly correlated economic shocks that affect different sectors and countries.

Efforts to reduce volatility in the price of carbon are particularly relevant for developing countries. Fluctuations in developing countries are typically more volatile, more persistent and less predictable. Therefore the gains from having carbon pricing instruments that are responsive to economic fluctuations are likely to be of greater benefit.