Carbon Pricing under Political Constraints. Insights for Accelerating Clean Energy Transitions

Jesse D. Jenkins and Valerie J. Karplus


For decades, the economically efficient prescription for the severe consequences of global climate change has been clear: establish a price on emissions of carbon dioxide (CO2) and other greenhouse gases (GHGs) that internalizes the far-reaching external costs of climate change in market transactions (e.g., Nordhaus 1992; Stavins 1997; Stern 2007). In sharp contrast to this prescription, a diverse patchwork of climate policy measures has proliferated, and where CO2 pricing policies do exist, the prices established typically fall far short of the levels necessary to fully internalize the estimated marginal social cost of climate damages.

The failure of governments to establish a pricing (or equivalent market- based) approach to climate change mitigation—or to adequately price carbon when they succeed in doing so—can be largely attributed to a variety of persistent political economy challenges. In particular, climate change mitigation is a global collective action challenge (Olson 1984), demanding coordination among many disparate stakeholders (e.g., nations, emitting industries, individual consumers). Meanwhile, the benefits of climate mitigation are uncertain, unevenly distributed, and accrue primarily to future generations (IPCC 2014), while the costs of climate mitigation are born immediately, with acute distributional impacts for particular constituencies (Burtraw et al. 2002; Bovenberg, Goulder, and Gurney 2005; Rausch and Karplus 2014). Climate mitigation thus has all the hallmarks of an intergenerational principal agent problem (Eisenhardt 1989), with private costs of mitigation out of proportion to the private benefits for many actors. Furthermore, climate policy must be established through political processes, which invoke classic challenges in public choice (Arrow 1970; Black 1987; Buchanan and Tullock 1999; Downs 1957) and are vulnerable to capture by vested interests (Stigler 1971). Voters frequently express limited tolerance for measures that have salient impacts on their private welfare (such as tax or energy price increases) (Kotchen, Boyle, and Leiserowitz 2013; Johnson and Nemet 2010). Industrial sectors with high concentrations of assets that would lose considerable value under carbon pricing policies (e.g., fossil energy extraction, fossil electricity production, fuel refining, concrete production, and energy-intensive manufacturing) have also mounted vociferous and often effective opposition to climate policies. As a result ofthese public choice dynamics, policy-makers tend to support policies that minimize salient impacts on businesses and households, minimize burdens on strategically important sectors, and/or redistribute rents in a manner that secures a politically-durable coalition. In practice, policy-makers have thus preferred command-and-control regulations that are narrowly targeted (and thus allow for regulatory capture while reducing scope for opposition) and subsidies (which allow for transfers of rents while spreading policy costs broadly and indirectly across the tax base), rather than uniformly pricing CO2 (Gawel, Strunz, and Lehmann 2014; Karplus 2011).

These persistent political economy constraints motivate a search for climate policies that are politically feasible, environmentally effective, and economically efficient (Jenkins 2014). As in many other domains of economic regulation, second best (Lipsey and Lancaster 1956) climate policy mechanisms abound. By paying close attention to the distributional impacts of different climate policy instruments and their interaction with potentially binding political constraints, economists, political scientists, and policy-makers can help design climate policy responses that are both palatable enough to be implemented today and economically superior to politically feasible alternatives.

In light of these challenges, this chapter aims to develop general insights about the design of climate policy in the face of binding political constraints. We employ a stylized partial-equilibrium model of the energy sector to explore the welfare implications of combining a CO2 price with the strategic application of revenues to compensate for and/or relieve several potential political constraints on carbon pricing policies. Specifically, we implement constraints of varying severity on: 1) the maximum feasible CO2 price itself; 2) the maximum tolerable increase in final energy prices; 3) a maximum tolerable decline in energy consumer surplus; and 4) a maximum decline in fossil energy producer surplus. Under each political constraint, we identify the CO2 price, subsidy for clean energy production, and lump-sum transfers to energy consumers or fossil energy producers that maximizes total welfare.

This chapter begins by contrasting the range of carbon pricing policies implemented across the world with estimates of the full social cost of carbon (Section 3.2). We then introduce our model formulation and stylized representations of four political constraints that could explain the relatively low carbon prices that have been achieved to date in real world policy-making contexts (Section 3.3). We then present numerical results demonstrating that improvements in total welfare and carbon abatement can be achieved by the strategic application of carbon pricing revenues under each of the four political constraints considered (Section 3.4). Finally, we discuss the implications of these findings for climate policy and ongoing research (Section 3.5).

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