How carbon prices could ensure equitable sustainable development

Effective climate change mitigation measures, such as carbon pricing or reforming fossil fuel subsidies, are often perceived to undermine inclusive economic development and are, thus, rejected. These concerns are ill-founded. In fact, such measures can reconcile the intertwined challenges of sustainable development, help to avoid detrimental carbon-intensive lock-ins and mobilize domestic resources for social safety nets or investments in basic public infrastructure.

[box type=”bio”] Dr. Jan Steckel heads the Working Group “Climate and Development” at MCC Berlin. His research focuses on climate change mitigation in developing and newly industrializing economies. He aims to understand how climate policies can be designed in a socially acceptable manner. He has authored multiple articles in leading academic journals and contributed to international assessment processes, such as the IPCC and UN Environment’s Emissions Gap Report. [/box]

[box type=”bio”] Ira Dorband is a PhD candidate at the MCC Berlin. She focuses on the political economy of climate change mitigation policies in the development context. In her quantitative research, she analyses how carbon pricing policies can be designed to foster equitable development in lower-income countries. Her qualitative work identifies the political obstacles of decarbonization, with a focus on the increasingly coal-intensive energy sectors in South East Asia. [/box]

Economists agree that carbon pricing is the most important policy to limit global warming. However, the majority of global greenhouse gas emissions remains unpriced, or priced at levels that are insufficient to achieve internationally agreed climate targets. Lower-income countries are particularly hesitant to consider meaningful carbon prices as a policy tool to achieve their climate commitments under the Paris Agreement. Often, they fear that climate policy, and carbon pricing in particular, could slow down economic growth. Carbon pricing is also perceived to have regressive distributional outcomes in the medium to long run, affecting low-income households relatively more than high-income households.

At the same time, these countries currently have the fastest growth in greenhouse gas emissions across the globe. This is not only true for prominent examples, such as China or India but also for other newly industrializing countries, such as Indonesia and Vietnam, which are experiencing increasingly carbon- and energy-intensive development paths. Even though starting from very low levels, it is also interesting to note that seven of the 10 countries with the highest emission growth rates in the world are located in Sub-Saharan Africa.

While carbon pricing is mainly discussed in the context of how emissions can be reduced, introducing effective carbon prices is at least as important to avoid investing in carbon-intensive infrastructure in order to avoid infrastructural lock-ins. One salient example is the electricity sector. Many developing and emerging countries continue to invest in carbon-intensive coal to fuel their rapidly growing electricity demand. The coal-fired power plants currently constructed or planned would – when operated until the end of their economic lifetime – consume a large share of the carbon budget still available for limiting global warming to well below 2°C1.

Carbon pricing can help reduce socio-economic inequalities

There is growing scientific evidence that, especially in lower-income countries, carbon prices tend to be progressive and thus eventually reduce income inequality.

A recent meta-analysis, synthesizing the available literature, finds that carbon pricing or fossil fuel subsidy reforms are more likely to have progressive income effects  in lower-income countries, even without using the carbon revenues for compensation measures2. In a similar vein, a recent cross-country analysis3 of more than 80 developing and newly-industrializing countries shows that in most countries, carbon pricing would generally be progressive. As illustrated in Figure 2, across 86 developing and newly industrializing countries, the relative effects of carbon pricing would be progressive in most countries, while the absolute effects of a USD 30 carbon price can still be large for the poorest parts of the population.

Figure 1: Relative (upper) and absolute (lower) income effects of a USD 30 carbon price on low-income groups.

Source: Dorband et al. 20193

How much a household is impacted by increasing carbon prices and how these impacts distribute across income groups depends primarily on energy consumption patterns, particularly on the proportion of expenditures for fossil energy commodities, as well as on the carbon intensity of different sectors. Figure 3 provides an intuition of what might drive distributional outcomes: In most sample countries, the direct consumption of fuels (without electricity) differs most across income groups and, thus, determines the progressive distribution. The impacts of increasing prices for electricity, goods and services are smaller and more evenly distributed. As these consumption patterns shift across income groups when countries become richer, carbon prices are more likely to become regressive as countries get richer.

Figure 2: Average income effect (short-term) of a carbon price (USD 30/tCO2)  by income quintiles (1 poor to 5 rich), decomposed into consumption categories.

Source: own calculation.

These studies do not consider important welfare-enhancing co-benefits of emission reductions, which also tend to disproportionally benefit lower-income households. Not only are poor households more vulnerable to negative climate change-related impacts such as more frequent droughts, extreme temperatures or flooding, they are also more heavily affected by the adverse health effects of air pollution, e.g. stemming from coal-fired power generation or motorized transportation. Hence, poor households would not only be impacted less by carbon pricing, they would also disproportionally benefit from associated emission reductions.

Carbon pricing, poverty and political challenges

Introducing carbon pricing policies has proven to be politically difficult. Protests in Ecuador are just the most recent example of public unrest following attempts to increase carbon prices by cutting fossil fuel subsidies. Such policies can add short-term stress on household incomes, especially when not offset by compensation, progressive or otherwise, of some sort.

Indeed, poor households can be impacted quite strongly in absolute terms under carbon pricing regimes. For example, a USD30/tCO2 carbon price would, at current consumption levels, take up to 3.5% of the poorest households’ income in India or Indonesia, and even up to 5.5% in South Africa (see Figure 1). Note that all three countries have invested heavily in coal in recent years, locking in high emissions for the decades to come.

A full-fledged analysis of poverty effects would require a deeper understanding of how poor households react to increasing prices for fuels. Research in this area is arguably scarce. If, for example, a carbon price led to poor households using more traditional biomass or charcoal, the environmental and health benefits might be jeopardized.

These (potential) impacts on the poor underline the necessity for accompanying compensation measures. Compensation schemes can, for example, target primarily low-income households by strengthening existing social safety nets or introducing targeted cash transfers4. Alternatively, revenues can be used to provide access to basic public facilities, which would directly contribute to the Agenda 2030 goals. In theory, in many countries revenues would suffice to cover the public investment needs to finance the full SDG agenda, including access to clean energy, water, sanitation and education. This is also shown by Figure 35, which indicates the fraction of public investment needs for the SDG agenda that could be financed by carbon pricing in line with the 2°C target.

Figure 3: Financing the SDGs with carbon pricing revenues. Note: Shading indicates that private investment needs are higher in the median country (Swaziland, 42%).

Source: Franks et al. (2018).5

Carbon pricing raises revenues

In this respect, it is important to recall that carbon pricing can raise substantial revenues. Particularly when tax-to-GDP ratios are low, carbon pricing revenues can create fiscal space to increase public investments in line with the Addis Ababa Action Agenda and support delivery of the SDGs as illustrated in Figure 3. Upstream carbon taxes, levied at the few points of entry of fossil fuels to the economy, such as refineries or points of import, are easier to administer and harder to evade than, for example, value added or income taxes. Particularly in countries with a large informal sector, they can increase the efficiency of the tax system by increasing the tax base. They are also less distorting than other taxes on income or imported goods.

For lower-income countries, carbon prices thus offer an efficient policy tool to both avoid detrimental carbon-intensive lock-ins and mobilize domestic resources to fund sustainable development. In many countries, carbon prices can support important development goals of reducing both poverty and inequality as they entail positive effects on income distribution and contribute to wider objectives such as improved health. In addition, revenues can be used to support poorer parts of society. In order to win broad public and political support for carbon pricing, it is indispensable to identify the most vulnerable groups and develop credible compensation measures to support them. Equally important is the need to engage the public in a participatory process of policy design, be transparent around the use of carbon pricing revenues and develop an effective communications campaign.

Further reading:

  1. Edenhofer, O., Steckel, J. C., Jakob, M. & Bertram, C. Reports of coal’s terminal decline may be exaggerated. Environ. Res. Lett. 13, 024019 (2018).
  2. Ohlendorf, N., Jakob, M., Minx, J. C., Schröder, C. & Steckel, J. Distributional Impacts of Climate Mitigation Policies – A Meta-Analysis. DIW Berl. Discuss. Pap. (2018) doi:10.2139/ssrn.3299337.
  3. Dorband, I. I., Jakob, M., Kalkuhl, M. & Steckel, J. C. Poverty and distributional effects of carbon pricing in low- and middle-income countries – A global comparative analysis. World Dev. 115, 246–257 (2019).
  4. Schaffitzel, F., Jakob, M., Soria, R., Vogt-Schilb, A. & Ward, H. Can government transfers make energy subsidy reform socially acceptable? A case study on Ecuador. Energy Policy (forthcoming).
    5. Franks, M., Lessmann, K., Jakob, M., Steckel, J. C. & Edenhofer, O. Mobilizing domestic resources for the Agenda 2030 via carbon pricing. Nat. Sustain. 1, 350–357 (2018).