Exploring Local Carbon Policy

Although the distribution of carbon reduction pledges in the Paris Agreement is roughly in line with the local social cost of carbon (LSCC), the magnitude of those pledges is largely insufficient to achieve the Agreement’s goals.

All regions of the world do not — and will not — experience the effects of CO2 emissions in the same way. Some will suffer greatly from the resultant climate change, while others may even benefit. These heterogeneous effects mean that different countries will have differing incentives to abide by the 2015 Paris Agreement, a climate change treaty meant to limit global warming below 2°C relative to pre-Industrial levels.

These differing incentives also complicate a classic economic tool to influence behavior: taxes or pricing. Do you want to reduce smoking? Increase cigarette taxes. Do you want to encourage home buying? Provide tax breaks. People respond to incentives, and price is a key incentive. In the case at hand, if you want to reduce carbon emissions to a desired level, tax their output accordingly. However, given the heterogeneous effects of CO2 emissions, what are the incentives to impose carbon taxes across different locations of the world? How are these incentives related to actual pledges in the Paris Agreement? What are the implications of these pledges for aggregate temperatures and the economies of different regions across the globe?

This novel research examines these questions by employing a spatial integrated assessment model that the authors developed in recent work¹ to determine a local social cost of carbon (LSCC). This allows the authors to address the challenge of linking heterogeneous climate effects with appropriate local action. Very briefly, the authors find the following:

• Most people would oppose a policy that simply imposes carbon taxes such that the carbon price everywhere is equal to the social cost of carbon. In other words, just as there is no single cost of carbon that applies to every region of the world, there is also no single tax that would appeal to all people.
• Setting carbon taxes to achieve the Paris Agreement’s goals would mean rates that most, if not all, countries would consider exorbitant and untenable, exceeding $200 per ton of CO2 in some scenarios. The authors consider such a policy so unrealistic that they question the feasibility of the 2°C target itself.
• Necessary carbon taxes to achieve Agreement goals would involve very large inter-temporal transfers, or differing effects across generations. Asking people to pay a high price today so someone can reap the benefits at a lower cost in 100 years, in other words, is not an easy political sell. When future generations are valued almost as much as the current one (including the effect on growth), the resulting welfare gains are small, but negative for most of the developed world. They turn positive when the elasticity of substitution between clean energy sources and fossil fuels is larger, or when this substitution is easier.

Bottom line: Increasing the elasticity of substitution between energy sources is essential to making required carbon policy among heterogeneous regions more palatable.

Originally published by Energy Policy Institute at the University of Chicago

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Working Paper: Local Carbon Policy

We study local carbon policy to address the consequences of climate change. Standard analysis suggests that the social cost of carbon determines optimal carbon policy. We start by using the spatial integrated assessment model in Cruz and Rossi-Hansberg (2021) to measure the local social monetary cost of CO2 emissions: the Local Social Cost of Carbon (LSCC). Although the largest welfare costs from global warming are concentrated in the warmest parts of the developing world, adjusting for the local marginal utility of income implies that the LSCC peaks in warm and high-income regions like the southern parts of the U.S. and Europe, as well as Australia. We then proceed to study the effect of the actual carbon reduction pledges in the Paris Agreement and the progress they can make in implementing the expressed goal of keeping global temperature increases below 2°C. We find that although the distribution of pledges is roughly in line with the LSCC, their magnitude is largely insufficient to achieve its goals. The required carbon taxes necessary to keep temperatures below 2°C over the current century are an order of magnitude higher and involve large implicit inter-temporal transfers. Increasing the elasticity of substitution across energy sources is important to reduce the carbon taxes necessary to achieve warming goals.

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Originally published by Energy Policy Institute at the University of Chicago.