Josephine V. Yam

Designing Carbon Pricing: Questions that Policymakers Should Address

In its 2012 publication entitled "Fiscal Policy to Mitigate Climate Change: A Guide for Policymakers", the International Monetary Fund (IMF) stated that revenue-raising carbon pricing is the instrument that effectively addresses climate change. It noted that carbon pricing can either be in the form of carbon taxes or cap-and-trade systems with allowance auctions. What is crucial is that it is well-designed in terms of comprehensively covering emissions.

Thus, in designing carbon pricing legislation, the IMF suggested that policymakers give due consideration to the following questions:
  • How strong is the case for carbon pricing instruments over regulatory approaches (e.g., standards for energy efficiency or mandates for renewables)? How do carbon taxes and cap-and-trade systems compare? What might be some promising alternatives if “ideal” pricing instruments are not viable initially?
  • How is a carbon pricing system best designed in terms of covering emissions sources, using revenues, overcoming implementation obstacles (e.g., by dealing with competitiveness and distributional concerns), and possibly combining them with other instruments (e.g., technology policies)? How might pricing policies be coordinated across different countries?
  • How should policymakers think about the appropriate level of emissions pricing?
  • How important is inclusion of the forest sector in carbon pricing schemes? How feasible is this in practice?
  • What should be the priorities for developing economies in terms of fiscal reforms to reduce emissions?
  • From the perspective of raising funds from developed economies to fund climate projects in developing economies, what are the most promising fiscal instruments? How should they be designed?
  • What lessons can be drawn from experience with emissions pricing programs, like the European Emissions Trading System (ETS) or the various carbon tax programs to date?

The IMF argued that the choice between carbon taxes and emissions trading systems is generally less crucial than implementing one of them and getting the design details right. What is important is that carbon pricing must comprehensively cover emissions and avoid wasting its revenue potential by granting free allowance allocations in cap-and-trade systems or allocating revenues for unimportant policy outcomes.