Carbon pricing doesn't have to be taxing

Carbon pricing has come under increasing pressure over the past 12 months amid affordability concerns, allegations of state overreach, and opposition parties using the issue to drive a wedge between voters. The outcome has been delays, proposals to slow the rate at which emissions must decline, and in some cases, even outright cancellation.

It doesn't have to be this way. How should governments respond to growing disquiet among their citizens over the impact of carbon pricing?

First off, lets quickly recap the theory as to why carbon pricing is so effective. The economist Arthur C. Pigou argued that a carbon price should be set at the Social Cost of Carbon (SCC), internalising the net economic damage resulting from CO2 emissions. This would incentivise consumers to switch away from carbon intensive goods and services and firms to increase their supply of low carbon alternatives.

A Pareto optimal carbon price occurs when it's impossible to make any one person better off without making at least one other person worse off. Pareto’s theory relies on a series of optimal conditions being in place that enables market participants to efficiently converge on the point at which welfare is maximised (see The Carbon Laffer Curve).

In reality, this is rarely if ever possible.

In response, governments seek to increase the publics acceptance of carbon pricing through various complementary policies, also referred to as revenue recycling. These include compensating the losers directly (uniform or targeted cash rebates), green spending (earmarking revenue for climate aligned projects), or some combination of the above.

No climate dividend

Economists have tended to favour uniform cash transfers, recognising that it is likely to maximise perceptions of fairness and any associated political benefits, while also not discouraging energy efficiency. Most studies suggest that the majority of households are likely to receive more in rebates than they pay out through higher prices. This should - in theory at least - create a groundswell of support for carbon pricing.