Only a carbon tax offers material incentives to ensure emission reductions.

3.1.1. The simple case for a carbon price. Following Pigou (1920), the vast majority of economists think that one cannot do without a sizable carbon price, despite its unpopularity.17 Carbon pricing applies the polluter-pay principle.18 Pricing has been shown to substantially alter behavior for other pollutants as well as carbon emissions. For example, the United Kingdom substantially reduced its CO2 emissions from the electricity sector almost overnight following the imposition of a carbon price floor (around €21/tCO2) in 2013 on top of the EU ETS price (which remained under €10/tCO2 between 2013 and 2018). This led to the phasing out of coal electricity generation, whose contribution to the UK electricity mix fell from 40% to 5% between 2013 and 2018 (Leroutier 2022). Before the energy crisis, it was estimated that a carbon price around €35–40/tCO2 sufficed to induce a switch from coal to natural gas, which pollutes half as much. The impact of the Swedish carbon tax, introduced in 1991 and equal to €114/tCO2 in 2021, has been meaningful as well.19

It is appealing to dream that emissions reductions might take place spontaneously without need for material incentives (another illustration of motivated beliefs), but history shows otherwise: Hitting economic decision makers where it really hurts, namely in their wallets, changes their behavior and unleashes innovations that can solve challenging problems.

A carbon price has at least five virtues:

1. It encourages those who can eliminate their pollution at a relatively low cost to do so. For example, a recent estimate shows a cumulative emissions reduction of 4–6% for a $40/tCO2 tax covering 30% of emissions in the European Union, with a low impact on employment and growth (Metcalf & Stock 2022).

2. It boosts green innovation. By monetizing the intellectual property associated with green R&D, it allows startups to receive financing from private investors and to reach the necessary scale.

3. It requires measuring emissions (which is not always straightforward) but no other information, and thus it reduces bureaucratic red tape and discretion relative to other methods of reducing pollution.

4. It is simple, in that it empowers consumers to act for the climate as the price they pay for a product captures the cost of all emissions along the value chain (they otherwise need detailed information if they want to make an informed choice; see Section 4).

5. Although this is not its purpose, it generates fiscal revenues that can be used to compensate certain categories of economic agents or to fund the green transition, for example.

3.1.2. Determination of the carbon price. How should the carbon price be set? Under the Pigouvian approach, the price of 1 ton of CO2 should be equal to the discounted value of the flow of damages it generates. There exists no consensus among economists about how large this Pigouvian carbon price should be (Rennert et al. 2022). Indeed, this approach raises issues related to the estimation of these damages, the treatment of deep uncertainties, and the choice of the discount rate (Pindyck 2017). For these reasons, most constituencies have targeted a quantity rather than a price, for example, by capping emissions allowances on carbon markets. International negotiations have been designed to generate commitments on emissions reductions. In this context, the carbon price must be interpreted as the shadow price of the carbon budget constraint.

According to the sixth report of the Intergovernmental Panel on Climate Change, “the current central estimate of the remaining carbon budget from 2020 onwards for limiting warming to 1.5°C with a probability of 50% has been assessed as 500 Gt CO2, and as 1150 Gt CO2 for a probability of 67% for limiting warming to 2°C” (IPCC 2022). In the absence of uncertainty, compliance with this carbon budget can be easily achieved by mirroring the implementation of the carbon budget for Europe20 through the volume of EU ETS allowances. The carbon price then results from market clearing: Those who find it too costly to reduce their pollution can purchase an allowance from those who hold unused allowances.21 This quantity-setting approach ensures that the objectives are met: If countries abide by it, there is no more pollution than planned to meet the COP 21 target. If banking of allowances is allowed, and if the political authority is credible about the intertemporal carbon budget, the timing of the auction of allowances is irrelevant: The market will efficiently determine the current level of emissions and the speed at which they will be reduced.