The Limitations of Market-Based Mechanisms

Markets Can Nudge, But They Can't Plan

As noted, a carbon price is likely to have positive incentives: for example, a price on carbon will dampen demand for high-carbon coal and make it less likely to be dispatched in price-based electricity markets. Similarly, a carbon price will increase the cost of transportation fuels, potentially increasing demand for efficient transportation and reducing the amount people drive.

These incentives, while positive, will not necessarily lead to the most efficient or effective path to a full-scale transition. For example, a modest carbon price could lead to investments in natural gas, locking in fossil fuels for decades to come. While shifting from reliance on coal to natural gas would reduce carbon emissions in the short-term, it could divert investments away from more sustainable alternatives. And, if we invest in natural gas now but then come to terms with its harm in a decade or two, well before the end of the power plants’ useful lives, having to decommission plants early would lead to "stranded assets" and increase the overall cost of transitioning.^[i]

Moreover, electricity sector investments require considerable coordination. Building transmission for new renewable generators will require extensive planning and coordination with multiple existing and potential generators and, in many cases, interstate coordination. Distributed generation, like rooftop solar, presents new challenges to utilities attempting to manage grid reliability. If and when transportation ends up transitioning from internal combustion to electricity, that will place new demands on the electricity sector and require a nationwide investment in charging infrastructure.

Thus, while a carbon price sends an important signal, it will not necessarily lead to the investments, like renewable energy and associated infrastructure, that are most essential to ultimate decarbonization. And a market price will not generate the utility and cross-sector planning essential to effectively develop and coordinate alternative resources.

One-Dimensional Policy for a Multi-Dimensional Challenge

A carbon price is designed to optimize reductions in a single pollutant: carbon – or, if designed to reduce greenhouse gases, in a single type of emissions. However, given the ubiquitous nature of carbon – and other greenhouse gas emissions – incentives to reduce carbon will have wide-ranging impacts on our energy and economic systems. Once the full range of factors is considered, the best way to reduce greenhouse gas emissions might not be the best way to transition to a green economy.

For example, if biofuels are considered carbon-neutral, a carbon price is likely to incentivize biofuel production and combustion.^[ii] However, the ultimate wisdom of transitioning from fossil fuels to biofuels depends on a wide variety of factors, including the impact of biofuel development on food production, fertilizer use, and ecological systems, as well as the impact of biofuel combustion on air quality. This is not to pass judgment on the ultimate role for biofuels; instead, the point is that a carbon price creates incentives based solely on carbon emissions, without considering all of the other factors that could determine the overall wisdom of biofuels as a fossil fuel substitute.

Similarly, future pathways will have pervasive socioeconomic impacts that a carbon price ignores. As fossil fuel use declines, the workers and regions that depend on them will experience significant disruption. At the same time, decarbonization options will create new opportunities in a greener economy. A carbon price will incentivize the most cost-effective reduction opportunities for regulated entities, like power generators and refineries, but those opportunities will not necessarily foster wider socioeconomic benefits and minimize socioeconomic harms. In other words, what is cost-effective for affected industries will not necessarily be optimal in light of the full range of costs and benefits flowing from decarbonization choices.

A carbon price optimizes only carbon reductions, and so misses the wide range of other considerations relevant to a clean transition. A more coherent approach would optimize costs and benefits by integrating environmental and socioeconomic implications into the policymaking process.

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