Comparing carbon prices with emission standards

Comparing prices with standards for reducing CO2 emissions towards net-zero emissions

MAGNUS HENNLOCK AND ÅSA LÖFGREN

Carbon pricing is often regarded as the Gold standard of policy instruments for reducing CO2 emissions, providing incentives for least-cost mitigation, and triggering behavioral changes. With 61 implemented or scheduled carbon-pricing initiatives, of which 31 are emissions trading systems and 30 are carbon taxes, carbon pricing is widely accepted around the globe.

In contrast, emissions standards set direct limits on CO2 emissions, which are often implemented in specific sectors, such as buildings, transportation, and power production. However, the Swedish Environmental Code prevents the government from using CO2 emissions standards in Sweden. This leaves Swedish policymakers with carbon pricing as the only direct policy approach for reducing CO2 emissions. But does carbon pricing work as expected, and how well does it perform? The major objective of carbon pricing, regardless of whether it is an emission trading system or a carbon tax, is not to raise revenue but to drive behavioral changes to reduce CO2 emissions until the emissions target behind a tax, or a cap in the emissions trading system, is reached with efficiency. The price adds a cost for generating an additional tonne of emissions. This cost is then passed on along the value chain of the product. Using carbon pricing to reach an emissions target with efficient measures builds on companies’ interest in reducing their total investment costs for CO2 reduction and total payments for taxes or permits. If, for instance, companies instead seek the least-cost mitigation per kg CO2 reduction, the reductions will usually be smaller than the target and the companies’ total costs will be larger. To this end, we conducted a field experiment with 166 managers from the Swedish industry who were randomized into two experimental treatment groups. The 166 managers made in total 1,494 hypothetical investment decisions under either a CO2 tax or a CO2 emissions limit, with identical emissions targets. With a carbon price, managers under-invested resulting in lower CO2 reductions The experimental control confirmed that managers in the group that was facing CO2 taxes underinvested in CO2 reduction, with the result that the target of the carbon pricing was not achieved for 33 percent of their decisions. One explanation for this was that the managers often sought the least-cost mitigation per kg CO2 reduction, failing a rational response that would minimize the total investment costs and total tax payments. With an emissions limit, managers failed to choose cost-effective investment alternatives

Our results show that managers in the group facing emissions standards, under-weighed the cost information, and therefore failed to choose cost-effective investment alternatives in almost 30 percent of their decisions when fulfilling emissions limits.

Managers’ understanding of price signals in decision-making needs to improve To improve fulfilment of the target of the policy, our experimental results indicate that the carbon price signal needs to become more salient in managerial processes regarding investment decisions. More research is needed to understand fully why the managers failed to follow a rational response that would have led to the achievement of the CO2 target reduction. In Mistra Carbon Exit Phase 2, we will expand our understanding of the cognitive processes in managers’ decision-making by testing augmented policy designs that can improve effective managerial responses to price signals in the EU ETS and CO2 taxation.

Literature

Hennlock, M., Löfgren Å. and Wollbrant, C., Prices versus Standards: Evidence from an Artefactual Field Experiment on Managerial Investment Behavior, Submitted to Journal of Environmental Economics and Management World Bank Group (2020). State and Trends of Carbon Pricing 2020, World Bank Group, Washington DC