Annex A. A brief description of climate policies

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1. This section describes and expands on the content of Table 5 “Assessment criteria for climate policies”, analysing how each climate policy fares along the assessment criteria: shortterm (i.e. static) minimisation of abatement costs; medium-long term (i.e. dynamic) minimisation of abatement costs; administrative costs; ability to deal with uncertainty; reallocation and distributional concerns; political economy and public acceptability; and fiscal revenues and expenditures.

Greenhouse gas tax

2. Imposing a price on greenhouse gas (GHG) emissions through a tax proportional to the carbon content of a good or service is a highly cost-effective way to reduce emissions. A broadbased greenhouse gas tax presents a low trade-off between economic activity and pollution, equalising abatement costs across firms and eliciting cost-effective behavioural responses from consumers and producers. A stable and predictable GHG tax also enhances long-term incentives to innovate and deploy low-emission technologies so as to reduce the tax burden. However, GHG taxes, as they are currently applied in many countries, have a narrow base as they apply to certain sectors, emissions, and fossil fuels (see Chapter 3 in OECD (2019[1]) for a discussion). 3. One main drawback of the GHG tax concerns, in some cases, high administrative costs, i.e. the cost associated with tax assessment, collection, and enforcement. Upstream GHG taxes applied on fuel imports have low administrative costs as they can be applied to the volume of the fuel. However, for downstream GHG taxes, administrative costs tend to be much higher as the number of agents liable to pay the tax is large (e.g. taxation at the industrial point of emission release). Difficulties in measuring the tax base also raise administrative costs. For instance, methane emissions in animal farming cannot be measured but only roughly estimated from several factors (the animals’ diet, manure storage, use of pasture). 4. The political and social acceptability of GHG carbon taxes is an additional challenge. GHG taxes increase the price of products and services and are highly visible, eliciting strong opposition from a large share of the population. Before considering their revenue use, the impact of the tax on prices is likely to be regressive, raising distributional concerns. GHG taxes can also reduce firms’ international competitiveness and engender job losses and stranded assets (in the short term), further reducing the political support for such an instrument. 5. A predictable carbon path can largely reduce these effects by aligning long-term investments with climate change goals. In principle, compensatory measures can offset GHG taxes’ regressive effect and negative impact on competitiveness. The additional tax revenues GHG taxes would generate could help to fund such compensatory measures. Yet, these measures have proved difficult to design and implement. For instance, in France, since its introduction in 2014, less than a quarter of the carbon tax revenues have been used to finance

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the green transition or to compensate vulnerable households, and have instead been used mostly to reduce the state budget deficit (OECD, forthcoming[2]).

Emission trading schemes

6. Emission trading schemes (ETS) set emission caps by issuing pollution permits and allowing for trading them. The forces of supply and demand determine pollution permits’ prices. Initial allocation of permits can be given out for free instead of auctioning, mostly preserving the incentives to abate emissions and improving significantly the acceptability of ETS (Bowen, 2015[3]). Yet, free allocation can provide an unfair competitive advantage to incumbents when based on past emissions (grandfathering) and recipients might appropriate windfall profits if they can pass-through the permit cost to consumers. 7. ETS have similar strengths and weaknesses to GHG taxes. The main difference is that ETS are a “quantity” instrument whereas GHG taxes are a “price” instrument. By reducing the emission cap at regular interval, ETS ensure that emissions will decline by a certain amount. This is an attractive feature as climate targets are often set in terms of emission quantities and these can be clearly communicated to the public. Moreover, governments find it easier to commit to progressive cap reductions than price increases in a GHG tax. However, ETS deal less effectively than GHG taxes with uncertainty over abatement costs as the variability of permits’ prices in the ETS market can blunt efforts to reduce emission. The volatility in permits prices could also discourage long-term investments in abatement technologies. 8. ETS usually entail higher administrative costs than GHG taxes. They require a costly infrastructure (i.e. trading platforms), on top of monitoring and enforcement activities. In addition, they impose informational and bureaucratic costs on participants, making them impractical for other than large firms and industrial plants. 9. Accurate policy design can temper some of the limitations of ETS. For instance, imposing a floor on prices can limit permits’ price volatility (as in the Regional Greenhouse Gas Initiative, a GHG market active is part of the United States). In addition, excessive permits supply can be reduced according to pre-determined rules (e.g. the market stability reserve in the EU ETS).

Taxes on polluting goods or activities

10. Pricing a proxy for emissions can be an alternative to pricing the GHG content of goods and services. The advantage of this approach compared with ETS and GHG taxes is that it lowers administrative and compliance costs while providing a similar incentive to firms and consumers to abate emissions and innovate. They involve lower administrative costs as taxes apply on the final output, eschewing the need of monitoring the exact emissions. This is one of the reasons why taxes on polluting goods and activities are more widespread than GHG taxes. They include excise taxes on fuels, extraction activities (as a proxy for fugitive emissions) and land-use change. 11. The drawback of taxing polluting goods and activities is the risk that the proxy relates only loosely with actual emissions. For example, taxes on electricity consumption reduce demand but do not encourage the use of renewable resources in electricity generation; vehicles excise taxes can reduce the number of vehicles but do not encourage using them less or the purchase of low-emitting vehicles.

ANNEX. A FRAMEWORK TO DECARBONISE THE ECONOMY

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12. Another major weakness of this indirect form of pricing is that they are often motivated by policy objectives other than decarbonisation, such as raising revenues. Their application is often fragmented due to many exemptions (unlike broad-based GHG taxes and ETS).

Abatement subsidies

13. Abatement subsidies involve payments for reducing emissions below a pre-defined baseline. Subsidies are an efficient instrument to reduce emissions as they equalise firms’ marginal abatement costs and leave firms the choice on how to reduce emissions. Subsidies provide firms with the same incentives to curb emissions as GHG taxes. One main difference is that, unlike GHG taxes, subsidies do not increase firms’ costs. For this reason, they tend to face less opposition than taxes, but they weigh on the public budget. 14. Abatement subsidies and GHG tax have different effects on prices and the incentives to relocate production. Abatement subsidies tend to lower output prices, thus supporting production and final consumption beyond what would be the social optimum (i.e. their levels without taxes and subsidies). At the same time, subsidies are less prone to cause carbon leakage because they encourage firms not to relocate production abroad (Fischer, Greaker and Rosendahl, 2012[4]). 15. Designing and implementing effective abatement subsidies present challenges. Measuring abatement efforts requires measuring the reduction in emission with respect to a baseline. The choice of the baseline can favour historical polluters while penalising those firms that were already keeping emissions low before the introduction of the subsidy. Moreover, it can be hard to determine whether the emission reduction is due to the subsidy or other factors. Therefore, abatement subsidies often target proxies, such as low-carbon products and activities (i.e. subsidies for electric cars), increasing the risk of introducing unwanted market distortions. For these reasons, abatement subsidies should be time limited and reviewed regularly.

Non-tradable performance standards/certificates

16. Non-tradable performance and efficiency standards mandate certain qualities and characteristics that products, services and production processes must comply with. Performance standards require that the pollution originating from a source, such as a manufacturing plant or vehicle, does not exceed pre-specified limits. Energy efficiency standards are a type of performance standard, frequently used for household appliances, vehicles (e.g. fuel economy standards), and buildings (e.g. building codes). 17. Performance standards tend to be less cost-effective than GHG taxes and ETS. One drawback is that they do not provide the same incentives to reduce emissions or energy consumption to all firms. Firms that already comply with performance and efficiency standards face no incentive to reduce pollution further whereas non-compliant firms are obliged to do so, even when the private and social costs of doing so are high. Moreover, performance standards exploit behavioural responses only to a very limited extent. For instance, a standard limiting the electricity consumption of an appliance, such as a washing machine, does not encourage reducing the frequency of use. Standards can actually lead to an increase in energy consumption (i.e. rebound effect) because of the lower energy cost of using the appliance. 18. Energy efficiency standards tend to be less effective than emission standards in reducing emission as they target a proxy rather than actual emissions. W hen they target fuel consumption, efficiency standards are similar to emission standards, but when they are “attribute-based”, for example when they target the weight of a vehicle, they are significantly

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less effective. Emission standards provide limited incentives to innovate and energy efficiency standards even less so.

19. Overall, performance and efficiency standards are less cost-effective than emission pricing schemes in reducing emissions, but they can still play an important role in a comprehensive decarbonisation strategy. In the presence of multiple market and government failures, performance and efficiency standards can complement emission pricing mechanisms and be welfare-enhancing by contributing to lower the carbon price needed to achieve a certain reduction in emissions (Stiglitz, 2019[5]). 20. A major advantage of performance standards is that they are easy to implement and their administrative costs are low. Standards can also help address one important drawback of pricing instruments: the non-responsiveness of consumers to prices. This is because standards require little or no behavioural response by consumers to work. Standards can enjoy more political support than pricing instruments as they hide the abatement costs they entail (which can be high). This can help to explain why standards face less political opposition than pricing instruments despite being more regressive in general (Levinson, 2019[6]).

Feebates

21. Feebates are policy instruments imposing a tax or providing a subsidy on consumption (or production) based on the difference between the emissions and a benchmark. Feebates are mostly used in vehicles sales. They take the form of a proportional fee on vehicles that are more polluting than the benchmark and a proportional rebate on those that are less polluting than the benchmark.

22. Feebates relate performance standards in the same way as GHG taxes relate to ETS, in that they are a “price mechanism”, whereas performance standards are a “quantity mechanism”. Feebates equalise incentives across firms to reduce pollution (i.e. by equalising marginal abatement costs) whereas standards provide strong incentives to reduce pollution only to non-compliant firms (Anderson and Sallee, 2016[7]). Overall, evidence suggests that feebates are more cost-effective than standards in some settings, such as vehicle emissions (Durrmeyer and Samano, 2017[8]). 23. Another advantage is that, being a price mechanism, feebates deal better than standards with uncertainties over abatement costs. Feebates are usually designed to be revenue-neutral (although this objective is seldom attained (Teusch and Braathen, 2019[9])), but in principle they could raise revenues or distribute net-subsidies by increasing or decreasing the benchmark. One study finds that middle-income consumers benefit from a vehicle feebate at the expense of low and high-income ones, with more progressive effects if a negativebalanced feebate is financed with an equivalent income tax (Durrmeyer, 2018[10]).

Technology Standards

24. A technology standard (or technology mandate) sets specific requirements for production processes, such as specific abatement technologies or production methods. Technology standards also include outright bans of materials or techniques, such as the ban in 1990 with the Montreal Protocol of chlorofluorocarbons (a gas once widely used in refrigerators and other industrial and domestic applications). 25. On the one hand, technology standards are transparent and relatively easy to monitor and enforce. On the other, like non-tradeable performance standards, they leave little room to

ANNEX. A FRAMEWORK TO DECARBONISE THE ECONOMY

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producers in choosing how to reduce emissions and do not encourage the reduction of emission-intensive output and the switching to less polluting fuels. Also, forcing the adoption of specific technologies can help their diffusion, but this provides no incentive to improve them. It can even reduce incentives to innovate in competing technologies. Moreover, technology standards can raise competition and market-neutrality concerns if they favour firms already using the chosen technology, or if it differentiates by vintage (e.g. including waivers for older plants because the new technology would be too costly). For all these reasons, technology standards though effective in some settings may entail high social and private costs. 26. On the other hand, technology standards have low administrative costs. In some circumstances, they may offer the only viable option to abate emissions in a short time. Technology standards may be advantageous also when frictions, such as asymmetric information, coordination problems or weak responses to prices, hinder the adoption of less polluting technologies. 27. Outright bans can be effective and are the best approach when the damages associated with the technology to be banned are so high that their use cannot be justified. This has been the case for chlorofluorocarbons and leaded gasoline. Such bans encouraged innovation in alternative products and processes (hydrofluorocarbons and unleaded gasoline in the example above).

Input Requirements

28. Input requirements mandate the use of certain intermediates or fuels in production processes. One widespread example are renewables portfolio standards, requiring electricity producers to generate a fraction of their electricity from renewable sources. These requirements are applied in more than 100 jurisdictions, including Belgium, the UK, Poland, Korea, and several US states (REN21, 2017[11]). 29. Input requirements are similar to technology standards in that they help to sustain demand for cleaner intermediates and establish unambiguous targets. Similarly to technology standards, they restrict producers’ choices, contributing to high abatements costs, but unlike technology standards they can offer a portfolio of choices rather than one single alternative, contributing to lower abatement costs.

Tradable performance standards and credits

30. Tradable performance standards oblige participants that are below a pre-defined benchmark to buy certificates from those that are above the same benchmark. As such, tradable performance standards are a more flexible alternative to performance or technological standards and have many aspects in common with an ETS. Examples of tradable standards programmes include white certificates (tradable certificates of a building energy efficiency level) and renewable portfolio standards (tradable certificates of a minimum amount of renewables used by power suppliers). A similar instrument to tradeable standards are baseline-and-credit systems, like the Clean Development Mechanism (CDM) established under the Kyoto Protocol. In this system, activities reducing emissions below a baseline generate credits that can be sold to participants expecting to exceed it. 31. Tradable standards, unlike firm-level standards, have the advantage of imposing an industry-wide requirement rather than a firm-level one. Therefore, they work like an industrywide ETS as they get firms with lower abatement costs to abate more. Tradeable performance standards are generally less effective than an ETS in reducing emissions because they do not

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increase as much the price for emission-intensive goods (Boom and Dijkstra, 2009[12]) and they put a price on emissions only if emissions are above a pre-defined benchmark (Pizer and Zhang, 2018[13]). Yet, these features support their acceptability by the public. 32. By imposing clear benchmarks and expressly focusing on producers, carefully designed tradable performance standards can encourage new technology adoption or innovation (Yeh, Burtraw and Sterner, 2020[14]). On the downside, tradeable standards raise implementation costs and pose specific monitoring challenges, similar to ETS.

Information, certification and voluntary approaches

33. Rating and labelling requirements, public information and education, training programmes, product certification and award schemes all contribute to reducing informational asymmetries and other market imperfections at the source of negative externalities (OECD, 2015[15]). For example, consumers with a preference for low-carbon goods can face difficulties in discriminating between low and high carbon content goods. Another example concerns households paying little attention to electricity prices or energy efficiency, raising energy consumption. 34. Reducing these frictions can be a cost-effective way to complement the policy instruments discussed above so far. For instance, tackling informational asymmetries can lower the level of taxes or subsidies needed to achieve a certain reduction in emission. Corporate disclosure policies can lead to higher investment in low-carbon assets. 35. One main drawback of certification and labelling approaches is that they tend to provide rigid attribute-based categories. This reduces firms’ incentives to abate beyond the requirements need to reach a certain category and can allow firms to appropriate the certification’s benefits by raising prices (Houde, 2018[16]).

ANNEX. A FRAMEWORK TO DECARBONISE THE ECONOMY