Carbon pricing not enough to reduce greenhouse gas emissions, but Saudi Arabia takes a regional lead

Governments are grappling with a simple question: What is the right price to reduce greenhouse gas emissions and should market forces set this or should it be through direct government legislation, such as taxation, to change behavior? 

Carbon dioxide represents the dominant share of all greenhouse gas emissions and is mostly a waste product from human activity. Releasing it into the atmosphere is a free means of disposal that has been exploited increasingly since the Industrial Revolution.

But carbon emissions are a pollutant – adding to global warming and climate change. To economists, greenhouse gas emissions are a classic negative externality: A benefit accrues to the emitter but at a cost to society that is not paid at the point of origin. In a market-based economy, the standard policy response proposed is a pure pricing mechanism. Is this the only solution?

The notion is simple: Charge the originator the full societal cost of their carbon emissions through taxation. The polluter then has an incentive not to pollute but, if they do, the collected tax revenue can be used to offset the consequences. It is the consumer who ultimately pays. Companies that produce goods and services will seek to pass on additional taxation to their clients. Consumers should pay extra for goods and services that entail greenhouse gas emissions in production, distribution or use.

But things are not so simple. There are three market mechanisms for reflecting the societal cost of carbon emissions: First, tax the distribution, sale and use of fossil fuels, based on their carbon content. This approach could cover all estimated carbon and greenhouse gas emissions embodied in all goods and services. But the broader the coverage, the more difficult it is to calculate the appropriate tax. 

A second approach would be “cap and trade” emissions quota systems. Licenses to pollute in a specified quantity are created, in line with an emissions budget, and are allocated, sold or auctioned to companies, which can trade unused allowances, therefore establishing a market price. 

A third method is carbon offsets. A polluter seeks to offset their emissions by contributing to carbon-reducing investments or other green projects (e.g. carbon sinks, such as rainforest preservation).

Saudi Arabia has once again led the way with the Public Investment Fund, in collaboration with Saudi Tadawul Group, announcing plans to roll out a voluntary exchange platform for carbon offsets and credits in the MENA region, with the new exchange platform coming as part of the Kingdom’s extended efforts to face climate change and encourage establishments to reduce carbon emissions. 

Allowing people to pollute if they are willing and able to pay the price is not an effective remedy. It could even increase pollution, since payment can make poor behavior socially acceptable. People may drive a bit less when the price of petrol or diesel rises, but they quickly return to previous behavior patterns. 

Dr. Mohamed Ramad

This Saudi initiative will be the primary destination and main platform for companies and institutions that target reducing their emissions, or contributing toward that, through the trading of verified, approved and high-quality carbon equivalent credit certificates.

There are many reasons why carbon pricing may be ineffective. A government’s fiscal situation cannot be overcome in the short-term — there may be no carbon budget left. If the world reached net-zero emissions tomorrow, the global warming process, which lags behind emissions, would likely continue for many years. 

Allowing people to pollute if they are willing and able to pay the price is not an effective remedy. It could even increase pollution, since payment can make poor behavior socially acceptable. People may drive a bit less when the price of petrol or diesel rises, but they quickly return to previous behavior patterns. 

Increasing fuel taxes sufficiently to take vehicles off the road risks a negative reaction, as seen in France in 2018 when weeks of street demonstrations by yellow-vest protesters forced the government to abandon its proposed tax rise. Taxes can be hard to make equitable: The rich can always afford to pay them.

Other reasons against taxation effectiveness are that high taxes incentivize evasion mechanisms, e.g. black markets or other illegal approaches. Tax arbitrage: Pricing carbon externalities in one country can cause production to move to a neighboring country where they aren’t priced. Different tax levels can distort that, however. Pricing the externality at the border would reduce trade in goods that cause carbon emissions, but it would be difficult to implement without causing more general trade wars.

Although there is carbon pricing on motor fuels in many developed countries, marine and aviation fuel is taxed less, if at all. Fuel on board an aircraft that crosses an international border is exempt from taxes and duties, thanks to the 1944 Chicago Convention on International Civil Aviation. Consistent with that, aviation fuel is supplied duty-free on a reciprocal basis. Attempts to impose air fuel duties unilaterally would be unlikely to go well. It could lead to “tankering,” in which planes fill to the brim with fuel in the lowest-duty regimes or even arrange flights in patterns that deliberately cross borders to pick up cheap fuel.

It is easy to be critical of carbon pricing, but rather harder to say what alternative policies should be used. One option is to intervene more directly in the economy. Legislation can be used to say: “Thou shalt (not).”

An example is the requirement for catalytic converters in cars. If one looks at the financial penalties for breaking the law, or avoiding rules, legislation can be interpreted as either a restriction on quantity or an extreme form of taxation. Hence it is a blunt instrument, creating distortions.

Carbon pricing and legislated controls are the two extreme ends of a political spectrum of choice. At one end, individuals are allowed to make whatever decision they please, based on incentives given to them. At the other end, people are expected to do as they are told. Given the magnitude of the challenge, carbon pricing will be necessary, but not sufficient. Direct legislation will also be required. The Saudi voluntary exchange platform for carbon offsets and credits is indeed welcome.

• Dr. Mohamed Ramady is a former senior banker and professor of finance and economics at King Fahd University of Petroleum and Minerals, Dhahran.