How to price carbon in good times… and bad

Headline issue

As the world economy slowly recovers from one of the longest and most severe global slowdowns in history, there has been growing interest in how fluctuations in economic activity interact with climate change policy. Of particular interest is how carbon pricing instruments, such as emissions trading systems and carbon taxes, are designed and operate. This policy brief analyses the relevant empirical evidence and theoretical research on how carbon pricing instruments function in recessions and booms.

Key findings

• Responsive cap-and-trade systems and carbon taxes can improve climate change policy by allowing higher greenhouse gas emissions during times of economic expansions and lower emissions during recessions.
• Raising and lowering the ‘cap’ on a cap-and-trade system according to the economic conditions would reduce volatility in the price of carbon.
• The existing European Union emissions trading system (EU ETS) was designed with little regard for the potentially disruptive effects of business cycles on prices, especially during downswings in economic activity.
• New emissions trading systems being set up around the world should incorporate lessons learned from the problems experienced by the EU ETS.
• Building the responsiveness mechanism into the system from the start is preferable to adding it on at a later date.
• Whatever instrument is chosen to price carbon, it is better to apply it to as large a
  group of emitters as feasible.