The Carbon Tax Signal

Most people agree that something should be done about climate change. Yet even though there is tremendous pressure on politicians to “do something”, widespread discontent usually follows whenever they take action. Why is that, and is there a solution? 

It helps to take a long-term perspective. Half a century ago, the depletion of natural resources was a major concern. The Club of Rome, in its book The Limits to Growth, summarized the gloomy Malthusian predictions of its experts. These commentators, however, overlooked fundamental factors — human ingenuity and technological innovation — perhaps because these impacts are hard to quantify and predict. 

In 1990, Paul Ehrlich, biologist and author of The Population Bomb, lost his famous bet against economist Julian Simon when he predicted 10 years earlier that prices of raw materials would increase over the long term due to limited supply and increased demand. Another biologist, Norman Borlaug, more productively contributed to the Green Revolution, which markedly improved agricultural yields.

A lesson we learned from this period is that fatalism is often unwarranted. Even though natural resources are limited, alternative sources of energy can be discovered, and new cultivation and extraction methods can be invented. 

More recently, climate change caused by greenhouse gas emissions has caused widespread concern. It is well known that carbon pricing schemes such as taxing pollution, subsidizing reductions in pollution or establishing markets for emission rights can help reduce emissions. These can be justified on the basis that emissions are a textbook example of an “externality” — a cost not borne by the producer. 

Are such measures effective though? The available evidence is not promising. Studies have shown that carbon taxes set at reasonable levels have a limited and sometimes insignificant effect on individual behaviour, including in Canada. 

Thus, the planned massive increase of this tax by Canada’s federal government would likely have a very limited effect on global carbon emissions, and at a high cost to Canadian businesses and households. (Canada only accounts for 1.5 per cent of global greenhouse gas emissions.) 

Moreover, substantial increases in Pigouvian taxes that account for the social cost of externalities can permanently antagonize a fraction of the population with regards to climate policies, and even trigger popular protests. A planned increase in gasoline taxation was the trigger for the widespread “gilets jaunes” insurrectional movement that paralyzed France for months. The current context is even more explosive because of inflation inherited from massive public spending during the Covid-19 pandemic and rises in housing costs due to a fast-growing population and higher interest rates. 

Bold words, little action 

Governments seem to be stuck between a rock and a hard place. It is perhaps not surprising that they often make bold claims about the importance of mitigating climate change without actually doing much. When they take action, as Justin Trudeau’s government did, they are criticized for the negative consequences on energy security, the energy sector, public finances and the division of power between federal and provincial governments. In the end, government decisions may mostly depend on electoral considerations. 

What would wise politicians do? For one thing, they would be wary of succumbing to the “do something” syndrome and remember the power of their words. By shaping public discourse and hinting at future policies, they can direct the attention of visionary entrepreneurs and scientists to the issue at hand. These brilliant minds will be the ones who find solutions to environmental problems.

In a few decades, the most effective policy on climate change could be nuclear fusion, some type of geo-engineering, space-based solar power or another technology unimaginable today. In the next few years, it could be the widespread adoption of solar power and electric cars — provided the electric grid is updated accordingly and the necessary raw materials are extracted. 

These are all initiatives that governments can either hinder or facilitate. Other useful measures include investing in scientific research, as well as science, engineering and business education, and ensuring that innovative firms can receive financing by cultivating a well-developed financial sector. 

Likewise, mechanisms such as carbon taxation may be useful not primarily because of their direct effects on carbon emissions, which will likely remain minor, especially on a global scale. Rather they can be impactful because the price signals they send would spur technological innovation and creative destruction. For this purpose, a credible specific commitment to putting in place a carbon pricing scheme in the future will suffice. Thus, even without apparently doing much, politicians can help shape the direction of technological innovation. 

To fight climate change, the world needs more scientists who will revolutionize the technological environment and more entrepreneurs who will ensure new technologies reach their full potential. Elon Musk noticed that the world needed only to harness a tiny fraction of the energy generated by the sun for all its energy needs. He built and acquired businesses based on solar energy and popularized electric cars. Meanwhile, politicians gave lots of speeches that offered encouraging signals (if not practical solutions). As imperfect as it is, this might be the winning combination the world needs right now.

 Pierre Chaigneau is an associate professor and Commerce ’77 Fellow of Finance at Smith School of Business. A version of this essay was first posted on The Conversation.