Prof. Nordhaus on Carbon Pricing

Economic Issues in a Designing a Global Agreement on Global Warming
William D. Nordhaus

Keynote Address Prepared for
Climate Change: Global Risks, Challenges, and Decisions
Copenhagen, Denmark
March 10-12, 2009

"...Virtually every human activity directly or indirectly involves the combustion of fossil fuels, producing emissions of carbon dioxide into the atmosphere. Emissions of carbon dioxide are externalities, i.e., social consequences that are not accounted for in the market place. They are market failures because people do not pay for the current and future costs of their emissions.

"If economics provides a single bottom line for policy, it is that we need to correct this market failure by ensuring that all people, everywhere, and for the indefinite future face a market price for the use of carbon that reflects the social costs of their activities. Economic participants—thousands of governments, millions of firms, billions of people, all making trillions of decisions each year—need to face realistic prices for the use of carbon if their decisions about consumption, investment, and innovation are to be appropriate.

"...Raising the market price of carbon provides strong incentives to reduce carbon emissions through four mechanisms. First, it provides signals to consumers about what goods and services produce high carbon emissions and should therefore be used more sparingly. Second, it provides signals to producers about which inputs (such as electricity from coal) use more carbon, and which inputs (such as electricity from wind) use less or none. It thereby induces producers to move to low-carbon technologies. Third, high carbon prices provide market signals and financial incentives to inventors and innovators to develop and introduce low-carbon products and processes which can eventually replace the current generation of carbon-intensive technologies. Finally, and most subtle of all, the use of carbon pricing economizes on the information requirements that market participants need to undertake each of these three tasks. Of course, placing a market price will not work magic. There remain many further externalities and market imperfections in energy and other markets. But without a strong price signal, there is simply no hope for making the vast number of decisions in a remotely efficient manner."

"Raising the price of carbon is a necessary condition for implementing carbon policies in a way that will reach the multitude of decisions and decision makers over space, time, nations, and sectors." (Emphasis added.)