UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT

G-24 Discussion Paper Series

Carbon Markets and Beyond:

The Limited Role of Prices and Taxes
in Climate and Development Policy
Frank Ackerman

No. 53, December 2008

UNITED NATIONS
 G-24 Discussion Paper Series

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on International Monetary Affairs and Development

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Carbon Markets and Beyond: The Limited Role of Prices and Taxes in Climate and Development Policy iii

Preface

The G-24 Discussion Paper Series is a collection of research papers prepared

under the UNCTAD Project of Technical Support to the Intergovernmental Group of
Twenty-Four on International Monetary Affairs and Development (G-24). The G-24 was
established in 1971 with a view to increasing the analytical capacity and the negotiating
strength of the developing countries in discussions and negotiations in the international
financial institutions. The G-24 is the only formal developing-country grouping within
the IMF and the World Bank. Its meetings are open to all developing countries.

The G-24 Project, which is administered by UNCTAD’s Division on Globalization

and Development Strategies, aims at enhancing the understanding of policy makers in
developing countries of the complex issues in the international monetary and financial
system, and at raising awareness outside developing countries of the need to introduce
a development dimension into the discussion of international financial and institutional
reform.

The research papers are discussed among experts and policy makers at the meetings
of the G-24 Technical Group, and provide inputs to the meetings of the G-24 Ministers
and Deputies in their preparations for negotiations and discussions in the framework of
the IMF’s International Monetary and Financial Committee (formerly Interim Committee)
and the Joint IMF/IBRD Development Committee, as well as in other forums.

The Project of Technical Support to the G-24 receives generous financial support
from the International Development Research Centre of Canada and contributions from
the countries participating in the meetings of the G-24.
Carbon Markets and Beyond:
The Limited Role of Prices and Taxes
in Climate and Development Policy
Frank Ackerman

Stockholm Environment Institute

and Tufts University

G-24 Discussion Paper No. 53

December 2008
Carbon Markets and Beyond: The Limited Role of Prices and Taxes in Climate and Development Policy vii

Abstract

The climate policy debate has advanced from science to economics, with a growing focus on creating
carbon markets and getting the prices right. This is necessary but far from sufficient for an effective
and equitable response to the climate challenge. While market-oriented forces such as the IMF and
the World Bank have focused almost exclusively on carbon markets, others, such as the Human
Development Report and the Stern Review, have emphasized the need for complementary, non-market
climate initiatives to promote energy conservation and above all, to create and adopt new low-carbon
technologies.

The equity implications of market-based policies depend on the price elasticity of demand. When
demand is elastic (i.e. the elasticity is large in absolute value), as in the case of industrial energy use,
price incentives are quite effective and distributional impacts are minimized. On the other hand, when
demand is inelastic (i.e. the price elasticity is close to zero), as in the case of transportation fuel use,
price incentives are less effective, worsening income inequality but doing little to change in energy
use and carbon emissions. Thus non-market policy instruments are particularly important in sectors
with inelastic demand for energy, such as transportation.

Price incentives alone cannot be relied on to spark the creation of new low-carbon technologies.
Many technologies display “learning curve” effects, starting out with high unit costs and becoming
cheaper as they are used more widely. Wind power, which is now commercially viable, only became
affordable as a result of decades of government subsidies and research support. The same will be
true of other low-carbon energy technologies, which will be needed for a sustainable solution to the
climate problem.

Policy debate has focused on the need for a globally harmonized price for carbon. This is not required
by economic theory; in an unequal world, the logic of market economics implies that richer countries
should, in effect, have a higher price for carbon. It appears likely, nonetheless, that a consistent global
price will eventually be adopted. This will make the benefit of reducing carbon emissions loom larger in
lower-income countries. As a result, a wider range of carbon-reducing technologies will be profitable
in developing countries, creating opportunities for “leapfrogging” beyond the technologies in use in
high-income countries – thereby helping to launch a new, green path to development.
 Carbon Markets and Beyond: The Limited Role of Prices and Taxes in Climate and Development Policy ix

Table of contents

Page

Preface . ............................................................................................................................................. iii

Abstract . .............................................................................................................................................vii
I. Introduction......................................................................................................................................1
II. The state of the debate......................................................................................................................2
III. What do carbon prices accomplish?.................................................................................................4
IV. Where do new technologies come from?.........................................................................................6
V. Carbon markets and developing countries.......................................................................................7
VI. Conclusion........................................................................................................................................8
Notes ....................................................................................................................................................9
References ....................................................................................................................................................9
 Carbon Markets and Beyond:
The Limited Role of Prices and Taxes
in Climate and Development Policy
Frank Ackerman*
I. Introduction
The good news is that all major voices in the
climate policy debate, including the Bretton Woods
institutions (the International Monetary Fund and the
World Bank), are taking the problem seriously. Skep-
ticism about the science is no longer an option: the
world’s scientists have never been so unanimous, and
so ominous, in their projections of future perils.
The bad news is that for too many participants in
the debate, including the Bretton Woods institutions,
climate policy primarily consists of manipulating
markets and prices. If the only tool you have is
market liberalization, then every problem looks like
a question of getting the prices right. But setting a
price for carbon emissions is only the beginning of
climate policy, not the end.
The message of this paper for developing
countries is that it is important to look beyond the
technical debates over carbon markets. To address the
threat of climate change, it is necessary to charge a
price for carbon emissions – and it is also necessary
for governments to do much more, taking action to
support innovation and diffusion of new, low-carbon
* This work was carried out under the UNCTAD Project of Technical Assistance to the Intergovernmental Group of Twenty-Four
on International Monetary Affairs and Development with the aid of a grant from the International Development Research Centre of
Canada.
technologies. A harmonized global price for carbon
emissions is not essential as a matter of economic
theory, but is nonetheless likely to be adopted. This
will make the opportunities and incentives for innova-
tion even greater in developing countries, creating the
economic basis for leapfrogging beyond the technolo-
gies adopted in high-income countries.
More specifically, this paper argues that appro-
priate carbon prices and functioning carbon markets
are necessary but not sufficient. It begins with a
review of recent publications on climate policy from
the IMF and the World Bank, contrasting them with
other recent recommendations. It then examines the
expected impacts of a higher price of carbon, which
will be both inequitable and, in some respects, inef-
fective if adopted alone. Turning to more positive
solutions, the nature of technology, particularly its
path dependence and learning curve effects, requires
carefully designed public investments to launch a
climate-friendly development path. And the impacts
of carbon prices and markets on developing countries
create both unique problems, such as proportionally
greater economic burdens, and unique opportunities,
in the proportionally greater incentive to innovate and
establish a new leadership position in 21st century
technologies.
2 G-24 Discussion Paper Series, No. 53
II. The state of the debate
The IMF simply assumes that climate policy
consists of getting the (carbon) price right:
An effective mitigation policy must be based
on setting a price path for the greenhouse gas
(GHG) emissions that drive climate change
(IMF, 2008, chapter 4: 2).
Although making an occasional nod to the im-
portance of developments such as hybrid vehicles
or energy efficiency,1 the IMF’s focus is almost en-
tirely on market instruments. Adaptation to climate
impacts will, the Fund notes, require large increases
in infrastructure spending – but much more is said
about market opportunities for hedging against
predictable short-term climate fluctuations, through
weather derivatives and “cat” (catastrophic risk)
bonds. Mitigation, i.e. emissions reduction, is ad-
dressed primarily through detailed modelling of the
expected effects of carbon taxes or trading schemes.
This modelling effort shows that the Organization
of the Petroleum Exporting Countries (OPEC) will
be the biggest losers from a moderate carbon price,
while global trading of emissions allowances will
probably benefit China above all, due to that country’s
massive opportunities for comparatively low-cost
emission reductions.
The IMF analysis sets a target of a 60 per cent
reduction in carbon emissions, relative to 2002 levels,
by 2100, in order to stabilize CO2 concentrations
at 550 parts per million (ppm). This is a signifi-
cant change from business-as-usual, although less
ambitious than the targets advocated by many govern-
ments and independent analysts; there is a growing
concern among climate scientists that 450 ppm or
even lower concentrations may be needed to avoid
serious risks of catastrophic change. Yet in the IMF’s
view, the world can move slowly and still reach the
target comfortably:
Carbon-pricing policies … must establish a
time horizon for steadily rising carbon prices
that people and businesses consider believable.
Increases in world carbon prices need not be
large – say a $0.01 initial increase in the price
of a gallon of gasoline that rises by $0.02 every
three years (IMF, 2008, chapter 4: 42).
Changes in carbon prices of this magnitude are
dwarfed by recent swings in the price of gasoline, a
topic discussed in the next section. While it may be
possible to achieve climate stabilization at moderate
total cost, considerable ingenuity and new policy
directions will be required; by themselves, price
changes of pennies per gallon of gas are not enough
to achieve anything of importance.
For the World Bank, the success of market based
policy is already obvious:
The carbon market is the most visible result
of early regulatory efforts to mitigate climate
change … Its biggest success so far has been to
send market signals for the price of mitigating
carbon emissions. This, in turn, has stimulated
innovation and carbon abatement worldwide,
as motivated individuals, communities, com-
panies and governments have cooperated
to reduce emissions (Capoor and Ambrosi,
2008: 1).
This success, according to the Bank, is based on
two major markets for carbon emissions, the EU’s
Emissions Trading Scheme (ETS) and the Clean
Development Mechanism (CDM) provisions of the
Kyoto Protocol. They account for about US$ 50 bil-
lion and $13 billion, respectively, of the $64 billion
in worldwide carbon market transactions in 2007
(Capoor and Ambrosi, 2008: 1). Both markets, as it
turns out, are works in progress: the ETS initially
gave away virtually all emission allowances to ex-
isting emitters, rather than auctioning them – and
set such a high cap that the price of allowances fell
embarrassingly close to zero. (Revisions to the ETS
framework are addressing these design flaws for
future years.) CDM has been beset by procedural
delays and complexity, imposing unduly burdensome
start-up costs. A large majority of CDM funding to
date has flowed to China, suggesting that CDM does
not yet provide a truly global mechanism for financ-
ing emission reduction.
Meanwhile, research sponsored by the World
Bank has demonstrated that there is substantial
variation in carbon emissions at the same level of
development:
The ranking of countries by emissions intensity
[i.e., emissions/GDP ratio] … was not system-
atically related to GDP per capita … Emissions
per capita were positively but only moderately
correlated with GDP per capita and showed no
evidence of an eventual decline in emissions
per capita at higher per capita income (the
Environmental Kuznets Curve phenomenon;
Bacon and Bhattacharya, 2007: 2).
 Carbon Markets and Beyond: The Limited Role of Prices and Taxes in Climate and Development Policy
This finding should give rise to curiosity about
the subtler economic and non-economic determinants
of emissions. It suggests that growth is not equally
good, or bad, for carbon emissions in all contexts.
Therefore, merely speeding up or slowing down eco-
nomic growth may not be the most efficient policy;
it is also important to understand what differentiates
high versus low emission countries at the same level
of economic development. (The same question can
be asked about states within the United States, which
differ in carbon emissions per capita by a ratio of
more than six to one.)
The World Bank’s overall approach to the issue
sounds multi-faceted, if somewhat abstract. A pro-
posed “strategic framework” (World Bank, 2008) for
the Bank lists six “pillars,” of which three are focused
exclusively on market instruments,2 while three are
more general or ambiguous.3 However, critics have
claimed that reality falls short of the World Bank’s
rhetoric. According to a report from the Institute for
Policy Studies (IPS), an NGO in Washington DC,
the Bank’s $2 billion in carbon finance projects suf-
fer from an extreme lack of transparency, and have
resulted in very little confirmed reduction in carbon
emissions (Redman, 2008). Less than 10 per cent of
the funding has gone to renewable energy, while 75 per
cent or more has gone to the coal, chemical, and iron
and steel industries. In the sponge iron industry in
India, IPS reports that the incentives for carbon reduc-
tion have been generous enough to cause a perverse
expansion of the relatively energy-inefficient industry,
in order to gain additional carbon reduction credits.
Other voices in the international debate have
recognized the greater urgency of the problem, and
have set more detailed reduction targets, such as
80 per cent reduction in developed countries and
50 per cent worldwide by 2050, with even greater
reductions required by 2100. Along with the urgency
of the issue, there has been a willingness to consider
a broader range of policy instruments. For the Human
Development Report (HDR):
Setting ambitious targets for mitigation is
an important first step. Translating targets
into policies is politically more challenging.
The starting point: putting a price on carbon
emissions … Carbon markets are a necessary
condition for the transition to a low-carbon
3
economy. They are not a sufficient condition.
Governments have a critical role to play in
setting regulatory standards and in supporting
low-carbon research, development and deploy-
ment (UNDP, 2007, Summary: 20, 21).
HDR calls for carbon markets to be accompa-
nied by government incentives for renewable energy
production, tightened standards for vehicle fuel ef-
ficiency, expanded research on carbon capture and
storage technology, and increased technology transfer
to developing countries.
One of the most detailed recent proposals is
Nicholas Stern’s “global deal on climate change”
(Stern, 2008). Stern argues that climate stabilization
requires cutting global emissions to half of the 1990
level by 2050, with continuing declines thereafter.
The 2050 target is so low – 2 tons per capita, not
much above the level of emissions today in India,
and less than half of China’s current emissions – that
there is virtually no room for any large country to be
significantly above the average. Stern calls for bind-
ing national reduction targets, to be adopted soon by
developed countries and the fastest-growing middle-
income countries, and by all other countries by 2020.
Stern envisions a carbon market, in the form of a
global cap-and-trade system that allows developing
countries to sell emission rights, combined with ar-
rangements for technology transfer, and large-scale
government support for the development of new
technologies. In the words of his summary,
The world should aim for a liquid international
carbon market in order to allow for the most
effective, efficient and equitable emissions
reductions. In addition, non-price interventions
are required to expand the global market for
low-carbon technologies, support common
standards and promote cost-effective reduced
deforestation (Stern, 2008: 3).
In short, all major proposals for climate policy
include a substantial role for carbon markets and
prices, either in the form of taxes or cap-and-trade
systems. Yet while the Bretton Woods institutions,
by their nature and by inclination, give primary
emphasis to manipulation of prices and financing in
carbon markets, others, such as Stern and the Human
Development Report, see carbon markets as one part
of a complex ensemble of policies.
4 G-24 Discussion Paper Series, No. 53
III. What do carbon prices accomplish?
Discussion of carbon markets often highlights
the distinction between effects on prices and effects
on emissions. A cap-and-trade system causes a pre-
dictable, explicitly stated reduction in emissions, but
could lead to unpredictable or fluctuating prices. A
carbon tax does the opposite, causing a predictable,
stable effect on prices, at the expense of an uncertain
reduction in emissions. Those who, like Stern, focus
on the need to achieve a specific level of emissions
reduction tend to prefer cap-and-trade markets; those
who worry more about economic disruption tend
to prefer the predictable prices achieved by carbon
taxes.
This is, however, only one question about the
effects of carbon markets. A related question has
received too little attention: when carbon prices are
increased, by a tax or a trading system, how large is
the (intended) effect on emissions, and how large is
the (unintended) effect on income distribution?
Increased energy costs to consumers fall dispro-
portionately on low-income groups; energy costs are
a larger fraction of income for the poor. As incomes
rise, total spending on energy also rises, but more
slowly; thus the fraction of income spent on energy
decreases. The one major exception to this pattern
occurs in countries where some people cannot afford
fossil fuels, and instead rely on traditional biomass
fuels. Among the population that buys and depends
on commercial fuels, energy price increases are
regressive, taking proportionately more from lower-
income households.
To summarize in advance the point of this sec-
tion, the effect of a carbon price increase depends
on the price elasticity of demand for energy. A larger
elasticity means that a price increase has more effect
on emissions and less effect on income distribution; a
smaller elasticity means that the same price increase
has less effect on emissions, but does more to increase
inequality.4 Since price elasticities are fairly small
for energy in general, and extraordinarily small for
petroleum products in the short run, price incentives
are a blunt and painful instrument for achieving lower
emissions.
The price elasticity of demand is, by definition,
the percentage change in demand that is caused by a
one per cent change in price. Consider the effects of a
Table 1
Impacts of a 20 per cent increase in
energy prices
Price elasticity of demand
-1 -0.5 -0.2 -0.05
Change in quantity
(per cent) -20 -10 -4 -1
Change in cost to
consumers (per cent) -4 +8 +15 +19
20 per cent increase in the price of energy at different
elasticities, as shown in table 1.
At an elasticity of -1, the 20 per cent increase in
price causes a 20 per cent drop in demand. Consum-
ers purchase 80 per cent as much energy as before,
at 120 per cent of the former price per unit, so the
total cost to consumers amounts to 96 per cent of
the former total. At this elasticity, most of the effect
is felt in the change in the quantity of energy (and
therefore emissions), while total consumer spending
is little affected.
In contrast, at an elasticity of -0.05, a 20 per cent
increase in price causes only a 1 per cent change in
quantity. Consumers buy 99 per cent as much energy
as before, at 120 per cent of the former price per unit,
for a total expenditure of 119 per cent of the earlier
cost. At this elasticity, there is almost no effect on
the quantity of energy and emissions, but a large ef-
fect on the total cost to consumers. The other values
shown in the table have intermediate results between
these two extremes. Judged as a strategy to reduce
energy consumption and the resulting emissions
with minimal burdens on consumers, energy price
increases seem quite effective at an elasticity of -1,
but decidedly inferior at an elasticity of -0.05.
What elasticity values are applicable in reality?
Separate estimates have been developed for major
energy markets including industrial energy use,
electricity, and transportation. The largest elasticities
are found in industry. Estimates from three research
groups for 15 countries found the price elasticity for
industrial energy demand to be between -0.77 and
-0.88. The estimates for India and Brazil were not
 Carbon Markets and Beyond: The Limited Role of Prices and Taxes in Climate and Development Policy
significantly different from those for the developed
countries included in the studies (Roy et al., 2006).
Industrial energy use, in other words, provides fertile
ground for the application of price incentives for
emission reduction. Indeed, industry lowered its en-
ergy use much farther and faster than any other sector
in response to the oil price shocks of the 1970s.
Household demand for electricity is much less
elastic than industrial energy use. Recent estimates
for the United States have found a short-run price
elasticity of -0.20, and a long-run price elasticity
of -0.32, broadly consistent with earlier research
(Bernstein and Griffin, 2006).5
This finding of a relatively small elasticity for
electricity does not appear to be unique to the United
States; the estimated long-run elasticity for Taiwan
is -0.16, described as “reasonably close” to the es-
timates in “numerous other studies” (Holtedahl and
Joutz, 2004: 216).
In both industrial energy use and electricity gen-
eration, there are alternative fuels that yield the same
result with differing carbon emissions. An increased
carbon price would cause a noticeable reduction in
industrial energy demand (less so in household elec-
tricity), and also a shift toward lower-carbon fuels
– such as replacing coal with natural gas.
The picture is different in the transportation sec-
tor, where there is essentially only one fuel choice:
almost all transportation uses petroleum fuels. (On
a global basis, the available supply of biofuels is too
small to make a noticeable dent in the demand for
oil.) In the wake of the oil crises of the 1970s, most
countries and industries have cut back on oil use
wherever possible; oil-fired electricity generation,
once relatively widespread, is now common only in
OPEC countries. Today a majority of crude oil is used
for transportation, and a portion of the remainder is
dedicated to non-fuel uses such as petrochemicals,
where there are no close substitutes. The connection
between petroleum and transportation is projected
to grow even tighter; an estimated two-thirds of
the growth in oil demand through 2030 will be for
transportation.6 Thus the oil/transport market is
almost disjoint from the market for other fuels and
end uses.
The lack of alternatives to oil means that in the
short run, price elasticity is close to zero for many
consumers. A household that lives in a completely
5
automobile-dependent environment – including the
great majority in the United States, large fractions
of many OECD countries, and increasing numbers
in fast-growing, middle-income countries – has little
control over the amount of driving required to go to
work, school, stores, and other essential services. So
in the short run, purchases of gasoline will be quite
insensitive to price.
In the long run, as cars are replaced, high oil
prices stimulate the sale of smaller and more fuel-
efficient vehicles, as began to happen in the United
States during the price spike of 2007–2008. This
will eventually affect oil consumption, as the fleet of
cars on the road slowly becomes more fuel-efficient,
implying that the price elasticity will be greater in
the long run than in the short run.
A comparative international analysis estimated oil
price elasticities for many countries for 1979–2000
(Cooper, 2003). For the United States, it found a
short-run elasticity of -0.06 and a long-run elastic-
ity of -0.46, broadly consistent with other published
estimates. For the G7 group of industrial countries,
short-run elasticities ranged from -0.024 to -0.071,
and long-run elasticities from -0.18 to -0.57. Using
these estimates for the United States, a doubling of
oil prices causes a 4 per cent reduction in demand
in the short run, and a 27 per cent reduction in the
long run.
A study focused specifically on the United
States gasoline consumption found that the short-run
price elasticity in 2001–2006 was -0.034 to -0.077,
lower than estimates for earlier periods (Hughes
et al., 2006). The data did not permit estimation of
a long-run elasticity. The authors speculated that
increasing suburbanization and decreased avail-
ability of mass transit have made it more difficult
for most households to reduce their automobile use
today. They concluded that changes in vehicle fuel
efficiency would be the key to future changes in the
United States gasoline consumption.
Short-run price elasticities for gasoline and
other transport fuels are close to zero; this is why the
2007–2008 surge in the price of oil did not cause an
immediate collapse in demand. (Many months later, a
global economic downturn led to lower incomes, oil
purchases and prices; that downturn was not solely,
or even primarily, caused by the high price of oil.)
An increase in oil prices is primarily a burden on
consumers, and causes only a modest change in short-
6 G-24 Discussion Paper Series, No. 53
run oil demand; its longer-term, beneficial effect is
to accelerate the transition to a more fuel-efficient
vehicle fleet.
Any plausible carbon policy would, in the near
term, raise fossil fuel prices by less than the oil price
increases of 2007–2008. While such a policy might
have an important effect on industrial energy use, it
would presumably have less effect on transportation
than the recent surge in oil prices. Something more
needs to be done, to reduce emissions on the scale
and timetable projected by Stern and others.
IV. Where do new technologies come
from?
Market-based incentives such as a carbon price
are much better at some objectives than others. Price
signals lead to efficient choices among existing
alternatives; this is the great success of the market
economy. On the other hand, as noted in the previous
section, carbon prices will generally make the dis-
tribution of income and resources more unequal. In
addition, carbon prices alone will not create the new
technologies needed to solve the climate crisis.
The pure theory of competitive markets has
little to say about technical change. If, as in the text-
book model, all commodities are bought and sold by
small, competitive firms, and all resources are used
to produce the maximum possible satisfaction for
consumers, who has the incentive and the ability to
invest in research? Yet new technologies do emerge,
and productivity grows over time. Conventional
economic models have often addressed this question
with the ad hoc assumption of a predictable, constant
rate of technical change, unrelated to investment
choices or policy decisions. In climate modelling, this
takes the form of an “autonomous energy efficiency
improvement” (AEEI) parameter.7 That assumption
has the unfortunate consequence of biasing results
toward waiting for new technology to appear: abate-
ment will always be cheaper if it is done later, after
better technologies have “autonomously” made their
appearance.
In reality, new technologies do not drop from the
sky, independent of investments and public policies.
New technologies are created by conscious effort;
they often start out expensive and become cheaper
over time, a process that is often described in terms
of “learning curves” or “experience curves.” As a
result, investment in start-up costs can determine
which technologies are cost-effective in the future.
Technological change is path-dependent: the current
suite of available choices depends on past policies
and actions, just as the available technological op-
tions in the future will depend on our policies and
actions today.
The learning curve phenomenon is particularly
important when there is a benefit to standardization;
in such cases, an early market leader can become
“locked in,” whether or not it represents the ideal
technology (as occurred with the Windows operating
system and other Microsoft software for computers).8
The current style of industrialization has been referred
to as “carbon lock-in,” meaning that carbon-intensive
technologies gained an early lead at a time when
fossil fuels were cheap and concern about global
warming was not yet on the horizon (Unruh and
Carrillo-Hermosilla, 2006). Today, the economic ben-
efits of standardization and the low costs of imitating
and replicating existing technology keep the world
locked into that same undesirable path.
Research on learning curves has often found that
as the cumulative total production of a new product
increases, the unit cost declines at a predictable rate.
This is measured by the “progress ratio,” defined as
the change in unit cost per doubling of cumulative
production. In a historic example from the early twen-
tieth century, Ford’s Model T had a progress ratio of
85 per cent throughout its long production run: every
time the cumulative total production of Model Ts
doubled, the price per car dropped by an average of
15 per cent (Abernathy and Wayne, 1974).
New energy technologies often display strong
learning-curve effects. Research on wind power has
found progress ratios as low as 80 per cent (i.e., cost
reductions as great as 20 per cent from doubling of
production) (Junginger et al., 2005). While wind
power is now competitive in the marketplace under
many conditions, this success was made possible by
decades of US and European government investment
in research and development. Brazilian ethanol pro-
duction, another industry launched by government
policy, reportedly had a progress ratio of 71 per cent
from 1985 through 2002 (Goldemberg et al., 2004).
With technological progress at these rates, it
is often the case that private enterprises only find it
profitable to buy a new product after someone else
 Carbon Markets and Beyond: The Limited Role of Prices and Taxes in Climate and Development Policy
has been buying it and bringing down the price for
ten or twenty years. Hence the role for public sec-
tor involvement: governments can and must choose
the new technologies to support, especially when
– as with climate policy – there is a clear need for
change. The market alone is not enough; without
public investment, no credible carbon price would
do an effective job of launching the crucial new re-
newable and low-carbon technologies. On the other
hand, with adequate public support, vast changes are
possible. A plausible model of energy development,
incorporating learning curves, projects that solar
photovoltaics, now one of the most expensive ways
to generate electricity, could be one of the cheapest
options by 2100 (Rao et al., 2006).
This is not a unique characteristic of new energy
technologies; rather, it is the norm in technological
change. The United States Government has funded
the development of numerous innovative weapon sys-
tems, technologies that would not have automatically
appeared without government support. Most of them,
fortunately, have never been used. Along the way,
many other technologies have been developed, with
more peaceful applications to civilian life. In the words
of a history of microelectronics (Morton, 1999),
The U.S. military initially purchased nearly
the total production of transistors in the early
1950’s, using them to make the new generation
of communications, radar and improved avion-
ics systems, command and control systems, as
well as for missiles and jet fighters…
The U.S. government acted as the major market
for integrated circuits in the early years… In
1962 … the U.S. government, with extensive
research interests in space, defense, and other
areas, purchased virtually 100 per cent of all
integrated circuits manufactured in the United
States.
As with wind power, a few decades of generous
public support were sufficient to launch the micro-
electronics industry as a success in the marketplace.
And the list goes on and on: computers got their
start with military purchases; the Internet grew out
of ARPANET, a Defense Department-sponsored
network set up in the 1960s to connect military re-
searchers around the country.
None of these technologies appeared auto-
matically; if the world had waited for autonomous
technical change or relied on getting the prices
right, microelectronics might never have happened.
7
Instead, the United States Government moved rapidly
and succeeded in launching a suite of technologies
that now dominate private markets and shape mod-
ern life.
V. Carbon markets and developing
countries
The discussion of learning curves, path depend-
ence, and technological lock-in applies equally to
climate policy and technologies in developed and
developing countries. However, the current discourse
on carbon markets and climate policies has unique
implications for developing countries, posing obsta-
cles and creating opportunities that are not present in
higher-income countries.
It has become commonplace to insist on the
need for a globally harmonized price of carbon. Price
harmonization is thought to ensure efficiency in the
worldwide distribution of abatement effort: with
appropriate market institutions, investment in emis-
sions reduction will flow to the countries (presumably
developing countries) where the costs of reduction are
lowest. Fears about the effects of unharmonized car-
bon charges have slowed climate policy initiatives in
some high-income countries, and have prompted an
unproductive and potentially protectionist discussion
of border tariff adjustments. This notion is mistaken
both in fact and in theory. Empirically, only a handful
of industries are so carbon-intensive that a difference
in carbon charges could lead them to move from one
country to another – and many of them have already
moved to middle- and low-income countries.
In theory, remarkably enough, marginal abate-
ment costs do not have to be equal in every country in
order to achieve economic efficiency. Theorists who
reach this conclusion generally rely on the unexam-
ined assumption that the world income distribution
is equitable – or equivalently, that increases in per
capita consumption are equally urgent everywhere
(Sheeran, 2006; Chichilnisky and Heal, 1994). In the
absence of that implausible assumption, it is more
efficient to carry out higher-cost abatement efforts in
richer countries. That is, in an inequitable world, ef-
ficiency can be improved by imposing higher carbon
prices in richer countries.
It seems unlikely, however, that the enthusiasm
for a consistent worldwide carbon price will be
8 G-24 Discussion Paper Series, No. 53
dampened by these considerations. Climate analyses
from the Bretton Woods institutions (see section II),
among many others, place a priority on establish-
ing a single global carbon market. Thus developing
countries are likely to face a global carbon price,
while their local prices for labour, land and other
inputs remain far below the levels of higher-income
countries. Carbon emissions, or the credits for avoid-
ing them, will account for a much larger fraction of
the value of production in lower-income countries.
The potential dissonance between expensive carbon
and cheaper local inputs creates both an obstacle and
an opportunity.
The obstacle is that development may be
distorted in the direction of activities that yield
marketable carbon reductions. Even undesirable
activities may be promoted, such as the expansion of
the sponge iron industry in India in order to generate
carbon credits (as cited in section II). Safeguards
are needed to prevent “carbon-allowance-seeking”
investments along these lines; in any global carbon
market, it will be essential to verify that emissions
are not newly created in order to profit by reducing
them. The temptation to seek such bogus allowances,
unfortunately, is a natural consequence of a global
carbon price in a low-cost local economy.
The positive side of the same pattern of prices
is that much deeper reductions in carbon emissions
will be economical in developing countries. In the
simplest terms, saving a ton of carbon is “worth”
more hours of labour at a lower wage rate. So there
may be a category of carbon-saving investments and
technologies that are profitable only in developing
countries, where the tradeoff between carbon and
other inputs is more favourable to emission reduc-
tion. With appropriate public initiatives and financing
for these technologies, developing countries could
“leapfrog” beyond the patterns of energy use in
higher-income countries, establishing a new frontier
for carbon reduction.
The potential for leapfrogging beyond the cur-
rent technology frontier has been much discussed,
but is difficult to achieve. The classic example is in
telephones, where developing countries can now skip
the expensive development of universal land lines,
and go directly to cell phones. This is not, however, an
example of jumping to an entirely new technology; it
became possible only after cell phones were invented
and commercialized in developed countries (Unruh
and Carillo-Hermosilla, 2006). Likewise, research on
the Chinese auto industry has shown that there is little
tendency toward leapfrogging beyond international
standards; in fact, the United States auto companies,
left to themselves, have often allowed their Chinese
plants to lag behind their home-country technologies
(Gallagher, 2006). Stronger Chinese government
policies and initiatives would be required to achieve
the potential for newer, cleaner vehicle technologies.
Even for a developing country with the extensive
resources and potential of China, there is much that
needs to be done to reach this new technological
frontier.
To realize the opportunity created by a global
carbon price in low-cost economies, there will be a
need for research and development in appropriate,
cutting-edge technologies for carbon reduction. As
with many of the new energy technologies that will
be needed around the world, decades of public invest-
ment may be required before the developing-country
technologies are successful in the marketplace. This
is one more reason why carbon prices are necessary,
but not sufficient, for an equitable solution to the
climate crisis.
VI. Conclusion
Setting a price for carbon emissions is a valuable
beginning, but not the end, of climate policy. Much
more needs to be done to complement the new mar-
kets in carbon emissions, and to ensure an effective
policy response to the threat of climate change.
Reliance on carbon price increases alone would
be both ineffective and inequitable. For end uses with
small price elasticities, such as residential electricity
and, above all, transportation, a higher fuel price leads
primarily to a less equal distribution of resources, not
to a reduction in carbon emissions. Other policies
are needed to offset the equity impacts of higher fuel
costs, and to launch the new, low-carbon energy tech-
nologies of the future. Because technology choice is
path-dependent, with strong learning curve effects,
public sector initiatives are essential to ensure that the
global economy follows a climate-friendly path.
The next international agreement on climate
policy is likely to move toward a globally harmonized
carbon price. This creates a unique opportunity for
developing countries, by making it cost-effective
to spend more local resources on carbon reduction
 Carbon Markets and Beyond: The Limited Role of Prices and Taxes in Climate and Development Policy
in lower-cost economies. A global carbon price
will make it profitable for developing countries
to “leapfrog” beyond the technologies in place in
higher-income countries.
Notes
1 E.g., “Energy-efficiency improvements are unlikely to
eliminate the need for carbon prices, but they would reduce
their level” (IMF, 2008, chapter 4: 40).
2 “Consolidating Efforts to Mobilize and Deliver Finance”,
“Expanding the Bank’s Role in Developing New Mar-
kets” and “Tapping Private Sector Resources for Climate
Friendly Development”.
3 “Scaling Up Operational Approaches to Integrating
Adaptation and Mitigation in Development Strategies”,
“Clarifying the Bank’s Role in Accelerating Technology
Development and Deployment” and “Stepping Up Policy
Research, Knowledge Management and Capacity Build-
ing”.
4 Price elasticities are, strictly speaking, negative numbers.
This discussion follows the common convention of refer-
ring to numbers farther from zero (or larger in absolute
value) as “larger” elasticities; thus an elasticity of -1 is
“larger” than an elasticity of -0.5.
5 See also Reiss and White (2005) estimating a long-run
price elasticity for California households of -0.39, and
commenting that high-quality past studies have generally
yielded estimates between -0.15 and -0.35.
6 United States EIA (2007) says transportation will account
for two-thirds of the growth in world oil use through 2030;
OPEC (2007) data implies that transport will absorb 62 per
cent of the growth in oil use.
7 The model used by the IMF, in the analysis discussed in
section II above, assumes an AEEI of 0.5 per cent per year
(IMF, 2008, chapter 4: 46).
8 The classic references on technological lock-in include
Paul David (1985) and Brian Arthur (1994).
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