For those around the world who remain concerned about the harm from climate change, a lynchpin of policy is to make energy sources that emit carbon dioxide more expensive than “clean” sources. But how we impose that price margin is a matter of (often fierce) debate.

Economists are fond of taxing carbon use, while tax-averse but climate-motivated politicians prefer to disguise the costs through regulation. The latter might mean mandating the supply of some minimum fraction of energy from renewable sources or providing tax credits for wind and solar generation or subsidies for electric vehicles.

This leaves the question of how big this price margin should be, either directly as a tax on CO₂ emissions or indirectly as a subsidy for clean alternatives. And roughly speaking, there are two basic options. One is to estimate the costs that today’s emissions would impose on future generations from emissions’ impact on atmospheric temperatures. Examples of such costs range from reduced agricultural productivity to damages from increased storm severity and sea level rise. This added cost is referred to as the “social cost of carbon” (SCC).

Estimating the SCC is difficult since there are uncertainties about both the size of the impact of emissions on future temperatures and the effect of changes in temperature on the value of future economic activity. Apart from those uncertainties, calculating the SCC involves controversial policy choices. Thus, in its first term, the Trump administration proposed reducing the Obama-era SCC by about 85 percent simply by restricting attention to climate effects on the U.S. (rather than the world) and increasing the rate at which future damage is discounted.

The second approach to finding the appropriate price margin is to start at the other end, mandating a limit on how much can be emitted and using a permit system to ensure that the limit is not exceeded. To reduce the overall cost of staying within that limit, these permits can typically be traded. This allows enterprises that have the ability to reduce emissions at low cost to take on more of the burden by selling permits to those who face higher containment costs without changing the total amount emitted. These “cap-and-trade” programs are used in the U.S. for limiting sulfur dioxideemissions and in the EU (as well as some states in the U.S.) to limit total CO₂ emissions. 

The term “net zero,” used as an aspirational target for CO₂ and other greenhouse gas emissions, looks a lot like this kind of quantity standard. It is “net zero” rather than “zero” because emissions could in theory be balanced by removal of greenhouse gases from the air. One method is carbon sequestration – in practice, expanding forests to take carbon from the atmosphere and store it in trees. Whether this actually works has long been debated, since one has to verify that the claimed extra forest would not have otherwise been planted (or preserved). 

The other method is direct air capture, which thus far remains quite expensive but, as we will see, may play an important role in emissions containment.

Social Cost of Carbon and Net Zero Approaches Aren’t the Same

If the result is the same price on carbon emissions, should it matter whether we use the SCC price approach or a net-zero quantity approach? If we had perfect foresight, the answer is no. One could pick a quantity to hit a preferred price target equal to the SCC. Or one could set a price that would lead to a preferred quantity of emissions – in this case net-zero emissions.

But we’re short on crystal balls. Changes in both economic activity and technology can alter the relationship between emissions prices and quantities, so one does not determine the other in advance. For example, other things equal, the greater the rate of economic growth, the greater the demand for fossil fuels and the greater the emission of CO₂. So the emissions price that implies net zero in today’s economy may mean a whole lot more emissions when the economy is 10 percent larger. Technological change that reduces fossil fuel use for a given level of output will have the opposite effect.

In his 1974 research paper, “Prices vs. Quantities,” Martin Weitzman of Harvard showed that the optimal policy approach depends on the nature of the harm inflicted by the pollutant – in this case, carbon dioxide. Leaving out the math as well as some complicating factors, the simple rule is that if the additional harm from each unit of pollutant is unchanged over time, a price rule such as a tax based on the SCC is best. Whether economic activity is larger or smaller, or technological change is faster or slower, polluters will emit more only if the benefit of doing so is enough to cover that constant cost.

On the other hand, suppose that harm is minimal until one reaches some critical threshold, after which harm drastically escalates – for example, through radically increased fatalities. If it is important that emissions stay below this critical level, a quantity-cap approach like net zero will be a better way to ensure that total emissions don’t exceed the cap.

This implies that the SCC price approach is likely to be better if incremental damages from increased carbon dioxide emissions are constant, while a net-zero approach will be better if there is a critical threshold. The best approach, then, depends on geophysical and economic facts regarding the harm done by greenhouse gas emissions. The crucial point here is that the two approaches to limiting emissions have different effects, and that the optimal choice will turn on how emissions drive damages. 

Net Zero of What?

Net zero intuitively seems more appropriate than the SCC approach if the concern is that beyond some level of atmospheric warming – say 2 degrees Celsius – one reaches a tipping point regarding, say, interruption of the Gulf Stream current that would impose major harm on the planet. But the next question to ask is “Net zero of what?”

I am not a geophysicist, but I am pretty sure that global warming depends on the total concentration of greenhouse gases in the atmosphere, not annual emissions of gas. If I’m right, it follows that net zero should be about capping the total amount of CO₂ emitted over time. If CO₂ lasts essentially forever in the atmosphere – it certainly can persist for hundreds or thousands of years – then achieving net zero means that one should treat the ability of the atmosphere to hold carbon dioxide below the critical level as a finite, exhaustible resource like, say, copper.

If so, the method for calculating a carbon emissions price should not be based on expected future damages, as with the SCC. Instead, one should apply what natural resource specialists call the Hotelling Rule, from a 1931 article by the mathematical economist Harold Hotelling. That rule implies that one should choose a carbon price for today and then let it increase over time by the expected rate of return on productive investments. (This is because one could “invest” in the future value of the resource by not using it today.) That initial price should be set so the demand for that resource just equals the current supply. 

If the goal is net zero, the carbon surcharge should be raised gradually so that the total (not annual) amount of carbon dioxide emitted should just equal this critical level and not go higher. That’s the idea, anyway. But finding the appropriate initial price for carbon requires considerable information regarding the future demand for fossil fuels. Whether this is more or less information that is needed to calculate the SCC is beyond my expertise.

Yes, But …

One positive complicating factor was mentioned above: the potential for direct air capture of greenhouse gases. The Hotelling time path for net zero would need to be set only so the price of emitted carbon dioxide never goes higher than the cost of removing CO₂ from the air. And there is a possibility that at some point it will be cheaper to capture carbon than to conserve energy or to switch from fossil fuels to renewables.

The bad caveat here is that getting to net zero would require the whole globe to adopt the net zero carbon price time path – no free riders, please. This is different than the SCC approach, where every ton of CO₂ not emitted avoids the estimated damage. And reaching such a global agreement (and sticking to it) seems even less likely after the U.S. has walked away from climate mitigation policy.