A Dynamic Comparison of the Cost-Effectiveness of Carbon Pricing Policies

To meet the goals of the Paris Agreement of avoiding dangerous climate change, decarbonisation of the global economy needs to proceed around three to five times faster over the coming decade than over the past two decades. This poses a great challenge for policy. Carbon pricing has often been put forward as the most efficient, or cost-effective, policy for achieving decarbonisation. This paper uses a stylised agent-based model to investigate whether implementing non-equilibrium dynamics and endogenous innovation results in more effective emission reductions for carbon tax compared with emission trading schemes. We find that the implementation of a carbon price is not policy-agnostic and that a carbon tax achieves faster emissions reduction, lower cumulative emissions, and lower cumulative (potentially wasted) investment in fossil fuel assets than a cap-and-trade policy with the same average carbon price. While a comparison between carbon pricing and alternative policies is outside the scope of this paper, we consider the broader policy implications that may be drawn from a new theoretical explanation for the difference in performance of the alternative carbon pricing approaches, and suggest that the traditional view that policy should aim to minimise the marginal emissions abatement cost is mistaken.