Getting to net-zero emissions is essential to achieve the goals of the Paris Agreement. A key question is how much carbon pricing can help reduce emissions, stimulate low-carbon investment, and fund emission captures. Indeed, carbon pricing generates various expectations. Some expect carbon pricing to incentivize technological change consistent with full decarbonization. Others aim at using carbon pricing to raise revenues and mobilize private financing that can eventually be channeled to environmental investments in the region. Truth be told, carbon prices used in Latin America and the Caribbean are not quite there yet. Let’s see why.
- Carbon pricing alone cannot be a transformational instrument
In theory, carbon prices, imposed using cap-and-trade systems or carbon taxes, can help incentivize emission reductions. But in practice, carbon prices used around the world have not had enough impact yet: emissions reductions from existing carbon prices are limited to between 0–2% per year.
In addition, the evidence suggests that carbon prices incentivize marginal operational changes—such as using existing gas power plants instead of existing coal power plants—but do not necessarily result in investments into the technology and infrastructure required to reach net-zero emissions—such as deploying more wind and solar power. A key reason is that carbon prices are often low, and they tend to not cover all sectors, gases, and emission sources. Another important reason is that carbon pricing cannot work in a vacuum: governments also need to act on regulations and infrastructure deployment to enable the transition. For instance, by reforming energy markets to leverage wind and solar power or building bike lanes and metro lines so that people do not depend on their cars for daily commutes.
- Carbon revenues can fund some environmental action, but redirecting other sources will be essential.
Revenue-wise, carbon pricing can help funnel resources to environmental protection. In Colombia, 80% of the carbon tax goes to a newly created environmental Fund. In Costa Rica, the local payment for ecosystem scheme, which has been instrumental in reforesting the country and preserving its breathtaking biodiversity, is funded by a tax on diesel and gasoline. Given that environmental protection is chronically underfunded, carbon revenues can make a very significant contribution.
But carbon pricing alone cannot fund the transition, which will require spending 7 to 19 percent of GDP every year on climate-related goals. At the macroeconomic level, proceeds are still very small. Due to the combination of low taxation and high fuel subsidies, the region collects the second lowest tax revenue from fossil fuels in the world: just 0.06 percent of GDP, compared to the world’s average of 0.7 percent of GDP. The key is to understand that climate change spending is often the same as development spending and that the transition is about redirecting existing flows. For instance, making the regulatory changes that will let private investors choose solar and wind, rather than gas or coal, to power household consumption and economic growth.
Voluntary carbon credit (or offset) markets are another possible funding source. But designing credible credit markets is not an easy task; it requires precise monitoring, reporting, and verification systems. A recent investigation found that many forest-preservation projects overestimate how much emission reduction they generate.
Moreover, the size of the voluntary carbon credit markets is still insufficient. In 2021, voluntary markets generated almost US$2 billion globally, whereas the region needs to invest $280 billion every year just to provide basic access to decarbonized and climate-resilient infrastructure services.
In addition, ministries of finance will need to consider that cooperation mechanisms under Article 6 of the Paris Agreement require corresponding adjustments between the transferring and the receiving party. Countries that sell credits abroad need to add those emissions to their inventories, making it more difficult to fulfill their own NDC.
- Energy subsidy reforms and carbon taxes are unpopular, in no small amount, because of their distributive impacts.
Even if carbon pricing can be a viable climate policy, the phasing out of fossil fuels subsidies may be the priority. The region spends about 1.1% of GDP subsidizing emissions. One issue, however, is that removing energy subsidies hurts consumers, especially by increasing the price of public transport, the cost of operating a car, and even the cost of food, which has to be transported from the farms to the cities. Theoretically, governments can redistribute carbon revenues back to consumers in the form of equal per capita transfers, ensuring that poor people would benefit. But in practice, doing so is difficult: a recent study shows that in the region, existing cash transfer programs do not reach all poor households. Moreover, cash transfers would not necessarily compensate the most affected households: those who own a car or use natural gas for cooking. Governments would need to broaden coverage of existing cash transfer programs or consider using instruments such as in-kind transfers to compensate households and make reforms more politically acceptable.
Is Carbon Pricing Seducing the Ministries of Economy and Finance?
Carbon pricing generates considerable interest among ministries of finance in Latin America and the Caribbean. Back in August 2022, they created the Regional Climate Change Platform of the Ministries of Economy and Finance to exchange knowledge in formulating fiscal policies to face the challenges posed by climate change. One of the 3 priorities for the work plan 2022-2023 is for ministries of finance to better understand what carbon pricing can achieve in the region. With this in mind, a working group on fiscal incentives for climate change was established under the leadership of the Ministry of Finance of Chile.
The group seeks to improve understanding of the constraints and barriers impeding progress in incorporating carbon pricing into the climate policy of Latin American and Caribbean governments. For this working group, the ministries agreed on a work plan that includes the following activities:
- Capacity building. Conduct regional workshops on carbon pricing, including carbon taxes, emissions trading programs, and Article 6 of the Paris Agreement. The first workshop was carried out in collaboration with the UNFCCC.
- Survey of expectations of finance ministries in the region regarding carbon pricing mechanisms and existing experiences such as challenges, progress in their implementation and impact results.
- Review of the empirical evidence on the results that carbon pricing mechanisms have had internationally vis a vis the expectations that ministries of finance have on them.
Some countries, such as Argentina, Colombia, Chile, Uruguay, and Mexico, have already developed carbon taxes. But carbon pricing can take other forms, such as tariffs and those arising from implementing Article 6 of the Paris Agreement. Knowledge of how these instruments work and their possible outcomes is still incipient in the region, with a wide array of expectations about them and how they can contribute to climate action or fiscal results.
Despite the challenges associated with carbon prices, they can still be helpful if well-designed, backed by strong institutional capacities, and used with realistic objectives within a mix of environmental policies. The Regional Climate Change Platform of Ministries of Economy and Finance is working to provide a practical and realistic view of what carbon price mechanisms can deliver. When the goal is to enable a transition to a net-zero economy, fixing all these issues can be as or more important than implementing a carbon price.