Projecting the Economic Implications of Carbon Pricing in China

As one of the largest greenhouse gas emitters, China has recently been increasing its efforts to reduce carbon dioxide emissions, which is the largest contributor to climate change. One of China’s goals, as set in last year’s Paris Agreement, was to cut emissions by 60 to 65 percent per unit of gross domestic production (GDP) by 2030, as compared to the 2005 levels of 0.872 kg per unit of GDP. To realize this goal, China must rethink its approach to economic development and implement specific environmental policies.

As China develops these environmental reforms, the economic consequences of the policies must be considered. A recent World Bank study, which was the first analysis of its kind, examines the economic impacts of China meeting its goal through a Recursive Dynamic Computable General Equilibrium Model of the Chinese economy. The study projects the changes based on a market mechanism — carbon pricing — in which all fossil fuels are taxed in proportion to their carbon content. The study finds that changing the carbon price and recycling carbon revenue back into the economy can actually influence the efficiency of carbon prices and enable China to meet its targeted reduction of CO2 emissions before 2030.

To examine the economic effects of the policy, the authors first develops a baseline through 2030 with existing energy plans and continuously rising carbon emissions. They compare this baseline to scenarios with different carbon pricing levels and a policy for additional investment in renewables. More specifically, the researchers study two scenarios, one with lower carbon pricing and another with higher carbon pricing, in order to assess what is needed to achieve a 60 and a 65 percent reduction in carbon intensity of GDP from 2005 levels. For the 65 percent target, they also compare a fixed carbon surcharge on fossil fuel over time to a trajectory where the surcharge starts low and rises every year. The results show that instead of remaining constant over time, the carbon price that gradually rises to the targeted intensity is more economically efficient in the sense that it corresponds to a higher GDP.

Recycling the revenues generated from carbon pricing is another important component of the overall carbon tax approach. The study evaluates two approaches: a lump sum transfer to households and cuts to the value-added tax (VAT) and capital income tax. The researchers conclude that the latter is more efficient than the former. When carbon revenue is recycled to cut existing taxes in this way, the carbon surcharge rises from 1.6 yuan per ton of CO2 in 2016 to 26 yuan per ton of CO2 in 2030, to achieve a 60 percent reduction in CO2 intensity. This surcharge decreases energy use by 2.6 percent, electricity use by 1.5 percent, and GDP by 0.11 percent. To achieve the 65 percent reduction goal, the carbon surcharge on fossil fuel rises to 157 yuan per ton in 2030 and lowers the GDP by 0.74 percent from the baseline case. By contrast, if the carbon revenues are given to households as a lump sum rebate, then GDP is 1.2 percent lower than the baseline case in 2030, instead of 0.74 percent lower. This result corresponds with the finding from many other scholars that recycling revenues from carbon pricing by reducing existing tax rates is a more efficient approach than household subsidies to mitigate negative economic impacts.

This study examines the economic consequences of a carbon pricing mechanism that could be used by China to reduce the energy intensity by 60 to 65 percent in 2030 compared to the 2005 level. The conclusion is that a carbon pricing policy that would lead to a 65 percent reduction in intensity would yield a modest cumulative loss in GDP. By 2030, the cost to GDP would be 0.74 percent lower than the base case by recycling the revenues generated from the carbon pricing back to the economy and cutting taxes. It is important to note that the study focuses only on the market mechanism of carbon pricing and does not reflect China’s actual plan that includes both market and non-market measures. Additionally, the researchers also leave the study of other greenhouse gas emissions like methane, nitrous oxide, and ozone to future work. In terms of impact, however, this study shows that carbon pricing policy has the potential to reduce energy use, to decrease the activity of energy intensive industries, and to promote the deployment of renewable energy in electricity and heat generation.

Article source: Jing Cao, Mun Ho, and Govinda Timilsina. “Impacts of Carbon Pricing in Reducing the Carbon Intensity of China’s GDP.” World Bank Policy Research Working Paper 7735, 2016.

Featured photo: cc/(Cedar_Liu, photo ID: 523399312, from iStock by Getty Images)