Carbon Pricing Isn’t Enough to Mitigate Climate Change

Last week, as a heat wave swept across Europe, temperatures passed 40 degrees Celsius (or 104 degrees Fahrenheit) for the first time in British history, grounding planes and melting train tracks. More than 2,000 people died in Spain and Portugal from heat-related causes; both countries suffered dangerous wildfires in addition to brutal heat. Italian crops have been parched by the worst drought for decades; French nuclear plants are running low on water for cooling; and in Germany, the Rhine River is inches from being too low to carry freight shipments.

This dangerous weather pattern and its effects are acute symptoms of the climate crisis, but they also present European states with an opportunity: This summer’s deadly heat wave could be the third major impetus in just two years for countries to acknowledge that tilting European markets through carbon pricing isn’t enough to address the climate crisis. To meet the existential challenge, states must intervene aggressively in markets, starting with energy regulations and industrial policies.

The coronavirus pandemic first provided momentum for aggressive state action on emissions, as European governments restricted transport to combat an invisible threat and borrowed and spent unprecedented sums of money. Through the European Union’s pandemic recovery package of 672.5 billion euros (or $683 billion), at least 37 percent of which must be spent on climate action, states began making capital investments closer to the level necessary to keep global warming below 2 degrees Celsius. For example, Italy is applying some of its EU funds toward tax credits for homeowners, worth 110 percent of the cost of green renovations. It also announced its support for a battery gigafactory, part of a broader push to spend more EU public funds on the energy storage industry.

Then, Russia’s war in Ukraine drastically exacerbated an energy shock that began in 2021 as governments lifted COVID-19 restrictions and demand rebounded. This summer, European gas and power prices have multiplied from their pre-pandemic levels. This shock has given European governments another push to take a stronger approach to controlling the energy sector. Germany plans to take a 30 percent stake in energy firm Uniper, which is going bankrupt without access to Russian gas. France has fully nationalized its own debt-laden power company, EDF. Italy, Romania, and Greece are levying a windfall tax on energy firms’ high profits as prices climb. Meanwhile, the European Commission has asked member states to take steps to reduce demand for energy and has proposed granting itself the power to declare an alert that would make these reductions mandatory.

These are unusually forceful moves for European governments that have long relied on carbon pricing to guide their energy sector and pursue climate targets. The EU’s Emissions Trading System is a cap-and-trade approach that requires power plants and industrial installations to buy a permit for each ton of carbon they emit. There is no question it has been useful, helping make the EU’s power sector 54 percent less emissions-intensive than in 1990. However, more statist economic management was always going to be necessary to address the climate crisis: Even with carbon pricing, markets do not move quickly enough to push out fossil fuels.

Like all market-based interventions, carbon pricing has limitations. For one, it is better at incrementally optimizing existing technologies and business models than promoting transformative change. Utilities will gradually convert coal-fired power plants to run on cleaner-burning natural gas, and steel producers will make their existing blast furnaces more efficient. But carbon pricing won’t be of much use in supporting alternative meat or persuading local politicians to change zoning laws to allow higher density; it struggles with high-hanging fruit.

The climate crisis is a systemic problem, bigger than market failure. Many obstacles to the energy transition are, in fact, non-price barriers—such as limited infrastructure, powerful firms determined to keep using gas pipelines to recoup their investment, or homeowners who don’t want wind turbines to ruin their view. These are examples of so-called carbon lock-in, when fossil fuel systems become entrenched not only because of the billions of dollars sunk in them but also because politicians, firm managers, and citizens get so used to them. Non-price barriers in part explain why Sweden, which has one of the world’s highest carbon prices (over $120 per ton of carbon dioxide) has barely reduced transport emissions since introducing the tax in 1991: People rarely buy new cars and won’t switch to electric vehicles if there aren’t enough chargers.

The laws of supply and demand can also inhibit the effectiveness of market-based tools. As demand for clean energy technologies increases, it pushes up the prices of the materials required to make them, offsetting economies of scale for things like electric car batteries. The prices of key minerals, such as cobalt and lithium, have risen drastically in the past year. The unfortunate flip side is that as more machines start to run on clean energy, demand for fossil fuels will fall, lowering their prices and leading to rebound effects. To avoid this, policymakers may not only have to tax carbon, but they may also have to proscribe it.

Furthermore, although not transformational, carbon pricing may ask too much of societies under strain in the short term. The current energy shock has reinforced that allowing high energy prices to undercut demand has serious constraints. Citizens react angrily to rising fuel prices, as with the recent truckers’ strike in Spain. The burden is especially heavy for poorer households, which spend the largest share of their income on energy. Few European governments have resisted public pressure to protect citizens with subsidies, and many countries are now releasing oil from strategic reserves or breaking climate pledges to support new drilling. It seems there are still limits to how far carbon pricing can go.

The EU is admittedly taking some steps to circumvent these constraints. The bloc is setting up a carbon border adjustment to tax imports from countries with weaker climate policies; that will allow it to stop handing out free pollution permits to domestic manufacturers—as it has done so the manufacturers can compete with foreign producers. It is also channeling some carbon pricing revenue into the Social Climate Fund, which will redistribute funds to citizens to make up for high fuel costs. Finally, it is pursuing innovative measures like carbon contracts for difference, whereby governments can make up the difference if carbon prices are not high enough to incentivize companies to switch to pricier manufacturing processes.

Even with these policies, it is difficult for carbon pricing to be aggressive enough to drive change at the pace needed to meet the Paris Agreement targets. Instead, governments must treat carbon pricing as just one tool and not be afraid to turn to supposedly radical regulation and state planning. This summer’s heat wave could allow reticent countries to abandon neoliberal market orthodoxy—which even social democrats are mostly loyal to—and adopt a more active approach to managing the energy transition. The EU has made progress on this front this year: The European Parliament has voted to ban new fossil-fueled cars by 2035, and Germany is banning installations of new gas boilers by 2024. This isn’t tilting markets; it’s steering them.

Europe also needs more old-fashioned industrial policy, where the state accelerates the development of specific sectors, technologies, or projects. By setting binding climate targets, states have already done this to a significant degree—implicitly favoring clean energy over the fossil fuel industry. The risks of doing too little to address the climate crisis are much greater than the danger of betting on electric vehicles over less efficient technologies like synthetic fuels for cars.

Crises like the heat wave that hit Europe this month can jolt governments into action. Polling from Australia, for example, found that people impacted by the 2019 bushfires were more likely than others to be very concerned about climate change, and in 2022, Australians voted out the climate laggards of the Liberal Party in favor of the greener Labor government. The latest heat wave has demonstrated the urgency of the threat—and it could accelerate a policy shift by showing that tilting markets and waiting for good emissions results won’t suffice.

Governments cannot approach aggressive energy regulations and industrial policy initiatives only as emergency response tools; they must be a permanent part of the toolkit. It’s great that the German bailout of Uniper’s gas business will finally force firms to diversify their gas supplies, but how can a government with ambitious wind power goals also allow a manufacturer to shut down the country’s last remaining factory for wind turbine blades? And why shouldn’t the EU go ahead and make its pandemic recovery fund permanent and invest in solutions to tomorrow’s problems?

The climate crisis strikes in slow motion. But these latest crises have at least given states the political cover and motivation to smash the glass and pull out the emergency tools. It’s time to plan.