Climate Policy Needs Carbon Pricing, Not Just Green Subsidies

Fighting climate change is difficult because it is a global problem that requires coordinated action across countries, industries, and individuals with differing interests and priorities. The benefits of reducing greenhouse gas emissions are often long-term and widely shared, while the costs of mitigation are immediate and concentrated on specific sectors and communities.

Economic growth, energy security, and political considerations can conflict with environmental objectives. In addition, climate change involves scientific uncertainty, unequal impacts across regions, and challenges in enforcing international agreements. Existing infrastructure and dependence on fossil fuels further slow the transition to cleaner technologies, making meaningful progress complex and contentious.

Given these myriad difficulties, it is instructive to learn what recent research covering the global economy tells us about what works and what does not when it comes to fighting climate change.

This research presents a dynamic integrated assessment model (IAM) of climate change and the economy with unprecedented geographical resolution. The authors build on Nobel laureate William Nordhaus’s seminal work, extending it while maintaining analytical tractability. The model combines neoclassical growth theory with detailed climate dynamics and a rich energy sector, thereby allowing for sophisticated policy analysis.

The model features several key components involving consumers, the inputs of labour and capital, and the energy sector. Countries exhibit heterogeneity in their energy mixes, with shared parameters calibrated to reflect actual fuel usage patterns.

A crucial innovation is the treatment of what economists call total factor productivity (TFP). Regional TFPs follow a hump-shaped relationship with temperature, peaking around 15°C. The damage function, estimated from cross-sectional productivity data, implies that colder regions may benefit from moderate warming while already hot regions suffer severely. The climate system uses Nordhaus’s three-carbon-sink structure updated with parameters from recent climate science that better replicate comprehensive global climate models.

Key Findings
The research conducts three policy experiments with striking results. First, a modest uniform global carbon tax of $30 per tonne of CO₂ (growing with world GDP) proves remarkably effective. The authors report that this tax reduces projected warming by nearly 3°C by 2140 compared with the laissez-faire situation.

Importantly, welfare effects are highly uneven. While northern countries may experience gains from moderate warming, tropical regions near the Sahara face devastating productivity losses equivalent to multiple Great Depressions. The tax largely prevents the most severe temperature increases that would otherwise force hundreds of millions into extremely hot conditions where productivity plummets.

Second, non-uniform policies that exempt the poorest countries from carbon taxation while raising taxes elsewhere to achieve the same temperature target prove highly inefficient. When countries below 25% of world GDP per capita face zero carbon taxes, other nations must increase their taxes 2.2-fold. The resulting welfare losses are approximately 1% of world consumption, with almost all continents suffering. While Africa and parts of Asia gain, these benefits are dwarfed by losses elsewhere. The authors argue that uniform taxation with compensatory transfers to poor countries would be superior.

Third, green technology subsidies without carbon taxes—resembling the US Inflation Reduction Act—perform poorly as a climate policy. Even when green energy prices fall by 2% annually worldwide and electrification increases substantially, warming reductions are modest. This policy fails because cheaper green energy increases overall energy consumption more than it displaces fossil fuels. When green technology improvements are confined to the US and the EU, the effect is essentially negligible.

Policy Implications
This research draws several important conclusions. First, carbon taxes are far more effective than green subsidies because they directly raise fossil fuel prices rather than simply lowering the cost of alternative energy. Second, policy uniformity matters greatly. Exempting poor countries from carbon taxation, while perhaps politically appealing, is economically costly. Third, the spatial dispersion of climate damage dominates average effects; aggregate welfare measures obscure substantial regional heterogeneity.

No research can meaningfully address every aspect of the devilishly difficult problem of fighting climate change, and the research described here is no different. Accordingly, the authors emphasise “deep uncertainty” surrounding climate sensitivity and damages and suggest that their framework can help evaluate policy robustness rather than prescribe optimal policies.

This research makes significant contributions to climate economics by developing a tractable, highly spatially disaggregated IAM. Its key insights—that modest uniform carbon taxes are remarkably effective, that non-uniform policies are inefficient, and that green subsidies alone cannot solve climate change—have important policy implications. The plug-and-play nature of the model should facilitate further research into regional heterogeneity in climate policy design.