When Non-Uniform Carbon Prices are Efficient and Fair: Implications for Transfer Schemes and Carbon Markets

An international carbon pricing regime offers significant efficiency gains by avoiding climate change and reducing emissions at least cost. We clarify the role that country-specific prices play with respect to efficiency and burden sharing in an unequal world. Country-specific carbon prices are efficient and serve society's equity objectives if second-best constraints exclude optimal transfers to deal with pre-existing inequalities. This also holds true within the framework of carbon markets, where trade at a common price is just one allocation at the (constrained) Pareto-efficient frontier if the initial permit allocation is fixed. A common carbon price aligns with social objectives if transfers or initial permit allocations can be freely adjusted, and otherwise differentiated prices may be preferable. But the social welfare gains from differentiated carbon prices may vary depending on empirical facts. We present a theoretical model which connects the level of national carbon prices to the choice of social welfare functions that capture various equity principles. With a calibrated integrated assessment model we quantify country-specific carbon prices for a large set of countries and show that they can significantly promote social welfare.