How does enforcement of an ETS work? And why is it that firms still comply at nearly 99% when enforcement of violations seems low. Those are the questions I tackle in my new podcast episode with Frank Venmans. He, together with Raphael Calel and Antoine Dechezleprêtre wrote a paper “Policing Carbon Markets”, which studies compliance and enforcement in the EU Emissions Trading System.

And their headline result is striking: compliance is extremely high, at around 99%. But the standard economic explanations fail to explain much of the variation in compliance. So what is going on? Well, tune in to find out!

Also, what I think the paper does really well is show a less glamorous but very important lesson: carbon markets are technically complex. Registries, reporting systems, verification, financial regulation, and data management all matter enormously for whether the system works in practice!

Paper: https://www.tandfonline.com/doi/full/10.1080/14693062.2025.2464699 , and

Frank Venmans’s site: https://www.fvenmans.com/

Transcript

Arvid Viaene:
After the past two episodes on the social cost of carbon, I want to return to one of our main tools for fighting climate change: carbon markets, and more specifically, the European Union Emissions Trading System.

We have already covered the EU ETS quite a bit on this podcast — its history, how it works, and possible future developments. But one element we haven’t tackled yet is how to deal with non-compliance by firms. You can set a cap on emissions all you want, but if firms don’t follow the rules, it might all be for nothing.

Carbon markets are also relatively new, so this problem can be challenging. When I discovered a paper called Policing Carbon Markets that tackles exactly this question, I was very excited. The paper was published in Climate Policy in 2025 and presents a comprehensive analysis of compliance in the EU Emissions Trading System, combining some impressive data collection with detailed empirical analysis.

I’m delighted to have one of its authors with me today, Frank Venmans. Frank is an Associate Professor and Deputy Research Director at the Grantham Research Institute at the London School of Economics. He studies how we can design effective climate policy under uncertainty, with a particular focus on the path to net zero, technological change, inequality, and climate risk. His work combines economic modeling with empirical research on carbon markets, climate litigation, economic growth, biodiversity, and carbon removals. With a background in forestry and soil management, he brings a broad perspective connecting economics, climate science, and policy.

Frank, welcome to the podcast.

Frank Venmans:
Hello, Arvid. Thanks for inviting me.

Arvid Viaene:
I’m very excited to have you on. Sometimes I become curious about a particular question, then discover a paper tackling exactly that issue, and I thought this was a really great paper. So to start, what question are you trying to answer?

How High Is Compliance in the EU ETS?

Frank Venmans:
The first question is simply: how good is compliance? What is the compliance rate? And there we observe relatively high compliance.

The second question is what can explain why some countries perform better than others. What mechanisms do regulators use? How do those mechanisms differ between countries, and can those differences explain some of the non-compliance we observe?

Then there is the question of enforcement: what actually happens when there is non-compliance? The general finding is that the consequences are not particularly dramatic in practice. That creates something of a contradiction. In a standard economic model, we would think of a company as maximizing profits. If there is an opportunity to cheat, it weighs the expected consequences — the punishment multiplied by the likelihood of getting caught — against the gains from cheating.

But that model turns out not to be especially well supported by the data. So we are left with something of a puzzle: very high compliance alongside relatively limited enforcement. We haven’t completely solved that puzzle, but we investigate a number of mechanisms that might explain it.

Arvid Viaene:
Could you say more about the actual rate of compliance you found?

Frank Venmans:
On average, 98.8 percent of companies are compliant, excluding 2005. The year 2005 was the first year of the system, and compliance was much worse. Around 22 percent were non-compliant. But this was effectively a trial phase, and the system had been established very rapidly.

The relevant EU legislation came in 2003, and trading started in 2005. That is also why it was smart to make the first phase largely separate from the later phases. You couldn’t bank allowances left over in 2007 and use them in 2008. Whatever went wrong during the first phase was therefore largely contained within that initial period.

Once you move beyond that phase, though, compliance is extremely high.

Arvid Viaene:
So essentially 99 percent of firms comply. Were you surprised by how high that number was?

Why Complying With an ETS Can Be Easier Than With Traditional Regulation

Frank Venmans:
We didn’t necessarily have a strong prior before starting the project.

More generally, I think large industrial companies tend to have a preference for complying with environmental regulations. But there is also something specific about the EU ETS.

Imagine a command-and-control regulation where a facility is not allowed to emit particulate matter above a particular level. Something might go wrong with an industrial oven, for example, and suddenly emissions exceed the regulatory threshold. There may not be an easy immediate solution.

With the EU ETS, the situation is different. If you emit more than your free allocation, you can simply buy additional allowances. That means non-compliance is much more clearly a choice. I used the word “cheating” earlier, although when you look closely at the data, not all non-compliance really qualifies as cheating.

We found examples of companies that simply did not know they were included in the system. I spoke with the Italian regulator, for example, and they described literally calling companies and telling them: “You know you’re part of the carbon market? You need to report your emissions.”

Those firms might initially be classified as non-compliant. They would eventually produce their emissions report and surrender the allowances, but perhaps too late. I wouldn’t describe that as cheating. It is more a case of poor information or administrative sloppiness.

Arvid Viaene:
And that makes the initial trial phase especially useful. Once those informational problems are resolved, firms seem to comply extremely well. I also hadn’t really thought about the difference you mentioned. With conventional regulation, if something goes wrong at your factory and emissions exceed the standard, switching technology immediately may be impossible. Under an ETS, however, you can simply buy additional allowances.

Frank Venmans:
Exactly.

Take the example of an industrial oven. If something goes wrong and the oven is not at the right temperature, it can generate significantly more pollution. There is an optimal temperature and oxygen input, much like a household heating system: if there isn’t enough oxygen, you can get soot coming out of the chimney.

Under conventional regulation, that incident could immediately put you out of compliance. Under the EU ETS, you can buy the additional allowances necessary to cover the extra emissions. In that sense, the system makes compliance easier.

The Gap Between Theoretical and Actual Fines

Arvid Viaene:
That brings us nicely to fines. Compliance is very high, but you also looked closely at what happens when firms do not comply. What did you find?

Frank Venmans:
First, I should make the compliance figure slightly more precise. The high compliance rate refers to the official compliance code regulators assign to companies. But in the underlying data we sometimes observe a company receiving a compliant code even though it apparently did not surrender enough allowances to cover its emissions on time.

We can see that it makes up the difference the following year. So perhaps it was two weeks late or a month late, and the regulator essentially said: “That’s fine. The substance of the requirement has been met; the administration was just late.” For our analysis, if the regulator classifies the firm as compliant, we treat it as compliant.

For the officially non-compliant firms, however, we calculate what the theoretical fines should have been. The EU-wide penalty was €40 per excess ton during the first phase and €100 per ton thereafter.

And importantly, paying the fine does not remove the obligation to surrender the missing allowances. You still have to provide those allowances later. So deliberately failing to comply can be extremely expensive.

When we calculate the theoretical fines based on observed non-compliance, we get approximately €13 billion. But we can only find evidence of roughly €2.1 billion actually being collected. So less than 20 percent of the theoretical fines appear to have been paid.

Arvid Viaene:
Why is there such a large gap? Do regulators have discretion over whether to impose the fine?

Frank Venmans:
One recurring issue in the interviews was what happens when companies close.

Suppose the regulator discovers non-compliance and tries to contact the company, but the company has already disappeared. There is nobody left in the office.

The regulator can block the company’s account. In the best case, there are still allowances in that account that can cover the emissions. But the company is still technically non-compliant.

In the worst case, the company sold all its remaining allowances while trying to stay afloat and then disappeared. That is true non-compliance in the sense that its emissions were never covered by allowances.

The regulator could begin a judicial process, but it would be pursuing a company that no longer exists. That can take years and may recover very little. So this is one reason some theoretical fines are simply never collected.

Are Firms Reporting Their Emissions Truthfully?

Arvid Viaene:
Another part of the paper I found really interesting concerns whether reported emissions themselves are truthful. It is one thing to observe a 99 percent compliance rate, but that only means something if the emissions firms report are accurate. You use some interesting statistical tests to investigate that. Could you explain them?

Frank Venmans:
One test we use is based on Benford’s Law.

Benford’s Law predicts the frequency with which different leading digits should appear in naturally occurring numerical datasets. Because our emissions data include everything from relatively small companies to extremely large firms, we would expect the leading digits in truthful emissions reports to follow that distribution.

The digit one, for example, appears as the first digit more frequently than nine. The law gives us a precise prediction for how frequently each leading digit should occur.

Manipulated data often deviate from Benford’s Law because people are not very good at inventing numbers that reproduce the natural distribution of digits. So if the reported emissions were being systematically manipulated, we might expect to see deviations.

The general result is that Benford’s Law fits the data well. We therefore do not see broad evidence of fabricated or manipulated emissions reporting.

There is one suggestive result involving smaller firms. Large firms are required to meet fairly strict verification standards, with around a 1 percent maximum measurement error. Smaller companies can use methods that permit larger measurement errors, potentially up to around 4 percent, in order to avoid excessive verification costs.

After the non-compliance penalty increased to €100 per ton, the smaller companies show somewhat larger deviations from Benford’s Law. We cannot perform a decisive statistical test on that comparison, so I would not interpret it as proof of manipulation. But it is suggestive that something may be happening.

Still, the overall picture is that the law fits well and we do not find general evidence of widespread misreporting.

Does the Choice of Emissions Verifier Matter?

Frank Venmans:
We also look at differences in verification rules across countries.

Emissions reports are verified by a third party — perhaps a company such as Bureau Veritas, Deloitte, or another accredited verifier. The regulated company generally pays the verifier. That potentially creates a conflict of interest. Because the company is paying the verifier, you might worry that the verifier has an incentive to keep its client happy.

Some countries therefore allow the regulator to appoint the verifier rather than letting the company choose. We test whether compliance improves in countries where regulators can appoint verifiers. It does not seem to.

We also examine whether emissions reports appear to bunch around the level of free allocation. During much of the period we study, many firms received free allowances. You can think of that free allocation as a kind of benchmark. If firms and verifiers were collaborating to underreport emissions, you might expect reported emissions to cluster just below the number of free allowances, because then the firm would avoid having to buy additional allowances.

We test for this bunching. We look at how many reports fall just above versus just below the free-allocation threshold. We do not find strong evidence of manipulation.

We also test other institutional differences. In some countries, regulators can train and supervise verifiers. That does not explain much variation either. In some countries, regulators can conduct their own on-site inspections. Again, we do not find that this explains much of the variation in compliance.

Do Larger Fines Actually Increase Compliance?

Arvid Viaene:
You also test the classic economic model directly: if the probability of being punished is greater, firms should be more likely to comply. What do you find?

Frank Venmans:
Yes. We wanted to test the canonical model in which a company maximizes profits. Under that framework, if I cheat, I avoid paying the carbon price. But the expected cost of cheating is the probability that I get caught multiplied by the fine I would pay if caught.

So we examine whether countries where non-compliant firms are more likely to be fined have higher compliance. They do, slightly. But the effect explains very little of the overall variation — perhaps around 5 or 10 percent. There is a great deal of compliance that the standard profit-maximizing model does not explain.

The Harrington Paradox

Arvid Viaene:
And that is where the paper becomes especially interesting. You have extremely high compliance, but when you examine the classic explanation — fines multiplied by the probability of getting caught — it explains only a small part of what you observe. How did you approach the remaining puzzle?

Frank Venmans:
This puzzle is actually not new. It is known as the Harrington paradox, after a 1988 paper studying water pollution regulation in the United States.

The paradox is essentially the coexistence of high compliance and low enforcement. Fines are relatively rare, and yet most companies comply with environmental regulations.

Economists have proposed several possible explanations over the years, and we test a number of them in the context of the EU ETS.

One possibility is naming and shaming. If a regulator publicly identifies a company as a polluter or a non-compliant firm, the resulting reputational damage might give companies an additional incentive to comply.

Interestingly, naming and shaming is explicitly part of regulatory policy in some countries but not others.

Arvid Viaene:
What does it mean for naming and shaming to be an explicit policy? Is it literally written into the regulatory approach that the names of non-compliant firms will be published?

Frank Venmans:
Yes.

Every country has to submit reports to the European Commission explaining aspects of how it administers the system. One question asks whether the regulator can appoint verifiers. Another asks whether the country uses naming and shaming for non-compliance.

In practice, a national registry might have a website reporting emissions and identifying companies that are non-compliant. There is already some transparency at the EU level because installations and their compliance information are available through the EU registry. But if you are just one non-compliant installation among thousands, you might reasonably hope nobody notices.

Active naming and shaming — putting the company on a prominent website or mentioning it publicly — is different.

We therefore compare compliance in countries that actively name and shame with countries that do not. Compliance is somewhat higher where naming and shaming is used, but the effect is not statistically significant.

We also test whether the effect is stronger for publicly listed companies, because they might care more about their reputation with shareholders. It is not. We test whether domestic companies with headquarters in the country are more sensitive to naming and shaming. Again, we do not find a stronger effect.

So our conclusion is that the impact is probably quite small, perhaps even zero.

Why the Paradox Remains a Paradox

Arvid Viaene:
So we are back at the Harrington paradox. Compliance is very high, but the enforcement mechanisms themselves do not seem to explain very much of it.

Frank Venmans:
Yes. In a way, the paper treats the Harrington paradox as a genuine paradox because several of its standard explanations do not receive much empirical support in our setting.

Another potential mechanism is that the regulator can punish a non-compliant firm informally in other ways. For example, perhaps a regulator sees that a company has failed to comply and responds by reducing its free allocation in the next phase. There would be no court process or public confrontation. The company would simply know that annoying the regulator has consequences.

We test whether non-compliant firms subsequently receive less free allocation. There is a small effect, but again it is not statistically significant.

That mechanism is also no longer really available because rules governing free allocation have become harmonized across the EU, which is actually a good development.

Another explanation used in traditional pollution regulation concerns targeting firms with particularly high abatement costs. A regulator may know which company will struggle most to meet an emissions standard and therefore inspect that firm more frequently.

That mechanism does not really apply to an emissions trading system because marginal abatement costs are equalized through the market. If your abatement costs are above the allowance price, you buy allowances. If they are below the allowance price, you reduce emissions and potentially sell allowances.

Another possibility is threatening to suspend an operating license. Some regulators have the authority to suspend licenses for non-compliant companies, whereas others do not. We test whether compliance is higher when regulators have this power, and again we do not find a statistically significant difference.

But based on the interviews, I actually think this kind of relationship matters quite a lot.

The Importance of Long-Term Relationships With Regulators

Frank Venmans:
I interviewed companies in industries such as cement, bricks, and lime. These are long-lived industrial facilities. A company may have been operating at the same site for 40 years and may have another 30 years remaining in its quarry.

The regulator is also going to be there for decades. So the firm and the regulator have a long-term relationship. Damaging that relationship over a relatively minor amount of emissions simply is not very smart.

At some point, the company may want to expand production. It may need its environmental permit renewed or extended. It may want approval for additional production capacity. Whenever a firm can keep the regulator happy at relatively low cost, there is a strong incentive to do so.

I think that repeated interaction is probably part of the explanation.

Arvid Viaene:
That makes sense. The standard economic framework almost treats compliance as a one-off decision. But in reality, this is a relationship that lasts for decades. If you are missing allowances for 10 percent of your emissions, you can simply buy them. Trying to hide the problem and risk damaging your relationship with the regulator may not be worthwhile.

Frank Venmans:
Exactly. In economics, we would call this a repeated game. Repeated games make cooperative outcomes easier to sustain.

There are also additional legal penalties countries can impose on top of the standard EU fine. The EU-level penalty is €40 or €100 per ton, depending on the period. But countries can add their own legal penalties for things such as misreporting.

Those additional financial penalties range from zero to as much as €15 million. Prison sentences for misreporting range from no prison penalty at all to as much as ten years.

We examine whether countries with harsher additional penalties have higher compliance. Again, the relationship is weak.

So I have to confess: we have not really solved the paradox. We tested many standard explanations, but we do not find strong statistical evidence for most of them.

Why Repeat Offenders May Be Different

Frank Venmans:
One other possible mechanism concerns repeat offenders.

Under conventional regulation, companies that repeatedly exceed pollution limits may face escalating punishment. The EU ETS penalty is set in law, which limits the regulator’s discretion. But because we observe cases where there is technical non-compliance without a fine being imposed, the regulator may still have some room to say: “This time we will let it go, but next time you will pay.”

That could help explain why firms do not repeatedly offend. The first instance creates a credible warning.

Arvid Viaene:
That brings us to another part of the paper I really enjoyed: the interviews with regulators and enforcement officials. After doing all of the quantitative analysis, what did you learn from talking to the people actually administering the system?

What the Interviews Revealed About Running a Carbon Market

Frank Venmans:
The interviews were very useful and actually quite fun. One of my main goals was simply to understand the data.

I think economists, policymakers, and especially countries currently establishing new emissions trading systems can underestimate how difficult the technical side is. The EU ETS was a European project that needed many countries on board, and not every country was equally motivated or equally well prepared.

Initially, the registries were managed at the national level. That is not necessarily the easiest way to run a large integrated system. You need complicated protocols governing how national registries communicate with the central European system.

France, for example, used an external IT company to help manage its registry. At one point, there was a coding error involving foreign allowances. As a result, a lot of data were missing.

The regulator might still have known whether a company was compliant and been able to assign the correct compliance code, but there were gaps in the underlying centralized dataset.

I also spoke with the regulator in Malta. They spent around two years deciding whether they even needed their own registry because there were only two regulated installations in the country, and creating a registry was expensive.

Eventually they did create one. But when I looked at the EU database, data for those two companies were frequently missing. The Maltese regulator told me: “I have the data. It is in my registry. I can see the allowances, verified emissions, and surrendered quantities.”

So the problem was not necessarily missing information at the national level. It was communication between the national and central registries.

I also performed basic data-quality checks. For example, the database contained cumulative emissions as well as annual emissions, so you can check whether cumulative emissions equal the sum of previous annual observations. Sometimes they did not.

When I raised issues like this with someone managing the central system, they became rather nervous. At some point, they seemed to wonder whether I had an agenda to damage the reputation of the EU ETS.

But I was simply doing ordinary data cleaning.

The broader point is that managing a huge dataset involving many parties is difficult. Once the system moved toward a centralized registry around 2013, it became much easier. There was one manager and one system.

But again, this reflects political reality. You have to convince a large number of countries to participate, and institutional design develops gradually.

What New Carbon Markets Can Learn From Europe

Arvid Viaene:
Given everything you found — very high compliance, relatively low collection of fines, weak effects from many of the enforcement mechanisms, and the technical challenges — what are the main takeaways from the paper?

Frank Venmans:
One takeaway follows directly from the technical issues we just discussed.

Suppose you are Vietnam, Mexico, Indonesia, or another country establishing an emissions trading system. Be very mindful of the technical complexity. You need to think carefully about which institution is going to administer and enforce the system.

If possible, it may help to place these responsibilities within an existing government institution that already has experience collecting money, managing company data, and performing functions similar to those required in tax administration.

Do not underestimate the complexity of building these systems. And do not underestimate the extent to which criminals may try to exploit the fact that you have created a valuable financial asset.

The EU ETS experienced serious problems with VAT carousel fraud. At one point, very large trading volumes were essentially connected to VAT fraud, contributing to billions of euros in lost tax revenue.

Initially, identity checks for people trading allowances were weaker than those applied to conventional financial assets. That problem has largely been addressed. Emissions allowances are now treated under financial regulation much more like stocks, bonds, and other financial assets. Repeating those VAT-carousel schemes would therefore be much harder today.

But the lesson remains: technical and financial-market regulation is crucial.

Why High European Compliance Should Not Be Taken for Granted Elsewhere

Frank Venmans:
The second takeaway is that although we struggle to distinguish the effects of relatively small differences in European enforcement rules, that does not mean enforcement institutions do not matter.

There is research from India, for example, examining the appointment of environmental auditors. That work finds substantial problems when companies themselves choose and pay their auditors. When auditors are assigned independently rather than selected by the regulated company, reporting becomes much more truthful.

We do not find a comparable effect in the EU ETS, but the Indian evidence shows that institutional context matters enormously.

Europe may simply be a relatively easy environment in which to run this kind of system. Institutions are generally strong, corruption is comparatively limited, and companies are accustomed to environmental regulation.

So I would not take 99 percent compliance for granted when designing emissions trading systems elsewhere.

Arvid Viaene:
Exactly. Within the European institutional setting, some of these differences may not explain very much. But in another institutional context they could become extremely important.

Frank Venmans:
Yes, exactly.

Closing Thoughts

Arvid Viaene:
Frank, thank you so much for coming on. I think this was a really interesting deep dive into an extremely important aspect of carbon markets: how to make sure firms actually comply.

Frank Venmans:
Thanks for inviting me.

I’m very motivated to make these results and this research accessible to a wider public because this work should ultimately be useful. Emissions trading systems are expanding. Many new systems are being established in different parts of the world.

The European experience is especially valuable because it was the first very large emissions trading system. It provides an example from which other jurisdictions can learn. We should therefore try to learn as much as possible from that experience.

Arvid Viaene:
Absolutely. Thank you very much, Frank.

Frank Venmans:
Thank you.

This is the transcript from episode 30. In this episode, I speak with Adam Brzezinski about his paper on narrative entanglement and what it reveals about climate politics.

We discuss why politicians often bundle together very different claims when talking about climate policy, presenting it as either good for both the environment and the economy or bad for both, even when those effects are factually separate.

Adam explains how he and Luis Garicano study this using speeches from the European Parliament, classified with large language models, and how Russia’s invasion of Ukraine provides a real-world test of what happens when the economic costs of climate policy suddenly become more salient.

We talk about:

• what “narrative entanglement” means

• why politicians often avoid talking about trade-offs

• how voter psychology and motivated reasoning shape climate narratives

• what changed in European climate discourse after the energy shock of 2022

• how shifts in narratives relate to actual voting on climate policy

This is a fascinating conversation about the politics behind climate policy and why the stories politicians tell can matter just as much as the policies themselves.

For questions, comments or suggestions, you can contact me at arvid.viaene.ce@gmail.com

Transcript

Arvid Viaene:
Today we are talking about narratives in climate policy and why they matter. A lot of climate policy debates are not only about climate policy itself, but also about other dimensions, especially the economy. For example: is climate policy good for the environment but costly for the economy? Is it unrelated to the economy? Or is it good for both?

That question is the starting point of today’s paper, Narrative Entanglement, by Adam Brzezinski and Luis Garicano. The paper studies how politicians, when discussing climate policy, often bring other dimensions into the discussion, and we will see why that matters.

I also really like the data analysis in this paper, because the authors use large language models to classify political speeches in the European Parliament along several dimensions. Then, as a case study, they analyze how Russia’s invasion of Ukraine affected climate policy narratives and voting. So there are a lot of very interesting things going on in this paper, and I think it is highly relevant for how we think about climate narratives going forward.

To discuss it, I’m delighted to be joined by Dr. Adam Brzezinski. Adam is a British Academy Postdoctoral Fellow at the London School of Economics and Political Science. He completed his doctoral studies in economics at the University of Oxford in 2023. He researches how narratives shape economic policy, how political narratives can be measured, and more broadly how politics and the economy interact. So Adam, welcome to the podcast.

Adam Brzezinski:
Thank you. It’s a great pleasure.

Arvid Viaene:
I already had Luis on the podcast, and we talked about the evolution of climate policy. He mentioned that you were working together on a new paper. So what is the paper about?

What Narrative Entanglement Means

Adam Brzezinski:
The paper is about what we call narrative entanglement, which describes the tendency of politicians to intertwine narratives about different policy effects, even when those policy effects are factually separate. Let me use climate policy as the example, although the concept is more general.

Climate policy has many different policy effects. Most obviously, it has an environmental effect. For example, building a wind farm reduces CO2 emissions by some number of tons. But climate policy also has economic effects. It may require upfront investment in green technologies, affect energy prices, affect house prices, jobs, and other outcomes.

Factually, these dimensions are separate. The economic effects of climate policy are driven by economic conditions, market structures, gas prices, and so on. The environmental effects are shaped by the laws of physics. If we build one more wind turbine, it reduces CO2 emissions by a certain amount. So in principle these two effects are factually distinct.

But in practice, what we observe is what we call narrative entanglement. Politicians intertwine their economic narratives and environmental narratives. They tend to say that climate policy is great for the environment and will help the economy a lot. Or they use the opposite entangled narrative: climate policy is not needed for the environment and would be economically devastating.

That is one aspect of narrative entanglement. Another, slightly more subtle aspect is that because these dimensions are entangled, when politicians change their story about environmental effects, they also feel pressure to change their story about economic effects, and vice versa. So one moves with the other, even when they are factually separate.

Arvid Viaene:
That makes a lot of sense. It also seems like this can happen at different levels. You can have very broad narrative entanglement, like “climate policy will create jobs and growth,” but also smaller-scale forms, like saying that because we have an emissions trading system and a carbon price, electricity prices will move in a certain way.

Adam Brzezinski:
Yes, absolutely. Narrative entanglement can operate on very different levels, and we see that in the speeches we analyze. You have broad statements, for example about the European Green Deal, where politicians say it will be great for the environment and create huge numbers of jobs. But you also see more specific speeches criticizing particular measures in an entangled way. Politicians might say: this policy will not help the environment anyway, and it will also be disastrous for jobs or prices. So yes, it can show up at multiple levels.

Why Narrative Entanglement Matters

Arvid Viaene:
One question people might have is: why should we care about narrative entanglement in the first place?

Adam Brzezinski:
I think we care about it for two reasons. One is that it matters in and of itself. The second is that it matters for policy.

Let me start with the policy side. In our paper, we argue that narratives and policy are jointly determined. Politicians do not only have a policy position on climate policy; they also have narratives that support that position. So, for example, a politician might support climate policy and say: I support it because it is good for the environment, even if it may be economically costly. That would be a non-entangled narrative.

But we show that in a framework with political competition, politicians often face pressure to hide trade-offs under certain conditions. So instead of saying, “I support climate policy because it is important for the environment, even though it may be costly,” they may instead say, “I support climate policy because it will save the environment and create millions of jobs.” Or they may say the opposite: “I oppose climate policy because it is not necessary for the environment and it would be disastrous for the economy.”

That matters because these entangled narratives support different policy positions than evidence-based narratives would. In particular, and this is what we show in the paper, entangled narratives make climate policy more vulnerable to shocks that do not actually change the environmental effects of climate policy.

Suppose economic conditions change and climate policy becomes more costly. In a world without narrative entanglement, politicians would simply say: climate policy has become more expensive, but it is still environmentally necessary. But in a world with entangled narratives, politicians may instead shift their entire narrative bundle. They no longer want to say climate policy helps the economy, because voters may no longer buy that. So they may also shift their environmental narrative. Once that happens, they no longer have the narrative needed to support climate policy, and they may shift their policy stance altogether.

Arvid Viaene:
That was really the key point I got from the paper. In good times, when climate policy can be framed as economically beneficial, that strengthens support. But in bad times, when there is an economic shock, the entanglement means climate policy takes an extra hit.

Why the European Parliament from 2019-2024 Is a Useful Case

Arvid Viaene:
So let’s talk about the empirical setting, because I think that part of the paper is really fascinating. You focus on the European Parliament, and specifically on the ninth Parliament from 2019 to 2024. Why?

Adam Brzezinski:
Nothing I’ve said so far is specific to Europe, or even to climate policy. But we study the ninth European Parliament for two main reasons.

First, that Parliament oversaw a major push toward climate policy through the European Green Deal. So climate policy was extremely salient during that period. And, as you mentioned, my co-author Luis Garicano was actually a member of that Parliament for some years and was involved in drafting some of these measures, including the Carbon Border Adjustment Mechanism and others. So there was this huge climate-policy push, which made the setting especially interesting.

Second, Russia invaded Ukraine in February 2022, in the middle of this Parliament. That invasion had many effects, but one especially important consequence for climate policy was that it raised energy prices sharply across Europe. So it changed the economic costs of climate policy. But it did not change the laws of physics. It did not change whether wind turbines reduce CO2 emissions.

So in a world without narrative entanglement, politicians should change how they talk about the economic effects of climate policy, but not how they talk about its environmental effects. In a world with narrative entanglement, by contrast, they will shift both. That gives us a very useful case for looking for narrative entanglement in the data.

Arvid Viaene:
Exactly. It gives you a really interesting shock to look at.

How the Paper Measures Narratives

Arvid Viaene:
Could you explain a bit more about how you actually measure narratives empirically? Because that is one of the really cool parts of the paper.

Adam Brzezinski:
Yes. In the theory, we try to define a narrative quite precisely. We think of a narrative as a subjective causal model. A climate-policy narrative, for example, tells you the causal effect of climate policy on the environment and on the economy. That is the theoretical object.

Empirically, we measure narratives by looking at all speeches made in the ninth European Parliament between 2019 and 2024. That is just under 50,000 speeches. We use large language models — in our case GPT models — to extract the causal statements from these speeches.

So we feed each speech separately into the model and ask it to identify the causal narratives about how climate policy affects the environment and how climate policy affects the economy. We do the same for other policy domains as well, such as immigration and digitization, though climate policy is by far the most salient in this period because of the European Green Deal.

Arvid Viaene:
So the model takes a speech and identifies whether it contains a statement like “climate policy is good for the environment,” and separately whether it says it is good or bad for the economy?

Adam Brzezinski:
Exactly. And importantly, we ask these questions in separate runs of the model. Each time, the model gets one speech and one classification task. We do not ask it to classify all dimensions at once.

That matters, because otherwise you might worry that the model would try to be too internally consistent and classify speeches as “all good” or “all bad” across dimensions. Doing it separately increases the cost, but it makes the results more convincing.

How Strong the Entanglement Is

Arvid Viaene:
And what do you actually find? How strong is the entanglement? Because I was pretty surprised by the results.

Adam Brzezinski:
At the speech level, we already see huge amounts of entanglement. The vast majority of speeches that discuss both the economic and environmental effects of climate policy are entangled. In other words, they do not discuss trade-offs. It is over 90 percent of speeches, according to our current estimates.

For immigration policy, the number is even slightly larger. That may be the most entangled domain among the ones we study.

When you aggregate to the party level, you see parties sitting in the corners. By that I mean that parties tend either to say climate policy is great for the environment and great for the economy, or they say it is unnecessary for the environment and bad for the economy. So you get a real bifurcation. That pattern also appears in other policy domains.

Arvid Viaene:
In a sense, the “economist quadrant” is empty — the quadrant where you say, yes, climate policy is good for the environment, but it may involve moderate economic costs.

Adam Brzezinski:
Yes. Economists love talking about trade-offs. We say: this policy helps here, but maybe has costs there. That is not what we find in the typical politician’s speech.

Why Politicians Use Entangled Narratives

Arvid Viaene:
One of the things I found so interesting in your paper is that this does not necessarily mean politicians themselves are unaware of trade-offs. The paper suggests the entanglement comes from political incentives — in a sense, from voter demand. Could you explain that logic?

Adam Brzezinski:
Yes, exactly. There is both a demand side and a supply side, if we want to use economist language. The demand side is voters. The supply side is politicians or parties who care about reelection.

These politicians choose narratives and policy positions in order to maximize their electoral chances. Voters, meanwhile, may have their own beliefs about how climate policy affects the economy and the environment. They also hear what politicians say and may or may not update their beliefs in response.

So where does the demand for entangled narratives come from? It helps to start with a world where narrative entanglement does not exist.

Imagine that every voter cares only about the truth, can perfectly tell whether a politician is telling the truth, and updates only when they hear something accurate. In that world, entangled narratives would not matter much. If a politician used a wrong entangled narrative, voters would ignore it.

Now imagine a more realistic setting where at least some voters care about climate policy, but do not have the time or capacity to verify everything politicians say. They still take political messages into account, but they do not check every claim.

In that setting, what drives belief updating? One plausible force is motivated reasoning — a long-established idea in psychology. Motivated reasoning means that when people are uncertain, they often prefer beliefs that make them feel better.

That seems quite reasonable, especially when being wrong does not generate immediate feedback. As a single voter, if you are wrong about climate policy and vote for the “wrong” politician, your mistake probably does not change the election outcome. So there is limited incentive to verify everything with precision. And at the same time, these policy questions are extremely complicated.

So in such a setting, some voters may be motivated reasoners. They may prefer the narrative that feels best to them. If someone wants to support climate policy, they would rather hear that it is great for the environment and great for jobs. If someone wants to oppose climate policy, they would rather hear that it is not really necessary for the environment and would be terrible for the economy.

So motivated reasoning creates demand for narratives that hide trade-offs. Politicians, in turn, respond to that demand. And that is why, when economic costs change, politicians may shift not only their economic narrative, but also their environmental narrative. That is what we call the narrative accelerator.

What Happened After Russia’s Invasion of Ukraine

Arvid Viaene:
That is a really nice bridge into your case study. So after Russia’s invasion of Ukraine, you have this major economic shock. What do you find happens to political narratives?

Adam Brzezinski:
Under narrative entanglement, the hypothesis is that when Russia’s invasion increases energy prices, politicians should shift both their economic narratives and their environmental narratives. And that is exactly what we find.

After Russia’s invasion of Ukraine, politicians become much more likely, on average, to use the narrative that climate policy is detrimental to the economy. But they also become much more likely to use the narrative that tighter climate policy is not necessary for the environment.

So both shifts happen together. The effects are very large. And importantly, we are looking at changes within the same politicians. We use politician fixed effects, which means we compare how the same politician speaks before and after the invasion.

We do find differences between left-wing and right-wing politicians, though. In our theoretical framework, politicians also first decide whether to speak about climate policy at all. That is the first-stage decision. Then, conditional on speaking, they choose what narrative to use.

What we find is that right-wing politicians become much more likely to speak on climate policy after the invasion. And when they do, they are much more likely to use the entangled narrative that climate policy is bad for the economy and unnecessary for the environment.

So overall, because the right is speaking more and speaking more skeptically, we see a shift toward more climate-skeptic narratives.

The numbers are large. Across all speeches in the Parliament — not just speeches on climate — the probability that a speech uses a climate-skeptic narrative increases by almost one percentage point. That may not sound huge, but relative to a baseline just below 2 percent, it is a very large effect. So voters are much more likely to hear climate-skeptic narratives after the invasion.

Arvid Viaene:
And that is what gives this volatile swing in the narrative environment. A big economic shock changes who speaks and what they say. And because of entanglement, the shift is broader than just “climate policy is more expensive now.”

Why Entanglement Can Accelerate or Delay Change

Arvid Viaene:
One thing I was wondering when reading the paper is whether narrative entanglement always makes politics more volatile. Because if the dimensions are bundled together, it almost sounds like narratives become more unstable.

Adam Brzezinski:
It is a bit more subtle than that. Narrative entanglement can lead to what we call the narrative accelerator, where things shift abruptly. But it can also have the opposite effect: it can delay change for a while.

In a world without entanglement, as the economic costs of climate policy rise, politicians’ messages would smoothly adjust. They would say: this policy is becoming somewhat more costly. But with entanglement, a politician who is strongly in the pro-climate camp may keep both narratives fixed for quite a while.

Because they want to continue supporting climate policy, their environmental narrative effectively “anchors” their economic narrative. So as costs rise a little, nothing changes.

But if costs rise sufficiently, then the whole narrative bundle can suddenly flip.

So entanglement can dampen small shifts, but then create sharp, discontinuous changes when the pressure becomes strong enough.

Arvid Viaene:
That makes sense. If the shock is small, then nothing moves. But once it crosses some threshold, you can get a big jump.

What This Means for Crafting Better Climate Narratives

Arvid Viaene:
So then the obvious question is: if entangled narratives are a political reality, how should climate policy advocates think about crafting narratives that are more robust?

Adam Brzezinski:
That is a very important but also very difficult question. Let me first say clearly that our paper is not advocating for misleading narratives. Quite the opposite. It is dangerous for narratives and policy to depart from truthful communication.

What we do want to highlight is that there is this reality of entangled narratives, and climate policy advocates have to contend with that. If some voters are motivated reasoners, then narratives that feel good will be especially powerful.

That means it matters how you frame things. A narrative that says everything is terrible and maybe we can make it slightly less terrible will feel very different from a narrative that says we face major challenges, but here are concrete ways we can improve people’s lives and build something better.

These can describe the same underlying reality, but one is much more likely to resonate.

There is of course a huge literature on framing effects, so this is not unique to our paper. But what our paper adds is an empirical demonstration that entangled narratives are pervasive, and that they have to be taken seriously as part of the political landscape.

What Surprised Adam While Writing the Paper

Arvid Viaene:
What surprised you most in the process of writing this paper?

Adam Brzezinski:
Many things.

On the theory side, one thing that was really satisfying was how much writing down the formal model deepened our intuition.

A good example is this: it was not obvious to me at all, at the start, that narrative entanglement could persist even if most voters were “Bayesians” — people who can detect whether politicians are telling the truth and update correctly.

You might think that if most voters are like that, entanglement should disappear. But that is not necessarily true.

Even if the majority are basically rational in that sense, a smaller group of motivated reasoners can still be enough to sustain entangled narratives. Why? Because the Bayesian voters may already be close to the truth, so telling them the truth does not shift their beliefs much. But persuading the motivated reasoners through entangled narratives may bring much larger electoral gains.

That was not obvious to me initially, but once you work through the model, it becomes clear.

On the empirical side, it was fascinating to see how well large language models could perform in classifying political narratives. When we started this project, this was still fairly new. It was not obvious how well it would work. But I think it gave us access to really interesting insights that would have been hard to get otherwise.

Why Large Language Models Are Useful for This Kind of Research

Arvid Viaene:
That part of the paper is also very exciting methodologically. It is easy to imagine other researchers taking your approach and applying it to other time periods, other parliaments, or other narrative dimensions.

Adam Brzezinski:
Exactly. That is one of the nice things about this approach. It is fairly reproducible. Once you have the prompts and the data, you can run the analysis again, extend it to new contexts, or modify the prompts.

Of course, it is not a perfect tool. Large language models have drawbacks, just as human coders do. But it is a very useful tool, and we are still learning how best to use it. That makes it a fascinating area to work in.

How Narratives and Voting Fit Together

Arvid Viaene:
Is there anything else in the paper that you would still like to highlight?

Adam Brzezinski:
Yes. The main focus of the paper is narratives and speeches, but we also care about policy outcomes.

So in the paper, we connect shifts in narratives to shifts in legislative voting by Members of the European Parliament on climate-policy issues. And we find a very strong relationship.

Politicians who shift more in their narratives also shift more in their voting on climate policy.

That may not sound surprising, because in our model narratives and policy positions are jointly determined. Politicians are not going to use one narrative and then vote in a completely unrelated way.

But I still think it is important, because it means narratives can give us a more granular way of tracking policy positions. Voting on climate policy only happens a limited number of times per year. Speeches happen all the time. So speeches and narratives give us a kind of higher-frequency measure of where politicians are moving.

Arvid Viaene:
Exactly. It becomes like a more real-time tracker of climate-policy positioning. And that also lines up with what other researchers have found in related contexts — that this is not just cheap talk. Speeches and voting do move together.

Closing Thoughts

Arvid Viaene:
Well, thank you so much, Adam. I really enjoyed this conversation.

What I liked about this paper is that a lot of other climate discussions focus on policies as designed by technocrats or policymakers. But this paper gets at something more real: how policy gets reframed and reshaped in political life.

It also helps make sense of all the discourse people see online, in speeches, and in public debate. I think this paper can help economists understand political discourse a bit better, especially when it feels confusing.

So thank you very much.

Adam Brzezinski:
Yes, me too. It was a great pleasure. Thanks a lot for your time

Introduction

What is the social cost of carbon, and why do estimates vary so widely?

In this episode, I speak with professor Frances Moore about her paper synthesizing nearly 150 studies on the social cost of carbon.

We discuss how the literature has evolved, why the distribution of estimates has such a long right tail, and why experts often underestimate the average value found across published studies.

Fran also explains how the paper combines a large literature review, an expert survey, and a machine-learning model to construct a new “synthetic” social cost of carbon distribution.

The result is striking: while the raw literature has a median estimate of around $40 per ton and a mean of roughly $130, the synthetic distribution shifts those figures to around $180 and $283 per ton.

We also discuss:

• the difference between level damages and growth-rate damages

• why discounting remains so important

• how tipping points and other structural modeling choices affect estimates

• the influence of models such as DICE

• why assigning climate damages a value of zero is inconsistent with the evidence

A useful conversation for anyone interested in climate economics, cost-benefit analysis, or how policymakers should value the damages caused by carbon emissions.

The paper:

F.C. Moore, M.A. Drupp, J. Rising, S. Dietz, I. Rudik, & G. Wagner, Synthesis of evidence yields high social cost of carbon due to structural model variation and uncertainties, Proc. Natl. Acad. Sci. U.S.A. 121 (52) e2410733121, https://doi.org/10.1073/pnas.2410733121 (2024).

Frances’ site: https://franmoore.faculty.ucdavis.edu/

Related episodes:

· #6 From $0 to $190: How U.S. Presidents Have Priced a Ton of CO₂: https://www.buzzsprout.com/2412056/episodes/17723637

· #21 Dr. Richard Tol on FUND, Climate Damages and Why Adaptation Matters: https://www.buzzsprout.com/2412056/episodes/19410124

· #32 Dr. Gernot Wagner: Why Tipping Points Matter: https://www.buzzsprout.com/2412056/episodes/19410124

Transcript

Hi, and welcome to another episode of the Climate Economics Podcast with me, your host, Arvid Viaene. Today, we are returning to one of the central concepts in climate economics: the social cost of carbon. This is the estimated harm caused by emitting one additional ton of CO₂ into the atmosphere.

We often talk about the social cost of carbon as if it were a single number. Under the Obama administration, many people became familiar with an estimate of around $50 per ton. More recently, the U.S. EPA produced an estimate closer to $190.

But behind these headline numbers sits a much wider academic literature, containing different models, discount rates, damage functions, and assumptions about how climate change affects society. And we already covered how such models are built in the episode 22 with Richard Tol.

So what does the complete distribution of estimates in that literature actually look like? Do experts have an accurate picture of it? And what happens when we give more weight to the model structures and assumptions that experts consider most appropriate?

These are the questions addressed in today’s paper, Synthesis of Evidence Yields High Social Cost of Carbon Due to Structural Model Variation and Uncertainties, which was published in Proceedings of the National Academy of Sciences (PNAS) in 2024

To discuss the paper, I’m delighted to be joined by one of its authors, Frances Moore.

Fran is a Professor in the Department of Environmental Science and Policy at UC Davis. She works at the intersection of environmental economics and climate science. Her research seeks to improve our understanding of the economic and social impacts of climate change and our ability to adapt to those impacts.

She currently also serves as the Hurlston Presidential Chair in the Department of Environmental Science and Policy and is a UC Davis Chancellor’s Fellow. From 2022 to 2023, Fran served as the Senior Economist covering climate and environmental issues at the Council of Economic Advisers in the Biden administration.

Fran, welcome to the podcast.

Frances Moore:
Hi, thanks for having me.

Arvid Viaene:
I am excited to discuss this paper. To kick us off, could you tell us what the paper is about?

Frances Moore:
The paper is an attempt to get to grips with the very large and growing literature estimating the social cost of carbon.

We look across a large number of papers — around 150 in total — that produce many different social cost of carbon estimates. We try to bring that literature together, synthesize it, and understand what is driving the variation across estimates.

We also place the literature in a broader context by asking what the researchers producing this work think about the estimates themselves. Ultimately, we use all of that information to develop what we see as our best estimate of the social cost of carbon.

Arvid Viaene:
The literature has evolved over time, and the models have improved. How did you approach such a large question?

Frances Moore:
The first thing was to assemble an excellent team of co-authors. I thought about who my dream team of social cost of carbon researchers would be and recruited them, because this was a major exercise to undertake.

We began with a structured search of the scientific literature. We entered specific keywords into academic search engines, which produced almost 3,000 abstracts.

A team of research assistants then reviewed those abstracts to identify papers containing original social cost of carbon estimates. The author team developed a structured data-collection template that allowed us to go through each paper systematically.

We ultimately included 147 papers. For each one, we extracted the social cost of carbon estimates as well as detailed information about the modeling choices, assumptions, and parameters used to produce them.

What the Raw Literature Says About the SCC: An Estimate of $130

Arvid Viaene:
Once you had collected the estimates, what did you find for the mean and median social cost of carbon?

Frances Moore:
If we look at the raw literature and give every paper and every estimate equal weight, the mean social cost of carbon in 2020 dollars is about $130 per ton.

But the distribution is highly skewed. The median is much lower, at around $40 per ton, while a long right tail extends to some very high estimates. Those extreme values pull the mean up to around $130.

Arvid Viaene:
You restricted the analysis to papers published between 2000 and 2020. Why did you exclude papers from before 2000?

Frances Moore:
The papers published before 2000 were quite early in the development of the literature. By around 2000, the methods used to generate social cost of carbon estimates had largely stabilized around several well-known integrated assessment models: DICE, FUND, and PAGE.

During the following two decades, researchers began developing new approaches and modifying those models in different ways. We wanted to capture that period of innovation.

Before 2000, the methods could be substantially different, and some assumptions in the earlier studies had become dated. We did not feel that every social cost of carbon estimate ever produced needed to remain in the sample indefinitely. It seemed reasonable to have a statute of limitations.

The 2020 cutoff was simply because that was when we began the project.

Why the Literature Distribution Is Not Enough to Interpret the SCC

Arvid Viaene:
The literature mean of around $130 is already much higher than the roughly $50 figure associated with the Obama administration, which was the reference point for many economists for a long time.

But you went further and surveyed experts about what they believed the social cost of carbon should be. Could you explain that part?

Frances Moore:
Yes. Our initial task was to comb through the literature and determine what it said. But we realized that the raw distribution was somewhat unsatisfying because it did not have a straightforward statistical interpretation.

The literature reflects an ad hoc sample of whatever researchers happened to be working on. It is not a random sample from a clearly defined population of possible estimates.

We therefore wanted to place the literature in a broader context through an expert survey. My co-author Moritz Drupp, who is now at ETH Zurich, had conducted several expert surveys before and led this part of the project.

We contacted the authors of the papers included in our review and asked them three fairly demanding questions.

First, we asked for their own best estimate of the social cost of carbon. Second, we asked what they believed the average estimate in the literature was. We were interested in the gap between those two answers, because it might reveal whether experts perceived some form of systematic bias or believed that the published literature differed from their preferred estimate.

Third, we asked about particular modeling choices used in social cost of carbon calculations. We focused less on individual parameter choices such as discount rates, which have already been discussed extensively, and more on structural choices — for example, how utility is represented or whether the model includes damages to economic growth rates.

We then combined the expert assessments with the literature review to produce a preferred social cost of carbon distribution.

Why Experts Underestimated the Literature Mean by $50t/CO2

Arvid Viaene:
One result I found especially interesting was the difference between what experts believed the literature mean was and what you actually found.

Frances Moore:
Yes, that was quite striking. When we asked experts what they thought the mean social cost of carbon in the literature was, they gave an estimate of around $60 per ton. That is less than half the actual mean we found.

Figure 3 from the paper

There are several possible explanations. One important reason is probably the long right tail of the literature distribution. There are some very high estimates that pull up the mean, and experts may not have been familiar with all of them or may not have incorporated them into their mental picture of the literature.

They may also have discounted some of the more extreme estimates. Because the mean is sensitive to the right tail, even a small change in how those estimates are treated can shift it substantially.

The experts’ estimate of around $60 was also close to the prominent Obama-era interagency working group figure of roughly $50 per ton. It is possible that experts were partly anchored to that number while giving less weight to the upper tail of the newer literature.

Arvid Viaene:
Were those high estimates concentrated in more recent papers? Perhaps experts had not yet incorporated them into their beliefs.

Frances Moore:
I cannot speak directly to every publication year, but we do examine the characteristics of estimates in the upper tail.

A lot of recent work that includes growth-rate damages produces much higher social cost of carbon estimates. That is an extremely important structural modeling choice because it changes how persistent climate damages are assumed to be.

Those studies were relatively recent. Some experts may not have been fully familiar with them, or may not have realized how large the estimates were relative to the rest of the literature and how strongly they affected the mean.

The Difference Between Level and Growth-Rate Damages and Its Importance

Arvid Viaene:
Could you explain the difference between damages to the level of the economy and damages to economic growth rates?

Frances Moore:
This debate became especially prominent around ten years ago, partly because of empirical studies examining the relationship between temperature shocks and economic growth.

Those studies often find that an unusually hot year is associated with lower growth rates, particularly in countries that are already hot or relatively poor. More importantly, growth does not always rebound the following year.

That means the economy may never recover the output that was lost. It remains permanently smaller than it otherwise would have been.

This differs from how damages are traditionally represented in many integrated assessment models. In those models, a temperature shock lowers productivity in a particular year, making the economy temporarily smaller. But if the temperature shock disappears, the economy returns to its previous growth path.

The crucial distinction is whether climate change creates a temporary reduction in productivity or affects the underlying drivers of growth. If climate change reduces growth rates, the cumulative effects over long periods can become extremely large.

This remains an active debate. Researchers are still studying whether climate change affects growth, over what time horizons, through which mechanisms, and how persistent those effects are.

But because our analysis focuses on structural modeling choices, we clearly identify the inclusion of growth-rate damages as one of the most important drivers of variation in social cost of carbon estimates.

Arvid Viaene:
The paper also has a very useful breakdown of these explanations. Figure 2 shows how discounting, damage functions, model assumptions, and growth-rate damages contribute to the distribution.

Fig. 2 of the paper

Building a Synthetic SCC Distribution

Arvid Viaene:
You collected estimates from the literature and surveyed experts, but then you took another step and created what you call a synthetic social cost of carbon distribution. How did that work?

Frances Moore:
This was one of those projects where the different elements came together nicely at the end.

We observed that experts believed there was a difference between the literature distribution and their preferred social cost of carbon estimates. We also asked them to assess the quality of studies that used different structural modeling approaches.

We could then use those quality assessments to resample or reweight the literature. In effect, we asked: what would the distribution look like if the literature contained more of the modeling characteristics that experts believe are appropriate?

To do that, we needed a statistical model capable of estimating how different assumptions and modeling choices affect the social cost of carbon. We trained a random forest model, which is a machine-learning method well suited to handling many variables, nonlinear relationships, and interactions.

We then queried the random forest using the experts’ preferred modeling structures and discounting assumptions. The discounting information came partly from an earlier expert survey led by Moritz Drupp.

This procedure effectively reweights the literature.

Whenever you combine many estimates into a single distribution, you need some weighting scheme. The simplest approach is uniform weighting, which is what we use in the first part of the paper. Other researchers sometimes apply their own judgments about the quality of different studies.

Our weighting scheme instead comes from the expert survey, combined with information from the random forest about which variables are actually most important for explaining variation in social cost of carbon estimates.

That produces what we call the synthetic SCC distribution. It is not one particular estimate. It is a structured reweighting of the literature based on expert assessments and a statistical model trained on the existing studies.

Which Modeling Choices Enter the Random Forest

Arvid Viaene:
Could you give an example of the inputs used in that model?

Frances Moore:
Figure 4 in the paper provides a detailed explanation of the process. We actually developed that figure in response to reviewer comments, and creating it helped us understand and communicate exactly what the method was doing.

Fig. 4 of the paper

The random forest is trained using all the explanatory variables we collected for each social cost of carbon estimate. There are around 30 variables in total.

These include whether the estimate incorporates uncertainty in climate sensitivity, which integrated assessment model was used, the year for which the social cost of carbon was calculated, the discount rate, whether distributional weighting was included, whether tipping points were modeled, and whether the estimate includes growth-rate damages.

The model builds many regression trees. Each tree divides the data through a sequence of binary decisions, choosing variables that best explain variation in the social cost of carbon.

Not every variable appears in every tree. The model tends to select the variables that are most useful for partitioning the data. We find that the SCC year and the discount rate are important, which is not surprising. But it also identifies structural choices such as the inclusion of growth-rate damages.

We can then ask the model to produce a distribution for a hypothetical estimate with a particular set of characteristics. For example, we might ask for an SCC calculated for 2020 using a 3 percent discount rate, incorporating tipping points, growth-rate damages, limited substitutability between market and nonmarket goods, and parametric uncertainty.

The random forest then produces a predicted distribution based on how estimates with those characteristics relate to the studies in our database.

We also make corrections for things such as publication year, because we generally want the synthetic distribution to reflect more recent work rather than giving equal relevance to older estimates.

The Synthetic Distribution of the SCC Is Much Higher than the Raw Distribution: From $130 to $280

Arvid Viaene:
Once you applied that process, how did the synthetic distribution compare with the unweighted literature?

Frances Moore:
The entire distribution shifts substantially to the right.

The median increases from around $40 per ton in the raw literature to roughly $180 per ton in the synthetic distribution. The mean rises from approximately $130 to around $280 per ton.

So the median increases by roughly a factor of four, while the mean approximately doubles.

We can also partially decompose what drives that increase. A significant share comes from updating discounting assumptions. But structural modeling choices also matter, including improvements in Earth-system modeling, the inclusion of growth-rate damages, and some forms of parametric uncertainty.

Arvid Viaene:
Figure 5 in the paper provides a very useful breakdown of those components. It shows that the increase is not driven entirely by discounting, even though discount rates remain very important.

The synthetic mean of roughly $283 per ton was much higher than the estimate I had in mind before reading the paper. I was probably anchored somewhere around $120, based on a combination of older policy estimates and selected newer studies.

The paper provides a useful way to update those beliefs because it brings all the literature together rather than relying on whichever estimates happen to be most familiar.

How Views of the SCC Have Shifted

Arvid Viaene:
Since the paper was published, have you seen people revise their views of the social cost of carbon?

Frances Moore:
I think so, although several things were happening at the same time. Our expert survey was conducted before the US Environmental Protection Agency released its updated social cost of carbon estimate. The paper was published afterward, so we were able to compare our estimate with the EPA figure.

The EPA update was significant. The estimate increased from roughly $50 to something closer to $200 per ton. However, I would describe the EPA methodology as fairly conservative in several ways. It does not include many of the structural innovations that have been important in the academic literature.

For example, it does not incorporate persistent growth-rate damages, climate tipping points, or some alternative representations of utility, such as Epstein–Zin preferences or limited substitutability between market and nonmarket goods.

Most of those additions would tend to increase the social cost of carbon. The EPA made several major improvements, and those changes pushed its estimate substantially higher. But our paper suggests that incorporating additional developments from the academic literature would raise it further.

If we repeated the expert survey today, I suspect that experts’ perceptions of the literature mean would be higher. Their preferred SCC estimates would probably also rise. Previously, the preferred estimate was around $150 per ton. Today, I suspect it might be $250 or more, based on the EPA update, our findings, and more recent evidence.

There are also newer empirical estimates, such as work using global temperature variation, that produce damages of $1,000 per ton or more. All of this is gradually pulling the research community’s assessment upward.

Changing of Her Own Priors

Arvid Viaene:
Was there anything that surprised you while working on the paper?

Frances Moore:
Part of the motivation for the paper was the observation that discounting receives a huge amount of attention, even though many other modeling choices matter too. Perhaps I should not have been surprised, but I was slightly disappointed that discounting kept emerging as such an important driver whenever we decomposed the variation.

Still, the other factors are important. From a policy perspective, discounting is also somewhat distinct from other modeling choices. When a government uses the social cost of carbon, it ultimately selects a discount rate. Academic research informs that decision, but it remains partly a choice parameter.

That differs from scientific and economic uncertainty about how climate damages actually occur. Questions about whether climate change affects economic growth, how tipping points operate, and how damages affect market and nonmarket goods are questions about the underlying structure of the world.

So I see the discount-rate debate as different from the question of how damaging climate change actually is. Another positive surprise was how favorably experts viewed many of the newer modeling innovations. We asked whether SCC estimates that incorporated particular features were preferable to estimates that did not. Academics are usually very good at identifying problems in the literature, so I expected more skepticism.

But collectively, experts were quite positive about many of the innovations researchers have introduced. That suggests it is important to incorporate these developments into policy estimates, especially when they are currently missing.

Why DICE Appears So Often in the Literature

Arvid Viaene:
Another important issue is the dominance of the DICE model. A large number of studies build on DICE, and that could mean many estimates inherit similar assumptions. How did you account for that?

Frances Moore:
We thought carefully about this when designing the data-collection process.

We did not want to collect the same DICE estimate repeatedly just because different papers had run the same model. We therefore limited the database to original social cost of carbon estimates.

If a paper modified DICE in a meaningful way, we treated the modified result as a new estimate. We also collected the paper’s baseline DICE run separately, which allowed us to compare the modified and unmodified versions and use that variation in some of our analysis. It is true that this still contributes to the prominence of DICE. The same is true of FUND, because Richard Tol and others have published many papers using that model.

Many researchers build on DICE because it is simple, tractable, transparent, and elegant. Those are major strengths. But it also means that later estimates may inherit assumptions embedded in the original model. The synthetic SCC method helps correct for some of that. If many studies inherit DICE’s discounting or damage assumptions, the reweighting process can partially adjust the literature toward the modeling characteristics experts currently prefer.

Why the SCC Matters for Policy

Arvid Viaene:
Is there anything else about the paper that you would like to highlight?

Frances Moore:
The broader policy context is important.

The paper was published in 2024, and the EPA released its updated social cost of carbon near the end of 2023. Since then, the Trump administration has moved away from many of the principles of benefit-cost analysis that originally motivated efforts to calculate the social cost of carbon.

For around 50 years, US federal agencies have been required to conduct benefit-cost analysis as an input into regulatory decisions. The basic idea is that agencies have significant power and should consider the costs and benefits to society when designing regulations.

When we evaluate climate regulations, the social cost of carbon provides a way to summarize their climate benefits. More recently, however, some regulatory analyses have simply declined to monetize environmental or climate benefits when repealing regulations. That is deeply problematic. Choosing not to monetize a cost does not mean the cost is absent. It effectively assigns it a precise value of zero.

The argument has sometimes been that the social cost of carbon is too uncertain to use. But our analysis can very confidently rule out a value of zero. The probability that the true social cost of carbon is exactly zero is exceedingly small.

So treating climate damages as zero is completely inconsistent with the evidence.

A Useful Entry Point Into the SCC Literature

Arvid Viaene:
I think that is an excellent point on which to conclude. The paper gives readers a much clearer understanding of what is happening across these models and why newer modeling developments matter. It also shows that experts themselves generally view many of these additions positively.

Frances, thank you so much for taking the time.

Frances Moore:
Thank you for your interest in the paper.

The social cost of carbon literature can be overwhelming for people coming to it for the first time. I hope this paper provides a useful entry point for readers who have some technical background and want to understand the literature as a whole before exploring particular parts of it in more detail.

Arvid Viaene:
I can highly recommend it. The graphs and explanations are especially helpful, and the visuals do an excellent job of breaking down the different components.

Thank you again.

Frances Moore:
Thank you.

When economists model climate change, they often focus on how rising greenhouse gas emissions increase global temperatures and create economic damages. But the climate system is not always smooth or linear. Some systems may cross tipping points: thresholds beyond which change becomes abrupt, irreversible, or self-reinforcing.

In this episode, I speak with Dr. Gernot Wagner, a climate economist at Columbia Business School and faculty director of the Climate Knowledge Initiative. Gernot has written widely on climate risk, policy, and technology, including books such as Climate Shock and Geoengineering: The Gamble.

We discuss Gernot’s research on how tipping points can be incorporated into climate-economic models. These include ice sheet collapse, permafrost carbon release, Arctic sea ice loss, AMOC slowdown, and Amazon rainforest dieback.

A central result from the paper is that tipping points can raise the social cost of carbonby roughly 25% to 50%, with a large right tail: there is a meaningful chance that tipping points could double or even triple the estimated social cost of carbon.

We also discuss why tipping-point damages are uneven across regions, why some effects are difficult to model, how the literature has evolved since the paper, and why tipping points should not distract us from the “slow burn” damages of climate change such as heat, productivity losses, mortality, and morbidity.

In this episode

• What climate tipping points are and why they matter for economics

• Examples: Greenland and West Antarctic ice sheets, permafrost, Arctic sea ice, AMOC, and Amazon dieback

• How tipping points can be incorporated into integrated assessment models

• Why tipping points increase the social cost of carbon

• Why tail risks matter as much as central estimates

• Why some tipping-point impacts are highly regional

• How methane and faster warming affect tipping-point risks

• Why “slow burn” damages are still central to climate economics

If you want to understand why climate risk is not just about gradual warming, but also about uncertainty, irreversibility, and tail risks, this episode is for you.

Paper: S. Dietz, J. Rising, T. Stoerk, & G. Wagner, Economic impacts of tipping points in the climate system, Proc. Natl. Acad. Sci. U.S.A. 118 (34) e2103081118, https://doi.org/10.1073/pnas.2103081118 (2021). https://www.pnas.org/doi/10.1073/pnas.2103081118

For questions, comments or suggestions, you can contact me at arvid.viaene.ce@gmail.com

Transcript

Arvid Viaene: When we think of climate change, we often think of greenhouse gas emissions that increase temperature. That is also the focus of most economic studies. Yet there is also the possibility of tipping points. After all, the climate is a complex system, and changes can trigger further changes, creating cascading effects. One example is the melting of Arctic ice. But tipping points are inherently uncertain and hard to model.

My guest today, Gernot Wagner, wrote a paper that incorporates tipping points into an economic framework and analyzes their impacts. Gernot is a climate economist at Columbia Business School and faculty director of its Climate Knowledge Initiative. He has written six books, including Climate Shock and, most recently, Geoengineering: The Gamble. His research, writing, and teaching focus on climate risks, technologies, and policy. Gernot holds a PhD and master’s in political economy and government from Harvard, and a master’s in economics from Stanford. I’m very happy to have him on as a guest today. He is someone whose research I greatly admire.

I also highly recommend checking him out on LinkedIn, where he publishes nearly daily, very insightful comments, as well as his website, which I will link in the show notes. So with that said, Gernot, welcome to the show.

Gernot Wagner:
Hi Arvid, great to be here.

Arvid Viaene:
I’m excited to discuss your research. So maybe to start: what motivated you to write this paper on the economic impacts of tipping points in the climate system?

Why We Need to Take Tipping Points Seriously

Gernot Wagner:
A call from Simon Dietz — one of my three co-authors on the paper — suggesting we work together. But more seriously, tipping points have, for better or worse, been part of the popular imagination for quite a while. We can probably blame Malcolm Gladwell for some of that. There is this pop-psychology idea of a small change leading to a rapid, cascading, large overall effect — the butterfly flapping its wings somewhere and the hurricane following, that sort of thing.

Now, moving from Malcolm Gladwell to climate science, Tim Lenton was the lead author on a really important 2008 paper that introduced tipping elements and tipping points into the climate conversation. The IPCC has since taken this up. The latest assessment report has a very good definition of tipping points: a critical threshold beyond which a system reorganizes, often abruptly and/or irreversibly. And as IPCC definitions go, every word there matters. “Abruptly and/or irreversibly” is doing a lot of work.

Abrupt change is the sort of thing people often think of when they hear “tipping point.” But irreversibility matters too. Something may not happen all at once next week or next year, but it may still be effectively irreversible on human timescales. Take the West Antarctic Ice Sheet. If that collapses, it leads to meters of sea level rise. That is not abrupt in the sense of happening next month. But it may well be irreversible once triggered. And in Earth-system terms, even a process that unfolds over centuries can still count as abrupt.

So climate tipping points come in different shapes and forms, but they share those broad characteristics. They are either relatively fast and/or effectively irreversible. And these are exactly the kinds of processes that are often missing from standard climate-economic damage functions, where economists try to estimate what happens as temperatures rise.

Arvid Viaene:
That seems to be one of the central points in your paper. Economists have long been aware of tipping points, but often treated them in a more ad hoc way.

Gernot Wagner:
Yes, exactly. Our contribution in the paper — which came out in 2021 — was to move beyond that. We started from a long list of possible tipping elements and narrowed that down to a smaller set, roughly eight tipping points, that we could quantify more systematically.

The key was that we did not just assign some rough point estimate to each tipping point. We went to the Earth-system science and climate-science literature and incorporated the actual processes and equations underlying those tipping elements into a consistent climate-economic model. So instead of just saying “temperature rises and tipping points get worse,” we used the science more directly and embedded it in an integrated framework.

The Different Types of Climate Tipping Points

Arvid Viaene:
Could you give a few examples of those tipping points? You mention about eight in the paper, and I think it would help listeners to hear what kinds of things you had in mind.

Gernot Wagner:
Of course. It is a fairly diverse list. One major category is ice sheets — for example the Greenland Ice Sheet and the West Antarctic Ice Sheet. The danger there is collapse, which ultimately means sea level rise. And the economic consequence is obvious: coastal flooding, enormous adaptation needs, seawalls, relocation, and in some places potentially giving up land near the coast altogether.

A second category is carbon-cycle feedbacks. Permafrost is a good example. There is a lot of carbon trapped in permanently frozen ground. If that melts, then carbon dioxide and methane are released, which creates additional warming. So warming triggers more emissions, which in turn trigger more warming.

Arctic sea ice is another case, though slightly different. Floating sea ice melting does not directly raise sea levels, but it changes the albedo of the planet. Bright white ice reflects sunlight; dark open water absorbs more heat. So once sea ice melts, warming can accelerate because the surface becomes more heat-absorbing.

A third category is changes in major circulation systems. The best-known example is the Atlantic Meridional Overturning Circulation, or AMOC — often loosely referred to as the Gulf Stream. If that slows dramatically or collapses, it has major consequences. One classic story is that parts of Europe could actually get cooler, at least relative to what they otherwise would have experienced under global warming. So this is an example where a tipping point can create more complicated regional effects.

And a fourth category is biome shifts, such as Amazon rainforest dieback. That would involve large-scale ecosystem loss, regional disruption, and major global spillovers as well. So yes, these tipping points are very different from one another, but they all involve the possibility of large, nonlinear change.

How the Paper Brings Tipping Points Into an Economic Model

Arvid Viaene:
One thing I really liked about the paper is that you first study these tipping points individually, but then you also look at how they interact with each other. Before we get to that, though: how do you actually go from these physical tipping points to economic damages in an integrated assessment model?

Gernot Wagner:
The model we built — which we call the METER model, because economists always need a nice acronym — integrates several different tipping points into one climate-economic framework. And yes, that then allows us to account for interactions between tipping points as well.

What we ultimately do is compare climate damages in a model with these tipping points to damages in a comparable model without them. In reality, of course, you cannot literally switch tipping points on and off. But as a modeling exercise, that is exactly what you do. That is how you isolate their effect.

And the headline result is that our best estimate is that tipping points increase the social cost of carbon by somewhere between about 25 percent and 50 percent — around 25 percent in the median estimate, and closer to 50 percent in the mean.

Now, some people reacted to that by saying: “Only 25 percent? I thought tipping points meant the end of life as we know it.” But that is misunderstanding what the numbers mean. A 25 percent increase in the social cost of carbon is already huge. And equally important, the distribution is very skewed. There is a large right tail.

There is about a 10 percent chance that tipping points double the social cost of carbon, and about a 2 percent chance that they triple it. So yes, the central estimates are already large, and the tail risks are even more dramatic.

What the Results Mean for the Social Cost of Carbon

Arvid Viaene:
And I think that is the point people often miss. They hear the central estimate and think it sounds modest, but they forget the right tail — the possibility of much larger outcomes. And the social cost of carbon is already high even before you add those effects.

Gernot Wagner:
Yes. In later work, with several co-authors including Simon Dietz and James Rising, and led by Francis Moore, we tried to synthesize the evidence on the social cost of carbon more broadly.

That paper looked across almost 2,000 estimates from around 150 published studies and then combined that with additional work and expert elicitation. The average estimate we ended up with was in the high 200s — around $280 per ton of CO2. That is already much higher than many of the numbers people still have in mind from earlier work. And yes, that estimate already includes tipping-point effects.

So if tipping points raise the social cost by around 25 percent or more, that is a very significant contribution on top of an already large baseline. And again, there is a wide distribution around that number. But the big takeaway is that tipping points matter economically in a very material way.

Why Tipping-Point Damages Are Uneven Across the World

Arvid Viaene:
And one thing your paper also shows very clearly is that these impacts are heterogeneous across the world.

Gernot Wagner:
Yes, absolutely. Different tipping points matter more in different places. Amazon dieback obviously has especially large consequences in the Amazon basin and in Latin America more broadly. AMOC slowdown or collapse has a bigger effect in Europe than elsewhere.

And that is another reason these models are difficult. The impacts are not evenly distributed, and in some cases the regional effects can look counterintuitive. For example, if AMOC weakens, parts of Europe may cool relative to the counterfactual path of warming. That does not mean it is “good.” But it shows that climate-economy interactions are more complicated than just “everything gets uniformly hotter everywhere.”

What Surprised Gernot While Working on the Paper

Arvid Viaene:
What surprised you during the research process? Did anything shift in your thinking as you worked on the paper?

Gernot Wagner:
Yes. One thing that surprised me was precisely that some of these tipping points create trade-offs in the modeling.

To be very clear, I am not saying climate change is good for Northern Europe. It is not. But take AMOC collapse: one of its effects could be to offset part of the warming in Europe, at least temporarily. So in a narrow temperature sense, that can dampen some of the warming effect.

Of course, that does not mean the tipping point is desirable. There are many other consequences our models do not capture well. Extreme weather, precipitation changes, ecosystem disruption — those effects are very real, and many of them probably make tipping points worse than our current estimates suggest.

So one surprise was that once you model these things carefully, the regional impacts can be more complex than one might expect. Another is just how much is still missing from the models.

How the Literature Has Evolved Since the Paper

Arvid Viaene:
Since the paper came out in 2021, how have you seen this literature develop?

Gernot Wagner:
The model has certainly been developed further, especially by my co-authors Thomas Sterner and James Rising, together with Simon Dietz and others.

One interesting extension has been to bring methane more directly into the picture. Methane is a much faster-acting greenhouse gas than CO2, and its importance is not just about long-run average warming but also about the rate of change. So when you think about tipping points, methane becomes especially relevant, because faster warming can be more important for crossing thresholds. That line of work has found larger short-term effects than you would get from looking at CO2 alone.

Another important development is that Bill Nordhaus’s latest work on DICE, done with Lint Barrage, now includes tipping-point damages calibrated partly from the METER model we developed. That does not mean DICE is now the perfect model. It is not. But it does show how science advances. These effects are gradually getting incorporated into mainstream climate-economic modeling. And yes, that is a step in the right direction.

Why Tipping Points Should Not Crowd Out “Slow Burn” Damages

Arvid Viaene:
Before we wrap up, is there anything we have not talked about that you would still like to highlight?

Gernot Wagner:
Yes — and this is actually quite important. Not everything is a tipping point.

That sounds obvious, but it matters. One of my earlier papers on tipping points was about definitions and how to bring them into economic analysis. More recently, Bob Kopp and co-authors wrote a paper whose title is basically that tipping points can confuse and distract from urgent climate action. And up to a point, I agree with that.

Tipping points are real, important, and scary. But when we focus heavily on them, we may lose sight of what you might call the “slow burn” damages of climate change. That phrase is also the title of Jisung Park’s book, Slow Burn. And I think it is a useful contrast.

On the one hand, you have climate shocks, tipping points, fat tails — large, abrupt, potentially catastrophic changes. On the other hand, you have small, cumulative changes that may seem almost undetectable in the short term but add up to massive damages over time.

A good example is heat and productivity. In one paper I worked on with Patrick Baylis and Jisung Park, we found that one additional day above 90 degrees Fahrenheit — 32 degrees Celsius — lowers annual payroll by 0.04 percent. That is a small number for one day. But climate change means many more such days. Those effects add up.

So yes, tipping points matter a lot. But so do the slow-burn damages: productivity losses, mortality, morbidity, repeated heat stress, and so on. It is both.

Closing Thoughts

Arvid Viaene:
I really like that framing, because your 20 to 25 percent increase is still an increase on a very large number. And at the same time, we should not forget the many other climate damages that are not tipping points but still matter enormously.

So Gernot, thank you so much for coming on. I really enjoyed this conversation. It has given me a lot to think about, and also a lot of ideas for future episodes — including on the slow-burn damages and the broader synthesis work. Thank you again for taking the time.

Gernot Wagner:
Thank you. That was fun.

With the Summer in full swing, I wanted to try my hand at a few solo-episodes on topics I have been thinking about. Here is one based on why you can likely be a bit more optimistic about climate change than you currently because of three reasons: increase in the coverage of emissions by carbon pricing, the increase in average carbon price, and developments like CBAM.

This episode is based on the World Bank Report “State and Trends of Carbon Pricing 2026”, available at https://www.worldbank.org/en/publication/state-and-trends-of-carbon-pricing

For questions, comments or suggestions, you can contact me at arvid.viaene.ce@gmail.com

Transcript

Recently, I had a couple of conversations with people working in climate policy and they were feeling discouraged. They felt that there’s a lot more push back on climate policy, that there are less funds available and that some initiatives are either canceled or scaled back substantially. But in this episode, I want to make a case for climate optimism. And not because the push back isn’t real, but because there has been a big big win in climate policy in the last decade. And that win is that there’s a great increase in carbon coverage and carbon pricing.

In this episode, I will tell you that you can probably be a bit more optimistic than you currently are for three reasons. First, the total emissions covered by carbon price is increasing. Second, the global average carbon price itself is increasing as well. And third, there are dynamic effects that are going on like EU CBAM regulations that are only going to further encourage carbon coverage.

I’m going to cover what’s happening, why it’s happening, and then also kind of give you a couple of insights you might not be aware of. Now, for those of you who are more the glass half empty type, I will also provide some caveats at the end of the episode if you want to keep a gloomy outlook.

Let’s start with the coverage of emissions by tax or emissions trading system. In 2016, according to the World Bank, global carbon taxes and emissions covered around 12% of global greenhouse gas emissions. So about 1 in 10 of emissions was covered, but in 2026, according to the World Bank—so only like 10 years—we now cover 30% of global greenhouse gas emissions. That is a big, big change. It means that now we are very close to 1/3 of global emissions being covered by some form of a direct carbon price.

The fact that it’s covered does not mean that it’s strongly priced, and of course there’s also 70% that it’s not covered. But it does mean something huge already: it means those 30% emissions are inside a system where there’s monitoring, reporting, verification, and a compliance obligation that firms or people have to meet. There’s an institution now that can be adjusted, tightened, and expanded. In climate policy, that matters a lot because the first step is often building the machine. It can take quite a long time to set up an Emissions Trading System (ETS) and can require a lot of political capital, but once the systems are in place, they can then be more easily expanded.

One of the big reasons behind the expansion is that China and India, who together account for around 40% of emissions in 2026, have started to implement an ETS. China’s ETS came into effect five years ago in 2021 and India only just launched its ETS for carbon last year in 2025. In addition, Japan’s ETS has entered its mandatory phase, Vietnam has an ETS in effect, and Brazil and Turkey are also preparing policies for upcoming ETS programs. These new systems are often not very stringent in the beginning, relying on intensity benchmarks or free allocation, but you gradually ramp up the stringency. A weak system naturally can become stronger once the things are in place.

The second argument for the win is that carbon prices have gone up. The World Bank reports that the average carbon price across implemented carbon taxes and emission trading systems has roughly doubled over the last decade, going from 10pertonofCO2in2016tonearly∗∗21 in 2026**. While $21 per ton is not a very high global carbon price compared to economic literature estimates of $100 to $280, relatively small prices can still have big impacts. For example, a $21 price can encourage power plants to switch from coal to natural gas, leading to a big decrease in emissions.

The main driver behind the increase in coverage is Emissions Trading Systems. Carbon tax coverage has stayed relatively stable at around 4 to 5% of global emissions, while ETS coverage has tripled since 2016. A carbon tax has the word “tax” in it, making it politically difficult to implement. We saw this with the European Union in the ‘90s, China’s Ministry of Finance in 2010, and movements like the yellow vests in France. ETSs can be more complicated mechanically, but that complexity makes them politically easier to implement because price increases in industries like the power sector are harder for consumers to see and organize against. Furthermore, ETSs provide a gradual path for increasing stringency, moving from free allocation to auctioning.

The third reason for optimism is the development of the EU’s Carbon Border Adjustment Mechanism (CBAM). While its direct emissions coverage is small, its political effect is large. It tells foreign exporters that if their product is carbon intensive and there is no equivalent carbon price paid at home, they may face a carbon cost at the EU border. This incentivizes foreign governments to implement their own ETS so that the revenue goes to the foreign government rather than to the EU. This could lead to a “climate club” of countries implementing carbon taxes, as suggested by Nobel Prize winner Bill Nordhaus.

I have presented a case for why you could be more optimistic about climate change and climate policy, looking at developments in China, India, Japan, Turkey, and Brazil. Now, for the caveats: 70% of emissions are still not covered, particularly in hard-to-reach sectors like agriculture, transport, and housing. Political durability is also not guaranteed, and carbon pricing can be reversed. Carbon pricing isn’t the highest yet, and we need to see absolute caps rather than intensity benchmarks.

The goal of this episode was to show that from a global perspective of carbon coverage and carbon pricing, developments are very promising. I really hope that in a decade from now I can do the same episode giving you much, much better numbers still. Thank you for tuning in

Introduction

Sometimes you hear: “we should stop subsidizing dirty industries.” But are we actually doing that—and how big is it?

In this episode, I’m joined (again) by Professor Joe Shapiro (UC Berkeley) to discuss his paper “The Environmental Bias of Trade Policy” (QJE, 2021). Joe’s core finding is striking: dirty industries tend to face lower trade protection, while cleaner industries face higher trade protection—a pattern that appears across countries, years, and even non-tariff barriers.

Joe then translates that pattern into an intuitive metric: if you interpret existing trade policy as a carbon tariff, it looks like an implicit carbon subsidy of around -$100 per ton of CO₂ (roughly -$85 to -$120/tCO₂) or $550 to $800 billion dollars per year. In other words, goods with higher embedded emissions often face less trade protection—trade policy gets the magnitude “about right,” but the sign wrong.

We unpack what drives this: tariff escalation linked to “upstreamness” (upstream, commodity-like inputs tend to be dirtier and receive lower protection; downstream consumer goods are cleaner and receive higher protection).
Finally, Joe walks through his model-based simulations showing that harmonizing protection between clean and dirty goods could modestly raise GDP while meaningfully reducing global emissions.

In this episode

• The key empirical fact: dirty industries have low tariffs; clean industries have high tariffs

• The implied magnitude: ~-$100/tCO₂ “implicit carbon tax” embedded in trade policy

• The mechanism: upstreamness → tariff escalation → environmental bias

• What the simulations show when you “flatten” the bias across sectors

• A surprising map result: countries with strong climate reputations can still have trade policy that tilts toward dirtier goods

If you care about CBAM, industrial policy, or the political economy of decarbonization, this episode is a powerful reminder: trade policy can be climate policy—even when nobody intended it.

For questions, comments or suggestions, you can contact me at arvid.viaene.ce@gmail.com

Transcript

Arvid Viaene:
Welcome to another episode. I’m your host, Arvid Viaene. Sometimes you hear the following statement: we should stop subsidizing dirty industries. Because if you want to tackle climate change, subsidizing dirty industries is one of the least productive things you can do.

But whenever I heard something like this, I often found myself thinking: is it true that we are subsidizing them? And if so, how large is the magnitude? Today we are going to discuss those questions, because I think it is vital to understand them. Especially since the implicit subsidies for dirty industries may be much bigger than you might suspect.

To do that, I’m delighted to have Professor Joe Shapiro join me again. He wrote an excellent article on this topic, published in the Quarterly Journal of Economics in 2021, called The Environmental Bias of Trade Policy.

Joe is an associate professor of economics at UC Berkeley and a research associate at the National Bureau of Economic Research and the Energy Institute at Haas. He studies climate change, air pollution, clean energy, and especially water pollution, with links to trade, public finance, and health. He holds a PhD in economics from MIT. And he is also the first repeat guest on my podcast.

So, Joe, welcome back.

Joseph Shapiro:
Thanks. I’m honored to be here again.

Arvid Viaene:
I had a wonderful time the first time. And now we’re talking about the environmental bias of trade policy. Could you explain what your paper is about?

Joseph Shapiro:
Yes. This paper asks: how does trade policy affect greenhouse gas emissions?

Usually when people ask that question, they want to know whether having a high level of tariffs affects carbon emissions. I approached it from a different angle. Most countries have different levels of tariffs across industries, and I wanted to know how those patterns affect carbon emissions.

I really started this paper because I was interested in a policy many countries had talked about, but at the time only one region had implemented. That policy is called carbon tariffs, or carbon border adjustment. Europe has one now. The concern is that if one region has a serious climate policy and other regions do not, then dirty industries will simply relocate away from the climate policy. In that case, global emissions do not actually decrease. People refer to that concern as leakage.

So, for example, if Europe seriously regulates carbon and other regions do not, then carbon could leak away from Europe. Europe might just start importing dirty goods from China, India, Mexico, and other trading partners. For many years, countries have said: if that is a problem, let’s create a tariff proportional to the carbon emitted in producing those goods — a high tariff on dirty goods, a low tariff on clean goods — and that will solve the leakage problem.

When I talk to undergraduates, they refer to this as a kind of whack-a-mole problem. Europe hits carbon at home, but then it pops up somewhere else. So I thought a long time ago: a carbon tariff is just a tariff by another name. It is simply a tariff with a high rate on dirty goods and a low rate on clean goods.

And then I thought: I wonder if countries already have this and nobody noticed. Maybe they already have high tariffs on dirty goods and low tariffs on clean goods. That would be plausible, because dirty industries spend a lot of resources on lobbying. One of the goals of lobbying is often to obtain protection from foreign competition. So I thought it was plausible that dirty industries could have high tariffs and clean industries lower ones. And I thought: let’s just look at the tariff data and see.

Arvid Viaene:
And I think, like you say, a carbon border adjustment mechanism is basically a tariff. It is a tariff between regions. So what did you find when you analyzed this problem?

The Surprising Trade Pattern

Joseph Shapiro:
I found exactly the opposite of what I expected, which is not what happens in most papers. I found that dirty industries have low tariffs and clean industries have high tariffs. That is true in the US, where I started. It is also true in most other countries in the world where I then expanded the research. It is also true for other trade policies like quotas and product standards.

People collectively refer to all of those as non-tariff barriers, because they are barriers to trade besides tariffs. I also found that this pattern was present in all the years of tariff data available for the US. In sciences like physics or biology, people often want to estimate parameters out to six decimal points. In economics, sometimes we are happy if we can just get agreement on the sign of something, let alone the magnitude.

So it is pretty rare to find a pattern like this that shows up in different datasets, different countries, different years, and different measures of policy. It seemed like a very systematic and quantitatively important pattern. And then the paper went on to try to understand why this pattern exists and what it means for the environment and the global economy.

Arvid Viaene:
So you started with the prior that maybe there was lower trade protection on greener goods, but then you found the opposite. And then you found it was consistent across countries, measures, and time periods. I imagine you were pretty surprised that it just kept showing up.

Joseph Shapiro:
I was, but it was revealed to me in stages. I actually thought of the idea when I was in graduate school, but at the time I never looked at the data. I assumed it would just be a simple scatterplot of tariffs against carbon.

Then, five or six years later, I had to take a train every day from New Haven to New York to use restricted-access data at a data center in New York. It was a two- or three-hour round trip with no internet. So each Tuesday, I would pick a paper idea that had been gathering dust and spend the day on it. Being who I am, I had tariff and carbon data on my laptop. So I spent a couple of hours on the train looking at this.

Just for the US, it jumped off the page that clean industries had high tariffs and dirty industries had lower tariffs. I thought: well, that is kind of interesting. That summer, I was going to several trade conferences. At the time, I was not deeply involved in trade papers. But when economists talk in hallways at conferences, they always ask what you are working on.

So I just started describing this in conversations. And basically everyone said: that is really interesting — why is it happening, and what does it mean? Then that fall, I was applying for a grant at the National Science Foundation. I was going to describe three papers. Two were already fairly advanced, and then I decided to include this as the third.

I thought I should look at countries beyond the US. I realized I could use input-output data and national accounts to do this for many countries. So I did the same analysis internationally. At that point, I realized this was happening in most countries, not just the US. Then I got comments back from the grant reviewers, and they basically said: papers one and two are fine, but paper three sounds really interesting — you should definitely pursue that one.

And then I thought, okay, everybody is telling me this thing I had initially dismissed is actually worth writing about. Then I looked at non-tariff barriers and found the same pattern.

So yes, the big surprise first came on the train, when I saw the US result had the opposite sign from what I expected. But I initially assumed it was probably a fluke. Once I looked across countries, I realized it was systematic. Academics can be slow to update their priors. It took me a while to become convinced this was a genuine scientific pattern. And I would say that understanding why it was happening was also important for persuading me that it was real.

The Magnitude of Implicit Subsidy for Dirty Industries

Arvid Viaene:
I want to get to the reasons in a moment, but first I wanted to give listeners a sense of the magnitudes. One thing is that you found the pattern consistently. The other question is whether it is substantial.

Joseph Shapiro:
I summarize the magnitude as an implicit carbon tax. What I mean by that is the following: if a region like the European Union imposes a carbon border adjustment, it is basically a tariff on carbon emissions. They have to choose a carbon price — maybe $50 a ton, or $100, or $200.

So I wanted to ask: if you look at the trade policies countries already have — not policies called carbon tariffs, just ordinary tariffs and non-tariff barriers — what carbon tax rate would those imply if you interpreted them as carbon tariffs? I calculated that, on average around the globe, trade policy was creating a carbon tax rate in the ballpark of negative $100 per ton. The range was roughly minus 85 to minus 120 dollars per ton.

The minus sign matters, because it means that the more carbon is emitted, the lower the level of trade protection. So imagine two bundles of goods arriving at a port. If one of those bundles emits an additional ton of carbon dioxide in production, it faces about $100 less in tariffs and tariff-equivalent barriers.

Is that large or small? Today, leading estimates suggest the optimal carbon tax is probably around $200 per ton. At the time I was writing the paper, many estimates were more in the range of $50 to $100 per ton. So my summary was that trade policy accidentally got the magnitude about right — it just got the sign wrong. Another way I tried to show the importance of the magnitude was to sum it globally and ask: if this were a carbon tariff, how much revenue would it generate?

The answer is over $500 billion per year. I think the range was roughly $550 to $800 billion. Some macroeconomists say, “Call me when you get to trillions.” But this is still a very large number. One benchmark is direct fossil fuel subsidies, which policymakers often worry about. India has historically subsidized kerosene. Venezuela subsidized diesel. The IMF and World Bank have repeatedly written about these direct subsidies.

If you sum those globally, they are in roughly the same ballpark — around $500 billion per year. So I took that comparison to mean: this implicit subsidy to carbon emissions, embedded in trade policy, is of the same order of magnitude as the direct fossil fuel subsidies that attract so much attention.

Now, of course, it may have a very different effect on actual carbon emissions, because it is a more indirect subsidy. But the scale is surprisingly large.

Arvid Viaene:
That was one of the things that startled me when I read the paper. There is already a lot of attention on direct subsidies. But if you take your results seriously, you almost have to add a second layer of subsidy on top of that — these implicit subsidies coming from different tariff rates.

Joseph Shapiro:
Yes, though I would add a grain of salt to that comparison. Even though the dollar magnitudes are similar, they are very different kinds of subsidy. Giving someone a dollar to burn a gallon of kerosene is probably going to increase kerosene use more directly than giving an extra dollar to somebody importing a bundle of goods with higher carbon content.

Partly for that reason, the final part of the paper uses a mathematical model of trade, energy, and emissions to calculate what this all adds up to in environmental terms.

Why This Happens: Upstreamness vs Downstreamness

Arvid Viaene:
So we have the magnitude, which is striking. They got the magnitude close to the social cost of carbon — but with the wrong sign, which is a huge deal. So what is driving these implicit subsidies?

Joseph Shapiro:
First, let me rule out a reason. I do not think trade policymakers sat around a table and said, “Let’s burn up the planet. How can we best do that through trade policy?” There is no rational reason to do that.

And also, I talked to a lot of trade policymakers around the world in the course of writing this paper, and I found zero who were aware this was happening. Several actually reached out and said: this is news to us — can we talk to you about it? I ended up working as a consultant to Europe’s Directorate-General for Trade, and I talked to European parliamentarians, politicians, and US trade policymakers. So this was definitely not something people had on their radar.

So why is it happening? I realized in the process of writing this paper that trade policy is a somewhat distinct field from trade economics more generally. Trade policy puts much more emphasis on game theory, political influence, and patterns across industries.

Trade policy researchers have, for decades, tried to understand why different industries have different levels of trade protection. I took a list of those explanations — from a handbook chapter by Dani Rodrik — and asked: which of these explanations can account for why dirty industries have low protection and clean industries high protection?

There were about 15 explanations. I looked at them first in the US and then internationally. And going in, I assumed perhaps 10 of the 15 would matter and we would get some messy combination. That was totally wrong. One explanation really jumped off the page. The term is one economists made up about a decade ago: upstreamness.

Upstreamness means that some industries mostly sell their output to other firms, whereas other industries mostly sell directly to final consumers. For example, hot-rolled coils of steel are not something you buy at a grocery store. They are sold to other companies, which then transform them into final products. That makes steel a very upstream industry.

By contrast, bubble gum is a very downstream industry. It is sold directly to consumers. It turns out that for well over half a century, upstream commodities have had very low tariffs, while more downstream processed goods have had higher tariffs. That pattern is called tariff escalation.

In the mid- to late 20th century, it was central in both policy and academic discussions of trade policy. There is even an old paper in the Journal of Political Economy by Corden that says tariff escalation is so well known that detailed substantiation is hardly needed.

That was the state of knowledge in the 1960s: everybody knew upstream goods had low protection and downstream goods had high protection. It was somewhat forgotten over the following half century. When I was doing this research, many trade and trade-policy researchers either only vaguely remembered it or thought it was irrelevant.

But it turns out to be one of the most powerful empirical forces determining tariffs and non-tariff barriers across countries. Upstream goods have low protection, downstream goods have high protection.

And the key observation is that upstream goods are systematically dirty, while downstream goods are systematically clean. The real lightbulb moment for me came when I looked at a paper measuring upstreamness in the US economy. The most upstream industries were steel, cement, refined petroleum, chemicals, and aluminum. Those are exactly the industries you see in environmental research as carbon-intensive sectors.

So I thought: if those are the most upstream industries, and we know for decades that upstream industries have low trade protection, and it is obvious they are the dirtiest industries, then this has to be the smoking gun. Once you account for an industry’s upstreamness — how far it is from final consumers, and how much it sells to firms rather than households — the relationship between carbon intensity and trade policy almost disappears.

In fact, the first graph in the paper is basically an X-shape: as you move from upstream to downstream industries, tariffs go up and carbon intensity goes down. I then made that graph for the global economy, and then separately for each country. Astonishingly, almost every country showed a similar X-pattern. Some graphs were neater than others, but the pattern was highly systematic around the world.

Arvid Viaene:
I would actually recommend people go look at that graph, because it really is compelling. So then the next question is: what drives that result? Why do downstream firms get so much more protection?

Why Tariff Escalation Happens

Joseph Shapiro:

That is a great question. Writing this paper felt a little bit like peeling an onion. First: do we have a carbon tariff? Yes, but it is negative. Why? Because of upstreamness. Then: why does upstreamness matter?The paper does talk a bit about this, but I felt this was really a good question for trade policy more generally. I did not think I could fully answer it in this paper.

So I offered what I thought was a sufficient explanation, though not necessarily the only one. The explanation I found most persuasive is upstream versus downstream lobbying. Industries want cheap inputs. So they lobby legislators for low trade protection on the goods they use as inputs.

Many industries in advanced economies use steel, directly or indirectly. Car manufacturers use steel directly. Producers of pipes, machines, and many other goods use it directly or further up the supply chain. So when you ask who is arguing for low trade protection on steel, it is a huge share of industries.

Now compare that to bubble gum, which is a downstream consumer good. Who argues for low protection on bubble gum? Basically just final consumers — millions of dispersed individuals. It is easy to organize three or five large manufacturers who use steel. It is very hard to organize hundreds of millions of consumers to argue for low protection on a final good.

So you end up with lots of industries lobbying for low trade protection on upstream goods. And the only people who might argue for lower protection on downstream goods are final consumers, who are much harder to organize. That is one sufficient explanation for tariff escalation. It may not be the only one, but it is a persuasive one. And it helps explain why tariff escalation shows up not just in tariffs, but also in quotas, product standards, and other non-tariff barriers.

Arvid Viaene:
Yes, exactly. The same logic applies to quotas and the rest. Those five concentrated firms can coordinate, whereas final consumers are much more dispersed. One thing I do want to ask: you mentioned that in the 1960s this broad pattern was more widely understood, even if the term upstreamness was not used. But when you published this paper, many economists and policymakers still seemed surprised. Have you noticed increasing awareness over time?

Has Awareness Increased?

Joseph Shapiro:
I think so. I have only a limited orbit, of course, but when I talk to people in the trade-policy and climate-policy space now, I do think this pattern is known.

When countries choose trade policy, there are many interest groups involved. There is the industry itself, downstream users, consumer groups, and so on. But environmental groups are usually not in that hallway, unless we are talking explicitly about solar, wind, or other clean-tech goods. That is not really what this paper is about.

So one idea I had was: when countries are deciding whether to put tariffs on steel, bubble gum, or fossil fuels, environmental groups actually have reasons to be in that conversation. I am not directly inside those negotiations. But my sense is that much of the conversation linking trade and the environment still focuses on carbon border adjustments and leakage.

That said, I do know that some regions have considered the kind of issues this paper raises when thinking about broader trade reform. For example, after COVID, the European Commission was discussing whether it should undertake major trade-policy reform, and this kind of issue was on the agenda. They have a trade-policy day each year, and I joined their trade-policy committee in Parliament and spoke about this.

So it is in the conversation. I do not know exactly how it will play out, but I think of research as starting a snowball rolling downhill. Hopefully it gathers momentum, but it is hard to predict how, where, and when.

Arvid Viaene:
Yes, exactly. And I partly hope this conversation helps spread that awareness too. Because like you say, once you see it, it is kind of hard to unsee it. It is so systematic — across countries, across quotas, across non-tariff measures, across the graphs.

And I think you are right: when it comes to the EU ETS or a carbon border adjustment mechanism, environmental groups are clearly in the room. But if it is “just” a tariff on a product, they may not be around that table.

Joseph Shapiro:
I think more broadly, I have been really excited by the rapid growth in research at the intersection of trade and the environment over the last five years. There have been a lot of creative papers trying to identify ways trade policy might improve environmental outcomes, even if those ideas are not yet central to policymaking.

Some are clearly environmental policy tools, like carbon tariffs or climate clubs. Others sit somewhere in the middle. I think it is exciting that frontier economic research is building new tools, methods, and ideas that are also useful for policy.

This paper is one contribution to that conversation, but far from the only one. At a broad level, I also took from this research the lesson that trade policy can have quantitatively important environmental effects.

That idea, I think, has become more accepted. One reason for all the discussion is that climate change is a global public good with a severe free-rider problem. If one city pollutes another, maybe a state can coordinate. If one state pollutes another, perhaps a national government can coordinate.

But with climate change, countries are polluting each other. And we do not have many strong sticks or carrots to coordinate them. Trade policy is one natural tool that can provide such sticks or carrots.

Of course, the ideal climate policy would just be a carbon price. Then trade policy would have no special role. But the world is nowhere close to that optimum. Only about a quarter of global carbon emissions face any price, and those prices are often low, fragmented, and inconsistent.

In that kind of second-best setting, there may be some scope for trade policy to improve environmental outcomes. Of course, there is also scope for trade policy to make environmental problems worse. And many trade researchers reasonably worry that trade policy itself has had a rough few years, and that tying trade and climate together could make both harder rather than better.

So it is not guaranteed that linking trade and environmental policy will improve either one. It requires proceeding carefully.

What the Simulations Show

Arvid Viaene:
Exactly. That brings me to the last point I wanted to raise. In the paper, you also run simulations to think about possible policy reform. Could you talk about those?

Joseph Shapiro:
Yes. I set up a mathematical model of production, consumption, and trade for most countries in the world. Then I asked: what if we reformed trade policy so that clean and dirty goods faced roughly the same level of protection?

In other words, we are not increasing or decreasing tariffs on average. We are just harmonizing trade policy between clean and dirty goods. I found that if most countries implemented that reform, there would be a very slight increase in global GDP, but also a meaningful decrease in global greenhouse gas emissions — on the order of magnitude of the estimated impact of Europe’s cap-and-trade market in the mid-2010s.

The reason is that current trade policy is sending the wrong price signal. It encourages production, consumption, and trade in dirty goods. Once you take away that policy distortion, there is no longer an incentive to specialize in fossil-fuel-intensive production. Policy is no longer putting its finger on the scale and tipping the global economy toward international sourcing of carbon-intensive goods.

What Joe Is Working on Now

Arvid Viaene:
That is really interesting. One thing I also wanted to ask is: since writing this paper, have you continued in this field? Are you working on related things?

Joseph Shapiro:
Yes.

The paper I wrote most immediately afterward looked quite different on the surface — it was about institutions and the environment — and I published it a year or two ago. But if you compare the two papers, they share a common principle: a commodity tax that differs across industries can encourage the global economy to shift toward one set of industries rather than another. I am also working on a few other papers on how trade policy affects carbon emissions.

Some are with collaborators — Eki Garcia-Lembergman, Natalia Raimondo, and Andrés Rodríguez-Clare.

One of those projects is about trade and value chains. It tries to understand how different it is if you tax carbon at the point of fossil-fuel extraction, versus at the point of producing goods that use fossil fuels, versus at the point of import and export.

Another looks at international finance and how investment in carbon-intensive or clean production abroad can help transfer clean technology around the world. And one question there is whether the $100 billion a year in transfers envisioned under the Paris Agreement could partly happen through foreign investment and multinational production in clean industries.

Arvid Viaene:
That is really cool. And like you said earlier, this is clearly a growing research area. I feel like there are more and more papers coming out at the intersection of trade and climate. So maybe there will have to be a part three. Before we wrap up, is there anything else you still wanted to add about this paper that we have not covered?

Countries with Strong Climate Regulations Can Have Higher Subsidies

Joseph Shapiro:
Yes, just one other thing. The paper includes a map showing the extent to which each country is imposing higher trade protection on cleaner goods — in other words, the implicit subsidy to carbon emissions embedded in trade policy. And it has some pretty surprising patterns.

The countries where trade policy is doing the most to accelerate climate change include places like France, Germany, and Norway. The countries where trade policy is doing the least to accelerate climate change, in this cross-industry sense, include places like Saudi Arabia, Egypt, and Iran. That seems very strange at first. It is not because Norway is a super-polluter and Saudi Arabia is super-green. Stereotypically, it is the opposite. But that actually reinforces the idea that countries are not intentionally doing this. They develop trade policy for political-economy reasons, and unfortunately it ends up being strongly correlated with carbon emissions.

To the atmosphere, though, it does not matter whether carbon is emitted from Ohio or Shanghai, or whether it is emitted because of trade policy, diesel subsidies, or anything else. Carbon is carbon.

Arvid Viaene:
Exactly. That is actually a really strong point. Countries with strong climate reputations, like Norway or France, may be very focused on climate policy in other domains and yet still not be aware of this bias. So I really do hope this conversation contributes to increased awareness.

And to listeners: I really recommend checking the paper out. Joe, thanks so much.

Joseph Shapiro:
Thanks, everybody. Great to talk to you. It was fun to discuss these topics.

Arvid Viaene:
Yeah, thanks. You too.

Introduction

A lot of climate economics focuses on carbon pricing and carbon markets. But what happens when firms don’t face an explicit cap on emissions? Why do some companies make real operational changes, while others focus on pledges and disclosure?

In this episode, I’m joined by Dr. Lily Hsueh to discuss her book Corporations at Climate Crossroads: Multi-Level Governance, Public Policy, and Global Climate Action. Lily argues that corporate climate behavior is shaped by a nested structure of governance: what happens inside the firm (leadership, incentives, organizational capabilities) interacts with domestic public policy and top-down global norms.

We talk about how to distinguish symbolic climate action from substantive emissions reductions, why managerial authority matters (data collection is not the same as decision power), and how domestic policy signals can change firm behavior. Lily also explains how she uses the Clean Power Plan as a quasi-experimental shock to identify mechanisms—and why “disclosure” isn’t enough without verification and accountability.

What we cover

• Why it’s misleading to treat firms as “unitary actors” (internal politics and incentives matter)

• How managerial capacity and complementary capabilities shape real climate outcomes

• The difference between pledges, disclosure, and measurable emissions reductions

• How domestic regulation and global norms influence corporate strategy

• Why corporations can engage and obstruct at the same time

• Why the next step is disclosure → verification → accountability

Links

Dr. Lily Hsueh’s website: https://www.lilyhsueh.com

Open-access book (MIT Press): https://direct.mit.edu/books/oa-monograph/6016/C

For questions, comments or suggestions, you can contact me at arvid.viaene.ce@gmail.com

Transcript

Arvid Viaene: Hi, and welcome to another episode with me, your host, Arvid Viaene. A lot of recent episodes have focused on carbon markets. But what happens when firms do not face an explicit cap on emissions? How do they decide on voluntary carbon reductions?

Those reductions are often costly and can put firms at a competitive disadvantage. And when we talk about firms, we often speak as if they were one unified actor. But firms are made up of people, divisions, incentives, and internal politics. They also operate under national laws and within an international environment. So the question of how firms make climate decisions is a complicated one.

Today’s guest, Lily Hsueh, has written a book that tackles exactly this question: Corporations at Climate Crossroads: Multi-Level Governance, Public Policy, and Global Climate Action.

Lily is an associate professor of economics and public policy at Arizona State University and a senior Global Futures scientist at ASU’s Julie Ann Wrigley Global Futures Laboratory. She is also an affiliate scholar with the Stanford Woods Institute for the Environment, and she earned her PhD in public policy and management from the University of Washington.

She studies how firms, markets, and government policy shape environmental and climate governance. So Lily, welcome to the podcast.

Lily Hsueh: Thank you so much for having me. It’s a pleasure.

What the Book Is About

Arvid Viaene: At its core, what is the book about?

Lily Hsueh: At its core, the book is about the supply and demand of corporate climate action.

We know the stakes. A relatively small number of fossil fuel producers are linked to a very large share of global industrial emissions. But because those emissions transcend national borders, it is not always possible to rely only on traditional jurisdiction-based policy tools. A large part of the global response therefore remains voluntary.

So I draw from economics, political science, and management to ask three broad questions. First, what political and economic factors drive firms to take climate action? Second, does voluntary or proactive action actually lead to lower emissions, or is it mostly symbolic? Third, how do these drivers change across sectors and across developed and developing economies?

To answer those questions, I move beyond seeing the firm as a black box or a simple profit maximizer. I examine internal organizational dynamics and managerial agency. I look at whether companies see climate change as a threat to be managed or as a strategic opportunity, and how that depends on leadership and on what I call complementary business capabilities — such as an existing capacity for innovation or a flexible supply chain.

The central argument is that corporate behavior is shaped by a nested structure of governance. That means firm-level dynamics, domestic public policy, and top-down global norms all interact. And together, they shape corporate climate behavior.

Empirically, I use econometric analysis of Fortune Global 500 and S&P 500 firms from 2011 to 2020 to show that when firms face high uncertainty, their response is not random. It is a strategic mix of executive leadership, organizational capabilities, and proactive engagement with domestic regulation and global governance.

One contribution of the book is that it differentiates between symbolic pledges and substantive emissions reductions. That lets me address the longstanding concern about greenwashing in a more systematic way.

Arvid Viaene: So why did you decide to write a book?

Lily Hsueh: As you said in the introduction, I’m an economist and policy scholar by training. This project really began about a decade ago when I attended a workshop on transnational governance at Oxford. I was in a room with political scientists and policy scholars, and they pushed me to look at climate action differently.

I realized that to truly understand climate action — especially the role of firms — you cannot isolate economics from politics. Multinational corporations operate in a nested structure of governance, where firm-level constraints are just as important as global-level drivers.

A book felt necessary because a standard journal article cannot fully capture that complexity. In an article, I could look at one policy, one sector, or one specific mechanism. But I wanted to show the interplay between market leverage, political authority, and organizational behavior.

These firms have the scale to change the course of human history. To understand what drives them, I needed a more holistic and multidisciplinary lens — one that could bring together economics, political science, and management.

The final push came around 2018, when an editor at MIT Press approached me at the ASSA conference. She had seen an abstract of an article I was writing on firms and climate mitigation and asked whether the topic might warrant a book. At that point, I realized the data and the framework I had been developing really needed a larger canvas.

Arvid Viaene: That came through very clearly to me when reading it. Each chapter highlights a different level of governance and their intersections, so I can see why a journal article would have been too narrow.

Why Large Firms Matter So Much for Global Emissions

Arvid Viaene: You focus mainly on large firms. Could you give listeners a sense of how much of global emissions these companies represent?

Lily Hsueh: Yes. Global businesses represent close to 70 percent of annual global industrial greenhouse gas emissions. In fact, a majority of global carbon emissions can be traced back to roughly 100 corporations.

When you consider not just their carbon footprints, but also their economic contribution and market power, it becomes clear why these companies deserve such close attention. We need to understand what they are doing, what motivates them, and what shapes their behavior — whether those factors are internal to the firm, embedded in domestic policy, or driven by global norms.

Arvid Viaene: A central part of the book is the data. You collected a lot of information yourself and also worked with the Carbon Disclosure Project. Could you talk a little more about that?

Lily Hsueh: The book is set during the critical period from 2011 to 2020 — essentially the decade surrounding the Paris Agreement. That gave me a window to observe how expectations of global governance translated into firm behavior on the ground.

To study this, I built a global sustainable business and climate action database. It is essentially a census of the world’s largest corporations by revenue and market capitalization — especially Fortune Global 500 firms and S&P 500 companies.

I did not want to look only at climate pledges, like net-zero commitments. I wanted to track actual effort. So the database follows firms’ voluntary carbon disclosure through the CDP, their adoption of internal carbon pricing, their quantitative emissions targets, and their actual emissions and emissions intensity. I also collected information at the market, sector, domestic policy, and global governance levels.

The CDP — formerly the Carbon Disclosure Project — is the world’s largest clearinghouse for corporate environmental data. It was founded in 2000 and is based in London. It operates on behalf of hundreds of institutional investors representing roughly $150 trillion in assets.

Each year, the CDP surveys thousands of global firms on matters such as emissions, risk management, and internal carbon pricing. For this book, I focused on its annual climate change survey. Between 2011 and 2020, close to two-thirds of S&P 500 companies voluntarily reported to the CDP, and by 2024 nearly all of them did.

Arvid Viaene: So you are really getting under the hood of these massive firms, not just using their public statements but combining those with detailed disclosure and firm-level variables.

How Managerial Capacity Shapes Climate Action Inside Firms

Arvid Viaene: One thing I found especially interesting in the book is the attention you give to people inside the firm — the different levels of authority and responsibility. Could you explain that part a bit more?

Lily Hsueh: Yes. At the firm level, I wanted to look beyond simple variables like assets or revenue. One thing the CDP asks firms is where the highest level of direct responsibility for climate change sits within the organization. It also asks whether the board has a committee responsible for climate risk strategy and planning.

Those questions allow me to measure managerial capacity and authority. There is a real difference between a company that hires a lower-level analyst to collect climate data and a company that has an executive or senior manager who can shape climate strategy, set priorities, and influence investment decisions.That distinction matters because the authority to gather data is not the same as the authority to drive organizational change.

How the Clean Power Plan Helped Identify Causality

Arvid Viaene: In the book, you also use the Clean Power Plan as a case to identify some of these mechanisms. Could you explain how that worked?

Lily Hsueh: Yes. To identify a more causal relationship between regulation and managerial agency, I needed some kind of exogenous shock — a change in the regulatory landscape that was independent of a particular firm’s own choices. The Clean Power Plan gave me that.

The Clean Power Plan was introduced by the Obama administration in 2015, but it had been developing for several years before that. It was a major EPA policy aimed at reducing carbon pollution from existing power plants. It was eventually repealed, but at the time it was perceived by firms as a credible signal of stricter regulation to come.

It followed a decade of legislative gridlock, but it also came after two important institutional developments: a 2007 Supreme Court decision establishing that greenhouse gases could fall under the Clean Air Act, and the EPA’s 2009 endangerment finding, which concluded that greenhouse gas emissions endangered public health. Together, those developments shifted the regulatory burden toward the EPA and created a legal environment that firms could not ignore.

What made the Clean Power Plan especially useful analytically was that it was a bureaucratic policy signal rather than a legislative compromise. At the time, firms perceived it as less vulnerable to lobbying and more likely to stick. And because it was a performance-based standard rather than a market mechanism like a carbon tax, it was also viewed as potentially costly. That gave firms a reason to start preparing before implementation. From an econometric perspective, this created a kind of pre-compliance window.

I used that as a quasi-experiment through a triple-differences design. I looked at before-versus-after the Clean Power Plan, whether a firm was greenhouse-gas intensive, and whether it had an executive or senior-level climate manager. Then I embedded that design in a model that allowed me to examine both the extensive margin — whether firms disclosed voluntarily through the CDP — and the intensive margin, meaning changes in actual emissions and emissions intensity.

What the Clean Power Plan Results Showed

Arvid Viaene: And what did you find?

Lily Hsueh: One key finding was that, overall, as disclosing firms increased in size, they reduced carbon emissions on a per-employee basis. So there was an operational efficiency effect. But a lot of that reduction in emissions intensity was driven by firms that actually felt regulatory pressure — especially greenhouse-gas-intensive firms. Those were the firms that saw the Clean Power Plan as a real threat and responded more seriously.

By contrast, in more consumer-oriented firms, such as retailers, I found more perverse results. Those companies often participated in carbon disclosure in ways that looked more like window dressing. In some cases, their carbon footprints increased significantly. That said, those were also not the firms most directly targeted by the Clean Power Plan. The larger point is that firms that faced regulation and had managerial capacity were the ones most likely to show substantive movement, especially in carbon-intensive sectors.

Arvid Viaene: That seems to go right back to your broader point: the internal capacity of the firm matters, especially when regulation creates credible pressure.

Lily Hsueh: Yes, and one related result was that firms with unique complementary business capabilities — such as green innovation capacity or flexible supply chains — were also better able to respond strategically. That is part of why I frame firms as operating in a nested structure of governance rather than just reacting mechanically to one rule or one price.

How Global Norms Influence Corporate Climate Behavior

Arvid Viaene: The Clean Power Plan is a good illustration of how firms respond to domestic regulation. But your book also moves to the international level. How did you bring that into the analysis?

Lily Hsueh: In the book’s multi-level governance framework, managers are not only regulation brokers. They are also norm brokers. That is where the global layer comes in. Firms view global governance institutions — such as the UN Global Compact, broader UN processes, and other international environmental initiatives — as signals of future domestic law and policy.

These ideas begin as global expectations, but they often later influence domestic implementation. Managers therefore engage in what international relations scholars would call epistemic communities: networks that include firms, nonprofits, international organizations, and other stakeholders who collectively define problems and circulate possible solutions.

I had the opportunity to observe some of this directly by attending large sustainability conferences, including conferences sponsored by both the private sector and the United Nations. At these events, firms were not just passively receiving norms. They were helping shape, translate, contest, and adapt them for their own corporate contexts. Something like internal carbon pricing is a good example. That idea circulated for years as a global governance norm before it became widely adopted as an internal business practice.

Arvid Viaene: So firms are not just sitting back and waiting for rules. They are actively giving input, shaping expectations, and then bringing those ideas back into their organizations.

Lily Hsueh: Exactly. And I try to capture that not only qualitatively through those narratives, but also quantitatively, even though norms are harder to measure than formal regulation.

What Surprised Lily Hsueh During the Research

Arvid Viaene: Was there anything that surprised you during the research and writing process?

Lily Hsueh: One thing I really enjoyed — and perhaps appreciated more than I expected — was the interview work. I am mainly a quantitative scholar, but for this book I also conducted around 50 interviews with corporate leaders and other stakeholders, and I found those conversations incredibly valuable.

I spoke to people in government, technology, finance, education, retail, apparel, and even hard-to-abate sectors. What I heard consistently from many corporate leaders — from firms like Intel to Adidas — was that they try, wherever possible, to align sustainability efforts across their global operations.

What was interesting is that this was often proactive. It was less a race to the bottom than a race to the top. Companies were trying to avoid patchwork adaptation later by harmonizing systems, collecting data more consistently, and preparing in advance for future demands from customers, investors, and employees. That was a recurring theme in the interviews, and I found it both surprising and important.

Why Corporations Can Engage and Obstruct at the Same Time

Arvid Viaene: What do you think is the most misunderstood aspect of corporations and climate governance?

Lily Hsueh: One of the most important points is that engagement and obstruction can happen at the same time. We may see active engagement from a company — even from firms in hard-to-abate sectors — while also seeing forms of delay, resistance, or adaptation to friendlier political environments. Those things are not mutually exclusive.

Take the current political moment in the United States. Oil and gas companies may respond to more favorable policies under a particular administration by expanding fossil fuel development. But some of those same firms are also investing heavily in renewable energy and clean technologies. Since 2016, global investments in clean energy have outpaced fossil fuel investment, and by 2025 that gap had widened significantly. So yes, we can observe obstruction or slowing in some areas, but that exists alongside substantial engagement and investment in decarbonization.

Walmart is a good example of the more constructive side. Its Project Gigaton, launched in 2017, aimed to cut one gigaton of supply chain emissions by 2030. The company reached that target six years early by working with suppliers on energy efficiency, packaging redesign, and food waste reduction. That happened while the business itself was still growing. So the key mistake is to treat corporations as if they are unitary actors. They are not. They are complex organizations facing multiple pressures and incentives at once.

Arvid Viaene: I really liked the way you put that. Firms can both engage and obstruct at the same time. Once you hear it, it sounds obvious, but it is not how people usually talk about them.

Lily Hsueh: Yes, and that is one reason I differentiate between symbolic and substantive action. If we want to understand what companies are really doing, we need to distinguish between public positioning and actual emissions outcomes.

Why Disclosure Alone Is Not Enough

Arvid Viaene: That brings us to the greenwashing issue. You talk a lot about the need to keep firms accountable. What does that look like in practice?

Lily Hsueh: I think the key is to move from disclosure to verification. Voluntary reporting and pledges are useful, but they need to be linked to actual performance if we want to know whether a company is truly leading or simply making noise. That means connecting disclosure to measurable emissions outcomes, independent verification, and accountability mechanisms. A useful model here is California’s cap-and-invest program. It combines binding targets with flexibility, while still tightening the emissions cap over time. In that sense, it transforms disclosure from a soft reporting exercise into something closer to a verified audit with real consequences.

That is a good example of a multi-level framework in action. Firms develop internal capacity and may take voluntary steps, but domestic policy provides accountability. And that accountability matters, because transparency without accountability is just part of the noise.

The Main Takeaway From Corporations at Climate Crossroads

Arvid Viaene: Before we wrap up, what is the main takeaway you hope readers come away with?

Lily Hsueh: The main takeaway is that corporate climate action does not happen in a vacuum. It is often a strategic response to bottom-up and top-down incentives, pressures, and institutions. In the book, I use firm, sector, market, and policy data across the decade surrounding the Paris Agreement to show that corporate response is a calculated mix of internal leadership, complementary capabilities, and proactive engagement with domestic and global governance.

But the book also tells a more nuanced story. Better performance can follow disclosure, but truly credible environmental outcomes require sustainability initiatives to be tethered to external policy levers or enforcement mechanisms — whether third-party audits, verification requirements, or other institutional constraints. Firms do not act in isolation. We need multi-level governance frameworks where top-down public policy aligns with the bottom-up realities of what firms can do, what they are learning, and how they are responding to strategic pressures such as talent retention, reputation, and uncertainty.

Companies are strategic, rational actors. But when they face uncertainty, they also experiment, learn by doing, and try new initiatives. If we understand those different layers properly, we can separate the noise from the real action.

Arvid Viaene: That is a great note to end on. Your book really helped me think more multidimensionally about firms. In basic economics, we often abstract from all the internal dynamics and say: here is a firm, it maximizes profit. But with very large firms, you cannot ignore the internal structure, the managerial dynamics, and the interaction with policy and global norms.

So thank you so much for taking the time and for discussing the book, Lily.

Lily Hsueh: Thank you for having me. It’s been a pleasure. I really enjoyed our conversation.

The EU ETS is up for review again in 2026, but the debate is noisy: volatile permit prices, politically sensitive energy costs, and lots of claims about whether the system is being “weakened” or “strengthened.”

If you listened to the two-part EU ETS primer with Professor Edwin Woerdman, this episode is the real-time application: what’s actually happening inside EU climate policy right now.

My guest is Jos Cozijnsen, a Dutch lawyer and long-time expert on carbon markets and international climate policy. He has worked on emissions trading since the 1990s, including the Kyoto era, and remains closely involved in today’s debates on ETS design, Article 6, and carbon markets.

In this episode we discuss:

• What an “EU ETS review” really means—and why geopolitics is changing the context

• The EU’s recent climate amendment and what it implies for the 2040 target package

• The MSR and why proposed changes are controversial (and detail-dependent)

• Why price controls like a corridor are politically tempting—and technically complicated

• Flexibility on the path forward: free allocation, removals, and possible Article 6 credits

• Why Jos calls the ETS a “docking station” for linking mechanisms over time

If you want a clear sense of what is substance versus signaling in the ETS debate—and what the next phase of EU carbon markets could look like—this episode is for you.

In addition, you can find many informative blog posts from Jos here: https://www.emissierechten.nl/

One such article is exonerating effects of the EU ETS https://www.emissierechten.nl/column/ex-lege-libertas-de-vrijwarende-werking-van-het-eu-emissiehandels-systeem/

For questions, comments or suggestions, you can contact me at arvid.viaene.ce@gmail.com

Transcript

Arvid Viaene:
Hi, and welcome to another episode of the Climate Economics Podcast. Right now, there is a lot of debate going on about EU climate policy, especially the European Union’s Emissions Trading System.

The EU ETS was the world’s first carbon market. In episode 11, with Jos Delbeke, we covered how it was created, the challenges it faced early on, and how it gradually became operational. Now, in 2026, the system is up for review again. Recently, emission permits have been volatile, energy prices have been politically sensitive, and there have been growing calls to change parts of the system.

But it can be hard to tell what reflects real policy momentum and what is mostly signaling. So I wanted to speak with an expert to better understand what is going on right now with EU climate policy.

I’m very happy to have Jos Cozijnsen as a guest today. Jos is a Dutch lawyer and longtime expert on carbon markets and international climate policy. He was part of the Dutch delegation to the United Nations climate negotiations in the 1990s, including the Kyoto Conference in 1997, and has worked for decades on emissions trading, Article 6 of the Paris Agreement, and both regulatory and voluntary carbon markets.

Over the years, he has advised governments, NGOs, and private organizations, including the Environmental Defense Fund, and he remains closely involved in current debates on the future of carbon market design. Jos, welcome to the podcast.

Jos Cozijnsen:
Hi, Arvid. It’s good to be here.

Why the EU ETS Is Back at the Center of EU Climate Policy (~1:26)

Arvid Viaene:
I’m very excited about today’s conversation because I’ve noticed I’m sometimes confused about what’s going on. So, what is going on right now with EU climate policy?

Jos Cozijnsen:
It is very much following what is happening in the world and in geopolitics. Climate policy is in a difficult situation economically because of geopolitical developments. There are the wars in Ukraine and the Middle East, and those have a big impact. Of course, climate policy also remains political. Some actors will say this is a good moment to weaken everything, while others will see it as a chance to strengthen things. So it remains political. But I always try to follow it in a neutral way, from the middle, and cool things down a bit. The ETS is here to stay, and it can serve a lot of the problems we are dealing with.

What the EU ETS Review Actually Means (~2:36)

Arvid Viaene:
And when people talk about the EU ETS review, what do they actually mean? What is actually being reviewed?

Jos Cozijnsen:
That too is political. Some say the ETS should be reviewed or revisited. But the review was already part of the deal. It is built into the legislation. After several years, it has to be reviewed. So that review has to happen.

If you had followed the earlier path of the ETS, you would have expected it to continue in a fairly straight line and keep tightening over time. But now the review will also take into account what is happening geopolitically. That is why the review will look a bit different from what many first expected. We thought it would simply be strengthened, but now it also needs to become more flexible. So this review is a chance to address current problems.

Arvid Viaene:
And when people talk about weakening or strengthening the ETS, is that mostly about the number of emission allowances that are going to be sold? I’m thinking of the linear reduction factor, which determines how fast we reduce the amount of emissions allowances available to industry. Is that mainly what they are talking about?

Jos Cozijnsen:
Yes. People who are very worried about climate change want to know when companies will really stop emitting — when actual emissions go to zero. They see the ETS as something that should accelerate that process, not delay it. So if they think the point at which real emissions end is being pushed back, they see that as a weakening.

But, as we will discuss, there are all kinds of flexibilities that can still keep the overall impact strong. For most people, “weakening” means that the fossil-free world will take more time. Another part of the story is that, in the current situation, greener companies — companies with lower CO2 intensity — may already have certain advantages because of geopolitics. So if you soften things a bit in order to reflect what is happening in the real economy, some people still see that as weakening because it is less favorable to the green frontrunners.

On the other hand, more fossil-intensive companies are being hit harder by geopolitics and may need some temporary relief. So any downward movement in ambition is seen by some people as weakening. That shows how political all of this is.

What Was Decided in the Recent EU Climate Amendment (~4:56)

Arvid Viaene:
Maybe we can even take a step back. I read on your site that you posted an article on the recent EU climate amendment, which I think was passed recently, on March 5. Could you talk a bit about what was decided in that amendment?

Jos Cozijnsen:
I’m glad you asked that, because it was an important decision. It had already been adopted by ministers last December, and then it was finally adopted with the European Parliament in March. It did not get much attention at all. The news in March focused much more on things like the CSDDD being weakened, or companies no longer needing to make a climate transition plan. But at the same time, this agreement was adopted that actually helps the EU in thinking about its 2040 targets.

Within that package, some important decisions were also taken about how the ETS review needs to be adapted. Then, only a few days later, there was a lot of noise from BASF, from Italian actors, and from German politicians, as if they were suddenly calling for a full change to the ETS.

But if you looked behind the lines, much of what they were referring to had already effectively been included in what was adopted. That was very interesting. It was almost as if some people were saying something loudly and politically, while in substance they were already getting most of what they wanted. Or maybe they did not fully understand what had already been agreed. Either way, it is worth discussing, because in that package adopted in March, quite a lot had already been said about the ETS.

Arvid Viaene:
Exactly. Maybe we can start with the fact that carbon removals were introduced and that they could potentially be integrated into the EU ETS. There was also some flexibility on the car package and ETS 2. Could you speak to that?

Jos Cozijnsen:
Yes, let’s walk through those elements. First, the Commission is asked, while reviewing the ETS, to develop the possibility that after 2039 there could still be a limited amount of emissions allowed. That is already a big change, because many people had assumed there would be no emissions after 2039 because there would be no new allowances after that date. So the Commission is being asked to revisit that and make room for some emissions after 2039. That could mean weakening the linear reduction factor, or finding other ways to create room.

Second, the Commission is asked to consider letting free allocation for industry last longer — in other words, to slow the phase-out of free allowances.

Third, the ETS is now expected to be linked to European carbon removals, at least in some form. The official certificates for permanent removals could be connected, especially for hard-to-abate sectors.

And fourth, there is the linkage to the global carbon market — indirectly, in my view. The EU as a whole would get the possibility, after 2036, to use international carbon credits through Article 6 of the Paris Agreement in order to help meet the overall 2040 target. That would mean that 85 percent still has to be reduced inside the EU, while 5 percent could be achieved outside the EU through carbon credits.

That is not a direct ETS link. But you already hear the Commission saying that because the EU as a whole may allow itself more flexibility, perhaps some of that extra space for emissions could eventually be reflected in ETS allowances too.

So you can see that this is becoming a broad package of flexibilities. We do not yet know exactly what it will mean for total reductions or for the carbon price. But I do like the fact that various flexibilities have now already been put into the package, and the Commission has to develop them further. And then, of course, there is also the more recent news about the MSR, the Market Stability Reserve.

How the Market Stability Reserve Works (~9:40)

Arvid Viaene:
Maybe you could explain again what the MSR is, because my episode with Jos Delbeke was popular, but not everybody will know why the Market Stability Reserve was developed and why it is now a point of contention.

Jos Cozijnsen:
Yes. After the financial crisis in 2008, there was a large oversupply of allowances. But the Commission kept auctioning allowances, which pushed the price down further over time. The Market Stability Reserve was designed to respond to that. Every year, the Commission checks how many allowances are circulating in the market.

It looks at how many emissions there were, how many allowances companies need to surrender, and how many allowances should remain available in the market to maintain liquidity. If there are more allowances circulating than 733 million, then part of that oversupply will be withheld from auction. In effect, fewer allowances are auctioned, and that reduces the glut in the market.

That was the function of the MSR: to get rid of oversupply. You also saw this during the COVID years. Production fell, energy use fell, emissions fell, and companies needed fewer allowances. That meant more allowances remained in circulation. In response, the Commission auctioned fewer allowances in the following year, which helped stabilize the price.

The same happened again later. So in recent years, the MSR has been useful in preventing new oversupply. Then, after COVID, economic activity picked up again, emissions rose again, and that shifted things back somewhat.

But overall, the MSR has worked. The price still reacts to supply and demand, to the weather, to politics, and to trader expectations. But in the long run, the MSR helps keep stability and also gradually tightens the available number of allowances. If, for example, innovation or subsidies lead to lower emissions in a certain year, then fewer allowances are needed. That means more are left over in the market, and then the following year fewer are auctioned. So it becomes another tightening mechanism over time. Now, if we look at the current moment, the Commission recently presented a first proposal to loosen the ETS somewhat by changing the way the MSR works.

Under the existing rule, if the MSR itself builds up too many allowances — more than 400 million — then the excess would be invalidated. In other words, those allowances would disappear entirely. That rule is now being removed. So instead of those allowances being canceled, they would remain in the MSR and could potentially be reissued later.

What effect that will have on the price or on total volumes, we do not yet know. That depends on what the trigger would be for releasing those allowances and how many would be released. So although some people reacted with a big outcry and said this is a major softening of the system, it really depends on the details. At this point, the Commission has mainly prepared the possibility that the MSR can be used more flexibly. That is already what happens in ETS 2.

Why Price Controls in the ETS Are Politically Sensitive (~14:40)

Arvid Viaene:
One thing that always strikes me is that the Market Stability Reserve has mostly been a one-way street. It removes allowances from future auctions when supply is too high. But is there also a way to go in the other direction? Suppose there is suddenly a shortage of liquidity and prices rise sharply. Is there a way to increase the number of allowances?

Jos Cozijnsen:
It works a bit differently than that. The MSR does not take allowances away from companies. It just reduces the number of allowances auctioned, so they remain in reserve. It is really an auction management tool. And the original objective was not to control the price. It was to control liquidity and volume. The price was never the trigger.

There is, however, another provision — Article 29a — which allows the Commission, together with member states, to intervene if the price rises very sharply in a short period. In that case, more allowances can be released from the reserve. But that tool has never really been triggered, because prices never rose that high, that fast. So that tool was already there.

Now, under the new thinking, the MSR may get an additional function. If the price goes above a certain level, then maybe a certain number of allowances could be released. But we do not yet know what the rule would be, what the price trigger would be, or what the volume would be. So yes, it could get a new function. The original function was to manage volume and liquidity. The new idea is that it may also be used to dampen prices. But that is complicated. If you auction more allowances, will companies simply buy them and hedge for the future? We do not know. There is also the interaction with electricity prices.

So it is not obvious that releasing extra allowances will reliably control the price over the long term. Maybe it helps in a short-term shock. But for a longer period of high prices, I am not so sure. Still, this is one of the possible changes we are now seeing. For years, many member states — perhaps more than ten — have supported the idea of a price corridor. That means a floor and a ceiling, both increasing gradually over time.

For example, maybe the ceiling is 150 euros and the floor is 40 euros. If the price falls to the floor, you auction less the next year. If it goes above the ceiling, you auction more. That kind of system is used in California, and ETS 2 has some similar elements. But as you can hear from the way I describe it, it is complicated. You never really know what the resulting price will be.

Arvid Viaene:
So one big issue here is that it changes the nature of the Market Stability Reserve. Instead of just controlling liquidity, it starts to become a mechanism for trying to steer prices into a certain range.

Jos Cozijnsen:
Exactly. It becomes more complex. The Commission always says it does not want to control prices. It wants to control volume. Because if you control the cap well, then you meet the emissions target, and the price is what the price is.

But we may now see a proposal that moves more toward price management. Whether it will be effective, nobody really knows. At least politically, it gives the appearance of doing something. Governments can go home and say they secured a corridor or some price safeguard. But whether that actually delivers the outcome they want is another question.

Arvid Viaene:
Do you still feel there is a push among member states toward such a corridor?

Jos Cozijnsen:
I think so, yes. It has not had much attention, though. Only the French occasionally discuss it openly. They did something similar in the ETS 2 debate. It is also difficult for governments to decide what a “good” carbon price is. Some people say the price should eventually be very high — perhaps 500 euros per ton.

But in my view, if companies are responding well through innovation and change, then maybe the price in the endgame will actually be low. A high price can also show that companies are not adapting well. So it is hard to say what the “right” price is.

Still, I expect governments want something they can present politically. A corridor sounds concrete. It sounds like a solution. ETS 2 already has something like that, and California has floor and ceiling prices too, so it might work. But no one will be entirely happy, because there will always be disagreement over what the right price should be. And behind that is a political question: who do you want to incentivize, and are you helping laggards too much or not enough?

Why the Linear Reduction Factor Matters (~22:00)

Arvid Viaene:
You also mentioned the linear reduction factor — the rate at which the number of allowances falls over time. My understanding was that by 2039 there would be no more new allowances issued. Is that correct? And is there now a proposal to soften that reduction path?

Jos Cozijnsen:
Yes, but it is important to be precise. If you follow the path that was adopted several years ago, then after 2039 there would be no more new allowances issued. But that does not mean no more emissions.

Companies could still use allowances they had banked from previous years. There are also still some allowances available in other parts of the system, such as for aviation and newer sectors. So the rule is not that there are no more emissions after 2039. The rule is that there would be no more newly issued allowances after 2039.

Now, I do expect that this path will be softened somewhat. Peter Liese, for example, proposed changing the reduction factor from 4.4 percent to something like 3.8 percent. That would mean that instead of new allowances ending in 2039, they might continue until 2042 or 2043. That is still fairly ambitious. It is still earlier than 2050. And in the current situation, I think that kind of softening can be justified.

Arvid Viaene:
Exactly. Because the overall EU goal is climate neutrality by 2050, but the interim target for 2040 is a 90 percent reduction. And just to restate it: even if no new allowances are issued after 2039, companies can still use allowances they have banked from the past.

Jos Cozijnsen:
Yes, of course. Although banking allowances is expensive, so it may only help some companies for a year or two. It is not something that can solve everything. But yes, it gives individual companies a bit more room to maneuver.

And as I said, I do think the linear reduction factor will be softened somewhat, so new allowances may still be issued until around 2042. Also, allowances are not the only flexibility. Emissions can also be captured or compensated through removals, CCS, or possibly Article 6 credits. So this all shows that there is no simple rule saying emissions end in 2039. What ends is the issuance of new allowances under the current path — and even that path may now be adjusted.

Why Jos Cozijnsen Calls the ETS a Docking Station (~26:00)

Arvid Viaene:
That brings me to something you mentioned before we started recording: your metaphor of the ETS as a docking station. Because this is no longer just about the ETS itself. We now also have the Carbon Border Adjustment Mechanism, ETS 2 for fuels, maritime emissions, and aviation questions. Could you talk a bit about how you see the broader ecosystem of EU climate policy?

Jos Cozijnsen:
Yes. I often say that I see the ETS as a docking station where you can plug in all kinds of escape routes, innovations, and flexible mechanisms.You can link the ETS with Article 6. You can link it with European carbon removals. The ETS started as a system to reduce emissions toward climate neutrality. But in the future, it could help the whole economy move from climate neutrality to becoming carbon negative.

Right now, the system is about reducing emissions down toward zero. But in the future, the reserve and the broader system could increasingly consist of removals rather than allowances. Then you no longer just move toward zero — you move beyond zero, into negative emissions.

Since the ETS is already a system that distributes costs across the companies involved, it makes sense to keep using it. Every company that produces emissions needs a permit to operate. In the future, if the whole economy has to become carbon negative, then those same companies may also need to participate in financing removals.

Some people say the government should do this all through taxpayer money. But we already have a functioning economic instrument that can distribute these costs and link them to a permit system. That is the ETS. So the ETS helps us now move from emissions toward zero. In the future, it can help move us from zero toward carbon positibe.

That also means that eventually all industries may need to be part of such a system — even sectors that historically did not have large direct emissions. Because if the economy as a whole must become net negative, then every sector has to play a role.

That is why I say the ETS is here to stay. It is a good tool. It is flexible. It is an economic instrument. And it can be linked to all kinds of international and domestic removal systems. So why not keep using it?

Why the ETS 2 is Separate from the EU ETS

Arvid Viaene:
But on the other hand, there was a possibility of integrating ETS 2 into the broader ETS, and they decided to keep it separate. Why?

Jos Cozijnsen:
I think that was the right decision. ETS 2 is an upstream system. You could say it covers the scope 3 emissions of oil refiners. The refinery is covered under ETS 1, but the fuel that people burn in their cars is covered under ETS 2. So it works very differently. If you merged ETS 2 into the main ETS too early, you risk having car users pay a higher and higher carbon price without the wider transition conditions being in place.

And yes, in principle higher prices should encourage lower consumption. But in practice, many people still need cars — to transport children, elderly people, goods, tools, and so on. So you cannot just rely on the price signal. You also need alternatives.

That is why ETS 2 requires complementary measures. Governments need to ensure there is enough support for home insulation, public transportation, district heating, and so on. If those alternatives are not available, then consumers simply face higher costs without a realistic transition path. That is what makes ETS 2 different from ETS 1. In industry and power generation, the companies themselves can make many of the changes. In buildings and transport, the transition is more social and infrastructural. You need governments, consumers, and producers all to move together.

Because of that, ETS 2 has built-in price control mechanisms. There is front-loading, and there is a large reserve in the early years so that governments, companies, and consumers have time to prepare. That should keep prices lower in the beginning. If prices rise above a threshold — say 60 euros per ton — then more allowances can be issued to dampen the price.

But that cannot continue forever. So linking ETS 2 and ETS 1 too soon would be risky. It could reduce investment in the sectors ETS 2 is meant to transform. So I think they should remain separate for now, both because their logic is different and because ETS 2 needs more protection in its early phase.

How More Flexibility Could Affect Cars and Industry (~33:30)

Arvid Viaene:
That also brings me to another point. I thought I understood that the recent amendment also made the phase-out of gasoline cars a bit more flexible. Is that right?

Jos Cozijnsen:
Yes, in a way. Originally, the idea was much closer to stopping combustion car production entirely by a certain date. Now the system seems more flexible. The idea is that maybe up to 10 percent could still be combustion cars, while compensating in other ways, such as by using more green steel.

If that works well, and the vehicles are greener overall, then total emissions in the economy still fall. That could work. I like that kind of flexibility, because it shows the Commission is still serious about climate goals. The overall emissions need to go down. But it also gives industry more room to maneuver.

And in the current geopolitical environment — with difficult power prices and industrial pressure — that kind of flexibility can be useful. It should not go too far. But it is an interesting approach.

Arvid Viaene:
And when you say green steel, you mean steel produced with lower carbon emissions?

Jos Cozijnsen:
Exactly. Or recycled steel, or steel produced with bio-based inputs. It is interesting because it supports innovation. Car producers would then have an incentive to secure access to greener steel, which gives a market advantage to the firms producing it.

So flexibility can sometimes create something positive. It is not only about lowering ambition. It can also open space for a different kind of progress. That is why I like this idea. Industry gets more room to maneuver, but the climate goal still matters.

And that is also what you see in the ETS more broadly. The goal stays ambitious, but there is some flexibility in how to get there.

How Free Allocation and Benchmarks Fit Into the ETS (~36:30)

Arvid Viaene:
I think that is also what I get from following you on LinkedIn. A lot of people react to any proposed change by immediately saying the climate targets are being weakened. But your view seems to be that the targets are not necessarily being weakened. Sometimes what is changing is just the flexibility in how to meet them.

Jos Cozijnsen:
Exactly. Flexibility after reflection. That is what I like about the ETS. It can serve many objectives at once. Some industries think, for example, that CCS will automatically become important because of the CO2 price. But if the target is met through other means, maybe CCS is not needed to the same extent.

So the ETS does not prescribe exactly how the transition must happen. That is part of what makes it interesting. Take benchmarks, for example. Recently there has been discussion about new benchmarks.

The CO2 benchmarks are used as the basis for allocating free allowances. If you produce steel, you tell the authorities how much steel you produce, and then you receive a certain number of free allowances per ton of production.

That benchmark is based on the emissions level of the 10 percent best-performing installations in that sector. But it has never been a binding norm. It is just a formula for allocation. You can still emit more if you want, as long as you buy allowances.Now the Commission has proposed new benchmarks for the period from 2026 to 2030. Some sectors, like refining, look a bit softer. Others look a bit tighter.

But what does that actually mean? Mostly it changes the distribution of free allowances. The total cap is still there. The system still reaches the same target. It just means some sectors may get more free allocation for longer. Some people say that is bad because it slows down the transition. That may be true in one sense. But if it gives firms more time while still staying within the overall cap, then I am comfortable with it. There is still an incentive to become more efficient. The more efficient you are, the fewer allowances you need to buy. That incentive never disappears.

Why Jos Cozijnsen Is Critical of the Current CBAM Logic (~40:20)

Arvid Viaene:
I think that is a useful point, especially because discussions about benchmarks often connect very quickly to CBAM. The Carbon Border Adjustment Mechanism is supposed to replace free allocation over time in sectors at risk, but now there seems to be a tension between how fast CBAM develops and how fast free allocation is phased out. What is your read on that?

Jos Cozijnsen:
Yes, exactly. That is an important point. The whole logic is based on the idea that if sectors are exposed to international competition, then they should not face unfair costs. That is why they get free allowances. But if you already know that European climate policy is much stricter than in the US, Japan, or China, then in my view that already justifies some kind of border adjustment. You do not first need to remove free allocation to justify CBAM.

That has always been my criticism of the idea that free allocation must disappear before CBAM can work properly. I do not think that is rational. You can have a border adjustment as long as you treat domestic industries and imports in an equivalent way. And since Europe already has tougher climate policy, that already provides a basis.

Arvid Viaene: But is the idea not to phase it out at the same rate?

Jos Cozijnsen: So I have always been critical of the logic that says you must first remove free allowances. And that is why, in the 2040 package, the Commission is now being asked to consider slowing the phase-out of free allowances. In the current situation, I do not think that hurts the climate, because the cap remains the same.

What it may do is ease some pressure on industry and improve the broader political atmosphere a bit. Especially developing countries do not like facing very high carbon-related costs on exports to the EU.

At the same time, CBAM has had one useful effect: it has pushed some countries to think more seriously about emissions trading systems of their own. Turkey is moving in that direction. China already has one. Other countries are asking how they can avoid CBAM by implementing their own carbon pricing. So it does have strategic effects. But I still think it is too risky to raise costs for European industry too quickly in the hope that CBAM alone will solve everything.

Arvid Viaene:
I also agree that Europe already has very strong regulation on almost every front. We already have some of the highest standards.

Jos Cozijnsen:
Yes, exactly. I understand why industry agreed to the original package. For sectors like aluminum and steel, the argument was: we will help you with a border adjustment, but in exchange you accept the phase-out of free allowances. That sounded acceptable at the time.

But now, with all the tariffs, trade tensions, and global overcapacity, many are rethinking that deal. They now feel it may not be enough to raise their own costs and rely on CBAM to protect them. So I think it is good that the Commission is being asked to delay that phase-out, at least for now.

How Aviation and Shipping Are Being Added to the ETS

Arvid Viaene:
One topic we have not covered yet is the extension to aviation and maritime emissions. Could you explain where things stand there?

Jos Cozijnsen:
Yes. For aviation, intra-European flights have already been included in the ETS for several years. Airlines started with a lot of free allowances, but from this year onward there are no more free allowances for airlines. They now have to buy allowances for all of their emissions covered by the system.

Aviation is still a growing sector, which is not good, but within the ETS it is only around 5 percent of total covered emissions. So it is in the budget, which is important. There is also the global aviation system, run through ICAO, called CORSIA. That is an offset mechanism for emissions growth. The EU considers it too weak and not ambitious enough.

So the Commission will review whether CORSIA is sufficient. If it is not, then maybe international aviation emissions should be included more directly in the ETS. But that would probably create political conflict. A more limited approach — maybe covering only part of those emissions — could be more realistic.

For shipping, intra-European emissions are included, and also half of international shipping emissions connected to EU routes. So if a cruise ship goes from New York to Europe and back, half of those emissions are covered. That could be a model for aviation too.

Within Europe, shipping in the ETS seems to be working reasonably well. Companies like Maersk are already internalizing the carbon price in their planning, and that helps them prepare for cleaner ships, such as those running on ammonia.

So the ETS family keeps growing. Governments like it because with one signature, so to speak, they can be confident they will meet the emissions target in that sector, because only that amount of allowances is available.

Arvid Viaene:
Exactly. That is the big advantage of the system. Once you set the target and have an ETS, you know you will get there. Then flexibility within that framework can be useful.

What People Still Misunderstand About the ETS

Arvid Viaene:
I also want to be mindful of your time. Is there something we have not talked about, or some misconception you see again and again in the debate, that you would still like to address?

Jos Cozijnsen:
Yes. One big misconception is that the carbon price should simply be high, as if the purpose is to make companies pay. That is not the purpose. The purpose is that companies comply and that the climate target is met. In the end, whatever companies pay is also paid by consumers like you and me. So a high price is not a goal in itself.

A second point is that I hope people understand the ETS a bit more and trust it a bit more. We will need it even more in the future. The cap is tightening, more sectors are being covered, and the system is expanding. If we do not trust it, then governments will start creating their own taxes and other tools, which may be worse.

And the third point is about what comes next. We are now going to test new things: European carbon removals and international carbon credits. But I do not think they will be linked directly right away.

I think we will first see indirect linking. That means a steel company in Europe will not immediately be sent out into the world to buy carbon credits itself. Instead, the Commission, the European Investment Bank, or governments may use auction revenues to buy the first removals or credits.

That way, quality can be controlled, volume can be monitored, and the price can be managed. Because removals are likely to be more expensive than the ETS price. So there will need to be some extra public-private finance or subsidy to make that connection useful. That is why I think “indirect linking” should be the buzzword. Through that approach, we can test monitoring, learn what works, learn what does not, and build safeguards. We cannot do without removals in the future. So this is a good testing phase.

The ETS is the compliance market that creates the demand for removals. The demand is there. Now the question is how to connect it carefully, in a way that controls quality, volume, and price.

Arvid Viaene:
That is great. I hope, exactly as you say, that this podcast and your explanations can help people better understand the ETS, the linkages, why they matter, and why the targets remain important. Thanks so much for taking the time, Jos. I really appreciate it.

Jos Cozijnsen:
The ETS is a docking station. Thanks, Arvid.

Arvid Viaene:
Thank you.

Introduction

This is Part 2 of my conversation with Professor Edwin Woerdman on the EU ETS. In Part 1, we covered the core mechanics of cap-and-trade—and why “2039” is an arithmetic consequence of the linear reduction factor.

In Part 2, we tackle the moving part that keeps returning to headlines whenever prices move: the Market Stability Reserve (MSR)—which Edwin calls the ETS “vacuum cleaner.” We discuss why it was created, how it changes auction supply, why its cancellation rules matter, and why the Commission is now reconsidering parts of it in the current energy and geopolitical context.

We also tackle why the EU ETS is mostly efficient, but also where it deviates from this efficiency. And why Edwin thinks the EU ETS is still on track

Outline

• How the Market Stability Reserve Works (1:52)

• Why the MSR Became More Stringent Over Time (4:04)

• Why the Commission Is Reconsidering the MSR Now (~11:00)

• Why There Can Still Be a Positive Carbon Price Even With an Allowance Surplus (~14:50)

• Why Free Allocation Is Not a Problem in Economic Theory (~16:50)

• Where the EU ETS Deviates From the First-Best Design (~19:45)

• What Changes to the EU ETS Are Now Being Considered (~26:30)

• Why Edwin Still Thinks the EU ETS Is on Track

Note that Professor Woerdman recently published a paper explaining a lot of what we cover in more detail. You can find the paper here: Woerdman, E. and Kotzampasakis, M., ‘EU Emissions Trading System’ (April 01, 2026), EU Climate Mitigation Law, Cheltenham: Edward Elgar Publishing, forthcoming 2027. Available at SSRN: https://ssrn.com/abstract=6633238or http://dx.doi.org/10.2139/ssrn.6633238

Up next: if you want to apply this toolkit to what’s happening right now in EU policy, the next episode with Jos Cozijnsen digs into current discussions, the 2040 targets, the MSR reform, and proposals around price controls.

For questions, comments or suggestions, you can contact me at arvid.viaene.ce@gmail.com

Transcript

Arvid Viaene: Hi and welcome back to Climate Economics. I’m Arvid Viaene. This is Part 2 of my conversation with Professor Edwin Woerdman on the EU ETS. In Part 1, we covered the core mechanics—coverage, allocation, and why “2039” is really an arithmetic implication of the linear reduction factor.

Today we turn to the component that keeps coming up in headlines whenever prices move: the Market Stability Reserve, which Edwin memorably describes as the ETS “vacuum cleaner.”
We’ll also discuss where the ETS design departs from the economic ideal—especially around free allocation rules and administrative complexity—and what kinds of tweaks might realistically show up in the 2026 review.

And after this episode, we’ll apply the toolkit to real-time policy: my next conversation is with Jos Cozijnsen on the 2040 targets, MSR reform, and potential price controls.

How the Market Stability Reserve Works

Arvid Viaene: The other thing that has been discussed a lot is the Market Stability Reserve, which may not be familiar to many people because it is relatively recent. Could you explain what it is and what it tries to do?

Edwin Woerdman: Yes, and that is a long story with a lot of details, but a very interesting one. I call the Market Stability Reserve - the MSR - the “vacuum cleaner” of the EU ETS. This vacuum cleaner was installed to reduce the allowance surplus that had accumulated in the system. One of the main causes of that surplus was the financial crisis of 2008. This crisis reduced production, lowered emissions below the cap, and turned allowance scarcity into an allowance surplus. That also contributed to a drop in the allowance price.

By the end of the second trading phase, that surplus had exceeded 2 billion allowances. As a policy response, after years of political discussion, the MSR was introduced in 2019 to gradually skim off and invalidate the surplus.

The MSR automatically reduces the volume of allowances to be auctioned when there is a surplus of allowances in circulation, based on predefined rules.

Arvid Viaene: And when you say surplus, you mean everything that is not handed in in that year - everything that is banked for the next year?

Edwin Woerdman: Exactly. These are allowances that are not used to cover emissions. They are somewhere in the system, floating around and banked by companies. Of course, you want scarcity in the EU ETS. Because of the financial crisis, that surplus built up to such an extent that the EU felt it had to do something about it.

There was a political discussion about that. Some said, in particular the Eastern European Member States: let it be, the EU ETS should not bite too much. Others, especially in North-West Europe, wanted a stronger system that does bite. And that is where the idea of the vacuum cleaner came from, but political compromises had to be made.

So the initial design was that if the surplus in a given year was large, 12 percent of that surplus would be placed in the reserve by reducing auction volumes in the following year. If the surplus became small, then 100 million allowances could be released again from the reserve.

That release function was important politically because it meant the system could also help prevent the allowance price from rising too fast.

Arvid Viaene: Just to clarify: when the reserve ‘takes in’ allowances, that is done by auctioning fewer allowances the next year. And when it ‘releases’ allowances, that means auctioning more.

Edwin Woerdman: Exactly. So the MSR always works through auctioning.

Why the MSR Became More Stringent Over Time

Edwin Woerdman: Now, this design of the MSR was later criticized because it did not necessarily remove allowances permanently. It could take them in, but it could also release them later.

In response to that criticism, the EU decided not only to double the annual intake rate from 12 to 24 percent, but also - very importantly - to invalidate the allowances in the MSR that exceeded the auction volume of the previous year, from 2023 onward.

That meant the MSR could only contain as many allowances as had been auctioned in the previous year. Anything above that would be invalidated. So I started calling it a “vacuum cleaner with a disposable bag”.

Then, from 2023 onward, the system was tightened even further. A new cancellation rule was adopted saying that the MSR may not contain more than 400 million allowances, and anything above that is no longer valid. There has been a lot of scientific debate about the impact of this invalidation policy.

Some people are optimistic and argue that overlapping climate policies now work more effectively. For example, if a government shuts down coal-fired power plants, then fewer allowances are needed, more allowances remain in circulation, more enter the MSR, and some of those would then automatically be invalidated. Others are more critical because the complexity of the MSR can increase price volatility, because it creates more uncertainty about future allowance supply.

Still, despite these debates, the surplus fell from about 2 billion allowances in 2013 to around 1 billion a couple of years ago. So it was roughly halved, largely due to the MSR and its invalidation mechanism. That also helped push the allowance price up from around 5 euros in 2013 to about 30 euros in 2020 and roughly 75 euros today.

Why the Commission Is Reconsidering the MSR Now (~11:00)

Edwin Woerdman: Now we have entered a new crisis - an energy crisis linked to the US-Iran war. That has raised gas prices, making power companies switch to coal, which is more carbon-intensive. That increases demand for allowances and therefore raises the allowance price.

That, in turn, has led to renewed calls to protect internationally competing industries in Europe. In response, the European Commission recently proposed to stop the automatic invalidation of allowances held in the MSR above 400 million.

So instead of being cancelled, those allowances would remain in the reserve. If this is adopted, the EU ETS would still have a vacuum cleaner that can suck up allowances, but it would also be able to spit them out again in case of allowance scarcity. In other words, we would have a vacuum cleaner that no longer throws away its bags. The intended result is that this would help companies by reducing the allowance price, or at least by limiting its increase.

And it is interesting because on the Commission website, the official position is that it does not speculate on carbon price developments or make projections about the price impact of legislative proposals, because the EU ETS remains a market-based system where prices are determined by supply and demand.

But then in March 2026, Ursula von der Leyen wrote a letter saying that the Commission will, and I quote, “present a proposal to increase the firepower of the MSR so that it can keep prices in check in the short term”. So you can see that this is really on their minds now.

Arvid Viaene: Yes, and you can almost see the logic develop over time. First, there was a big surplus, so the system needed to become tighter. Now, because of the energy crisis and higher demand for allowances, the concern is that it might be biting too hard.

Edwin Woerdman: Exactly.

Why There Can Still Be a Positive Carbon Price Even With an Allowance Surplus (~14:50)

Arvid Viaene: This is a bit speculative, but do you think we will still have the same kind of surplus going forward? Because demand seems to be rising a lot again.

Edwin Woerdman: Based on the data I have seen, there is still a surplus, although it is declining. What is interesting is that one might expect a surplus to imply a zero price, based on basic microeconomics. But that is not what happens. Companies know that because of the linear reduction factor and the long-term trajectory of the system, the ETS will become tighter over time. So even with a current surplus, they anticipate future scarcity.

That is why there is still a positive and rising price. Companies are forward-looking. They know the system is heading toward much tighter scarcity in the future, whether that point comes in 2039 or a few years later. So they are already pricing that in.

Arvid Viaene: That gives a very useful background to understand current discussions.

Why Free Allocation Is Not a Problem in Economic Theory (~16:50)

Arvid Viaene: I want to move to what you call second-order efficiency. You write something I really liked, but which may not be intuitive to a lot of people: that the allocation of free allowances is not a problem from an economic point of view. Could you explain what you mean by that?

Edwin Woerdman: Yes, absolutely. I work as an economist and political scientist in a law faculty, so I have had this discussion with lawyers for many years. They still sometimes don’t understand this very well. Free allocation of allowances is not a problem from an economic point of view. Free allowances do imply a financial advantage for the receiving companies. Their shareholders become richer. That part is easy to understand.

But it does not mean that the use of free allowances is costless. That is the harder part to understand. If those free allowances are used to cover emissions, then they can no longer be sold. And as far as possible, the company will pass on those lost sales revenues - the opportunity costs - to the consumer.

A more easy way to explain this is as follows. Passing on the market value of CO2 to customers is the intention of emissions trading. Greenhouse gas emissions should have a price, so that consumers face the damage cost of their consumption, regardless of whether the producer received the allowances for free or bought them at auction. So in principle, for the efficiency of emissions trading, it does not matter whether allowances are distributed for free or sold at auction.

What matters is that companies can trade allowances under a yearly declining cap to make cost-savings possible. That said, economists do still prefer auctioning because of the broader welfare benefits. Auctioning is an efficient allocation mechanism, and the revenues can be used for things like clean innovation subsidies or lowering labour taxes.

Where the EU ETS Deviates From the First-Best Design (~19:45)

Arvid Viaene: Now, while free allowances are not a problem from an economic point of view, you do argue in your paper that the EU ETS free allocation rules work somewhat differently from the first-best version. Could you expand on that?

Edwin Woerdman: Yes. For reasons of fairness, the allocation of allowances in the EU ETS deviates from the economist’s ideal. I have been following this for many years, and I have seen the energy-intensive industry lobby openly - for decades - not only for free allowances, but also for extra free allowances when a company increases production.

That persistent lobby was ultimately successful. The 2018 amendment of the EU ETS Directive stipulates that the number of free allowances allocated must be adjusted upwards during 2021 to 2030 if production in a plant has increased by an average of more than 15 percent in the previous two years.

This means that if production rises by more than 15 percent, the company gets more free allowances. This is inefficient for two reasons.

First, it acts as an output subsidy for energy-intensive products. There is then no financial incentive for the company to fully internalize the social cost of the extra emissions when deciding whether to expand production.

Second, it substantially increases administrative costs. Competent authorities - like the Dutch Emissions Authority - now have to process and verify not only emissions data, but also production data for thousands of firms and their installations.

Those administrative costs could have been avoided if firms simply received fewer free allowances each year regardless of output changes. Then more production would mean they had to buy more allowances on the market or reduce emissions further.

Arvid Viaene: Yes, I see that. It is not only a production subsidy, it also creates a large administrative burden because now you have to track production as well.

Edwin Woerdman: Exactly. I spoke with officials at the Dutch Emissions Authority, and they told me they had to hire quite a few extra people for this. And that is just one authority in one country. In some Member States, like Poland, there are multiple competent authorities, so the administrative burden can become very large[EW1] . And I do not hear much discussion about that. From an internalization perspective, though, the output subsidy is probably the bigger problem.

I was quite surprised by how this evolved. I remember public conferences where industry representatives and Commission officials were openly clashing over this. The Commission would say: no, this is against the logic of environmental economics. Industry would say: if production goes up, we want more free allowances.

In the end, industry got their way. And I do not know exactly why, but persistent lobbying apparently matters. Politicians also worry about employment and reelection, and industry knows how to frame the issue that way. Another dynamic is that officials at the Commission or at national administrations move to other positions or departments. So one official who might have resisted the industry lobby could move on. And then another official comes in which gives companies another opportunity to lobby and then they can get their way.

What Changes to the EU ETS Are Now Being Considered (~26:30)

Arvid Viaene: Any upcoming changes that are currently planned?

Edwin Woerdman: Yes. This will be a very interesting year. A comprehensive review of the ETS is expected in July later this year, and I am very curious to see what it will bring. In the letter by Ursula von der Leyen that I mentioned before, she says the Commission aims “to set out a more realistic decarbonization trajectory beyond 2030”.

That phrase - ‘more realistic’ - has made people curious. It could point to a modest weakening of the linear reduction factor, so that the end of new allowance issuance moves somewhat closer to 2050 rather than 2039. And as I mentioned earlier, the Commission has already proposed to stop the automatic invalidation of allowances in the MSR, so that the reserve can not only absorb allowances but also release them.

That is quite striking, because eight years ago the sentiment was exactly the opposite. At that time, the goal was to make the system bite more. Now the concern is that it may be biting too hard because of the energy crisis. In my view, however, these are all incremental changes. They do not substantially affect the climate targets or the cap-and-trade structure of the EU ETS. What they do show is that, for the moment, the economy is being prioritized more than climate action [EW2] compared to the previous decade. And that has everything to do with the US withdrawal from the Paris Agreement and the current energy crisis following the US-Iran war.

Why Edwin Still Thinks the EU ETS Is on Track

Arvid Viaene: Yes, these are definitely unforeseen developments that make the system bite more than people may have expected when it was designed. Before we finish: is there anything else you would like to add?

Edwin Woerdman:

Actually, I have said more than I was intending to, so I have been quite open about my experience and my views. But yes, I think it is good that we are now considering some changes and tweaks to the system. As long as we stick to the net-zero goal for 2050, I am not so worried. We can soften the system a little bit for the companies involved.

I do wonder how much effect the currently contemplated measures will really have. They may have some effect, but probably only a small one on the allowance price and on the year when no new allowances will be released. So it is all very incremental and marginal, I would say. And that is actually positive. The emissions trading system is like a train that was put on the rails in 2005 and given a push. It is driving towards net zero in 2050, and it will continue to do that even in spite of the changes that are now being considered.

Arvid Viaene: I really like that metaphor. That is also what I take away. The train is still going toward net zero in 2050. What we are discussing now is more about the speed and some adjustments along the way.

I think that helps people avoid being shocked every time they hear something like, ‘they are going to change the linear reduction factor,’ as if that automatically means Europe is abandoning its climate promises.

The more I learn about this and the more I talk with people like you, the more it seems that the targets are still there. The discussion is more about how to make some tweaks, not about abandoning the overall direction.

Edwin Woerdman: Yes, exactly. Of course, if you weaken the linear reduction factor slightly or change the rules of the MSR a bit, that has effects. But I think there is also some psychology of loss aversion here. People hear that something is being softened and immediately think: climate policy is being rolled back, everything is falling apart. Globally, there are indeed many reasons to worry. We need the US and many other countries on board for climate action. But these small tweaks within the EU ETS - a system that still has declining caps and a clear net-zero direction - are not the same thing as abandoning the climate objective. If the end point shifts by a few years, that does not matter very much in the larger picture.

Arvid Viaene: I feel like as economists we bring inspiring messages, we just have to bring it in that way. That is the positive thing to take away. And I think that point about loss aversion is a very good one. So Edwin, thanks so much for taking the time.

Edwin Woerdman: Thank you so much. It was absolutely an honor to be with you on this podcast series. Thank you for inviting me.

Arvid Viaene:

Thank you very much. I can’t wait to share this.

Introduction

The EU Emissions Trading System is back in the spotlight. Permit prices have moved, energy prices are politically sensitive, and in 2026 the ETS is up for review. But in the public debate, a lot of the confusion comes from the basics: what does the ETS cover, how does it work, and what are the key building blocks?

In this episode, I’m joined by Professor Edwin Woerdman (University of Groningen), a specialist in carbon market regulation and EU climate law and economics.

This is Part 1 of a short mini-series on the EU ETS. We cover the fundamentals:

• How Emission Allowances Are Allocated in the EU ETS (~5:00) 3

• Why the EU ETS Moved From Grandfathering to Benchmarking (~08:40)

• What the Cross-Sectoral Correction Factor Does (~11:09)

• How Auction Revenues Are Supposed to Be Used (~13:46)

• Why the EU ETS Has Been Effective at Cutting Emissions (~16:00)

• Linear Reduction Factor and the 2039 Target of No New Allowances (~22:25)

• Why Small Changes to the Linear Reduction Factor Do Not Change the 2050 Goal

Next week (Part 2): we dive into the Market Stability Reserve, price volatility, and why the ETS is being tweaked in 2026.

Note that Professor Woerdman recently published a paper explaining a lot of what we cover in more detail. You can find the paper here: Woerdman, E. and Kotzampasakis, M., ‘EU Emissions Trading System’ (April 01, 2026), EU Climate Mitigation Law, Cheltenham: Edward Elgar Publishing, forthcoming 2027. Available at SSRN: https://ssrn.com/abstract=6633238or http://dx.doi.org/10.2139/ssrn.6633238

Transcript

Arvid Viaene: Hi everybody, and welcome to another episode. There is a lot of debate going on right now around EU climate policy, especially the EU’s Emissions Trading System. The EU ETS was the world’s first carbon market. In episode 11, with Jos Delbeke, we covered how it was created and the challenges it faced early on.

But now, in 2026, the system is up for review again. Recently, emission permit prices have been volatile, energy prices have been sensitive, and there is a lot going on. So there are growing calls to change parts of the system. But I noticed there is also a lot of confusion in the public debate about how the EU ETS actually functions, and I myself am sometimes confused.

So this is part 1 of a short mini-series to build a clear toolkit to understand what is going on. So in part 1, we will cover the fundamentals, what the ETS covers, how the allocation mechanism works, and why the system reduced emissions faster than expected and why 2039 shows up a lot through the linear reduction factor.

So today I’m very happy to have Edwin Woerdman as a guest to do so. Edwin is a professor of markets and regulation at the University of Groningen in the Netherlands since 2018. He is also managing board member of the Groningen Centre of Energy Law and Sustainability since 2007.

He defended his PhD on climate law and economics in Groningen in 2002. Professor Woerdman has specialized in energy and carbon market regulation, concentrating on emissions trading and other tradable rights.

He has published more than 100 articles, chapters, and monographs, including Essential EU Climate Law. Two of his papers on emissions trading appeared in the top 20 most downloaded articles of the Review of Law and Economics.

So, Edwin, welcome to the podcast.

Edwin Woerdman: Thank you so much.

Arvid Viaene: I’m very happy to have you on because, like I said, there’s a lot of confusion right now. I think many people would benefit from having a clear picture of what the EU ETS actually is. For an economist, the concept is simple, but the details are varied, which I think we’ll get to. So maybe let’s start there: what emissions are actually covered by the EU ETS?

Edwin Woerdman: The EU ETS is currently active in the 27 EU Member States plus Norway, Iceland, and Liechtenstein. It has also been linked to Switzerland’s emissions trading system. It covers about 12,000 emitters responsible for approximately 40 percent of greenhouse gas emissions in the EU.

And as you were asking, the system mainly focuses on reducing carbon dioxide emissions. But not only that. Since 2013, it also includes emissions of nitrous oxide from the production of certain chemicals, and emissions of what are called PFCs - perfluorocarbons - from the production of aluminum. And since this year, the EU ETS also covers methane and nitrous oxide emissions from maritime transport.

The Two Efficiencies of Emissions Trading

Arvid Viaene: That is a huge range. And I also wanted to ask you about something you wrote in a paper that I studied for this interview. Before we get into the details, you say that an emissions trading system has two efficiencies. Could you talk about those?

Edwin Woerdman: Yes. In that paper, I make a distinction between first-order efficiency and second-order efficiency goals of emissions trading. You can find that distinction in economic theory. It sounds very fancy, but applied to climate policy it comes down to effectiveness and cost savings.

First-order efficiency concerns the effectiveness with which climate damage is reduced by actually realizing the intended emission reductions. According to economists, effectiveness is part of efficiency. Ineffective climate policy is inefficient because greenhouse gas emissions are not reduced to the economically optimal or socially desirable level to prevent or reduce climate damage. Then second-order efficiency concerns the extent to which the intended emission reductions are realized at the lowest possible cost.

And in the course of our conversation, I hope to explain that the EU ETS meets the first-order efficiency requirement and largely, but only partly, meets the second-order efficiency requirement.

Arvid Viaene: So it is very effective, but only partially efficient in the second-order sense.

How Emission Allowances Are Allocated in the EU ETS

Arvid Viaene: Part of cap-and-trade is that you need permits to trade. So how are those allocated? How does the allocation of emissions work in the EU ETS?

Edwin Woerdman: That is a good question, and an important part of the EU ETS. In the first and second trading phases - so the phases starting in 2005 and the second trading phase running up to 2012 – (respectively) 95 to 90 percent of the allowances were allocated to companies free of charge, based on Article 10 of the EU ETS Directive.

Only about 5 to 10 percent of the allowances were auctioned. So in the beginning there was very little auctioning. That changed in 2013. Since then, 57 percent of the total number of allowances in the EU ETS are auctioned. That applied in the third trading phase and also in the current fourth trading phase, which runs from 2021 to 2030.

Energy producers must purchase all of their emission allowances at auction. The basic idea is that energy companies do not compete on an international product market, so they can pass on most of their carbon costs to electricity consumers. But many energy-intensive industries do compete internationally. They are exposed to competition from non-EU firms in countries without carbon pricing. This can lead to carbon leakage - the unwanted relocation of installations, production, or investments, and therefore emissions to countries without an emissions trading system or carbon tax.

To prevent these leakage effects, exposed industries are included on the so-called carbon leakage list and they receive their emission allowances for free, provided they meet a few additional criteria. The European Commission draws up a new list for every trading phase. The most recent list is from 2019 and applies to the years 2021 to 2030. For the few energy-intensive industries that are not on this list, their free allocation decreases each year and ultimately falls to zero in 2030. And of course, the number of allowances available for free allocation decreases in line with the total emissions cap for the system as a whole.

Arvid Viaene: So for energy-intensive users that are not on the list, by 2030 they receive no more free permits.

Edwin Woerdman: Exactly.

Arvid Viaene: Whereas for those on the list, their allocation still decreases along with the overall cap, but they continue to receive some free permits.

Edwin Woerdman: Exactly. And with the current energy situation, one of the ideas now being discussed is whether to extend or adjust some of these arrangements. But we can come back to that later.

Why the EU ETS Moved From Grandfathering to Benchmarking

Arvid Viaene: Exactly. So that is how much they get for free versus how much they have to buy. Then how does the process work? We had different regimes, right? In the beginning there was a system of grandfathering, and then that evolved. Could you talk more about that?

Edwin Woerdman: Yes, absolutely. Basically, we went from grandfathering to benchmarking. In the first two trading phases, between 2005 and 2012, free allowances were based on grandfathering, which means they were allocated based on historical emissions. This method favors dirtier companies with relatively high emissions. But at the start of the EU ETS, that was considered politically necessary to promote industry acceptance and protect the competitive position of Member States.

Since 2013, however, free allocation takes place on the basis of benchmarking. A benchmark is a carbon standard per unit of production multiplied by the level of production in a base year. This emissions standard - called an ex-ante benchmark in the EU ETS Directive - is determined based on the average emissions of 10 percent of the installations with the lowest carbon emissions per unit of product or energy output in an industrial sector.

So in other words, the relatively clean companies. An advantage of this is that benchmarking favors cleaner companies, which then receive free allowances based on better low-carbon performance.

Arvid Viaene: So we moved from a system where you got permits based on how much you used to pollute, to a system where we look at the most efficient firms and determine allocation based on that.

Edwin Woerdman: Yes. That is how free allowances are determined for the industry. For the sectors that had to buy all of their allowances at auction, like power producers, this does not apply in the same way because they buy their allowances anyway.

What the Cross-Sectoral Correction Factor Does

Arvid Viaene: Another term that comes up in this context is the cross-sectoral correction factor - a very technical term. What does it mean, and what does it do?

Edwin Woerdman: Yes. I always try to come up with more intuitive words for these things. The cross-sectoral correction factor is what I call a “cheese slicer”. I’m from the Netherlands, and we like cheese, so that is the image that came to mind.

The cross-sectoral correction factor was designed to deal with the possibility that the total number of free allowances calculated for companies, based on these benchmarks, would exceed the total EU emissions cap. If that would happen, the correction factor would be applied. That means each company would receive slightly fewer free allowances.

Arvid Viaene: So if the cap had to be 100 allowances, but because of the benchmarking calculations we got to 110, this would bring it back down to 100.

Edwin Woerdman: Exactly. And then the cheese slicer would apply to all those companies. It is quite technical in detail, but that is the basic idea. And what was interesting in recent years is that industries were very worried that this would happen. They were counting on a certain number of free allowances, and then the Commission might come in and say: sorry, if we add everything up, it is too much, so you all get a bit less. That means they would have to buy additional allowances, which is of course an extra cost.

Arvid Viaene: So I see the advantage of benchmarking: it rewards cleaner firms. But the disadvantage is that firms do not always know in advance exactly how much they will get.

Edwin Woerdman: Exactly. Hence the cheese slicer.

How Auction Revenues Are Supposed to Be Used

Arvid Viaene:

Auctioning permits means there is an auction, which also means there are auction revenues. How are those revenues supposed to be used? I think not a lot of people have this front of mind, but there is substantial money generated by this.

Edwin Woerdman: That is true. Previously, EU Member States were urged to use at least 50 percent of their auction revenues for emission reduction and climate adaptation measures and technologies. That includes renewable energy, energy efficiency, carbon capture and storage, and also things like retraining workers in coal regions.

Thanks to the revised EU ETS Directive, this increased to 100 percent from 2023 onward. And it is no longer just a recommendation - it is now a spending obligation. That said, this obligation looks stricter than it is, because in practice Member States were already spending on average more than 75 percent of their auction revenues on climate and energy measures.

Arvid Viaene: Which I find interesting. I was surprised that the number was already that high.

Edwin Woerdman: I was surprised too, to be honest. That number comes from one of the Commission’s reports on the state of the EU ETS. I have not done my own deep dive into what exactly is counted there, but if someone wanted to investigate how that percentage is composed, I would be very interested to see it.

Arvid Viaene: I think that is a really interesting topic in itself - how those revenues are used.

Why the EU ETS Has Been Effective at Cutting Emissions (~16:00)

Arvid Viaene: That brings us to the effectiveness of the system. Since it is a cap-and-trade system, what were the original emission reduction targets, and how were they sharpened over time?

Edwin Woerdman: Exactly. Now we are looking at first-order efficiency - the effectiveness properties of the EU ETS. The EU set itself the goal of reducing total greenhouse gas emissions by 20 percent in 2020 compared to 1990. To achieve this, companies under the EU ETS were required to reduce emissions by 21 percent by 2020 compared to 2005.

What is interesting is that this goal was already achieved in 2014. By 2020, ETS installations had reduced their greenhouse gas emissions by 43 percent compared to 2005. While over the same period, non-ETS sectors such as road transport, buildings, and agriculture had reduced emissions by 16 percent.

The EU ETS thus contributed significantly to the overall 34 percent reduction in total EU emissions achieved in 2020. These figures show that companies in the EU ETS not only stayed below the emissions caps, but even reduced emissions beyond what was required.

Now, I have to add that these extra reductions can be partly explained by the financial crisis of 2008 and the COVID-19 pandemic, both of which reduced industrial activity and energy demand. But these extra reductions also reflect technical and operational improvements, as companies adopted innovative energy-saving or CO2-saving technologies and practices, which enabled them to sell surplus allowances or bank them for future use.

The EU initially intended to reduce greenhouse gas emissions by 40 percent by 2030 compared to 1990. For ETS companies, that translated into a 43 percent reduction compared to 2005. But as I just said, the EU ETS already achieved that goal in 2020.

Because climate damage became increasingly severe and visible, and because emissions could be reduced at lower cost than expected - the allowance price was only around 5 euros in the previous decade - the EU tightened its 2030 target to a 55 percent net reduction compared to 1990. That is the Fit for 55 package. As part of this goal, companies in the EU ETS now have to achieve emission reductions of 62 percent by 2030 compared to 2005. And for 2050, the ultimate EU goal was initially an 80 to 95 percent reduction, but that was tightened in the European Climate Law of 2021 to net-zero emissions by 2050, in line with the Paris Agreement to limit global warming to well below 2 degrees Celcius.

Arvid Viaene: That is a lot of targets. But one thing I took away is that the system reduced emissions much faster than many expected.

Edwin Woerdman: Yes, exactly. The 2020 target was achieved well ahead of time, and the ETS-specific reduction target was also already met by 2020. So the system was moving faster than many had initially expected. That is also why the 2030 target could be strengthened. And in my view, that low allowance price in the previous decade was actually a success, not a failure. Many people complained about it, but I think it was a great achievement. The system was meeting the cap at low cost, which is exactly what an emissions trading system is supposed to do. And because it was doing that, it created political room to tighten the cap.

Arvid Viaene: Exactly. If you think of an abatement cost curve, you would expect that in the beginning there are cheaper reductions available. If the system is effective and those reductions are cheap, that is a good thing.

Edwin Woerdman: Yes, very true.

Linear Reduction Factor and the 2039 Target of No New Allowances (~22:25)

Arvid Viaene: One number that comes up often in the current debate is the linear reduction factor. Could you talk about what that is?

Edwin Woerdman: Yes. The linear reduction factor is the percentage by which the emissions cap decreases each year for emitters under the EU ETS.

Arvid Viaene: So given that the long-term target is net zero by 2050, why is the current system often described as having a kind of 2039 endpoint for no new allowance allocations?

Edwin Woerdman: The year 2039 was not so much chosen as a goal in itself. It was the de facto consequence of the increased linear reduction factor. Article 9 of the revised EU ETS Directive stipulates that the emissions cap will be lowered each year to ensure that total emissions continue to decline in line with the European Climate Law. The required annual reduction was 2.2 percent up to 2021. It then increased to 4.3 percent and is set to reach 4.4 percent from 2028 onward. This doubling of the linear reduction factor means a much tighter annual decline of the cap. And the consequence of that is that from 2039 onward, no new emission allowances will be issued.

In the beginning, I do not think that was entirely clear to everyone involved. I was not involved in the negotiations myself, so I did not get to look behind the closed doors, but for many economists and lawyers the 2039 date of no new emission allowances came as quite a surprise and it is now also under discussion.

Arvid Viaene: So it was not that they explicitly chose 2039 as a symbolic target. It is more that they chose a reduction path, and 2039 follows from that.

Edwin Woerdman: Exactly.

Why Small Changes to the Linear Reduction Factor Do Not Change the 2050 Goal

Arvid Viaene: That brings up the natural question. If you slightly soften the linear reduction factor, and that pushes the zero-new-allowances date from 2039 to 2042 or 2043, that still seems consistent with the net-zero-by-2050 goal.

Edwin Woerdman: Yes, I fully agree. The 2050 goal is what we need to keep in mind. Tightening or loosening the reduction path a little bit and moving that date by a few years does not make a huge difference to the climate outcome, as long as we remain committed to net zero by 2050.

If we keep the cap-and-trade structure and the broader target in place, then we are still on the right path.

Arvid Viaene: So that was a walk-through of the building blocks: coverage, allocation, why the ETS delivered big emissions cuts, and how the linear reduction factor creates that “2039” talking point.

Next week, we go one level deeper: the Market Stability Reserve—why it was created, how it affects auction supply, and why the Commission is reconsidering parts of it in the current energy and geopolitical context. We will also discuss why the allocation mechanism of free emissions may not be economically efficient.

If you found this useful, follow the show so you don’t miss Part 2.

I just released an interview with professor Luis Garicano where we discuss how to rethink EU Climate policy. I am a big fan of EU climate policy, especially the EU ETS and CBAM (see for example, my interview #11 with Jos Delbeke on the EU ETS and #18 with Kim Clausing on CBAM).

However, that does not mean EU Climate policy is far from perfect. For example, with the EU ETS in place, I think we have far too many additional restrictions and regulations in place.

So when I saw Luis’s blog article “Ten Principles for a New Climate Economy”, I was really interested by his views (I highly recommend his blog “Silicon Continent”). Luis has a unique point of view as he has been an academic and a politician, both at the national level and EU level. For example, he was a co-drafter of the legislation for the European Recovery and Reconstruction Fund, of the initial legislation on the Carbon Adjustment Mechanism

So in our podcast episode, Luis argues for a more honest climate policy conversation. One that keeps the strengths of price-based tools like the ETS and CBAM, while being more cautious with mandates and target-driven rule stacks.

What we discuss:

• Why “win-win” climate narratives could backfire when households face higher energy prices

• Carbon pricing vs mandates: where each works, and where mandates can create backlash with limited climate gains

• How EU institutions and political incentives shape policy design—and make course-correction hard

• Why “public support” is a core climate policy input, not an afterthought

Timestamps:

2:01 - Why Climate Policy is Not Cost Free
4:56 - The Case for Trade-offs in Climate Policy
10:24 - Why Carbon Pricing Works Better Than Mandates
14:56 - Energy Prices, Abundance, and Public Support
18:05 - Why Climate Policy Is Hard to Change in Europe
22:53 - From Academic Economist to European Politician
25:30 - What Economists Misunderstand about Policy Making
34:17 - How Economists Can Influence Public Policy

Guest
Dr. Luis Garicano is a professor at the London School of Economics and a former Member of the European Parliament (2019–2022), where he worked on major economic policy issues and helped shape early CBAM thinking.

For questions, comments or suggestions, you can contact me at arvid.viaene.ce@gmail.com

Transcript

Arvid Viaene:
I think the European Union has been a leader in climate policy. For example, it created the world’s first CO2 cap-and-trade market. Currently, the European Union is also innovating with the Carbon Border Adjustment Mechanism, as well as expanding the EU ETS for fuels.

Now, I view these as very good developments. However, that does not take away from the fact that we can still be critical of EU climate policy. My guest today, Luis Garicano, is someone who is both critical and constructive. In January 2025, he wrote a blog post called 10 Principles for a New Climate Policy. In that post, he suggested 10 principles to improve EU climate policy.

Many of these principles sound very intuitive to economists. For example, we should use incentives rather than mandates. Or, more generally, trade-offs are real. These ideas sound obvious to economists, so the question becomes: why is this not already happening, and what are the barriers?

So I’m excited to have him on today to discuss both his views and how they may have evolved. Whether you agree with him or not, I think you can learn a lot from him, because climate policy can always be improved at the margin.

My guest today is Luis Garicano, who has been active in both academia and policy, which I think makes him quite unique. He is currently a professor at the London School of Economics and one of Europe’s leading economists on technology, organizations, and growth. He has held senior academic positions at both LSE and the University of Chicago Booth School of Business, and his research has been published in top journals.

From 2019 to 2022, he also served as a member of the European Parliament, where he worked on major economic policy issues, including the European Recovery Fund and support for Ukraine. During this time, he also helped shape the Carbon Border Adjustment Mechanism He holds degrees in economics, law, and European studies, as well as a master’s and PhD in economics from the University of Chicago.

So, Luis, welcome to the podcast.

Luis Garicano:
Hello. It’s my pleasure. Thanks for having me.

Arvid Viaene:
I’m very excited to have you on. I really like your website and your blog posts. I think you always have very interesting things to say. So maybe just to start: why did you decide, in January 2025, to write this blog post about climate policy?

Why Climate Policy Is Not Cost-Free

Luis Garicano:
It was, in some sense, an attempt to state the obvious. We’ve been scared of breaking the consensus on climate, or of saying things that might cause people to rethink the prevailing narrative. As a result, ideas that are obvious to almost anybody who thinks seriously about climate and economics have gradually disappeared from the discourse.

Take the basic idea of trade-offs. Fighting global warming is a key priority for the world and for the planet. But it is not going to come for free. It is going to cost us something. Instead, climate policy has often been sold as if it were all win-win — the Green Deal for jobs, green growth, no sacrifices required. But the truth is that if you make energy more expensive, people will pay more for energy. That has consequences. There is a tendency to minimize those costs, or even hide them, and present everything as benefits.

I remember very clearly Ursula von der Leyen, in one of my first sessions in Parliament, defending the Green Deal on the basis that it would create more jobs. Olaf Scholz said in March 2023 that green investment would help Germany achieve growth rates last seen in the 1950s.

But the postwar boom was based on huge investment to create new productive capacity. Here, much of the investment is about replacing existing capacity, not creating new capacity. Replacing boilers with heat pumps, for example, is not the same thing.

So I wanted to put these things on the table and try to have a more honest debate about climate. I was worried about how people would react, because I’m clearly someone who has supported climate legislation, pushed for legislation, and argued that climate goals should be taken very seriously.

But I also want to be honest with citizens and say: some of these things are going to cost money, and we need to say that clearly. I think EVs are the future, for sure. There is no question that electric vehicles are the future. But I do not think that banning internal combustion engines for everybody in 2035 is necessarily good policy. We can come back to that later.

Arvid Viaene:
Yes, and I think that is worth emphasizing. I do not want this to become a conversation only about what could be improved, because, as you say — and as you make clear in the article — you are a strong proponent of the EU Emissions Trading System.

People on this podcast know this is my favorite topic, because I think these systems are brilliant. You have worked on the Carbon Border Adjustment Mechanism. You also make it very clear that climate change is real and that it carries very real costs.

I want to put that up front because, as you say, there is often a fear that the moment you say anything that goes against the “there is no cost” narrative, you get pushed into a certain corner.

The Case for Trade-Offs in Climate Policy

Luis Garicano:
I agree. The debate has become very black and white. Either you are for climate policy or you are against it. I wrote a paper with Adam Brzezinski, a postdoc here at LSE, on what we call narrative entanglement.

We looked at speeches in the European Parliament to find evidence of trade-offs. What we found was that two positions had become tightly associated: first, that climate policy is necessary to fight climate change, and second, that climate policy will create jobs and be beneficial across the board.

But those two things do not need to go together. You can absolutely believe that climate policy is necessary — and in particular that price-based policies like the ETS and CBAM are essential — while also recognizing that some climate policies come with real costs.

I think part of the problem is social media. We have moved toward a simplified view of the world where everything has to be black or white, and everyone has to fit into one camp or the other.

Some listeners are probably trying to figure out whether I’m some kind of reactionary. Others may wonder whether I’m just another green ideologue. But the truth is that we should simply think carefully through the arguments and judge them on the basis of cost-benefit analysis.

The benefits include reducing global warming. The costs include, for example, people struggling to pay their electricity bills. We need to take all of that seriously and work policy by policy. That has been my position. But in a world of quick takes and social media polarization, it is not an easy position to hold.

Arvid Viaene:
And that is interesting. Even for someone like you, with your track record on things like CBAM, it still seems difficult to say openly that climate change has costs and climate policy has costs too.

Do you feel that this is evolving, where there is less and less room for this kind of debate? Because it does seem like whenever these policies are discussed, the message is always that we will have climate policy and strong growth at the same time, with almost no space for talking about trade-offs.

Luis Garicano:
Yes. Once you put targets on the table, everything starts to revolve around whether you are for or against those targets. The way EU policy works is by setting targets and then measuring everything against whether those targets are being upheld. From that point onward, cost-benefit analysis is largely forgotten.

In my view, it has become harder to argue in a more balanced way. And it is not just climate policy. Trade policy, fiscal policy, migration policy, almost everything is simplified into these narratively entangled positions, where one side is assumed to be good on every dimension and the other is assumed to be bad on every dimension.

There is no reason policy positions have to line up that way. I understand that public political discourse has to simplify things to some extent. But when we are talking in a podcast, or writing a blog, and trying to communicate honestly with people who actually want to think things through, then it should be possible to put both costs and benefits on the table.

My own view is that the price-based policies we have put in place — ETS and CBAM — are extremely useful and beneficial. We need to improve CBAM, obviously. At the same time, I think a lot of the quantity-based policies and mandates are dangerous. They can create enormous misgivings among citizens while delivering very little additional climate benefit.

Take some of the heat pump policies in Germany, or the rules in France that can make it impossible for an older woman to rent out her house because the property is poorly insulated. She may have invested all her savings in that house, and suddenly the asset becomes almost worthless because it falls into a certain energy category and can no longer legally be rented out. That may simply not be good policy.

Why Carbon Pricing Works Better Than Mandates

Arvid Viaene:
That brings us to a point my advisor Michael Greenstone sometimes makes. Once you have the EU ETS, and to some extent CBAM, you have priced the externality. You have put a price on the social cost of carbon. At that point, many of the other interventions become much harder to justify.

Luis Garicano:
Exactly. I do not think people fully understand that. Instead, climate policy becomes this increasingly complex set of rules — rules that may signal virtue but do not necessarily achieve very much in terms of actual climate outcomes.

The question should always be: how much emissions reduction do you actually get from this rule? If you price the externality, then carbon consumption moves toward the optimal level, innovation happens, and climate change is addressed more efficiently. You do not need to get deep into people’s personal lives and tell them exactly what to do.

I think it is very damaging when people are told things like: you should not fly to Mallorca for a holiday. Meanwhile, the people making those arguments are often flying around the world themselves for conferences.

Ordinary people understandably react by saying: of course I want to go on holiday. And the answer should be: yes, you can go on holiday, but the carbon-intensive version may become a bit more expensive. That is the right framework.

We should move away from a culture of hectoring people and toward a culture of possibility. More energy is better, not less. Let’s make that energy cleaner — through renewables, through nuclear, through better pricing. We do not need a culture of guilt around using air conditioning. If you are in Madrid in the summer, of course you need air conditioning.

We should aim for cleaner energy abundance, not moralized energy scarcity. Unfortunately, a lot of the discourse has moved in the other direction, and that is making citizens less supportive of the policies that are actually necessary.

Arvid Viaene:
I hear two things there. First, because Europe works through quantity targets, there is often no real discussion of the social cost of carbon. In the US, there are debates over the social cost of carbon itself — Trump lowered it, Biden raised it — but at least the framework exists. In Europe, it often feels like any policy proposal is judged immediately in terms of whether it appears to weaken a target that was previously agreed. The cost-benefit discussion seems to disappear.

Luis Garicano:
It does disappear. There is the target for climate neutrality, the 2035 targets, all these different milestones — and the debate becomes entirely about whether Europe is “going back” or not. But that is not the right question.

The right question is whether a given policy is good or bad. If it is a bad policy, then get rid of it. You should not keep it just because it helps preserve the appearance of consistency with some previously announced target.

And the truth is that we are actually quite lucky, because the main way these climate objectives are going to be reached is through innovation — and innovation is progressing faster than many of us expected. If you look at annual generation capacity in solar and wind, especially solar, growth has been extraordinary. The pace of deployment has been much faster than in many other energy technologies, including nuclear. Once batteries improve further, we will be much closer to where we need to be. And because of shocks like the war in Ukraine and the war in Iran, people are also increasingly aware of the importance of the energy transition.

So if we get prices right and do not lose the support of citizens, I think we can get there.

Energy Prices, Abundance, and Public Support

Arvid Viaene:
Has anything shifted in your thinking recently because of the war in Iran? We are seeing very high energy prices again, and it reminds people just how painful energy price increases are. Governments are once again thinking about emergency support for citizens.

Luis Garicano:
My main reaction is that it is very depressing. During the previous energy crisis, governments subsidized consumption left and right. We introduced huge subsidies for carbon consumption. In Spain, for example, there were substantial subsidies for driving, even though we are supposedly trying to penalizing fossil fuel use.

And those subsidies are not even well targeted. The poorest 20 percent of the population often do not drive, or drive very little. So the subsidies disproportionately help people driving large SUVs. That makes them unequal, costly, poorly targeted, and counterproductive for climate policy.

So in that sense, we have not learned enough from the Ukraine crisis. At the same time, these shocks do remind us that we need the energy transition. We need to reduce dependence on fossil fuels. They also remind us how central energy is to everything — farmers, households, businesses, everyone depends on it.

So yes, the transition is necessary. But it also shows why we need to get the policy design right. For me, the key word missing in the European debate — a word that is gaining ground in the United States — is abundance. The European mindset is often very Calvinist: economize, punish, feel guilty, consume less.

But as Hannah Ritchie argues in Not the End of the World, she is writing to avoid catastrophism, which is another of the principles in my list. She says that we are on the path to solving this. Richer societies tend to become cleaner societies. They protect ecosystems more. They invest more in environmental quality. And we have already decoupled economic growth from emissions to a remarkable extent.

So let us not frame this around sacrifice. Let us frame it around abundance: more solar, more wind, more nuclear, more clean energy.

Why Climate Policy Is Hard to Change in Europe

Arvid Viaene:
I agree, and I think that is a very good book. You have laid out a set of principles, and we have talked about how climate politics has become more black and white. So where do you see the biggest barriers to moving toward these principles in practice?

Luis Garicano:
In Europe, the biggest issue is institutional and political. Europe is governed through broad coalition structures — center-right, center-left, Greens — and those coalitions are often the same coalitions that design the legislation and then later have to revise it.

That creates a problem. If a coalition goes too far in one direction, the same people who passed the original laws are often the ones who later have to admit that mistakes were made. Ursula von der Leyen, for example, has had to try to undo some of the effects of her own earlier agenda.

The same is true in Parliament. The people in committees who would need to revise legislation are often the same people who originally drafted and celebrated it. They are proud of every piece of it, so they are not eager to change it.

That makes correction very difficult. And there is also a broader structural bias in Europe toward more legislation. The European Parliament, Commission, and Council do not really have a large common budget with which to make policy. Their main way of making a mark is by producing rules. So that creates an inherent bias towards making more rules.

Arvid Viaene:
That makes a lot of sense. In an ideal world, you would have the EU ETS, the ETS 2 extension, and CBAM. You set the carbon price, and then a lot of the mandates could be reduced. But politically, I can imagine that it is much easier to say, “I passed Regulation X,” than to say, “I removed Regulation X because it turned out to be unnecessary.”

Luis Garicano:
Exactly. It is very hard to build a political identity around removing your own previous legislation, even when that is the right thing to do. So if you are a politician, your achievement is that you passed Regulation X.

It is much harder to go to voters later and say: my next great achievement is that I repealed Regulation X. But in some cases, that is exactly what should happen. Ursula von der Leyen is in a somewhat unusual position because she is not directly elected by citizens, but even so, it is can be hard togain recognition for dismantling policies you previously championed.

From Academic Economist to European Politician

Arvid Viaene:
Maybe we can turn to your own story in politics then. You began as an academic. How did you end up getting into politics?

Luis Garicano:
It started with the financial crisis. Just as many economists of the 1950s and 1960s were shaped by the Great Depression, I became politically engaged because of the global financial crisis. Spain was hit very hard. We lost a great deal of growth, and it became obvious that our existing growth model — based on construction and low productivity — was not working.

So I started a blog with a few other economists called Nada es Gratis — “No Free Lunch.” At the time, I was based in the US, and we began writing about economic reform and policy.

That blog had real impact, and over time I became more directly involved in policy. I eventually joined a political party in Spain. It was a centrist party, and they asked me to help write a reform-oriented program for them — one focused on innovation, education, and productivity. I often framed Spain’s choice as Denmark versus Venezuela. Spain needed to go in the direction of Denmark, not drift toward Venezuela.

The party did well. It won a substantial number of seats in the national parliament. Then I was asked by the party leader, Albert Rivera, to head the list for the European elections. In Europe, you vote for lists, not individual candidates, and we ended up winning nine seats.

From there, I became head of our delegation and joined the Renew Europe group, alongside Macron’s movement, the Dutch liberals, the Swedish liberals, and others.

And at that point, I became deeply involved not just in policy ideas, but also in actual politics — traveling around Spain, speaking with voters, explaining Europe, appearing on television and radio, and campaigning for votes. For an economist, it was a very unusual experience.

What Economists Misunderstand about Policy Making

Arvid Viaene:
What stood out to you the most? What had you not expected from that experience?

Luis Garicano:
I think economists often think of policy as a matter of optimizing a welfare function. Maybe we assume that some political groups get more weight than they should in that function, but we still imagine policymaking as fundamentally about selecting the best option. What we tend to underestimate is the enormous importance of process, implementation, and staff.

Staff matter tremendously. In the European Parliament, accredited parliamentary assistants and group advisers draft and negotiate a large share of legislation. Many politicians are not deeply engaged in the technical details of policy. They rely heavily on staff, sometimes receiving their briefing just before they speak.

That does not necessarily mean something has gone wrong. Politicians hire staff who align with their political outlook, and delegation is inevitable. But it does mean that staff play a huge role in shaping outcomes.

Why Implementation Often Fails After a Law Is Passed

The second thing is on process, on implementation. People often underestimate how many steps lie between having a good idea, passing it into law, and actually making a difference in the real world.

Jennifer Pahlka talks very well about this in a podcast with Ezra Klein, and also in her book. She explains how the Obamacare website almost failed because politicians had imposed so many requirements that building a functioning website on time became nearly impossible.

That kind of thing happens much more than people think. You can get everyone nominally on board with a program — ministers, civil servants, agencies — but once you try to implement it, there are all these practical bottlenecks and frictions that no one had really thought through.

So process matters. Implementation matters. And in the EU, they matter even more because policymaking is relatively remote from voters. There is no real European public opinion in the same way there is Spanish public opinion or German public opinion. I can write in the Financial Times, or place an article in Le Monde or the Frankfurter Allgemeine Zeitung, but that is not the same as speaking directly to a shared European electorate. And because of that distance, it becomes harder to hold both politicians and bureaucracies accountable.

Arvid Viaene:
That reminds me of something the Belgian economist Paul De Grauwe once said about politics. He was surprised by how long everything took, and how many procedural steps were involved. He wanted to create change, but found that the process moved very slowly.

At the same time, on the EU level, you did help shape the initial CBAM legislation. So maybe things were moving more quickly than one might think.

Luis Garicano:
Yes, actually, I am quite satisfied with how much progress we made. If anything, Parliament was too successful at passing laws. There was broad consensus that climate change had to be addressed, and legislation moved quickly. We passed many pieces of climate-related legislation — some of them useful, some of them less ideal, for the reasons we discussed earlier.

Sometimes these laws were finalized at four in the morning in trilogue negotiations, which is not always conducive to the best policymaking. But overall, I am proud of the work I did on climate. I produced the first initiative report on the Carbon Border Adjustment Mechanism, which was meant to make sure that imports from countries without carbon pricing would face a comparable carbon cost in the European market, so that European producers would not be disadvantaged.

The challenge with CBAM is that it needs to be comprehensive. If you tax aluminum but not steel, firms can switch materials. If you tax inputs like aluminum but not final goods like cars, then production simply moves abroad and you import the finished goods instead.

So I was very conscious of those trade-offs and tried to design something that took them into account. Of course, implementation constraints mattered too. If you include everything, the system becomes too complex.

The final system is not ideal in every respect, but I do think the work on CBAM was important. I also think the ETS reforms and the extension of the ETS were positive developments. So yes, I am happy with what we achieved. I also worked on the sanctions to Russia from invading Ukraine.

How Economists Can Influence Public Policy

Arvid Viaene:
Did you get the sense, while you were there, that there was any openness to a cost-benefit way of thinking? You argue for these principles now, but I imagine you were already advocating for them while you were in policy. Was there much openness to that?

Luis Garicano:
Not very much. That is one reason I wrote the paper on narrative entanglement with Adam Brzezinski. We looked at around 47,000 speeches from the European Parliament and found a strong tendency to bundle all arguments together — to see the world in black and white rather than in terms of trade-offs.

My sense is that voters do not want subtlety. They want a coherent, simple message. If they hear a nuanced conversation like the one we are having, they may feel uncertain. Is this policy good or bad? That uncertainty is politically uncomfortable.

But the whole point of a serious discussion is to think through the relevant considerations carefully. That necessarily requires nuance. In political speeches, however, that nuance often disappears. And that gets reflected in legislation too.

Arvid Viaene:
I have also read arguments suggesting that speeches can sometimes diverge from what politicians are actually willing to negotiate behind closed doors. Did you get that sense?

Luis Garicano:
That can happen, yes. But in our data, speeches seemed fairly closely related to voting behavior. So although there may be some signalling, the general relationship between rhetoric and actual positions was real.

I remember sitting through a major debate — I think it was on CBAM — and listening to every speech because I had initiated the proposal and wanted to see how people framed it. Out of all those speeches, I remember only one person who really talked in terms of trade-offs and openly acknowledged that the policy would be costly but still worth doing. That was striking.

Arvid Viaene:
So what made you shift back from policy to academia?

Because in one sense, you were a top economist in policy, which suggests your marginal value there was very high.

Luis Garicano:
You could also say I am now someone who understands politics unusually well within academia.

That is still how I see my role: being at the intersection of the two worlds. I am now in the School of Public Policy at LSE, and I teach a large number of students how to think about policy, how to influence the process, and how to get things done.

So in a way, I am back in academia, but with all this practical experience behind me. I try to teach students what I wish I had known when I first entered policy. I hope that is useful.

Why Policy Narratives Matter

Arvid Viaene:
What would you recommend to economists or students who want to engage more with policymaking — whether on climate or something else?

Luis Garicano:
I think economists need to understand both voters and politicians more deeply than we often do. Voters do not have the time to get into the weeds on trade, migration, or climate. Bryan Caplan’s book The Myth of the Rational Voter makes this point well. If an individual vote almost never changes the outcome, then it is not very rational for a voter to invest large amounts of time in mastering policy details. People vote based on identity, broad impressions, moral intuitions, and narratives. They are not going to study your policy proposal in detail and compare welfare effects.

Politicians, meanwhile, are in some ways exactly what political economy models say they are. They want to be re-elected, and they want policies that work, or at least appear to work, and that appeal to voters.

So economists often make proposals that are neither easy for voters to understand nor politically attractive for politicians to support. A good example is a proposal I pushed in Spain for a wage supplement for low-income workers — something similar in spirit to the Earned Income Tax Credit in the US. Economically, it made a lot of sense. But it was very hard to explain and I don’t think I managed very well. If I had simply said, “the state will give 100 euros to low-income workers,” everyone would have understood that. But once you start describing a negative income tax, you lose people.

So I teach students to think about policy in four layers. First, start with cost-benefit analysis. That is the foundation. The policy has to make sense economically.

Second, think through the political economy. What do the interest groups think? How will unions react? How will parties react? If the political economy does not work, then even a very good idea may go nowhere. Third, think about narrative. Can you explain the policy in a way that voters can actually understand?

And fourth, think about implementation. Does the state actually have the capacity to carry this out? Do civil servants have the incentives and administrative tools to make it work? Implementation considerations can completely change what the best policy looks like.

For example, if you create a subsidy program that requires everyone to write a detailed memo justifying the subsidy, you may create an administrative bottleneck that overwhelms the system. It may be better to deliver the same support through the tax system, where people automatically receive the benefit when they make the qualifying investment.

So yes: always start from cost-benefit analysis, but then also think through political economy, narrative, and implementation.

Arvid Viaene:
That was excellent. I really appreciated that, and I think it is also a very useful framework for me personally.

We have covered a lot — energy policy, your career, and the politics of climate policy. There are many more questions I could ask, but in the interest of time, is there anything important on EU climate and energy policy that you feel we have not covered?

Why Innovation Should Be Europe’s Climate Priority

Luis Garicano:
My main thought is this: if politicians and policymakers want the climate agenda to succeed globally, then innovation has to be the priority.

Innovation is the only way we are going to get countries like China and India to reduce emissions at scale. So Europe needs to become an innovation powerhouse — not only in AI and information technology, where we are already behind, but also in climate technology.

To make that possible, we need to reduce regulatory barriers, make it easier to start businesses, easier to grow them, easier to fail and try again, and get the single market right. Innovation first should be the guiding principle across the board.

Arvid Viaene:
And I agree with that. The EU produces only around 6 percent of global emissions. So while Europe reaching net zero matters, what really determines the global trajectory is innovation that can scale across the world — especially to places like China and India, where emissions are much larger.

So I thought that was an excellent point. Luis, thank you so much for taking the time. I really enjoyed this.

Luis Garicano:
Thank you. It was a great conversation. I really appreciate it.

One of the most successful examples is the Home Energy Report—a simple letter that tells households how their electricity use compares to their neighbors. The effects are modest but remarkably consistent (around 1–2% reductions), and the intervention scaled widely across the United States. But there’s also been a long-standing puzzle: most of the impact appears to persist even years after the reports stop—something that doesn’t happen nearly as often in other domains like charitable giving, voting, or savings.

In this conversation, I’m joined by Alec Brandon (Johns Hopkins Carey Business School), co-author of “Do the Effects of Nudges Persist? Theory and Evidence from 38 Natural Field Experiments.” (Link) We discuss what explains this unusual persistence—and why the answer may have less to do with habit formation than with something more durable: technology adoption that “locks in” behavior.

Once you see the mechanism, it changes how you think about nudges—not just as a way to shift short-run actions, but as a tool for triggering longer-run changes in homes, policies, and institutions.

Enjoy the conversation and let me know if you which topics you would like to see covered!

Arvid

Introduction

Arvid Viaene: Because climate change is essentially an unpriced externality, the obvious solution is to put a price on it, either through a carbon tax or cap-and-trade. We’ve discussed those solutions already on multiple episodes. However, another complementary approach that has gotten a lot of attention in the past decade is changing behavior directly through nudges.

One example is sending a home energy report that tells people how their energy use compares with that of their neighbors. Research has shown that these types of reports can reduce average energy consumption by 1% to 2% consistently.

That is a great result, because it is generally very hard to change people’s electricity use. As a result, energy providers in the United States have widely adopted these reports, and policymakers have praised them heavily. The company that developed them was even acquired for more than $500 million.

While that is a great success story on the surface, there has also been a puzzle in the literature: the majority of the short-run effects persist even two years after the energy reports are discontinued. However, that result stands in contrast to other areas like charitable giving, financial savings, voter turnout, and so on, where those nudges do not persist.

So the paper we are going to discuss today figures out why nudges in energy conservation can be so successful in homes, and why they may be persistent in ways that differ from other contexts.

Once you get the idea—which is both simple and really cool—you may start to see opportunities to apply these insights to climate policy, other policy areas, and maybe even your personal life.

I’m happy to have Alec Brandon on. Alec is an author of the paper and an assistant professor at the Johns Hopkins Carey Business School. His research focuses on behavioral economics.

Using a variety of empirical methods, Alec has studied the long-term effectiveness of nudges in different areas, as well as the extent of racial profiling in policy. His research has been published in leading journals like Science and the Proceedings of the National Academy of Sciences.

Before joining Carey, Alec received his PhD in economics from the University of Chicago. Alec, welcome to the podcast.

Alec Brandon: Thank you.

Arvid Viaene: I’m excited to have you on. I also forgot to mention the title of your paper during the introduction, so let me do that now. The title is Do the Effects of Nudges Persist? Theory and Evidence from 38 Natural Field Experiments. What is your paper about, and what would you like people to take away from it?

Alec Brandon: Big picture, our paper is about trying to understand whether this really promising line of research on nudges can produce persistent, long-term effects. That matters in general, but it is especially important for something like climate change. If nudges do persist, the next question is why. And if we can answer that “why” question, then maybe we can replicate the success of persistent nudges and design them more effectively. That is probably the multi-sentence summary.

What the paper finds

Short-run nudges versus long-run effects

Arvid Viaene: I think that’s a really good summary of why this research matters. What did you find in the paper?

Alec Brandon: One of the things that motivated us was the mixed early evidence on whether nudges continued to change behavior after people stopped receiving them. Back in the earlier period—say around 2015—there was some evidence that nudge effects could persist for a couple of weeks or maybe a few months, but they tended to fade fairly quickly.

Arvid Viaene: What would be an example of that kind of nudge?

Alec Brandon: The examples that come to mind are nudges encouraging people to exercise more, turn out to vote, or give to charities.

In those settings, it did not really seem like nudges were transforming who people were.

But then there were a few papers on water conservation and energy conservation that found really striking persistence. Some water conservation studies found that a single letter led to savings that lasted for years.

There were also industry white papers and academic papers on the home energy reports we study, showing that 80% or 90% of the effect remained even after the reports were randomly discontinued.

That raised the question for us: why would nudges persist in one area but not in others?

The core idea: technology can lock in behavior

Alec Brandon: The simple idea we had was that maybe the reason nudges persist in energy and water conservation is that those are settings where people can adopt technology.

If someone tells you, “You’re using more energy or water than your neighbors,” you can respond by making a change to the home. That technology can then keep producing conservation even if behavior itself doesn’t continue changing.

Other behaviors are not really like that. Voting, charitable giving, and exercise do not have the same kind of built-in technological fix.

That observation is what set us down this path.

Arvid Viaene: Right. With voting, for example, you might get a nudge and then go vote. But at the next election, if you no longer get the nudge, you stop going.

Whereas with an energy report, the nudge might get you to install something more efficient, and then that change remains.

Alec Brandon: Yes, that is exactly the idea.

Why the authors were skeptical of habit formation

A different explanation from the standard story

Arvid Viaene: Did you already have that idea going in, or did it develop as you looked at the data?

Alec Brandon: We more or less had that idea going in.

At the same time that nudges were becoming popular, there was also a lot of work on habit formation using experiments, often with incentives. Researchers would incentivize a behavior, remove the incentive, and then see whether the behavior persisted.

There really was not much evidence of habit formation at the level needed to explain the persistence being found in energy and water conservation.

Some papers from around 2008 or 2009 might find that 5% or 10% of the effect persisted and call that habit formation. That may be enough to reject a null of no habit formation, but it is nowhere near large enough to explain the levels of persistence people were reporting for some nudges.

So we were skeptical of habit formation as the full explanation.

To be completely honest, the habit formation model began as a way to describe things like addiction to cigarettes or heroin. That story makes sense to me because there is a chemical component involved.

But with a brief incentive to exercise, save more money, or respond to a nudge, I don’t think that is really changing who people are. And nudges, by design, are supposed to be light-touch. They are not intended to transform identity.

So one building block of the project was skepticism about the usual mechanism people were pointing to.

The importance of households moving

Alec Brandon: A second building block came from the earlier Opower papers.

Arvid Viaene: Opower, by the way, is the company that sent out these energy reports.

Alec Brandon: Yes, thank you. Opower was the company that designed and developed the Home Energy Report.

In the earlier papers, the researchers mentioned that they had to drop homes when someone moved. They were doing that for econometric reasons—they wanted a balanced panel.

We don’t need to get too deep into that. But we noticed that the company could observe when someone moved, and we realized that feature could help separate the effect on the individual from the effect on the home itself.

How home energy reports work

The design of the intervention

Arvid Viaene: I think that gets to the core of your paper. Could you explain the setup of the energy report experiment?

Alec Brandon: Sure. Let me start with the report itself.

There were at least 100 of these home energy report experiments run between roughly 2008 and 2015, and they may still be running. The basic setup was that an energy provider partnered with Opower.

To demonstrate effectiveness, Opower would create a small control group—maybe 20% to 40% of homes—and then a treatment group that received these reports monthly or quarterly.

The letters told households how much energy they used, how much their neighbors used, and how much their most efficient neighbors used. They also included a simple evaluation of your performance.

If you used less than your efficient neighbors, you might get a smiley face. If you used more than your efficient neighbors but less than all neighbors, you got a neutral face. If you used more than all your neighbors, you got a frowny face.

Those letters were sent regularly. Opower also tested different frequencies, but the exact cadence did not seem to matter much.

Why movers reveal the mechanism

Alec Brandon: There was also another quirk: once the homeowner moved, the house was removed from the experiment and the letters stopped.

I do not think that was an intentional research feature. It was just common sense. The energy provider did not want the new resident receiving a rating based on someone else’s energy use.

That ended up being very useful for us. If the letters stop after the original resident moves, but Opower continues observing energy use in the home, then we can measure how much of the effect stays with the home itself.

That lets us separate the effect on the original person from the effect that persists because of something about the house.

Arvid Viaene: Because before that, the assumption was that people received the nudge and changed their own behavior in the home.

Alec Brandon: Exactly.

The main result - More than half of the effect stays with the home

Alec Brandon: The effect of getting the home energy report on the household is about 1% to 2%. In our sample, it was 2.1%.

Then, once the initial resident moves, the report still has an effect of about 1.1% on the home. So a little more than 50% of the original effect remains after the original resident is gone.

Arvid Viaene: And that is the technology story.

Alec Brandon: Yes. We attribute that remaining effect to technology adoption.

The rest we attribute to habit formation, or at least to some role for habits.

Renters versus homeowners - Why the distinction matters

Arvid Viaene: One of the most interesting parts of your paper is the difference between renters and homeowners.

In general, you find that about half of the total effect is habit and half is technology. But the renter-owner comparison is especially interesting.

Alec Brandon: That analysis started partly as a way to convince referees that what we were doing made sense, but it turned into an interesting result in its own right.

Earlier papers on the Home Energy Report found that whether someone rented or owned their home did not affect whether the report produced energy savings.

That is interesting because, especially in the United States, there is not much of a culture of renters adopting energy-efficient technology.

Part of that is contractual. If you rent, you usually are not allowed to make major changes to the property.

But it is also financial. Why would you invest in energy-efficient technology if you are not going to live there long enough to recoup the benefit?

Renters mostly change habits, not technology

Alec Brandon: What we find is that renters respond similarly to homeowners while they are in the home. But once the renter moves out and a new renter moves in, none of the effect remains.

That suggests renters are changing something significant while they live there, but that change leaves with them. So in that group, the persistence seems to come from habits, not technology.

If someone believes in habit formation, this is a result they can really point to.

Arvid Viaene: That makes sense. Renters mostly have one way to reduce energy use: they change their behavior.

They turn off lights more consistently, adjust how they use appliances, and do all the small daily things that reduce electricity use. In that sense, their changes are cost-free.

When they leave, they take those habits with them.

Alec Brandon: Yes, though I would add that in an accounting sense they are cost-free. There may still be psychic costs or effort costs to adopting those habits.

I am not an expert on that specific question, but I agree with the general point. In terms of standard measurable outcomes, habits are appealing because you are getting something without a direct capital expenditure.

The hidden cost of persistent nudges - Technology adoption changes the cost-benefit calculation

Arvid Viaene: One of the important points in your paper is that when homeowners respond by adopting technology, that is not cost-free. It may have been overlooked in earlier cost-effectiveness discussions.

Alec Brandon: Yes, that is one of the main implications we try to emphasize.

A lot of people want to evaluate whether interventions work, whether in government or in the private sector. I think that kind of evaluation is extremely important.

But it is tricky, because the outcomes you observe may not capture everything people are doing in response to the intervention.

In our setting, if homeowners are adopting energy-saving technologies because of the reports, then those expenditures should be counted when you compare the benefits of the program to its costs.

We did not have direct information on exactly what technologies people were adopting, so we used back-of-the-envelope estimates from the literature on the cost per kilowatt-hour saved through technology adoption.

We chose a lower bound and an upper bound.

The exact estimate of net benefits depends on those assumptions. But the broader conclusion does not: the program still has positive net benefits either way.

Arvid Viaene: So it remains net beneficial, but the total benefits are meaningfully smaller once you account for those costs.

Alec Brandon: Yes. It takes a chunk out of the benefits.

That is basically just accounting, and accounting points are nice because you can be fairly confident you are right.

Why earlier papers missed the technology channel

Rebate data was too narrow

Arvid Viaene: Earlier papers, such as Allcott and Rogers and another by Ferraro and coauthors, looked at technology and seemed to rule it out. Why are you more confident their conclusion was incomplete?

Alec Brandon: Those papers were broadly contemporaneous, and they looked at related interventions.

The Allcott and Rogers paper, on energy conservation, used data from utility rebate programs. The idea was to see whether people who got the Home Energy Report were more likely to participate in rebates for energy-efficient purchases.

They found basically no difference between treatment and control. Their back-of-the-envelope conclusion was that maybe only 1% of the report’s effect came through that rebate channel.

The water conservation paper used an early version of a movers design and found that no effect remained in the home.

I suspect that in both cases, these analyses were somewhat speculative and placed toward the end of the paper.

In the case of the rebate analysis, I think the issue is that many of the relevant technology changes are too small or too inconvenient to show up in rebate data.

If someone installs efficient light bulbs or adds a door sweep, there may technically be a rebate. But are people really going to file the paperwork for that? Probably not. Those programs are notoriously undersubscribed.

So unless the Home Energy Report was causing large, contractor-driven renovations, rebate participation was probably the wrong thing to measure.

Observing the home directly is different

Arvid Viaene: Right, and your design is different because you do not need to infer behavior from rebate participation. You keep observing the home after people move out.

Alec Brandon: Exactly. It is always nice to have data that directly tells you what people are doing, but we basically accepted that this might be impossible in this setting.

The kinds of changes people make may simply be too small to observe directly.

That is actually a broader challenge with nudges. Nudges usually have small effects, but they are cheap enough to implement at large scale, which makes it possible to detect those effects.

The flip side is that small effects are hard to unpack mechanistically. It is hard to run surveys with high response rates when you are just sending letters. It is hard to get the “smoking gun” evidence people would ideally like.

So our approach is to infer the mechanism from what remains in the home. That is a strength, but also a limitation.

Arvid Viaene: Right. You cannot identify exactly which technology people installed. You can only see that something about the home changed.

Alec Brandon: Exactly.

What this means for climate policy

Nudges work better when paired with something durable

Arvid Viaene: One thing I really like about the paper is that it changes how you think about nudges.

Instead of only asking whether a nudge changes behavior in the short run, you ask whether it can trigger a technological or institutional change that keeps affecting behavior over time.

For example, with voting, maybe the nudge could get someone to install an app or sign up for a system that keeps nudging them. In climate policy, maybe the key is to get people to adopt something that keeps the effect going.

Alec Brandon: I think that gets to the most important implication of the paper.

Nudging for the sake of nudging is still worthwhile. It helps us learn what works, and the things that work can sometimes be scaled.

But I think it also makes sense to ask what the underlying response actually is. What do you expect people to do in response to your nudge? And are the conditions there for that response to stick?

In energy, that is straightforward. If there is a low-cost technology you want people to adopt, then a nudge that grabs attention and gets people to consider action can complement that technology nicely.

So instead of taking a purely reduced-form approach—“I do not care how people respond, I only know the experiment works”—our paper is pushing people to think more concretely.

What technologies would be useful if people adopted them today? Can you design a nudge that gets attention and leads to adoption?

Or, alternatively, can you pair a nudge that works in the short term with something that makes long-term persistence more likely?

Pair nudges with defaults or new incentives

Alec Brandon: For example, maybe a voting nudge could have stronger long-term effects if it also included a form that helps people sign up for mail-in voting. That would reduce the cost of repeating the behavior in the future.

Or in energy, maybe the nudge could encourage enrollment in critical peak pricing, which changes the incentives people face over time.

That is still a conjecture, but that is where we hope people take the paper: thinking more clearly about what exactly is going to produce the long-run effect.

Arvid Viaene: Yes, being more rigorous about what is actually changing.

I also like your point that behavioral economics is very good at grabbing attention. The smiley-face report gets people to notice something. Then you can use that moment to connect them to a pricing program, a technology, or a more durable change.

Alec Brandon: Exactly.

Behavioral economics offers a very useful toolkit for getting people’s attention. The field has a more uneven track record when it comes to very long-run effects.

So one promising direction is to combine those tools with more traditional economics—changing incentives, reducing friction, encouraging technology adoption.

That could let you get the best of both worlds: the immediate change in behavior and the more durable effects that come from structural changes.

Examples beyond the paper - Heat pumps, solar panels, and framing

Arvid Viaene: I think that is especially relevant for climate and energy policy.

Take heat pumps in Europe. Energy prices are high, and for many homes heat pumps can be a very good option. But a lot of people are not aware of what they are or how they work.

Behavioral economics seems useful here because it can grab attention and help people recognize that something could genuinely benefit them.

Another example is a paper by Verboven and De Groote on solar panel adoption in Belgium. Unlike in the United States, Belgium had a very complicated subsidy system.

It was not something simple like “you buy this and get 50% back.” Instead, you bought something for €10,000 and got the rebate gradually through electricity credits over many years. People just did not realize how favorable the deal was.

That seems like a case where behavioral tools could help people understand how valuable the policy actually is.

Alec Brandon: I agree.

One way to put that is that prices are always framed in some way. There is no such thing as a frame-free price.

Behavioral economics gives us tools to think about which frames are better and which are worse.

What you are describing in Belgium sounds like a case where the policy may have been framed in a way that made it much harder for people to understand how attractive it actually was.

Additional result from the paper - Homes with electric heating show more persistence

Arvid Viaene: Is there anything else from the paper that we have not covered and that you would like to add?

Alec Brandon: The only other thing I would emphasize is a result that is sort of a counterpart to the renter finding.

We also had a similarly sized sample of homes that used electric heating rather than natural gas. Since our outcome is electricity use, those homes had more scope to generate savings through technology adoption.

And that is exactly what we see. In those homes, around 60% to 65% of the initial effect persists, compared with about 50% on average and zero for renters.

So the story I tell myself is that people may prioritize technology adoption because it is the easiest way to get a better report card from the utility.

But if that option is not available, and you keep sending the letters long enough, maybe people do adopt habits instead.

That is a conjecture, but I think it is a useful way to connect the different results.

Related research on energy technology

Smart thermostats may not save energy

Arvid Viaene: Are you doing any further research in the energy nudges space?

Alec Brandon: Not at the moment. But I am finishing another paper that your listeners might find interesting.

It is a more conventional technology-evaluation paper in which smart thermostats were randomized.

In the United States, there is a lot of subsidy money available for people who replace their thermostat with a smart thermostat. These thermostats connect to the internet and can be controlled from your phone.

We studied a field experiment in California where people were recruited and, if randomized into treatment, got a smart thermostat installed for free.

And we do not find any energy savings from the people who received the smart thermostat compared with those who did not.

So I am not claiming that technology is always the answer. Smart thermostats do not seem to deliver the kind of energy savings that households in the home energy report study were apparently finding through other changes.

Arvid Viaene: That also shows the kind of critical mindset you need as a researcher.

Even if you are interested in technology as a mechanism, you still need to test whether a specific technology actually works.

So if anyone listening works at an energy provider, has a promising intervention, and wants to run a serious field experiment, Alec is clearly someone worth contacting.

Alec Brandon: Yes, feel free to email me.

Arvid Viaene: Alec, thank you so much for taking the time.

Alec Brandon: My pleasure.

Introduction: Welcome back to Part 2 of my conversation with Richard Tol.

In the first part, we focused on the structure of the FUND model: what integrated assessment models are trying to do, why adaptation matters, and why climate damages depend not only on warming itself, but also on development, institutions, public goods, and technological change.

In this episode, we move from model structure to model use. We talk about the social cost of carbon, how the Obama-era EPA worked with models like FUND, DICE, and PAGE, and why Richard argues that the hard part is often not running a model, but understanding it well enough to use it responsibly.

That matters because once a model enters policy, its output is no longer just an academic result. It can shape regulatory analysis, legal reasoning, and the way governments justify action. And at that point, disagreements about models are no longer purely technical. They become disagreements about assumptions, uncertainty, judgement, and politics.

So this second part is about what happens when integrated assessment models leave the seminar room and enter the policy process. We discuss the social cost of carbon, why single headline numbers can be both useful and misleading, why misunderstood models can be dangerous, and what the debate around IAMs reveals about the uneasy boundary between economics and climate politics.

And if you have not yet listened to Part 1, I’d recommend starting there, because that episode unpacks the logic of FUND itself — and that gives the policy debate in this episode much more context.

If Part 1 was about how the machinery works, Part 2 is about what happens when that machinery is actually used.

Arvid Viaene: When I started the introduction, I mentioned how under the Obama administration they used three models—DICE, PAGE, and FUND—to estimate the social cost of carbon. Those were, as I understand it, independently developed, so in that sense you get equal weighting. How did you view that process by the EPA or the Obama administration’s interagency working group? Because to me, from a distance, it always seemed like a good way to do it. You said there shouldn’t be a single estimate, but as a policymaker you do ultimately need one number to put on a carbon tax.

Richard Tol: Yes, absolutely. It is right and proper that the EPA does the filtering process and then comes out with a single number. That is not my job. It would be entirely wrong for me as a professor to narrow the range to a single number. That is the job of policy advisers, not policy analysts.

The experience with the EPA was very interesting, and I was not involved in the decision-making at all. What the EPA did was spend two years understanding these three integrated assessment models and running them. That tells you something about what the EPA was like then.

Arvid Viaene: Yeah—they took two years to understand them.

Richard Tol: And it took two years not to learn how to run the model, because that certainly doesn’t take two years. Depending on the version, it’s often just a single command.

What they spent those two years on was having a team of analysts fully understand the model—every parameter—and understand it so well that they could explain it to their political bosses. That was very enriching, because the EPA hires PhDs from top programs. Working with people who are really clever and who devote a lot of time to understanding your work is a great experience.

After that, they understood the models so well that some of them were actually contributing to the literature on the social cost of carbon and climate economics more generally.

Then they took it through the political process, and I had no influence over that. They were not interested in my opinions on that at all. One of the debates we had—which later came back to bite them—was whether the social cost of carbon for the United States should reflect only impacts falling on the United States, since that is under U.S. jurisdiction, or whether it should also include impacts caused outside the United States.

We had long debates about that. In the end, it was the politicians and the lawyers who decided, and they never presented a U.S.-only social cost of carbon. And of course, that was the first thing Trump changed.

Arvid Viaene: Yeah, exactly. I actually did a solo episode on that. One of the few tweaks Trump made was to look only at U.S. estimates and change the discount rate, which drastically lowered the figure.

Richard Tol: Mm-hmm. Yes, absolutely.

How models are misunderstood

Arvid Viaene: Let me quote something from your website because I think it’s really interesting. On the FUND model website, you write: It is the developer’s firm belief that most researchers should be locked away in an ivory tower. Models are often quite useless in inexperienced hands, and sometimes misleading. No one is smart enough to master in a short period what took someone else years to develop. Not understood models are irrelevant, half-understood models treacherous, and misunderstood models dangerous.

In that sense, it sounds like EPA took a good course by spending two years understanding the models. But that made me wonder: what do you think are the most misunderstood aspects of the FUND model, and how have you seen that translate into misuse?

Richard Tol: That quote does not refer to the EPA. Absolutely not. That was a very enriching experience. The quote reflects, first, my general understanding of my fellow academics.

There are two things I want to say about this. One is the Edmunds strategy.

Arvid Viaene: The what? The Edmunds—

The “Edmunds strategy” and unrealistic premises

Richard Tol: The Edmunds strategy. Edmonds is a prominent figure in integrated assessment modeling and has advised on environmental and energy policy for 40 years or more.

One thing Edmonds used to do when presenting results from his models was say things like: “Yes, we can meet this target if we scale up nuclear by so-and-so much”—for example, if you build 400 nuclear power plants in the next 20 years.

There were always two reactions in the room when he said that. The people who understood nuclear power would fall over laughing, because the idea of building 400 nuclear plants in 20 years, when we had only built about 200 over the previous 40 years, was obviously unrealistic.

So Edmonds gave the technically correct advice: if we could expand nuclear really fast, we could make a serious dent in CO2 emissions. But half the room understood that the premise was absurd. The other half heard only, “We can do this,” and walked away with the wrong impression—that these very stringent emissions targets were economically and technically feasible.

That is what I mean when I say that if you do not understand the model, you can walk away with the wrong conclusion. Some people use that as a strategy.

A case study in misuse and version control

The other episode that remark refers to is Ackerman, who took our model, changed it, found ridiculous results, and then blamed us. In particular, Ackerman claimed that in the model we divided by zero, which is not something you should do—and if you try to do that in numerical code, it generally does not work.

Arvid Viaene: Okay, yeah.

Richard Tol: Ackerman was particularly dishonest because we explained to him many times that we did not divide by zero, and that there was no reason to think we did. We had all sorts of checks in the model before the final result emerged, so even if we had tried to divide by zero, or divide by something close to zero, we would have caught it. But he published the claim anyway.

Arvid Viaene: So after you told him this wasn’t something your model did, and that there were many checks before it got there—this was over multiple conversations—

Richard Tol: Yes.

Arvid Viaene: He still published results saying that is what you did?

Richard Tol: Yes. Which of course served a political agenda in his case, namely attacking one of the three assessment models used for cost-benefit analysis at the time.

We learned lessons from that. One of them was to put the code online—not just on a website, but now on GitHub with version control and everything. So now you can’t just take our model, change it, and then claim we made a mistake. We can show that you made the mistake, which we couldn’t do back then because we had no version control.

It was not a pleasant experience, as you can imagine, because Ackerman was reasonably prominent in certain circles. A lot of people believed him, and a lot of people wanted to believe him. But it was just nonsense.

Arvid Viaene: Yeah, okay. I think that helps frame that quote.

Criticism of IAMs and debates around damage functions

Nordhaus, politics, and historical context

Arvid Viaene: Another quote of yours I wanted to get to is about how climate estimates are never politically neutral: for some they are too low, and for others too high. You write that an integrated assessment model like FUND is used to advise policymakers about proper and not-so-proper strategies, but it always reflects the developer’s worldview and is therefore regularly contrary to political rhetoric and occasionally politically incorrect.

That struck me because I once saw an economist on several podcasts saying Bill Nordhaus is “climate’s worst enemy” because the damages in DICE weren’t large enough. I wondered whether, as one of the authors of a leading integrated assessment model, you’ve seen that same tension.

Richard Tol: The guy you’re talking about is Steve Keen, right?

Going back to Nordhaus: Nordhaus worked in the Carter-era White House, and he was one of the architects of the early investments in renewables. Carter had that famous stunt of putting solar panels on the White House. That was a bit ridiculous because they were very expensive and did not generate much electricity, but another thing Carter did was start the research program into renewables that is now paying off big time. Had that not been started in the 1970s, we would not be where we are now.

Nordhaus was one of the architects of that. Throughout his career, he has always advocated for climate policy, and usually for more stringent climate policy than U.S. politicians wanted, including under Clinton-Gore. Nordhaus was far greener than Clinton and Gore when they were actually in office.

He also, with his brother, helped design the sulfur emissions trading scheme, which became the blueprint for emissions trading for carbon dioxide and other greenhouse gases in Europe. He also helped persuade President George H. W. Bush to sign the United Nations Framework Convention on Climate Change. During the Rio negotiations, the DICE model was running in the background to see whether the U.S. could afford to sign on.

Without that reassurance from one of the most prominent macroeconomists in the United States, I doubt Bush would have signed the UNFCCC.

So the idea that Nordhaus is the enemy of climate policy is historical revisionism on an epic scale. It’s just people who do not understand how things really worked, or what he actually did.

A lot of that fire has been directed at Nordhaus, but he’s handled it cleverly by not engaging. He writes papers; he very rarely writes op-eds or gives interviews, and he definitely doesn’t do social media.

Now, I do those things, as you know, and that’s one reason I’m here. So I draw a lot of fire as well, mostly from Greens who think I’m the devil. But I have advocated for a carbon tax since the beginning of my career—except in Europe, where I’ve said the price of CO2 permits is roughly correct. In most of the rest of the world, I’ve said for the last 35 years that the price is too low.

As you noted earlier, I helped formulate climate policy under Obama and Biden, and indirectly even under Trump, because Trump wanted to set the social cost of carbon to zero. But the courts stepped in and said the estimates were sufficiently robust that you could not set it to zero.

That robustness was not just my work—it was Nordhaus and Chris Hope as well. Apparently our work was strong enough to withstand the legal challenge.

I also helped formulate the carbon tax in Ireland and the landfill tax in the UK. So the idea that I am against climate policy, or that I have hindered it, is just wrong. People just don’t know the facts.

At the same time, people who think climate change is a hoax—or invented by the Chinese or Russians or whatever—don’t like me either, because I think climate change is real, caused by humans, and a problem that should be solved.

Arvid Viaene: Thanks for that.

I also wanted to add something from one of your Substack posts, “Economic Impact of Climate Change.” You write that many people express skepticism about the economic impact functions used in integrated assessment models for cost-benefit analysis, especially the modest impacts at very high warming. But you call this a red herring, because the damages are already large enough to justify keeping warming well below 3 degrees Celsius. The assumptions about what happens at 4 degrees may be spectacularly wrong, but they do not influence the model results.

I think that’s important because sometimes people say the damages aren’t big enough, but as you say, the assumed damages are already sufficient to justify climate policy.

Why extreme-warming damages may not drive model optima

Richard Tol: Let’s get a bit technical. What matters in an optimizing model like DICE is the value function, not the utility function. What matters is what happens in the optimal scenario.

In the DICE model, temperatures rarely get above about 3.5 degrees, and it’s a model without uncertainty. So really it is irrelevant what happens above 4 degrees. You can make the impact function extra steep after 4 degrees—you can multiply everything by 10 or 100—and it won’t affect the result because the model never goes there.

What I suspect is that people who are not mathematically trained look at the equations and parameterizations and focus on the objective function instead of the value function. They just get it wrong. For people without a PhD in economics, I understand the confusion. They look at the functions and think: this can’t be right.

The problem is that there is actually very little literature on the impacts of climate change at 4 degrees or 8 degrees of warming. Most studies focus on 2 or 3 degrees, maybe 4 at most. So those are your calibration points. Beyond that, you are extrapolating.

We know very little about those worlds. But fortunately, what we find is that even with these assumptions, we recommend a carbon tax that ensures we don’t go to those places about which we know so little. That is a good thing. I don’t know what a 4-degree world would look like. It seems very scary.

Cost-benefit analysis vs. European climate targets

Why EU climate policy favored cap-and-trade

Arvid Viaene: Yeah, I think so too.

I also wanted to ask about cost-benefit analysis and EU climate policy. I should say I’ve really enjoyed your writing. I didn’t know you before except through the FUND model, but I’ve been reading your papers and blog posts, and I really appreciate the style.

One of your posts is on the role of cost-benefit analysis. And I want to get to EU climate policy because there it’s mostly quantity targeting—net zero, cap-and-trade, fixed emissions quantities. I’m very U.S.-trained by Michael Greenstone, so I’ve always thought in terms of the social cost of carbon and cost-benefit analysis.

You wrote: Cost-benefit analysis has been used to propose a target for greenhouse gas emissions reduction. This inevitably starts a brawl because cost-benefit analysis forces you to make explicit all assumptions and value judgments that imply said target. There are other, less abrasive ways to set targets, but those can be reverse-engineered to reveal the implicit assumptions that make them optimal in the sense of cost-benefit analysis. I think it is better to be upfront about your assumptions and values. Cost-benefit analysis is a good way to get published in an economics journal. It is less suitable for climate policy advice.

I agree that it’s better to be upfront about assumptions and values. But I wanted to hear more about why cost-benefit analysis is good for economics, but less suitable for climate policy advice.

Richard Tol: If you want to be an academic, you should be honest. If you want to be a politician, you should not. That’s just not how you build coalitions. There is an inevitable conflict between the two.

The reason the EU went for cap-and-trade rather than a carbon tax is not that they did not want a carbon tax, or that the Commission’s policy analysts did not understand the differences. In fact, they were trained at places like Harvard and MIT and knew very well from Marty Weitzman’s work that a carbon tax is theoretically superior to cap-and-trade.

The reason they chose cap-and-trade was political. It had to do with the prospect of tax harmonization in the EU. The British and the Irish basically said there would be no European tax, so the next-best alternative was cap-and-trade.

Once you choose cap-and-trade, you immediately get into the question of what the target should be. Environmentalists also like the idea of capping the maximum amount of pollution. So it was much more political than analytical or economic.

In principle, it is not a terrible policy. You can quibble with things, but the alternatives would have been worse.

The targets politicians have set in Europe are very stringent, but again, this is politics. The political strategy is to promise to do a lot long after you have left office while doing relatively little while in office. That has essentially been the strategy of European politicians. That is why we have targets for 2050. That is still four or five elections away. It’s not really mytarget.

What we now see happening in Europe is that politicians are beginning to backtrack—not on 2050, which is still far away, but on current climate policy. People are starting to realize that this is expensive, and perhaps the short-run targets should be relaxed, even if the long-run ones remain.

Arvid Viaene: Yeah, okay. Thanks.

Richard Tol: And this goes back to cost-benefit analysis: it’s not free. You need to take both costs and benefits into account.

Has the social cost of carbon been “discredited” in the EU?

Arvid Viaene: Exactly. I once read in a policy book on EU climate policy that the social cost of carbon had been discredited in political circles. I never quite understood what they meant. Have you heard that idea—that the social cost of carbon has been discredited at the EU level?

Richard Tol: Well, they never liked it because it wasn’t high enough to justify the targets. The EU is obliged to do cost-benefit analysis for any major policy initiative, including climate policy. But if you look at the analyses published by the European Commission, they are never really proper cost-benefit analyses.

They are always distorted because they know they cannot justify the long-term targets with a textbook cost-benefit analysis. The author of the first climate cost-benefit analysis by the European Commission is actually an old friend of mine, and he told me: “Yes, I’m doing it wrong. That’s what the political masters told me to do.” And it has been like that ever since.

Arvid Viaene: Got it. Okay. Thanks, because that had always been a little confusing to me. Coming from the U.S., where one president comes in and changes the number dramatically, cap-and-trade seems more stable in the short run.

I’ve already enjoyed this conversation a lot and learned a lot. Is there anything we haven’t touched on that you would like to add?

Richard Tol: No, I think we have covered most of what you intended to cover.

Arvid Viaene: Yeah, I think so too.

Current research: Transfers, population, and welfare assumptions

Arvid Viaene: I think the only thing we haven’t really covered is the frontier—what you’re working on now. You’re clearly still writing a lot of papers, and it sounds like the meta-analysis is taking a lot of your time.

Richard Tol: There are two things I’m working on at the moment. One, going back to Schelling—I’m a big fan of Schelling—is trying to quantify the income transfers implied by climate change.

We have a paper doing that at the national level, and it turns out to be a bit different from what people think. A lot of people think the income transfer implied by climate change is from rich to poor—that the rich emit, and the poor suffer. That is actually not true, because the emissions intensity of middle-income countries is higher than that of rich countries.

So rich people, relative to their income, do not emit that much, and they are also not very vulnerable to climate change. As a result, the transfer is actually more from the poor to the middle-income than from the poor to the rich.

Arvid Viaene: Oh, I see.

Richard Tol: That paper is basically done. We are doing the same for income classes and for ethnicities, and the ethnicities work is something I’m particularly excited about.

The other thing I’m working on is endogenizing population growth in these models, and especially working through the welfare implications. The standard assumption in most of applied economics is that social welfare is proportional to the number of people times average utility. That’s sort of the Benthamite view of ethics.

In the climate change case, that can lead to very peculiar results. If climate change slows economic growth—and there is good reason to believe it does—and if slower economic growth slows the demographic transition, then climate change implies that more babies will be born in the future.

In a Benthamite model, that is actually a good thing, because Bentham says the more the merrier. If you just plug those assumptions in, then you should actually subsidize CO2 emissions because that means more babies.

If you then add in the mortality effects of climate change, that completely reverses the result and you get something like the Bressler result, where the social cost of carbon should be multiplied by 10 or 100.

But if you recalibrate the model, switch to a less Benthamite and more Millian welfare function, or introduce ideas like a life worth living in a Blackorby-type approach to social welfare, then that result disappears as well.

So this will probably be an intellectually interesting paper, but numerically it is disappointing. At the end of the day, all these effects cancel out and I’m back to something like the Nordhaus result.

I have four or five moving parts in the paper that are all interesting, and after calibrating everything, it all cancels out. That probably rules out publication in Nature or Science, because they want dramatic results. But it may be more interesting for an economics journal.

Those are the things I’m currently working on in the climate space.

Arvid Viaene: Cool, awesome. Thank you so much for taking the time. I really enjoyed this. One of my goals was to understand more about the FUND model—its history, insights, and design choices—and I definitely got that. I also hope this helps other economists understand the history and the reasoning behind the model.

I feel that hearing the researcher talk about the history and implications brings the model to life much more than simply reading an academic paper.

Richard Tol: Well, absolutely. We can say things here that we could never write in a paper, right?

Arvid Viaene: Exactly. So thank you so much. I think this will definitely help with that.

Arvid Viaene: Hi, and welcome to another episode. Climate change is the mother of all externalities. It is larger, more complex, and more uncertain than any other environmental problem. Those are the words my guest wrote in 2009. As an economist, the natural question is: what are the damages of those externalities?

What do those damages consist of? How large are they? And what are the uncertainties? My guest today, Richard Tol, has been one of the leading scholars trying to answer those questions, in particular through the use of an integrated assessment model called the FUND model. FUND stands for the Climate Framework for Uncertainty, Negotiation, and Distribution.

This type of model takes estimates of climate change and economic outcomes and turns them into estimates of economic damages. We’ll talk much more about that later. But first, I want to provide some context on the importance of the FUND model. When I was doing my PhD in economics from 2012 to 2018, there were three leading integrated assessment models, as I saw it.

One was Bill Nordhaus’s model, for which he later received the Nobel Prize in Economics. Another was developed by researchers at the University of Cambridge. And the third was the FUND model by Richard Tol. These three models were used by the Obama administration to arrive at a number for the social cost of carbon, the guiding figure for cost-benefit calculations in the United States related to climate change.

So these models have greatly shaped U.S. environmental policy.

Let me also give you some of Richard’s bio, which is very impressive. Richard is a professor in the Department of Economics at the University of Sussex and professor of the Economics of Climate Change at the Institute for Environmental Studies and the Department of Spatial Economics at Vrije Universiteit Amsterdam.

He is a member of the Academia Europaea and a fellow of the Royal Economic Society. Richard received an MSc in Econometrics in 1992 and a PhD in Economics in 1997 from Vrije Universiteit Amsterdam. To give you an idea of his impact, he has over 300 journal publications with more than 100 co-authors.

He is ranked among the top 100 most-cited economists in the world, as well as the top 100 most-cited climate scientists. He has published two books, three edited volumes, and many smaller publications. He specializes in the economics of energy, environment, and climate, and is also interested in tourism and scientometrics. So, Richard, welcome to the podcast.

Richard Tol: Thanks for having me.

What is an integrated assessment model?

Arvid Viaene: When I started this podcast, a conversation with you about FUND was actually on my wish list, so I’m very excited to have you on. But not all of my listeners may be aware of what integrated assessment models are. Could you give us a sense of what they are and what they are used for?

Richard Tol: Integrated assessment model consists of three words, right? The last one is model, which is essentially a mathematical or computational representation of how we think the world works.

The word assessment refers to the fact that these models are meant to advise policy. They’re not designed to further our understanding of reality; they’re designed to improve policy.

And the word integrated, the first word in integrated assessment model, means that the model is constructed to respect the boundaries of the problem, rather than the boundaries of academic disciplines. So in the case of climate change, you would have demographic components, economic components, engineering components, a carbon cycle—that is, how CO2 moves through the atmosphere and other carbon sinks like the ocean and the terrestrial biosphere.

You would have a climate model, and you would have impact models that are partly economic but also partly related to human health. So you span all the disciplines necessary to understand the climate problem.

The start of FUND - From econometrics to climate negotiations and cost-benefit analysis

Arvid Viaene: Awesome. Thank you. I’m wondering what got you started on these types of models. What made you decide to pursue them?

Richard Tol: I don’t think it was my decision at all. Just after I graduated, I was looking for things to do, and I found this job at the Institute for Environmental Studies. I’m still affiliated with them.

Even though my original training was in econometrics and statistics, they put me on this project. It was much more about cost-benefit analysis and a lot of game theory about how to set up international negotiations around climate change.

This was not my first choice, and in the beginning I didn’t really like it. But after a while you get used to what you’re doing, you get better at it, and it becomes more interesting as you understand more of it. So it was not by design; it was an accident. As John Lennon says, life is what happens to you while you’re busy making other plans.

Arvid Viaene: Yeah. And was it then part of your PhD, that they put you on this project?

Richard Tol: This eventually turned out to be my PhD as well. I started in 1992, actually, on this project, constructing this integrated assessment model, and that became a major part of my PhD.

Building a multi-regional model in the early 1990s

Arvid Viaene: Yeah, because at the time, I think Bill Nordhaus published his first paper in 1992, or maybe earlier, on the DICE model. How did you go about constructing the FUND model? To me it seems like such a huge exercise. There are so many components that just getting started seems daunting.

Richard Tol: It’s been a long time, right? Nordhaus’s work was known at the time. Actually, what we planned to do was build a multi-regional version of DICE. At the time, we didn’t know about Zili Yang and the RICE model. That was already fairly advanced, but we weren’t aware of it.

We were aware of the work of Carlo Carraro and Scott Barrett. Their work was circulating as working papers at the time. So essentially the plan was to build a multi-regional version of DICE and deviate from Barrett and Carraro by allowing heterogeneity across regions. At that time, they assumed every country was the same, which is a peculiar assumption that I still don’t understand how game theorists worked with.

So that was the starting point and the aim. How do you start building a model? You start by understanding what needs to go into it. We had a good bit of guidance from Nordhaus: what the components were and what they might look like. Not just Nordhaus—the CETA model by Peck and Teisberg was actually slightly earlier.

We had access to those as well. And then you just start building. The main challenge was regionalizing the model and regionalizing the impacts of climate change. Some of Nordhaus’s work was only available in draft at that stage, but it was still a big help.

Arvid Viaene: Right. I think one of the big differences at the time versus DICE was that you started creating these 16 regions, whereas DICE had—

Richard Tol: Nine. Sixteen came later, yes.

Arvid Viaene: Okay—whereas DICE was just one model for the world. So once you got into that, were there other parts of FUND that started to differentiate it from the other models?

How FUND differs from DICE and PAGE - Sector-by-sector impacts and adaptation dynamics

Richard Tol: One thing FUND has always done differently from all other integrated assessment models used for cost-benefit analysis—apart from the GIVE model by RFF—is that we have separate impacts for different sectors. In that sense, we are similar to GIVE.

I never quite understood why all sectors should move in tandem, or why they should all have a quadratic functional form. Conceptually, and more importantly, because different sectors develop differently depending on how the economy grows, you naturally create dynamics in your impacts.

That’s something a structure like PAGE or DICE completely lacks. If you look at the equations in DICE, the impacts of climate change are a function of climate—really a function of temperature. Then they are just scaled up and down with the size of the economy. But things like the provision of public goods or the structure of the population simply aren’t there.

We know those things are important because adaptation is terribly important for the impacts of climate change, and a good part of adaptation has to do with the provision of public goods. Nordhaus essentially assumes that the provision of public goods is constant across space and time, which is a very peculiar assumption.

Similarly, if you look at health impacts, things like malaria particularly affect children between zero and six months old, while heat stress particularly affects the elderly. Assuming that the structure of the population doesn’t change over time is also a very peculiar assumption. By allowing different sectors, you can build in more of that richness in how impacts evolve over time.

It also allows you to follow Tom Schelling’s advice. Schelling is, of course, a very prominent economist, and he won the Nobel Prize for his work on game theory. His contributions to the economics of climate change are a bit overlooked. Nordhaus was the first economist to talk about climate change in 1975 or 1977, but Schelling was not far behind; he published in the public literature by 1984.

From very early on, Schelling said that developing countries are much more vulnerable to climate change than developed countries, for the reasons I just gave, but also because of the structure of the economy, access to technology, provision of public goods, and so on.

That immediately implies that there are two ways of reducing the impacts of climate change. One is reducing greenhouse gas emissions, which is the only tool Nordhaus allows. But you could also stimulate economic growth in general, or target particularly vulnerable sectors through targeted development or targeted technological change. That would also reduce climate damages without directly affecting climate change itself.

That is one of the main ways in which FUND differs from other integrated assessment models: we actually include those policy options in the model.

Malaria, public health, and technological change

Richard Tol: That difference has turned out to be important, and reality has borne it out as well. If I think back to the 1990s, one of the things people were terribly worried about was what climate change would do to the spread of tropical diseases like malaria. People were talking about millions of premature deaths per year because of malaria.

That concern has now basically gone away. First Bruce the Younger came with bed nets, then the ban on DDT was reversed, and then Bill Gates funded the development of a malaria vaccine. Malaria is now technically under control. The current problem is that the Trump administration’s attack on foreign aid is reversing some of the progress made under the previous Republican president, but that is probably temporary.

That major concern—malaria—has essentially been reduced by better public health provision and technological progress in medicine. A model like DICE simply can’t do that. It’s not designed to ask that question, whereas FUND is.

Arvid Viaene: There’s also a big point my advisor, Michael Greenstone, makes: like you said, the impacts of extreme heat on mortality are mostly skewed toward the elderly, but especially in countries where there’s less adaptation—less air conditioning, less heating. As income rises, people also have an easier time adapting. Would that be easier to capture in the FUND model?

Richard Tol: Yes. Michael Greenstone, I think, was a co-author on the Deschênes paper with Olivier Deschênes, where they looked at the sensitivity of mortality to heat over a century in the United States and found a secular decline in vulnerability, particularly because of air conditioning, but also because of improvements in healthcare.

Absolutely. FUND is designed to look at those things, and that is, I think, its main selling point.

Arvid Viaene: To be fair, when you describe it that way—and I think I got a presentation by David in Berkeley back in 2015 making this point as well, David Anthoff, your co-author now developing FUND—it made me wonder why Nordhaus or PAGE didn’t take a similar route. It sounds very attractive when you explain it that way.

Calibrating FUND using evidence

Arvid Viaene: On the flip side, what you did sounds very hard, because now you’ve got multiple sectors and have to parameterize or estimate impacts from the literature across different regions and sectors. It’s a much harder problem because you’re breaking it down. How did you go about getting the estimates for the model?

Richard Tol: Essentially, what I now realize—and wish I had realized earlier—is that it’s basically a meta-analysis. You have all these different impacts, and what I did was read the literature, which at the time was still pretty thin, and synthesize from it.

For the impact of climate change on agriculture, there were four or five published studies, and what went into FUND was basically the average of those studies. Similarly for health, there were a handful of studies. In some cases there was only one study, and that’s what I used.

Over time, of course, the literature has thickened—not as much as people think, but definitely more than in the mid-1990s. Recalibrating the model still follows the same principle: what goes into FUND is typically the average and standard deviation of what you find in the literature on a particular impact.

The same is true for the costs of reducing greenhouse gas emissions. What goes in is not some calibrated structural model, but essentially parameters representing the average of what you find in the literature about the cost of reducing methane, CO2, nitrous oxide, and so on.

Arvid Viaene: Maybe I misunderstood, but when you said you wish you had realized this earlier, would that have shaped the model in a different way—as a kind of meta-analysis?

Richard Tol: When I first did this, I didn’t even know meta-analysis existed. It was just what I did. And the literature was so small that there was no need to formalize the process. But as the literature grows, there are more and more studies, and it becomes harder to explain all the choices you make in summarizing the literature.

One of the things I’m currently working on is formalizing that whole process—from the data you find in academic papers to the parameters you find in the integrated assessment model. It’s a statistical problem.

Social cost of carbon meta-analysis and a fast-growing literature

Arvid Viaene: Exactly, because there’s the question of which parameters you use to inform a model. And then you also have a database for the meta-analysis of the social cost of carbon. You have a database including 528 papers on integrated assessment models, which isn’t that many, but a lot of them were published recently. I think almost 10% were published in the last year. Is that because it has become easier? When you started, there weren’t that many studies to pull from, and not that many models. How have you seen the evolution?

Richard Tol: The literature on the social cost of carbon is now very large and growing very rapidly. One of the things I think is wrong in policy advice is relying on a single estimate, because there are so many degrees of freedom and so many things reasonable people can reasonably disagree on. It’s much better to have a panel of experts. But lacking that, one alternative is simply to summarize the literature.

That’s interesting in all sorts of ways. You can detect trends, blind spots, and people parroting each other. All of that is going on in this literature.

When I did my first meta-analysis of the social cost of carbon, it was still a relatively thin literature. At that point, I decided to include all published estimates, or all estimates that seemed to have had some influence on policy. The reason was, first, to increase the sample size so that more interesting statistical analysis could be done.

But second, meta-analysis is well established for data, while a meta-analysis of model outcomes is something quite different. These are not observations sampled from a population; they are outputs of models. Doing statistics on them requires different approaches.

And the main purpose of publishing an estimate of the social cost of carbon is to say: this is what the tax on greenhouse gas emissions should be. So, at that stage, I decided to include republished estimates as well.

If people published a slight variant of the DICE model with a slightly different number, I counted that too. This allowed me to say: well, this is the most prominent model, the most prominent advice. It’s not just Nordhaus saying this—it’s Nordhaus saying the same thing over and over again, and other people picking up his model, making a few tweaks, and publishing essentially the same result. That increases the weight of the policy advice, because it measures pedigree, essentially.

I made that decision back then, and it is now coming back to bite me, because many recent publications simply pick up work by the U.S. EPA, or RFF, or Nordhaus, and say, “I’m going to use this as the best estimate of the social cost of carbon.” That is where much of the growth in the literature is coming from—not necessarily original or independent estimates, but people endorsing previous ones.

Arvid Viaene: Yeah, exactly. It’s like derivations.

Richard Tol: Including a lot of people who miscite previous studies, which is quite intriguing. They say, “I’m going to use Reynolds’s number,” and then use something different.

Arvid Viaene: Yeah, go ahead. Because in that sense, if a lot of people reuse the EPA or RFF or DICE model with some tweaks, then it’s reasonable that you get similar results.

Outro: That was Part 1 of my conversation with Richard Tol. Next week, in Part 2, we move from the structure of FUND to its role in policy — including the social cost of carbon, the Obama-era EPA, and why misunderstood models can be dangerous.

Arvid Viaene: Hi, welcome to another episode of the Climate Economics Podcast with me, your host, Arvid Viaene. Sometimes I come across a paper and I’m really intrigued by its results. Today’s paper is one of those: “Willingness to Pay for Carbon Mitigation: Field Evidence from the Market for Carbon Offsets.”

On this podcast, we’ve already tackled carbon offsets in two other episodes—Episode 4 with Ben Probst, and Episode 17 with Beatriz Granziera. But those were more on the supply side. This paper looks at the demand side: how much people are willing to pay for carbon mitigation.

And importantly, not just what people say they are willing to pay, but what they are actually willing to pay. We’ll also discuss what influences willingness to pay and the field experiment behind these results.

To discuss the paper, I’m delighted to have the author with me: Matthias Rodemeier, Assistant Professor of Finance at Bocconi University. His research sits at the intersection of behavioral economics and public finance, bringing behavioral insights to environmental policy, taxation, and household finance. Many of his studies use field experiments with private and public organizations.

Matthias, welcome to the podcast.

Matthias Rodemeier: Thanks a lot. Thanks for having me.

Arvid Viaene: I was very intrigued when I saw your paper. To start: what’s the number one thing you’d want people to take away from it?

Matthias Rodemeier: The paper studies the market for voluntary carbon mitigation using a field experiment with a large online supermarket in Germany. The supermarket gave consumers the option to compensate the emissions of their delivery. We randomized different features of that option.

What we find is intuitive in one respect: when the offset becomes cheaper for consumers, they buy more—meaning they’re more likely to buy the offset. But when it becomes more impactful—when it mitigates more emissions—nothing happens to demand. People are fully impact-inelastic: they don’t respond to the impact at all. We then explore why this happens and how it can be mitigated.

A final key takeaway is that firm participation matters a lot. If the firm tells consumers it will share part of the cost, people become more willing to buy offsets—and they also become more impact elastic. They start responding to how much emissions the offset actually compensates.

Field Experiment in a German Online Supermarket

How the carbon offset option worked at checkout

Arvid Viaene: Let’s dig into the “price elasticity versus impact inelasticity” result. As I understand it: when prices go down, people buy more offsets—but if you keep price constant and the offset reduces more CO₂, nothing happens. Is that right?

Matthias Rodemeier: Yes. Concretely, this was an online shop where, at checkout, we introduced a box you could click that said: “I would like to mitigate the emissions of a typical delivery.”

That could be, say, two kilograms of CO₂—that’s the “impact” attribute. The other attribute is what it costs—maybe €0.20, €0.40, €0.60, or €1.00.

We randomized both attributes: the price and the impact. Impact could be 2 kg, 4 kg, or 8 kg of CO₂, for example. What we see is that varying impact does absolutely nothing to demand. People buy just as much whether the offset compensates 8 kg or 2 kg.

That’s striking. A market analogy would be: if I sell you one Snickers bar or four Snickers bars for the same price, you’d normally care. Here, people either struggle to understand what they’re buying—or they don’t care.

Key Result: Price Elastic, Impact Inelastic

Warm glow vs valuing real mitigation

Arvid Viaene: That suggests people buy offsets for reasons other than mitigation.

Matthias Rodemeier: The classic interpretation—often discussed as “scope insensitivity”—goes back to early work by Kahneman and Knetsch, and also relates to Andreoni’s, “warm glow” idea.

Warm glow means: people do something good to feel good, but they don’t really care how good it is or how much impact it has. They’re still price elastic—if doing good becomes cheaper, they do more. But if doing good becomes more impactful, they don’t respond. They just want the warm feeling.

Arvid Viaene: So they buy more because they can get more of the warm feeling when it’s cheaper, but the impact itself doesn’t matter.

Matthias Rodemeier: That’s the classic warm glow interpretation, yes. And then we test whether it’s really warm glow—or whether people just don’t understand the impact dimension.

Learning Effects: People Start Valuing Impact Over Time

Arvid Viaene: You tried to separate intrinsic valuation from warm glow, right?

Matthias Rodemeier: Yes. A key feature is that we didn’t only randomize impact between people; we also randomized it within the same person over time. The same customer might visit the website multiple times, and across visits they see different impact levels. That allows learning, because “2 kg of CO₂” versus “4 kg” is not intuitive for most people. People don’t naturally know what those magnitudes mean.

But if today you see 4 kg and yesterday you saw 2 kg, you can at least infer: “This is twice as much as before.” If demand starts responding over time, that suggests people weren’t purely warm-glow-driven—they were also struggling to evaluate the product. And that’s what we see: with experience, people start becoming more responsive to impact.

How Much Do People Actually Pay per Ton of CO₂?

Arvid Viaene: You transform the experiment’s units into the standard “euros per ton of CO₂.” What magnitudes do you find?

Matthias Rodemeier: If you only look across people (ignoring learning), you’d conclude willingness to pay for the mitigated carbon is basically zero—people buy offsets, but not because of mitigation.

But once you allow for learning through repeated exposure, people start being more likely to purchase when the offset has higher impact. Then we estimate willingness to pay of about €13–€16 per ton of CO₂.

That’s still far below common estimates of the social cost of carbon, and below many policy carbon prices. So even after learning, voluntary markets do not come close to fully internalizing the climate externality.But it quantifies how far away this private market is from the social cost of carbon.

Arvid Viaene: For reference, the EU ETS is much higher than that. And some social cost estimates go far higher too.

So if I understand correctly: at first, people might mostly be buying for warm glow, but over time they learn what the impact means—and then they start buying partly for actual reductions.

Matthias Rodemeier: They may still buy for warm glow—the warm glow doesn’t necessarily disappear. But as they learn the magnitudes, they start valuing impact as well. They begin to choose offsets that have higher mitigation impact.

Arvid Viaene: Did you also estimate warm glow in comparable units?

Matthias Rodemeier: Yes. If you decompose it: the intrinsic willingness to pay is about €13 per ton of CO₂. Warm glow is about €1. And if the firm chips in, that adds about €2 more. That’s how you get up to around €16 per ton in our highest estimates.

Firm Participation Changes Demand and Impact Sensitivity

Subsidies vs matching contributions

Arvid Viaene: Let’s talk about the role of firms. You looked at both subsidies and matching, right?

Matthias Rodemeier: Exactly. We randomized whether the firm told consumers it would pay a share of the offset cost. A subsidy looks like: “This offset normally costs 40 cents, but we as the firm will chip in 50%, so you only pay 20 cents.” Alternatively, the firm could do a match: not making it cheaper, but increasing the amount of carbon mitigated. For example: “If you offset 2 kg, we’ll offset another 2 kg at our expense.”

We compare these in terms of cost-effectiveness. If you’re a firm deciding where to spend your next euro—on a subsidy or on a match—you want to go for the match. Offsets are price elastic, but not extremely so. With a subsidy, additional mitigation mostly comes from marginal consumers who buy only because the price dropped.

With a match, everyone’s purchase becomes more effective—including the people who would have bought anyway. That makes matching much more cost-effective than subsidizing the price.

Arvid Viaene: So the match is better because the subsidy doesn’t bring in that many new buyers, whereas the match increases mitigation across the board.

Matthias Rodemeier: Exactly.

Surveys vs Real Choices: The Hypothetical Bias Gap

Arvid Viaene: Another part of the paper is that you also surveyed people about what they were willing to pay.

Matthias Rodemeier: Yes. There’s a huge literature in environmental economics estimating willingness to pay through surveys—contingent valuation. Historically, economists used surveys because there was no way to incentivize these choices—no real market. The market for carbon offsets gives us an opportunity to observe real behavior and estimate willingness to pay from revealed preferences.

But we also wanted to know: if we had done it the “old school” way—asking people in a survey—would we get the same results? So after the field experiment, we invited some consumers to a survey and asked them, hypothetically, what they would be willing to pay for the same offset product.

The numbers were more than an order of magnitude larger. Survey respondents were willing to pay over €200 per ton of CO₂ on average, compared to about €13 per ton revealed by choices. That’s exactly why field experiments matter: what people do can differ enormously from what they say.

Arvid Viaene: Do you have a sense of why the gap is so large?

Matthias Rodemeier: We designed the survey carefully to be apples-to-apples: we asked about the same offset product, not about policy instruments like carbon taxes. Even then, the gap remains.

This is consistent with a big literature on hypothetical bias—including work by John List. People tend to overstate generosity in surveys. There’s also social desirability bias: people want to look good when answering. And even without intentional misrepresentation, it’s hard to predict what you would do in a real market context. “Talk is cheap,” as economists like to say.

How the Experiment Got Started

Arvid Viaene: How did you go about setting up this experiment? You reached 250,000 consumers with one of the largest online supermarkets—so how did you get it off the ground?

Matthias Rodemeier: I’ve been running field experiments with firms for quite a long time—I started doing this at the outset of my PhD.

One thing that surprised me early on was how long these projects can take. Sometimes it’s years from the first contact with a firm until you actually run the experiment. In this case, it was much more efficient. The company was very open to testing these kinds of strategies.

Part of the reason is that they’re in a booming industry right now—home delivery. Whether it’s Amazon, grocery delivery, fast food delivery—everything comes to your door now. And of course, that produces emissions that consumers might worry about, especially in European cities where the alternative is often to walk to the supermarket or take a bike.

So it was somewhat natural for this firm to think about carbon offsetting and other mitigation strategies. The way we started was actually pretty simple: I kept seeing their trucks driving around everywhere in my city.

At some point I picked up the phone, tried to figure out who the CEO was, and talked to him about why they weren’t offering carbon offsets—and whether this could be something we could do together. And they were very excited.

Arvid Viaene: Awesome. That’s the entrepreneurial mindset you need for field experiments—someone has to get it moving. And as I read it, you did the experiment in 2020, and it’s only now published—so congratulations.

Matthias Rodemeier: Yeah—these things take a lot of time.

Arvid Viaene: It takes a long time. From the experiment to publication, five years.

Matthias Rodemeier: Yeah. Welcome to academia.

What comes next in research

Arvid Viaene: Have you done further work in this field? Are there new working papers or projects building on this?

Matthias Rodemeier: I’ve been talking with various firms to study the market for carbon offsets further. I’m also partnering with a firm that installs cookstoves in Tanzania and tracks emissions through digital trackers. We’re about to run field experiments there as well. I’m also talking with companies that offer offsetting for events they organize. This has become something I’m really interested in.

It takes time—there’s always a lag. But I’ve been encouraged. Since the paper came out, a lot of people have talked to me about related ideas. A lot of PhD students I’ve met are working on carbon offsetting now—trying to understand what drives willingness to pay for carbon mitigation. It’s a growing field, especially at the intersection of behavioral and environmental economics, and I’m getting excited about it.

And we’re going to do much more on this—but you’ll probably have to wait another five years for it to get published.

What the results imply for climate policy

Arvid Viaene: In the paper, you write that the €13 intrinsic value suggests voluntary climate protection initiatives may internalize only a small fraction of climate externalities, which has implications for environmental policy. What’s your takeaway there?

Matthias Rodemeier: I think there are two issues. One we pay a lot of attention to in the paper is trust. We don’t know ex ante how much people trust these offsets. One reason we observe willingness to pay that isn’t terribly high is that people have a lot of distrust in this market.

And a lot of distrust is justified because it’s a market with a lot of adverse selection. We took a long time choosing an offset that was a high-quality one, but people may still distrust the market. And we have some evidence in the paper that this is part of the story.

Now, regarding the €13 estimate: I think it tells us that given the current market environment—which may include distrust and adverse selection—this is what the private market can currently do in terms of mitigating the externality from consumption.

And I think it tells us that this market can really only be a complement in a world with imperfect environmental policy. But it can certainly not be a substitute. We cannot think of this market as something that can replace important regulation. We need environmental regulation—cap-and-trade or carbon pricing—to get to what economists call the first best: internalizing the externalities from emissions.

Quantifying willingness to pay in this market is informative because it quantifies the gap between what we think the social cost of carbon is and what people voluntarily are willing to pay.

Arvid Viaene: That makes sense. Complement, not substitute—and the gap is informative.

Matthias Rodemeier: One thing I should add is that the way we estimate willingness to pay actually takes care of much of the distrust. Broadly speaking, we look at how demand responds to price chxanges and to impact changes, and we use that relationship to estimate willingness to pay. To some extent, distrust “washes out” in those estimates. We show that more formally in the paper—there’s a long appendix on that if anyone feels unconvinced.

Arvid Viaene: That’s good.

Matthias Rodemeier: We say only referee two reads the appendix.

Arvid Viaene: Yeah, exactly.

Market integrity and greenwashing risk

Arvid Viaene: Is there anything we haven’t talked about that you’d like to highlight?

Matthias Rodemeier: I think we covered the important parts. Maybe one thing I should really highlight is that this market is growing rapidly and becoming more important. The finding that—without additional learning and help—consumers seem to be fully unresponsive to how impactful these carbon offsets are is quite concerning. Because not only do we have adverse selection on the supply side, as you discussed in other podcast episodes, but we also find that on the demand side, consumers have a hard time telling apart a low-impact offset from a high-impact one. That’s concerning because it suggests even more incentives for firms to greenwash: to offer something that looks good, but doesn’t really have much impact. So I think we need to think hard about solutions that help consumers make better decisions.

Closing

Arvid Viaene: Awesome. Thank you so much, Matthias, for taking the time. I really appreciate it.

Matthias Rodemeier: Thanks for having me.

Transcript

Arvid Viaene: Hi and welcome back to Climate Economics. I’m Arvid Viaene.

In the last episode, we talked about the EU’s Carbon Border Adjustment Mechanism. In particular, we discussed the following big-picture question: what are the global impacts of the Carbon Border adjustment Mechanism—who gains, who loses, and what it means for consumers and firms.
We discussed both theory and estimates. And I recommend checking out that episode if you want a good overview of the global effects.

Now, I think overall that this border adjument mechanism is a really good one. But here’s the reality: a good idea on paper can still fail in practice—or at least create a lot of friction—if implementation is messy. And with CBAM, implementation is definitely challenging.

Because CBAM is trying to do something incredibly ambitious: it is trying to copy the logic of the EU ETS beyond Europe.
Because the EU ETS prices emissions at the level of an installation—a plant. And to do that, it has developed a system where monitoring and verification have been built up over years. However, CBAM is different. For CBAM, the EU has to price emissions in a product coming into the EU. And that product may pass through multiple tiers of suppliers and in multiple countries. So that shift—from plant-level pricing to product-level accounting—sounds subtle, but it changes everything.

It raises practical questions like: what counts as “embedded emissions” for a specific shipment? And how can monitoring and verification work? In addition, and in the situation where companies don’t have this data, they have to resort to default values set by the EU. But how are those set and how high are they? And what kinds of uncertainty does this create for firms trying to plan, budget, and stay compliant?

Those are the questions we will tackle in this episode. By the end, you’ll have a clear mental model for default values versus reported emissions, a sense of the difficulties of reporting and verification, and a practical map of the upcoming milestones and remaining open questions that matter most for companies.

And to unpack all of this, I’m joined by Pauline Miquel, a policy expert working directly on CBAM implementation.

Pauline’s work focuses on monitoring regulatory evolutions across jurisdictions, external affairs, and public-facing content creation. She holds a dual master’s in environmental economics and climate change from PKU and LSE, with research focused on CBAM implications for the steel industry. Previously, she worked as a corporate sustainability project manager in steel supply chains. Pauline, welcome to the podcast.

Pauline Miquel: Thank you. Thanks for having me.

Expected costs of CBAM likely are much higher for importers

Arvid Viaene: I generally ask guests this first: what is the number one thing you want people to take away about CBAM and what’s happening right now?

Pauline Miquel: In the context of CBAM right now—at the end of 2025—we’ve seen lots of changes in terms of how the policy will actually look when it goes live in 2026, especially around the magnitude of the cost for different products.

One key thing people should know is that we expected costs to be much lower than what has finally been decided by the Commission, in a very last-minute move in mid-December. For most importers—if they rely on what we call “default values” (and I’m sure we’ll get into the details)—CBAM charges will be much higher than they expected until now.

Arvid Viaene: Can you speak more about that? What happened that it’s suddenly more expensive than expected? They changed those values?

Pauline Miquel: The short answer is: they never published those values until the 17th of December. And yes—that’s the kind of reaction we get when we say this, but it’s true. There was a lot of information leaked throughout the process of determining those values, so we had hints about what they might look like. But ultimately, we only knew the exact values last week—from the 17th of December.

How CBAM works in practice: coverage, supply chains, data, and default values

Arvid Viaene: We’ll come back to that, but first: which industries are covered by CBAM?

Pauline Miquel: There are six industries covered initially. These are the most emissions-intensive sectors in the ETS, and also the sectors the Commission thinks are most exposed to carbon leakage.

The industries are: cement, steel, aluminum, hydrogen, electricity, and fertilizers.

Within those industries, you have a list of customs codes—what we call CN codes—that are covered. So it’s very specific in terms of which products are covered.

It’s also worth specifying that it’s supposed to cover mostly raw materials—say, a ton of raw steel. But it also goes down to some more finished or semi-finished goods. You have things like screws, fasteners, nuts, and bolts that are already covered by CBAM.

So it’s starting to go into some downstream products already.

Arvid Viaene: The big challenge, as I see it, is that it took a long while to get the EU ETS set up and running. In my conversation with Jos Delbeke, he said there was a long period where they tried to get the statistics. But we don’t have those statistics for foreign firms.Ideally, firms use their own values, but then there are “default values.” Can you explain how this will work for producers?

Pauline Miquel: The policy was designed with a transitional period from 2023 to 2025—which we’re reaching the end of now—where importers could declare emissions values quarterly without facing the financial charge CBAM introduces. It was meant to be a trial phase.

Internally, we think this transitional phase was almost wasted, because no real enforcement happened. Not the financial charges of CBAM, but even the penalties that were supposed to be imposed on importers misdeclaring emissions—those weren’t applied.

So the data collection hasn’t necessarily been very good. And the core principle behind CBAM is that importers collect a lot of information from their supply chains—several tiers, up to the raw material producers. That’s very difficult for companies that weren’t used to doing this before, especially importers who were not facing the ETS at all—which is most CBAM declarants.

There’s been a huge need for education, and that’s part of what my company has been doing for the past two years.

But whether values were correct—we have no idea, because nothing has been verified or enforced properly. A lot of companies might not have declared anything. We don’t really know. The Commission knows, but there’s very little published information. There is a report that was published recently showing some numbers, but it’s still broad.

Now, another issue with the transitional phase is that the default values—the emissions data, the emission factors—were all for the transitional phase only.

Arvid Viaene: When you say “default values,” that’s like: if a company doesn’t use its own values, it defaults back to some number the Commission proposed, right?

Pauline Miquel: Exactly. There was a list of values used in the transitional period—but it was always going to be the list for the transitional phase.

In the definitive period of CBAM, which starts next week, there is a new list of values—the final list. And again, we only saw it last week.

The default values essentially determine cost for importers, because we’re multiplying embedded emissions by the price of carbon. The formula is more complex, but as a simplified explanation, that’s the idea.

Arvid Viaene: Right—say you get two tons of CO₂ per ton of steel, and an ETS price of €60 per ton. Multiply them, and it’s €120 per ton of steel.

Pauline Miquel: That’s a very simplified explanation, but it’s the broad idea. We’re basically imposing the EU carbon price onto imports. But we first need to know what the emissions are in the imported product. In the EU ETS, we price carbon based on emissions of an installation—a plant or factory. With imports, we’re talking about a product. That’s a major difference between ETS and CBAM. We’re trying to replicate what is done with ETS onto manufactured goods—which involves far more information from different tiers in the supply chain.

Why default values are punitive (and why that matters)

Arvid Viaene: I’ve read that the Commission’s default values are based on the most polluting firms, to create an incentive for importing firms to declare actual emissions. Is that right?

Pauline Miquel: Yes. One defining principle is to encourage supply-chain data collection—to map emissions intensity globally—and reward best-in-class producers. That’s also what makes it a climate policy and not a trade policy. The Commission portrays CBAM as a climate tool, not a trade barrier—and in the global geopolitical context, that matters.

So there’s a list of default values—emission factors—that say, for example, “one ton of steel produced in China emits X tons of carbon.” It’s done at the country level and per product, tied to CN codes.

Those default values apply if there is no actual data being collected from the supply chain. To maintain the incentive, the Commission had to come up with values that represent a worst-case scenario. Technically on paper, they’re supposed to reflect a country average, and then there is a markup—a punitive element—added on top.

Arvid Viaene: So is it based on China’s average, or the worst producers in Europe?

Pauline Miquel: It’s per country, so it should be the average in China—but that’s the part we’re somewhat unsure about. Did they use worst producers in China? An average? Or did they just listen to EU industry lobbying for a high value? Technically, it’s supposed to be a country average, and then in order to make it punitive, a markup is added to ensure it’s higher than what you’d get if you collect actual data.

Arvid Viaene: And is the cost increase you mentioned earlier because the final default values are higher than the transition values?

Pauline Miquel: Absolutely. In the transitional period, the values were not country-level. They were an average emissions intensity for production outside the EU, per product. That was much easier to work with. But it wasn’t really reflective of the world’s diversity in production routes and emissions performance. So transitional CBAM was a simplified version.

Can countries contest the default values?

Arvid Viaene: Can countries or industries contest those default values?

Pauline Miquel: There is no formal channel for the Commission to get feedback from other countries. The Commission is working with trading partners to fine-tune the policy, but those values are supposedly final for 2026—they won’t change for the first year.

They will be reviewed in 2027. That’s something we learned recently—because there is uncertainty about the values. The values were kind of rushed. I assume feedback from industry, countries, and others will be taken into account, but what that means in practice is hard to say.

Arvid Viaene: And the big change is: transitional phase was one average per product, and now it’s per product per country—so big differences.

Pauline Miquel: Exactly. And in 2026, the punitive markup is 10% the first year. It goes up to 20% in 2027, and from 2028 onwards it will be 30%.

Arvid Viaene: That could have a huge impact.

Pauline Miquel: It does. For example, steel from Indonesia—in the 2026 list—is quantified at nine tons of CO₂ per ton of steel. It’s extremely high.

Arvid Viaene: So you would add 30% on top of that. And what’s the average in Europe?

Pauline Miquel: About 1.5 to 2.

Arvid Viaene: Yes, that is a big difference

Verification: the “ETS logic,” but globally

Arvid Viaene: CBAM is trying to incentivize firms to use actual emissions. What determines whether reported numbers are acceptable?

Pauline Miquel: In the transitional phase, there was no real threshold—it wasn’t monitored. It was about the exercise of getting information into quarterly reports, and helping the Commission identify hotspots and administrative burden.

In the definitive period, a verification mechanism is introduced. Reported values need to be verified by a third-party auditor—similar to the ETS. In the ETS, installations in Europe are audited so their numbers can determine how many permits they need. With CBAM, the EU wants CBAM to mirror the ETS: a replica of the ETS on trade. But in practice it’s a whole different level of complexity: you’re sending auditors around the world, auditing emissions in many countries with different contexts and political structures. And for one imported good—especially in steel, where supply chains are fragmented—you might need auditing for multiple installations from raw material to manufactured product.

Arvid Viaene: That sounds like a gigantic undertaking. Because there are only so many resources and know-how available. Because with Jos Delbeke, we did not even talk abouth the verification part.

Pauline Miquel: Yes. These are the details that people were probably amazed by, if not completely shocked by, at the beginning of EU ETS. But now people take just take it as given.

A major uncertainty: costs, timing, and the “omnibus” simplifications

Arvid Viaene: What additional sources of uncertainty are there for importers?

Pauline Miquel: The verification process is very theoretical right now. There’s huge uncertainty in how it will work in practice. Verification is required before values can be used to determine how many CBAM certificates are needed—so, how much CBAM costs.

But in the first year there’s a particular regime. Emissions from 2026 determine cost—but you need the full year of carbon accounting before a verifier can certify the values. That makes it very challenging for importers to predict their CBAM liability.

Even the best-prepared importers—who engaged suppliers for two years—still can’t be sure their numbers are correct. Suppliers may overlook parts of carbon intensity. And because transitional values weren’t enforced, it’s hard to rely on those data to predict the future.

If you decide, “To be safe, we’ll rely on default values in 2026,” then the cost becomes huge for most importers—especially because a lot of affected volumes are imported from Asia, with higher carbon intensity (particularly steel and aluminum).

Another complication: the financial cost of CBAM has been postponed to 2027 through the simplification reform—often referred to as the omnibus—introduced in February and formally adopted in October 2025.

The main CBAM simplification is that the threshold was changed from €150 worth of goods to 50 tons of annual imports as the minimum threshold for CBAM to apply.

Another, more subtle change is that the Commission decided to start the sale of CBAM certificates—so the actual financial liability—in 2027. Importers can only start purchasing CBAM certificates from February 2027. So the year 2026 is almost like walking in the dark: there is an invisible liability. Also, reporting used to be quarterly; it will now be annual. The 2026 emissions report is due in September 2027.

Arvid Viaene: That’s a lot of uncertainty—prediction, readjusting, and updating.

Pauline Miquel: Exactly.

What CBAMBOO does (and why companies are struggling)

Arvid Viaene: I looked at your site. Could you share what CBAMBOO does to support companies through this uncertainty?

Pauline Miquel: The company was set up in 2023 by the two co-founders, Gabriel Rosenberg and Daniel Sharpe. The idea was to build digital tools to manage this new trade problem from an importer’s perspective—by building a database of emissions information from suppliers worldwide, linked to European importing companies.

CBAM is largely about data sharing. CBAMBOO built software that helps importers collect information from suppliers by onboarding suppliers onto a platform where they can create a profile with emissions intensity for different products. There’s a network effect: that information can be shared with other European customers who need it.

Originally, it was a software alternative to the Commission’s proposed system—a bunch of spreadsheets. The Excel template was changing every month, and it was meant to be emailed back and forth across many companies, then uploaded into the EU registry. The founders thought: this system will break. We need a more rigorous IT infrastructure.

Now the company has evolved into a companion for any importer taking CBAM seriously: the software supports information flow, but we also support importers in tracking changes and understanding where things are going.

A lot of businesses in Europe are left behind. They don’t understand how much they’ll have to pay, where to get emissions data, how to engage suppliers, or how to educate suppliers. Sometimes we step in and talk to suppliers directly to explain what information they need to provide—because the Commission created a unique methodology instead of using an ISO standard.

We’ve also tried to educate companies to treat CBAM as a business process, not just a reporting mandate. During the transitional period, some companies treated it like a sustainability reporting obligation: report and you’re done.

But CBAM reporting was meant to prepare companies for the fact that the information they collect determines their bill. They will need to buy tradable certificates. So they got used to reporting it, but not realizing it will be used for the financial payments. So it becomes a whole new business practice—like ETS.

And we go further: how do you price this for your own customers? How do you pass costs downstream? How do you reflect it in supplier contracts? How do you involve finance teams? How do you train procurement?

Arvid Viaene: Because procurement decisions used to be quality and price. Now you have to integrate carbon intensity too.

Pauline Miquel: Exactly. Different supplier profiles emerge. To compare suppliers—even within the same country—you need emissions information integrated into your business processes and systems, like your ERP.

Are suppliers outside the EU preparing?

Arvid Viaene: Are you seeing suppliers abroad get ready to provide this information?

Pauline Miquel: Yes. The largest companies, especially those dependent on the European market, are trying to get ready. It’s been challenging for suppliers abroad too—they’re not simply trying to get around the system as you sometimes hear in the EU. Many are trying to understand how to turn this into an advantage.

But it’s not obvious how to calculate emissions, and suppliers don’t necessarily have easy access to Commission information. If EU importers are lost, imagine suppliers in China.

Still, especially among companies we work with, many are trying to get this right. In China, firms are trying to turn it into an opportunity—setting up emissions monitoring systems. They’re starting to understand that carbon is becoming a new competitive advantage.

And in that sense, from a policy perspective, CBAM has good prospects. I think it can have a very positive impact—but it will take time to implement properly, like the ETS. It’s just a next level of complexity.

One more technical point: the benchmark (and why it matters)

Arvid Viaene: Is there anything else we haven’t discussed that you want to mention?

Pauline Miquel: One critical aspect is the formula. It’s not as straightforward as “emissions times carbon price.” There are about five variables, including a key one: the benchmark.

The benchmark is supposed to reflect the level of free allocations that EU producers of the same good still benefit from under the ETS. If CBAM priced carbon at the border in full, without reflecting free allocations in the EU, then it wouldn’t be fair. So CBAM takes that into account. The benchmark is something deducted from embedded emissions, set at a level supposedly reflecting best performance in the EU.This is important because it determines the cost too. Lower benchmarks mean higher costs—it’s an inverse relationship. And similarly to the default values, we received these benchmarks only last week.

Arvid Viaene: That seems to be a theme. I actually lost track of the updates. All of these have come in the past for

Pauline Miquel: Yes—for 2026. And then in 2027, it’s back on the table.

Closing Remarks

Arvid Viaene: How do you keep track of all of this?

Pauline Miquel: It’s hard. The EU policymaking process is transparent on paper, but there’s a lot behind the scenes. It helps to connect with people who understand lobbying dynamics and the policymaking process in Brussels—and to track changes across websites constantly.

Arvid Viaene: Pauline, thanks so much for taking the time. This conversation really shows how much uncertainty is involved, and how much practical detail matters. Thanks again.

Pauline Miquel: Of course. Thank you so much for having me.

Arvid Viaene: Thank you.

That is why I was excited to discuss Kimberly’s paper “The Global Effects of CBAM”, which aims to quantify the costs and benefits of CBAM, both for the EU and globally, as well as for consumers and producers.

I think this article is a great gateway into understanding the big-picture mechanisms and effects of CBAM.

Transcript

Arvid Viaene: So, welcome to another episode of Climate Economics with your host Arvid Viaene. Climate change has an inherent free rider problem because individual countries bear the costs of their domestic carbon regulation, while the benefits of reducing CO2 are shared globally.

To solve the free rider problem, the European Union has introduced a carbon border adjustment mechanism, which came into effect this year. With this mechanism, the EU wants to address this free rider problem.

The idea is that you impose a carbon tax on importing firms similar to those on the domestic firms. As a result, you can improve domestic competitiveness, reduce emission leakage, and encourage other countries to tax carbon.

Now, those are great goals in principle, but what are the estimated effects in practice? That is the topic of today’s discussion, based on a paper called The Global Effects of Carbon Border Adjustment Mechanisms.

I think it’s an amazing paper which tackles all of these topics. In addition, this paper also analyzes the worry expressed by the European Union that CBAM could have a larger impact on lower-income countries.

Arvid Viaene: To discuss this paper, I’m delighted to have one of its authors with me today, namely Kim Clausing. Kim is the Eric M. Zolt Chair in Tax Law and Policy at UCLA School of Law, and a non-resident senior fellow at the Peterson Institute for International Economics, as well as a research associate at the National Bureau of Economic Research.

During the early Biden administration, she served as Deputy Assistant Secretary for Tax Analysis at the United States Department of the Treasury, acting as the lead economist in the Office of Tax Policy.

Arvid Viaene: Her work focuses on how government policy and corporate behavior interact in the global economy, with publications on taxation, international trade, and climate policy. So Kim, welcome to the podcast.

Kim Clausing: Thanks so much for having me.

What CBAM is and why it matters

Arvid Viaene: CBAM is one of the most exciting developments taking place right now in climate economics. I gave a brief introduction already, but would you mind explaining what the carbon border adjustment mechanism is and why you decided to study it?

Kim Clausing: Absolutely. I agree with you that it’s one of the most exciting things happening in climate policy. What’s really great about the CBAM is it provides an answer to the free rider problem, as you described it, because it makes it easier for countries to adopt ambitious climate policies, and it also makes it easier to facilitate climate action abroad.

Let me explain how it works. Imagine you’re in Europe and there’s an emissions trading system. Because you are phasing out the free allowances, your firms are now facing more and more costs associated with their carbon emissions.

That puts your firms at a disadvantage relative to firms in other countries. You’d worry that consumers might substitute goods that are dirtier than the domestically produced goods. What a carbon border adjustment mechanism does is simply negate that self-imposed competitiveness disadvantage. So it’s not protectionist; it’s more re-leveling the playing field after you’ve harmed your own producers by making them internalize this carbon cost.

A nice feature of the EU carbon border adjustment mechanism is it also provides a credit if other countries have imposed carbon prices of their own. So imagine Indonesia has a carbon price equivalent of 20 euro and the European Union has a carbon price equivalent of 80 euro. Then the difference of 60 euro would be the border adjustment mechanism, but they’d get credit for having a carbon price of their own.

Kim Clausing: This policy can handle three important goals:

1. addressing the leakage problem of people substituting for dirtier sources of production—or even moving production to lightly regulated jurisdictions;

2. facilitating carbon price adoption at home, because it has an answer to that competitiveness problem; and

3. facilitating carbon price adoption abroad, because countries can convert foreign tariff revenue into domestic revenue and achieve some of their own climate policy goals.

Source: https://asuene.com/us/blog/cbam-the-eus-carbon-border-adjustment-mechanism-and-its-latest-developments

Stylized fact I: Carbon pricing and competitiveness

Arvid Viaene: Thank you. Maybe we can start with some of the stylized facts you have in your paper, because I read some of those and I was surprised by some of your results. They provide a nice framework to talk about your results.

Arvid Viaene: The first stylized fact, or question, is: how does carbon pricing affect competitiveness? Could you talk about that?

Kim Clausing: Yes. Carbon pricing raises costs for your domestic firms. That’s going to harm their competitiveness absent some sort of carbon border adjustment mechanism. What the carbon border adjustment mechanism does is subject foreign producers to your carbon price should they be serving your market. It doesn’t really address the export problem, and that’s part of why it’s important to also incentivize action abroad.

Let’s say you’re a German firm and you’re subject to the European price. You can rest assured that in Europe, foreign firms will be subject to that too. But that doesn’t mean you’ll be on a level playing field when you’re both trying to serve a third market abroad.

So it’s also important to think about how to facilitate more and more carbon price adoption throughout the world if you want to handle the worldwide competitiveness problem. But at least the carbon border adjustment mechanism can solve the domestic competitiveness problem.

Arvid Viaene: Exactly. It’s like leveling the playing field domestically, but internationally it will remain different.

Kim Clausing: Exactly.

Source: https://www.fertilizerseurope.com/fitfor55-ets-cbam/

Surprising Results on emissions intensity and lower-income countries

Arvid Viaene: One thing I was surprised by is you look at how carbon pricing affects producers in lower-income countries. The story you often hear is that there might be emission leakage and companies might move abroad where environmental regulations are less stringent, so emissions would go up. You look at emissions intensity for those countries. Could you talk about that?

Kim Clausing: Yes, absolutely. We were somewhat surprised by this finding that there wasn’t a correlation between income per capita in countries and their emissions intensity.

I think a lot of people going into this thought, “It’s probably the case that poorer countries have dirtier production, and so this would disproportionately harm them.”

Kim Clausing: Many early observers also made the mistake of not thinking through the true incidence of the carbon border adjustment mechanism. It’s not so much that it’s harming poor countries if they’re sending goods to Europe, because the European price will be higher because of carbon pricing—and the border adjustment mechanism is just undoing an advantage that they would otherwise be handing to the rest of the world.

Kim Clausing: There are two misconceptions here. One is the incidence question of who’s really bearing the burden of this policy. The second is which firms will win and lose under this scenario.

Kim Clausing: Europe’s going to have a higher price for goods like aluminum and steel. So selling to Europe comes with a premium. Those firms that are particularly green will, on net, benefit because they’ll get a higher price, but their carbon fee won’t be enough to offset the benefits of that high price.

Arvid Viaene: All right.

Kim Clausing: Whereas the dirty firms may find that this is bad for them because they’re so carbon intensive that, if they did serve Europe, they would have to face a high fee. They might end up reallocating their exports to other markets that aren’t regulated, but then the prices in those markets will be driven down by the increase in supply. So you get this tale of two types of firms where the clean ones may actually benefit and the dirty ones are harmed. It becomes really important which firms are clean and which are dirty.

One thing we find, using detailed plant-level data on every aluminum smelter in the world and most steel plants in the world, is that there isn’t a tight correlation between GDP per capita and emissions intensity.This is true even if you control for variables you might think matter, like scale, foreign ownership, and the like. That was surprising to us. But it’s an encouraging message for the EU because they can implement this policy without worrying that it’s going to have disproportionately negative effects on the poor countries of the world—who are suffering disproportionately from climate change because of where they’re located.

Arvid Viaene: Yeah. Rephrasing that: there’s also a lot of very efficient firms abroad that are not often captured in this story. So people say there’s going to be a disproportional burden, but those countries also have very efficient firms that don’t emit a lot. That’s something I really learned.

Why steel and aluminum, and what data the paper uses

Arvid Viaene: That’s a good transition to talk about the two industries you study. You mentioned aluminum and you mentioned steel. Could you talk about why you chose those industries?

Kim Clausing: Yes. The European Union CBAM was the policy instrument we were interested in looking at, and it applies to other industries as well. It applies to aluminum and steel, and those are the two we focus on, but also fertilizers, cement, hydrogen, and electricity. If you look at all of those industries, aluminum and steel—and we use steel broadly to include both iron and steel—are the two industries that are both emissions intensive and highly traded.

Together, those metals account for about 14% of the world’s carbon emissions if you include scope one—not just the production process emissions, but also the electricity emissions used in production. That’s a lot.

If you look at those other industries, aside from electricity, they’re less important emissions-wise, and they’re also less traded. Cement is very important emissions-wise, but isn’t traded. Fertilizer is less important emissions-wise, even though it is traded.

But these two industries are both highly traded and very emissions intensive. In steel, more than 20% of output is exported; in aluminum, more than 40% of output is exported.

Arvid Viaene: It seems like it was also a very big data undertaking to get all this data. People might not appreciate the scope—could you talk about that?

Kim Clausing: Once we identified those industries as most important, we found very detailed data on production and emissions. In the aluminum sector, we have data from every smelter in the world, acquired from Wood Mackenzie. The steel data are from Climate Trace, and they’re also at the plant level.

This level of detail really helps the analysis because we get much more precise estimates of how markets are going to react to carbon pricing in the CBAM, accounting for heterogeneity. Firms vary in important dimensions—not just emissions intensity (and there’s a lot of variation there), but in other dimensions as well. This happens both across countries and within countries.

Within China, for instance, some firms are much sturdier than others, and that’s true for a lot of countries. You want to account for what’s going on at the plant level as well as at the country level.

Arvid Viaene: I should also mention there’s some really good econometrics in the paper, which is not going to be today’s discussion, but I really recommend it. It was interesting econometrics and identification.

Kim Clausing: Thank you.

Baseline scenario: $100 carbon tax with and without CBAM

Arvid Viaene: I usually skip that because I just assume it works, but for people interested, I recommend it. Maybe we can talk about some of the results. Your baseline analysis starts from a $100 carbon tax, where you analyze the world with and without the carbon border adjustment mechanism. Could you talk us through some of the results?

Kim Clausing: Sure. When you’re thinking about the tax all by itself, it shouldn’t surprise economists that taxes reduce consumer and producer surplus and raise government revenue. That’s a second-week-of–Econ-101 result, and that happens here too. One thing that was a little surprising is the magnitudes aren’t huge. When you look at overall welfare effects of implementing carbon pricing, with and without the CBAM, globally it’s not moving the dial very much. We get numbers like a billion dollars, and you wonder, since not that much is happening quantitatively, why these policies are so hard to do. But the policy analysis also tells you why. Producers do get hurt by carbon pricing and can be expected to object.

One interesting thing about the carbon border adjustment mechanism is it reduces the producer surplus losses. It doesn’t eliminate them, but it makes the tax a little easier for producers. The cost of that is imposing more of a burden on consumers because, without the border adjustment mechanism, some consumer pain is ameliorated by imports that come in and offset higher prices that would otherwise occur.

So the border adjustment mechanism creates a mini redistribution away from consumers in the country doing the policy and toward producers. Government revenue is substantial, but mostly from the pricing. You’re not getting a lot of revenue out of the CBAM itself. But what the CBAM is doing is making it easier to carbon price in the first place. You see that in the results: the countries implementing the CBAM will find it’s net helpful to them relative to a situation without a CBAM. Again, though, the magnitudes are not enormous.

Arvid Viaene: And when you said “easier to implement,” that’s maybe because the objections from industry might be a little less.

Kim Clausing: Yes. And the welfare effects are just a tiny bit less bad. So that’s helpful too.

Arvid Viaene: I think one of the points in your paper is that CBAM revenue is a lot lower than you might expect, because companies internationally reshuffle: cleaner production gets sent to Europe and dirtier products get sold abroad. That reallocation makes projected CBAM revenues lower.

Kim Clausing: Yeah—from the CBAM. The carbon price is still bringing in a lot of revenue. Countries might think about their fiscal needs as they contemplate these policies. Can they come up with any idea that’s more efficient than a carbon price? Most other taxes create inefficiency, whereas a carbon price helps efficiency by reducing the negative effects of the externality. Most economists love carbon prices for a reason.

Arvid Viaene: It’s true. I’m a big fan of it. Anytime this topic comes up, I’m very positive about it. One of the main results is producer surplus falls by 23 billion, but then it changes after CBAM where there’s an improvement—while consumers lose. Could you talk about those trade-offs?

Kim Clausing: Yes—and I should emphasize that quantitatively it’s not a huge effect, but it’s in the direction we would expect. For producers, because the CBAM offsets the disadvantage of serving their own market, they recoup some of the lost market share they would have had if the carbon price occurred absent the CBAM.

That’s a benefit to them, but consumers are on the other side of that in a nearly symmetrical way. The dollars producers recoup, consumers lose as they don’t get cheaper, dirtier imports.

But when you look at the magnitude of consumer loss here, it shouldn’t be standing in the way of policy adoption. It’s incredibly small as a share of these markets—and if you think about a consumer’s bundle: if you’re losing $2 billion in consumer surplus in all of Europe from the aluminum market, it’s an indiscernible tiny share of people’s consumption.

Kim Clausing: The consumer side of this shouldn’t be stopping policy. The key is to find a policy that producers can stomach enough that government can get it through, and that’s where the CBAM helps.

Arvid Viaene: Exactly. Also because producers are more concentrated—easier for them to coordinate.

Spillovers abroad: who wins and loses outside Europe

Arvid Viaene: People say poor-income countries or other countries might be impacted by CBAM, but what they forget is that prices in Europe will go up, while prices abroad might decrease—so it might actually be good for consumers abroad. Could you talk about that mechanism? You did calculations for India, too. The narrative is usually driven by producers abroad being vocal about it.

Kim Clausing: There are diverse effects. Consumers in unregulated markets benefit from the increase in supply. We have a table in the paper. One of the big winners is U.S. consumers. We have a large market and we’re importing a lot of these metals. When the price falls in unregulated markets, that helps consumers.

There are consumers that lose in the regulated market, and producers that win and lose. The winners tend to be firms in the clean-energy space: they get the benefits of a higher-price market without fully offsetting that benefit with additional carbon fees through purchasing permits in the ETS.

Beneficiaries tend to be firms with very clean production, and losers are firms with dirtier production. If administered at the plant level, it’s possible that within one country you’d have both winners and losers. We also talk later about trade-offs between administering at the plant level versus the country level.

How big are consumer price effects?

Arvid Viaene: You said the consumer losses in Europe aren’t big—around 2 billion. Was that surprising to you? What reactions have you gotten?

Kim Clausing: I was a little surprised, because you hear a lot of anxiety around higher energy prices. That’s understandable for Europeans who faced price shocks around Russia’s invasion of Ukraine and what that did to utility bills and heating costs.

So people are anxious about energy prices writ large. But in these heavy industries—which are a substantial share of worldwide emissions—these price effects are really quite small for the typical consumer bundle.

I don’t think it makes sense to base climate policy on fear. Just because people are worried about utility bills to say, “Oh, we can’t raise the cost of a toaster by one dollar if it might have metal in it,” or one cent—that’s not going to be very much.

People should have perspective and some understanding of the magnitudes. And it’s not going to be that salient. If these basic goods’ prices increase, you’re not going to see that at the cash register, because these are input goods into complicated production processes with lots of other costs. So it’s not going to have a noticeable impact on end consumers.

Emissions reductions and leakage under CBAM

Arvid Viaene: Another part of your paper is the goal to prevent emission leakage. Could you talk about the emission leakage results?

Kim Clausing: Yes. Emissions go down substantially from the carbon pricing itself. Even at a semi-conservative social cost of carbon, you can see that global welfare—if you included the benefits from reduced emissions—improves with this policy. In the working paper version, we show global welfare on the private side without including the negative effects of the externality.

But the emissions reductions are substantial and would move the policy into a welfare-enhancing regime at most social costs of carbon. Emissions reductions are larger with the CBAM than without. It’s not an enormous difference because there are confounding effects, but you get more emissions reductions—maybe on the order of 5% or 10% more with the CBAM than without.

That’s particularly true when it’s just Europe as the regulator, which is the policy experiment we’re looking at right now. If you add China in, things get more complicated, and that’s worth looking at too because China is such an important producer in these heavy industry goods.

China’s role and the climate club logic

Kim Clausing: China is a dominant producer—really 50 to 60% of these metals. Ideally, China would join a coalition that priced carbon at reasonable levels and levied a carbon border adjustment mechanism too. In that instance, you don’t see as big of an impact with the CBAM. In a way, the CBAM isn’t doing the work because you already have the lion’s share of world production carbon pricing.

Then the CBAM becomes more of an incidental tool—effective in expanding incentives to carbon price in the first place. We show that when a country decides whether to carbon price, they see it’s better for them if they also include a CBAM. That should tilt people toward joining those regimes.

Arvid Viaene: When you say “better,” it becomes less costly because Europe has already imposed this cost. It’s still costly for China, but relatively less costly once the CBAM is in place.

Kim Clausing: Yes. And China should consider doing a CBAM when they implement, because that will also make their policy more welfare-enhancing for China.

Arvid Viaene: Exactly. China being 50 to 60% of emissions in these industries is huge. It’s almost the Nordhaus climate club vision.

Kim Clausing: I don’t think it’s a ridiculous dream. They’re a huge part of emissions in these industries. Overall their footprint isn’t 50 to 60%, but they’re very important in heavy industries. They’ve shown willingness to do carbon pricing in these industries. Recent Chinese policy expanded their emissions trading system to include these heavy industries, which is thoughtful.

Right now the prices are quite low, so they’re far from Europe price-wise, but the approach is similar. That’s promising for a Nordhaus-type climate coalition. And at the recent COP—there was announced more coordination on carbon pricing toward moving in that direction, and that could be helpful.

Arvid Viaene: Exactly. That’s encouraging. I recently talked to a policy expert on CBAM, and one of the things you get because of CBAM is companies abroad start to measure everything—get the measurement problem right. People forget how measurement-intensive this is. Even the EU ETS took a long time to set up mechanisms to monitor and ensure it’s right.

Investment response: how CBAM can encourage cleaner production

Arvid Viaene: You have an interesting simulation of how CBAM could encourage green investment. Could you talk about what you did there and what the idea is?

Kim Clausing: The idea is to allow emissions intensity to respond to carbon taxation. We take, as given, a semi-elasticity, which one can vary. Then we simulate market expansion over time.

You could imagine that over time the world is growing and demand is growing. If you allow new capacity in these sectors to respond by adopting mitigation steps that lower emissions intensity, you find that the policy amplifies emissions reductions and lowers abatement costs, because firms can respond by adopting cleaner processes.

One tricky thing in the short run is we have the smelters and plants that we do. They can expand supply a bit, but we’re not looking as carefully at what the next plants look like. Letting emissions intensity respond is a nice feature of that exercise and provides encouraging results: larger emissions reductions and lower abatement costs.

Arvid Viaene: Exactly. Reading the paper, it’s easy to get lost in technical details, but this was like: this has a lot of really good impacts.

Kim Clausing: Yeah.

Her number 1 take-away from the paper

Arvid Viaene: What’s the number one thing you want listeners to take away from the paper?

Kim Clausing: One of the hard things about global collective action is the incentive problem. With climate change, it’s tricky because there are free rider effects between ambitious jurisdictions and less ambitious jurisdictions.

There are also competitiveness effects: if you impose costs on your industry, you’re hurting them relative to industries in other countries in this global marketplace. The big lesson is that this is an important new tool. We model key implications of the tool. But one thing we don’t get to is the importance of this in political economy stance.

What the paper can show you is what happens when we adopt CBAM, and it’s a pretty nice story—it’s straightforward, it’s what you would expect. Where it gets really exciting is thinking about what happens at future COPs and what pushes countries to solve the global collective action problem.

You need an answer to jurisdictional spillover questions. CBAM has a big impact in political economy: it makes it easier to carbon price domestically because you have an answer to domestic industry on competitiveness.

It also makes it easier to encourage more countries to come into the fold and do carbon pricing as governments see they can convert tariff revenue that would have accrued to regulating countries into domestic revenue—which every country needs for its fiscal situation. That’s the biggest takeaway.

Arvid Viaene: Thanks. When you say it, I can see the process over many COPs where China raises it a little bit, that makes it more costly for others who then raise it a little bit. You get an iterative process of inching upward to more global cooperation on carbon.

Kim Clausing: Right.

What surprised her the most most while writing the paper

Arvid Viaene: Was there something that surprised you during the writing of the paper that you hadn’t anticipated?

Kim Clausing: Two things surprised me. One was this flat emissions gradient. People make assumptions about emissions intensity that don’t fully reflect reality.

One example: aluminum is incredibly electricity-intensive. If you’re making aluminum where you can rely on hydropower—and many poor countries have hydropower, Mozambique is one example—you can make aluminum with a much smaller carbon footprint than people might think.

So there isn’t this sense that richer countries, in a per-capita income sense, have lower emissions intensity at the plant level in these industries. That’s encouraging for the policy.

A second thing that surprised me is the small quantitative effects here. We’re talking about something that could affect—if you take all the CBAM industries—maybe as much as a fifth of global emissions.

And we’re letting tiny welfare losses, and tiny consumer and producer losses, stand in the way of progress.A meta message is: there aren’t many negatives associated with doing the right thing here. You’re not going to have trouble offsetting these kinds of costs with other policies. The tax policy toolkit is filled with tools where you could offset negatives and still achieve massive emissions reductions.

So the small size of consumer and producer surplus losses—and welfare losses—is indirectly encouraging, even if it’s hard to wave in front of referees: “Oh, look, small numbers.” In this context, small numbers can be a good thing.

Arvid Viaene: Thanks so much. I think that was great. We can end it there. Your paper really helps put numbers on the debate and not just get stuck. I was one of the people who had this idea of varying carbon emissions intensity in my mind. Thanks for the paper, and for joining.

Kim Clausing: Happy to help. Our revision of this paper to satisfy various journals will include other industries in the stylized facts. It tends to hold up. For electricity, you see a flat gradient, and for fertilizer as well. We haven’t looked at cement, but cement is non-traded anyway. People aren’t lugging cement across borders very often.

Arvid Viaene: Awesome. Thank you so much, Kim.

Kim Clausing: All right. Take care.

Now, in my view, one of the main criticisms is a credibility concern. And it is a legitimate one, because in the past there have been major credibility issues with offsets. For example, in episode four of this podcast, I interviewed Ben Probst, an ETH Zurich professor, who co-authored a paper finding that for a sample of one billion credits under the Kyoto Protocol, only one out of five credits actually reduced CO2.

And as we saw in episode 11 with Jos Delbeke, the supply of cheap, sometimes fraudulent credits drastically reduced prices in the EU’s emissions trading scheme. So as a result, the EU cut them out in 2013. However, the EU has now put carbon offsets back on the table. But here is the key element. The EU deal specified that those carbon offsets have to be generated under Article 6 of the Paris Agreement. And the Paris Agreement Article 6 is the world’s attempt to create better rules, but I know very little about it.

So in this episode, we’ll discuss what Article 6 of the Paris Agreement is, what it covers, and whether it can avoid some mistakes of the past. And to do so, I’m delighted to be joined by Beatriz Granziera, an expert on this topic. Beatriz is a senior policy advisor at the Nature Conservancy, where she leads TNC’s global strategy on international carbon credits and large scale forest programs.

She brings extensive experience on the Paris Agreement Article 6 negotiations and its links with nature and other carbon markets. and has been supporting developing countries in translating Article 6 rules into domestic policy. And Beatriz has authored several publications, including an Article 6 explainer, which I read and I really recommend it, an Article 6 implementation article, REDD+, and Article 6 explainers, contributing to the global understanding and application of complex climate themes.

She holds a Master’s in Environmental Policy from Yale University and a Master’s in Environmental Law from the Catholic University of São Paulo. So welcome to the podcast.

Beatriz Granziera: It’s a pleasure to be here. Thanks.

What is Article 6?

Arvid Viaene: As I said, I think Article 6 is now on people’s radar, but it’s a very unknown quantity. Just to get us started, would you mind explaining kind of what Article 6 is?

Beatriz Granziera: Yes, absolutely. And I think just that question tends to get very tricky, very fast. So, Article 6 of the Paris Agreement is a framework that allows countries to work together to meet their mitigation targets more cheaply and effectively.

And with that, hopefully, to raise ambition. There are three ways in which countries can do that. So I’m going to very briefly just talk about them. Two of them are market-based and one is a non-market approach.

So the first market approach is called Article 6.2. This is not a great name, but this is just how it’s known. Article 6.2 sets rules for countries to cooperate directly—typically through a bilateral agreement. It’s a direct relationship between countries—through a bilateral agreement, for example, or even between a country and a company. And because it’s a direct relationship, there’s a lot of flexibility from the buyer and the seller to decide what they want to trade and how they want to trade.

The second mechanism, it’s called Article 6.4 or the Paris Agreement crediting mechanism. And that’s different. So this is a centralized system overseen by the United Nations. And it’s very similar to what we had in the past in the Kyoto Protocol with the Clean Development Mechanism. Because the UN centralizes this mechanism, it decides what methodologies are eligible, what sectors are in, what sectors are out and what rules apply.

And then third, you have the only non-market approach under Article 6, which is called Article 6.8. And it’s basically around climate finance. So the main point here is that there are no expectations of trading of carbon credits. And this mechanism is way, way less developed than the market track. So I’m not really going to focus on that here.

But before we move on and before we get into the individual components of Article 6, I think it’s important to take just a quick step back to understand what Article 6 means in a broader landscape of carbon markets. Because today you have several different markets that work in parallel. So you have the voluntary carbon markets where companies can purchase carbon credits to meet their voluntary climate targets. You have a lot of domestic compliance markets. You have some international markets such as the aviation market or CORSIA, you have Article 6. And what’s very interesting about this moment that we are living right now is that the lines between these markets are blurring more and more. So they are continuing to function in parallel, but more and more one market is influencing the other and they don’t work in isolation anymore. So to that question, what is Article 6? And when we talk about this, I think we can no longer assume that Article 6 is just another technical rulebook under the UN because now Article 6 is really a mechanism that sits at the center of the super complex landscape of carbon markets. And it’s already influencing how these other markets are evolving.

Arvid Viaene: So thank you. So if I were to summarize it, it’s you’ve got several of these markets, you’ve got the voluntary carbon market, you’ve got the aviation one, and now Article 6 is like the new player in town. And it’s already starting to shape the other ones. And then in Article 6, we’ve got Article 6.2, which is kind of buy, a It’s kind of a relationship between two parties. And so it’s kind of or like companies, countries, and it’s more flexible. And then you’ve got Article 6.4, which is the centralized system. So UN rules apply and govern the carbon offsets.

Beatriz Granziera: Yes, exactly. I think you nailed it. So one is very flexible. of course, you still have to follow some rules like, and sorry, So yeah, exactly. one is way more flexible and allows countries and the buyer and the seller to have a lot more flexibility to decide again what they’re going to trade.

And Article 6.4, because you have that centralized UN body, which is called supervisory body, then it’s basically you have to follow the rules that this body sets. So I think just some countries might want to move faster and want have more flexibility, might choose to go with Article 6.2. Other countries want that standardized credit with a UN stamp, that hopefully get where guarantees quality. So they might go with Article 6.4.

How Paris differs from Kyoto

Arvid Viaene: And that leads me to the next question is that think the prior interview Ben Probst, he was looking at carbon offsets under the Kyoto Protocol. Now we’ve got the Paris Agreement., what has changed in this Paris Agreement versus the Kyoto Protocol with the clean development mechanism?

Beatriz Granziera: There are a few very big shifts there since Kyoto. So first, right, Kyoto was just one centralized system, the Clean Development Mechanism, very similar to what I just mentioned around Article 6.4. At the time, we also had this centralized UN body controlling everything related to the operationalization of the Clean Development Mechanism. But under the Paris Agreement, as I mentioned, countries have a lot more flexibility to decide how to engage in markets, for example, through just signing a bilateral deal under Article 6.2.

Second, and I think this is a really key difference here, that under the Kyoto Protocol, only developed countries had binding targets for climate. That means that developing countries could then sell carbon credits without that really affecting their national accounting. So as a result, double counting was not really a concern back then. But this is different now under the Paris Agreement because every country has a mitigation target or an NDC, and that basically changes everything. So If a country sells a carbon credit today, it has to adjust its own emission balance to make sure that the same emission reduction is not counted in another country at the same time. Because if you’re counting one emission reduction twice, that won’t help as the goals of the Paris Agreement. And then that has some major implications that we get can get more into later. But now developing countries have to really think what kind of credits they are selling and what quantities and at what price.

And just, I’ll say that the third big difference here, a little bit related to what I’ve already mentioned, is that the landscape of carbon markets today is way more complex than what we had under Kyoto.

Now you have more than a decade of experience with voluntary carbon markets and a lot of lessons learned from what worked and what really did not work. You have large scale forest programs generating credits for the first time. and on top of that, there are today over 70 regulated carbon pricing systems around the world, including carbon taxes and emission trading systems. So with countries, for example, like Brazil now entering the space. So Article 6 is both shaped by and shaping all of these markets as well. And the rules are also hopefully learning from all this experience that happened in the past couple of decades.

Arvid Viaene: Thank you. And I think it’s also worthwhile pointing out that this is something I learned that I wasn’t aware of is that exactly under the Kyoto Protocol, there were no targets for some of these countries. So they could sell credits without it impacting their goals. But now that has changed with the Paris Agreement. So the double counting topic that you can only use it once becomes really important. And I was even kind of surprised that this used to be the case. You could just buy credits that the other person then didn’t need to account for. So, yeah, first when I read that, I’m like, huh? But it makes sense that is now a goal. So, and then this double counting is, as I understand it, addressed in Article 6.4, which is kind of the centralized system, if I can call it that.

Arvid Viaene: Is that also there in Article 6.2 in this bilateral system?

Beatriz Granziera: Yes, it is. Article 6.4 and Article 6.2 both need tools in place to avoid double counting. This may sound simple and obvious, but it was one of the main sticking points in the negotiations for years. Article 6 is one of the many articles of the Paris Agreement, and it took countries almost a decade to finalize rules. Almost all other articles were largely agreed in 2018 in COP 24, but Article 6 is really complex and that issue around how you really address the double counting was at the core of very heated debates throughout all these years.

Arvid Viaene: Why was it so heated?

Beatriz Granziera: Because we were coming from the Kyoto Protocol. So developing countries, a lot of them still had some expectations that they could still sell credits without really that affecting their own climate commitments under the Paris Agreement. So, and I think there is, Kyoto was divided between developing countries and developed countries. So it took a lot of time for countries to transition to this new Paris universe.

And I think addressing the double counting for all countries is a key point of Article 6 and really the core of why this system can work. Because unless you have, all countries moving towards reducing emissions, the system just, it doesn’t make sense in this new reality that we have right now.

Arvid Viaene: Exactly. So, and I can also, imagining that the EU exactly has this as a big condition that you want to have this double counting or otherwise it won’t reduce global emissions. So...

How big is the Article 6 market today?

Beatriz Granziera: Yes, exactly.

Arvid Viaene: Just to get like a sense of what the market is before we dive into the further technicalities, could you just give us an idea of the size of these carbon offsets, like how have been generated over the past or the past five years? And I know might get complicated with like those issued under Kyoto and now, but just kind of getting a sense of the landscape.

Beatriz Granziera: Now, I think that’s actually a really important question because there’s a lot of buzz around Article 6 right now. But when you look at the actual market and what’s happening, you realize very fast that we’re just at the very, very beginning. Just to break it down, you have around Article 6.2, So the bilateral agreements, you actually have a lot of momentum. There are over 80 bilateral agreements that have been signed between countries to date. But then when you look at the actual trades between countries, the number falls to two. So only two trades have happened. One was between Switzerland and Thailand back in 2024. And the second one happened a few months ago between Switzerland and Ghana.

So this is a market that hasn’t really even started yet. So there are a lot of reasons why that’s the case. So first of all, after a decade or almost a decade of negotiations, a lot of countries are still regulating Article 6 domestically. And that’s complicated. That requires sometimes congressional approvals, different legislations, different, negotiations. So that just takes time. The second [reason] is that there’s a lot of uncertainty now about how countries will get to their climate targets. Just to explain, climate targets under Paris Agreement, they are updated every five years. And then the next target to 2030, it’s coming up, but countries are not absolutely sure yet where they’re going to be there. So they have to be careful about how many credits they want to sell under Article 6, because these credits will not be able to use for them to meet this climate target. So this is a very big component. And the third thing is that demand for Article 6 credits is still small and quite fragmented. So overall, Article 6 is up and running, but it hasn’t really turned into a liquid market yet. So to your question, like how many credits we’re talking in terms of supply, we don’t know yet.

And there are very few countries that have, the legal framework in place, the institutions in place and a pipeline of carbon credits that could qualify for Article 6.

Arvid Viaene: Thank you. And then I think that does stand in contrast to the voluntary carbon market, where I think one of the big things that I’m learning is this course, yeah, like the aviation is like a big source of demand for credits.

Could you maybe speak a little bit more to that? Because even in your projected demand for 2030, they were in there.

Beatriz Granziera: Yes, absolutely. So I was talking before about supply of Article 6 credits and how that is slowing happening. But then another huge component of any market is where the demand is coming from, right? Who is going to buy in the end Article 6 credits? So today, as I mentioned, Article 6 demand is not there yet. It’s fairly small, but it’s slowly emerging. So demand for Article 6 comes basically from two sides. One, you have buyer countries, mostly developed countries like Switzerland, Singapore, Sweden, South Korea, Norway and Japan. They want to use Article 6 credits to meet their own climate targets.

So these countries have announced some demand, and this is by 2030 200 million tons of CO2. But as you very correctly mentioned, the bulk of Article 6 demand comes from CORSIA, which is the aviation sector where companies would be purchasing credits to meet their own goals under this Corsia market. But I think there’s one thing that is important to mention here, that this is just, the numbers that I mentioned are just a photo of what we have today, and they will for sure change in the future. So as we get closer to 2030 and also closer to 2040, more and more countries might rely on Article 6 to meet their own climate targets.

And I think one of the biggest examples that we have is the European Union that announced just in December of last year, 2040 target, which allows of 5% of Article 6 credits. So that 5% might not sound a big number, but it’s actually a huge game changer for Article 6 demand. And just the EU alone could double all the current Article 6 demand that we have today to 2030. So that’s definitely going to be a big deal in how the market progresses.

Arvid Viaene: Could we talk about the EU demand just for a second? Because one of the things I was surprised by when I read your article is the timeline of the EU demand. So could you maybe talk about how they’re thinking of implementing this?

EU 2040 target and the return of international credits

Beatriz Granziera: Yes, absolutely. So, as I mentioned just last month, the EU finally agreed on their 2040 targets, and that’s a 90% reduction in emissions compared to 1990 levels. The big novelty here, as you mentioned in your introduction, is that for the first time in many years, the EU will allow 5% of this target to come from the use of international credits, and that’s basically Article 6 credits.

Arvid Viaene: Article 6.4, right?.

Beatriz Granziera: Article 6 in general,

Arvid Viaene: Got it

Beatriz Granziera: Yes, the EU, from what the EU has been announcing, it’s not yet clear. And I can talk a little bit more about the uncertainties that we have coming up in 2026 and the following years. But just in terms of timing, the use of international credits would be available from 2036 onward. And before that, you’d have a pilot phase running from 2031 to 2035. There’s not a lot of clarity on how the pilot phase is going to work. But that’s that’s just how the EU is structured. That’s the target.

And again, I think I want to emphasize this many times because, when you hear 5%, that might sound small, but politically it’s actually a big shift for the EU. Because for a long, long time, the EU has been very clear that it wanted to meet its its climate targets only with domestic mitigation inside the EU. So this decision to reopen the door to international creditS has definitely made the waves here in Brussels and well beyond.

Beatriz Granziera: And I can talk a little bit about the different positions here.

Arvid Viaene: Yeah. and Did it surprise you? Had you seen something coming?

Beatriz Granziera: Actually, it did surprise me when it first came. So these discussions, the first announcement came in July of this year. And we are used to see the EU in the Article 6 negotiating rooms, very clear that they won’t use these credits for, maybe, a decade of negotiation. So that was that was actually a surprise. But at the same time, the EU has been one of the main negotiators and decision makers in this process. The EU has been around the negotiation since the Kyoto Protocol. So on the other side, it makes sense that you might want to use, that is one of the flexibility mechanisms.

Arvid Viaene: Maybe we then, know, because they announced that some people were surprised and some people were against the use saying, we should keep all reductions domestic. I think there’s a case to be made to use credits from just a theoretical point. If you want, can reduce them somewhere cheaper. But there are then, of course, some worries. And I think one of the worries we talked about with Ben in his episode is what I would call flooding of past low quality credits.

Because under the Kyoto Protocol, you had these credits that sometimes were of lower quality or sometimes might have not mitigated CO2 or might have not reduced CO2. and now there’s this whole discussion as I get it about how do we transition those prior credits, if at all. So maybe could you talk about what the transition mechanism could you talk about what the transition mechanism is. Because I imagine those are also intense discussions.

Can old Kyoto credits flood the market?

Beatriz Granziera: Yes, absolutely. And you’re right. That has also been another important seeking point. So I think your question has two points there. one the criticism about the EU being open to the use of Article 6 credits in general. And the other thing, how this old Kyoto Protocol credits, and a lot of them, don’t have the same quality standards, would get into this mechanism. So I’ll just break it down and start talking about the criticism that we have been hearing here in process.

So I think one of the major concerns is whether relying on international credits would weaken climate ambition inside the EU or even risk increasing emissions domestically. Right. And I think that’s a very valid concern and definitely deserves serious attention, but I think this is only part of the picture because using Article 6 isn’t automatically good or bad, and it doesn’t decrease or increase ambition. What really matters it’s like are the details, right? And many of these details haven’t haven’t been decided yet. And this is what the Commission is going to start doing this year now.

So big questions that are still unanswered are: which sectors are going to be allowed, which methodologies? Is the EU going to use Article 6.2 Article 6.4 only? What safeguards will be in place? How will member states participate in the decision of how to purchase these credits.And, I think very importantly, what kind of buffers and quality controls will ensure that the credits coming in the EU are actually high quality and real and additional and verified.

And I think there’s also another point that I feel that is often overlooked in this discussion as well. By entering this market, EU is not only benefiting from the credit credits, but because the EU represents such a huge demand, it will also shape how the supply of credits will develop.

And right now, I mentioned before, we’re just at the beginning of the market. So supply has not yet been locked in. So the fact that EU is entering the market represents a big opportunity for Europe to shape how developing countries are developing the credits at what quality criteria with what ambition. And I think this is a very rare and timely opportunity that the EU have in the end, the EU participation could really drive more global ambition of this market, depending on how it’s done.

Arvid Viaene: Yeah. And in some sense, it’s because they then represent such a big potential demand, they can also have potentially more influence on the rules that go into it.

Beatriz Granziera: Yes, absolutely. Because, developing countries are looking at demand. So if there’s a clear demand signal to use, certain standards and, to have certain ambition, that’s how, where the market’s going to evolve. And the EU is one of the very few players in the market that has, the size and and scale to really shape all of this.

So I think this is, and this is like the side that I don’t feel it’s being talked about in Brussels that much, that the EU could have a huge influence on the quality of carbon credits that could then be developed in the future.

Arvid Viaene: And then we have the transition of the old credits.

Beatriz Granziera: Yes. So you’re right. The Clean Development Mechanism, some Clean Development Mechanism credits could transition to Article 6.4, but that’s there is one catch there. For most product projects, the deadline has already passed. So it was established in 2021 that like old projects from the Clean Development Mechanism could request transition until 2023, with the exception of afforestation and afforestation projects, which extended the deadline until 2025.

But then even when the project developer requests the transition, it’s up to the host country to decide if they will allow the transition. So this is a very important point. And this is one thing that was very discussed at COP30 in Bellin just a few months ago or couple months ago. That deadline for countries to approve the transition was extended by six months until June 2026. Without that approval, the transition won’t happen.

So if you look just in terms of how many projects requested transition, you have around 1,400 projects that could lead to, in the higher end, maybe a billion credits entering transition. maybe flooding at the Article 6 market. But in reality, the number of projects and credits that we transition will transition will be much lower because you require that host country approval.

Arvid Viaene: I think I read somewhere it’s like of the billion around 300 million would be allowed to enter or do I get that wrong?

Beatriz Granziera: Yes, I think that there are some estimates. I think the World Bank has come up with estimates around that number. But for me, when I talk to countries that are going through the very bureaucratic process of approving, the projects and people that have on their desks just a pile of projects that they are deciding to approve, I feel that this is still quite uncertain. Because a lot of countries, they still don’t know if they want to approve the projects for the reasons that I mentioned before.

If they approve the transition with a corresponding adjustment, that means that they cannot use these credits to meet their climate targets. So countries are being very careful. And I think it’s very hard to estimate how many credits are going to enter the market. The other important issue here is that it’s a market, right? So even if some credits from the CDM are allowed to transition, it’s up to the buyers to decide to buy them.

So if the EU, as you mentioned, like that concern that the EU would then be, buying CDM credits, that’s up to the EU. The EU can decide what kind of credits they will buy. And I think there is a big concern around quality on the CDM project. So I’m very curious to see how the market reacts to them and how much demand for these credits are and what price.

Quality control under Article 6.4

Arvid Viaene: So maybe that’s a good point to transition to Article 6.4 and the quality control on credits. Because as the way I read your explainer, it seems like there’s a lot of stringent quality control going on with the supervisory board. Could you talk more about what that supervisory board is doing and what the status is?

Beatriz Granziera: Yes, absolutely. And I think 2025 was a big year for Article 6.4 and the supervisory body. And everyone there worked really, really hard, including the UNFCCC Secretariat. So we had some very big milestones. For example, the first ever methodology eligible under Article 6.4 was approved just back in October for landfill methane. The first projects also started to transition.

Arvid Viaene: Just when you say it’s been approved for landfill methane, that means that every project in landfill methane meets all these requirements, it can officially enter in Article 6.4. There’s no more need for approval or like you would need some verification. Just what does that actually mean that now it’s been approved?

Beatriz Granziera: Oh, there’s a lot of approval. let me clarify: I think 2025 was a very big year for the Paris Agreement crediting mechanism or Article 6.4, with some very important milestones that the supervisory body and the UNFCCC secretariat achieved. Just to mention some of them, there were, for example, some very important rules that were draft. These are overarching rules around technical issues on permanence and additionality, leakage, baselines and all of that. Very important and very technical issues on how the market will work.

On top of the super broad and overarching rules, now they are also working to approve specific methodologies. So methodologies are basic, like, activity tailored rules that every project would have to apply to be eligible for Article 6.4. This will take time. The first methodology has been approved already. It was approved in October of 2025. And it’s just for landfill methane.

But now for 2026, the supervisory body will likely consider a lot more methodologies. So more projects and more types of activities can also be considered under Article 6.4. And then the other milestone is that projects already started to transition. So far, we don’t have any new project because we didn’t have methodologies until October, but we have some of those CDM-old projects that were that transitioned to Article 6.4. So definitely some very big moments for Article 6 right now.

And I think in terms of quality, this is a very key component because most of when you look at who is making these decisions, a lot of them were around making the same decisions under the CDM. So they, they [experienced the difficulties of the CDM quality control]. In fact, in many aspects, the quality issue was a big problem there. So you see that like quality control is a really big focus, as it should be. I think in general, it was a deliberate decision that one way to control quality is that to make very stringent rules. And with that, of course, you’re going to reduce the supply of credits that would be available to be generated.

So I think this is where we are right now. But I think there are other points to be considered in these discussions as well that were very, very evident and very important in 2025, because what you’re actually developing is a market, right? And a market needs to be feasible and needs to work if you want to deliver the goals of the Paris Agreement.

So if you implement rules that are really good on paper, but just they don’t work in practice, the system just won’t deliver mitigation and scale to meet the goals of the Paris Agreement. So I feel that right now you have that this tension between two sides. One side pushing to make rules very, very stringent and as they should be. But also some questions around to what point you pushed too much in a sense that you actually don’t deliver any of the goals that you are intended to deliver within a carbon market mechanism.

Arvid Viaene: So it’s like the balance between too stringent, it won’t generate any credits and then to lose you, you get a big concern about the quality. But right now, it sounds like if the rules get too stringent, there might just not be any, not, if the rules get too stringent, there might not be any credits. If, that’s a summary.

Beatriz Granziera: Just to give you an example, I think one of the biggest discussions of last year was around the role of nature-based credits within this market and how that would work. So, I think starting in the summer until the very end of last year, that was one of the biggest and most heated topics that I think it really went from, the super technical like policy nerd discussion to become a very big political issue. We had, Forbes, Reuters covering this issue. So it really became important. But basically, the supervisory body was drafting rules around permanence and the risk of reversals. And hundreds and hundreds of stakeholders in many countries raised concerns that these roles were so stringent that they would basically exclude nature from Article 6.4 altogether. And, as I was mentioning, this is not only about Article 6.4, because now all these markets are interconnected.

So this would really mean that nature would be affected in other markets as well, such as the voluntary carbon markets and other compliance markets. So I think this is an example of how, rules that might sound good on paper, in the end, could exclude one of the most important sources of supply. And nature is not only about reducing emissions, you have very important co-benefits for communities, for water, for so many other things. So, again , I think there are concerns around quality are important and they needed to be addressed. But I think risks should be addressed with risk management mechanisms, not only simply excluding full sectors from the market.

Arvid Viaene: It sounds like the rules might even get too stringent.

Beatriz Granziera: What I think is that the supervisory body developed some very important rules that are looking at quality controls. And as I mentioned many times, you cannot have a market if you don’t have very stringent quality control. So this is for sure important and this is what is wanted. But to your question on whether the supervisory body went too far, I think we don’t know yet because there are still a lot of rules that are going to be discussed in 2026, some very important components as well.

And I think to answer your question, we’re really going to have to wait until the methodologies are approved. So, as I mentioned, you have overarching rules, but like these discussions will come back over and over again when you when you approve methodologies.

All methodologies need to be approved by the supervisory body and all projects also need to be approved by the supervisory body. So these discussions will come back over and over again. And I think only then we will have a real sense of, how the market’s going to work.

Arvid Viaene: So, It sounds like the Article 6 is really like taking off like 6.4, the landfill methane was approved. Next year, we’re going to look at other projects. I think that’s my sense and takeaway is that this is all starting. This is all happening right now. Like it took a long time until COP29 to kind of agree on the things. And now it’s like starting to kick off for Article 6.4.

Beatriz Granziera: Yes, exactly. For Article 6.4, it has been a very slow development. So Article 6.4 is just now becoming operational for the first time. So, you haven’t had any trades yet. And this is, I think we only see how the market evolves when you actually have the trades. We will only see how stringent or how, feasible the market is when you actually start to have trades.

So I think I agree with you. This is a very exciting time to see how things evolve for, again, for a market that has the potential to be, a very big deal within the landscape of carbon markets and that is already influencing, how other markets consider high quality.

Arvid Viaene: Perfect, thank you for coming on. I think this is going to really help people get a sense of Article 6 instead of the abstract to actually get to know it. So thank you so much.

Beatriz Granziera: Awesome. That works. Great. Thanks, Arvid. It was really a pleasure to meet you and thanks So much for the invitation. It was great to participate here.

Introduction

International carbon credits are back in the policy conversation—especially after the EU’s new 2040 proposal reopened the question of whether (and how) Paris Agreement Article 6 credits might play a role.

But “offsets” are a loaded term for a reason: past systems created large volumes of credits, and a recurring critique is that too many didn’t represent real, additional emissions cuts.

So what is Article 6, what’s genuinely different under Paris, and what still isn’t settled?

In Episode #18, I’m joined by Beatriz Granziera (Senior Policy Advisor at The Nature Conservancy), who works on Article 6 negotiations and implementation, including supporting developing countries on domestic Article 6 policy.

We cover:

· What Article 6 is trying to do—and the difference between 6.2 (bilateral/decentralized) and 6.4 (UN-governed centralized mechanism)

· Why Paris differs from Kyoto: every country has an NDC, so accounting rules matter—and how corresponding adjustments aim to prevent double counting

· A market reality check: many agreements, but very little actual trading so far—and why countries may be cautious about selling reductions they might need for their own targets

· The EU angle: why EU demand could reshape standards (and why details matter more than slogans)

· Transitioning old Kyoto/CDM projects into Article 6.4: what “flooding” risks look like in practice and why host-country approval becomes pivotal

· The core tension ahead: quality vs scale—rules can be strong on paper, but too stringent rules can leave a mechanism that can’t generate meaningful supply

Related episodes:

· #4 Dr. Ben Probst — Can We Trust Carbon Offsets? Evidence from 1 Billion Credits

· #11 Dr. Jos Delbeke — The History of the EU ETS: Key Turning Points, Challenges and Policy Lessons

Start Transcript

Arvid Viaene: Hi, and welcome to another episode of the Climate Economics Podcast. And recently, the European Union set new 2040 climate targets. And a novel twist is that the 90% reduction target allows international carbon offset credits to be used for 5% of those reductions. And carbon offsets are a mechanism where a country or company can buy CO2 reductions from another country or company. Now, this decision by the EU has sparked a big reaction and pushback for a variety of reasons.

Now, in my view, one of the main criticisms is a credibility concern. And it is a legitimate one, because in the past there have been major credibility issues with offsets. For example, in episode four of this podcast, I interviewed Ben Probst, an ETH Zurich professor, who co-authored a paper finding that for a sample of one billion credits under the Kyoto Protocol, only one out of five credits actually reduced CO2.

And as we saw in episode 11 with Jos Delbeke, the supply of cheap, sometimes fraudulent credits drastically reduced prices in the EU’s emissions trading scheme. So as a result, the EU cut them out in 2013. However, the EU has now put carbon offsets back on the table. But here is the key element. The EU deal specified that those carbon offsets have to be generated under Article 6 of the Paris Agreement. And the Paris Agreement Article 6 is the world’s attempt to create better rules, but I know very little about it.

So in this episode, we’ll discuss what Article 6 of the Paris Agreement is, what it covers, and whether it can avoid some mistakes of the past. And to do so, I’m delighted to be joined by Beatriz Granziera, an expert on this topic. Beatriz is a senior policy advisor at the Nature Conservancy, where she leads TNC’s global strategy on international carbon credits and large scale forest programs.

She brings extensive experience on the Paris Agreement Article 6 negotiations and its links with nature and other carbon markets. and has been supporting developing countries in translating Article 6 rules into domestic policy. And Beatriz has authored several publications, including an Article 6 explainer, which I read and I really recommend it, an Article 6 implementation article, REDD+, and Article 6 explainers, contributing to the global understanding and application of complex climate themes.

She holds a Master’s in Environmental Policy from Yale University and a Master’s in Environmental Law from the Catholic University of São Paulo. So welcome to the podcast.

Beatriz Granziera: It’s a pleasure to be here. Thanks.

What is Article 6?

Arvid Viaene: As I said, I think Article 6 is now on people’s radar, but it’s a very unknown quantity. Just to get us started, would you mind explaining kind of what Article 6 is?

Beatriz Granziera: Yes, absolutely. And I think just that question tends to get very tricky, very fast. So, Article 6 of the Paris Agreement is a framework that allows countries to work together to meet their mitigation targets more cheaply and effectively.

And with that, hopefully, to raise ambition. There are three ways in which countries can do that. So I’m going to very briefly just talk about them. Two of them are market-based and one is a non-market approach.

So the first market approach is called Article 6.2. This is not a great name, but this is just how it’s known. Article 6.2 sets rules for countries to cooperate directly—typically through a bilateral agreement. It’s a direct relationship between countries—through a bilateral agreement, for example, or even between a country and a company. And because it’s a direct relationship, there’s a lot of flexibility from the buyer and the seller to decide what they want to trade and how they want to trade.

The second mechanism, it’s called Article 6.4 or the Paris Agreement crediting mechanism. And that’s different. So this is a centralized system overseen by the United Nations. And it’s very similar to what we had in the past in the Kyoto Protocol with the Clean Development Mechanism. Because the UN centralizes this mechanism, it decides what methodologies are eligible, what sectors are in, what sectors are out and what rules apply.

And then third, you have the only non-market approach under Article 6, which is called Article 6.8. And it’s basically around climate finance. So the main point here is that there are no expectations of trading of carbon credits. And this mechanism is way, way less developed than the market track. So I’m not really going to focus on that here.

But before we move on and before we get into the individual components of Article 6, I think it’s important to take just a quick step back to understand what Article 6 means in a broader landscape of carbon markets. Because today you have several different markets that work in parallel. So you have the voluntary carbon markets where companies can purchase carbon credits to meet their voluntary climate targets. You have a lot of domestic compliance markets. You have some international markets such as the aviation market or CORSIA, you have Article 6. And what’s very interesting about this moment that we are living right now is that the lines between these markets are blurring more and more. So they are continuing to function in parallel, but more and more one market is influencing the other and they don’t work in isolation anymore. So to that question, what is Article 6? And when we talk about this, I think we can no longer assume that Article 6 is just another technical rulebook under the UN because now Article 6 is really a mechanism that sits at the center of the super complex landscape of carbon markets. And it’s already influencing how these other markets are evolving.

Arvid Viaene: So thank you. So if I were to summarize it, it’s you’ve got several of these markets, you’ve got the voluntary carbon market, you’ve got the aviation one, and now Article 6 is like the new player in town. And it’s already starting to shape the other ones. And then in Article 6, we’ve got Article 6.2, which is kind of buy, a It’s kind of a relationship between two parties. And so it’s kind of or like companies, countries, and it’s more flexible. And then you’ve got Article 6.4, which is the centralized system. So UN rules apply and govern the carbon offsets.

Beatriz Granziera: Yes, exactly. I think you nailed it. So one is very flexible. of course, you still have to follow some rules like, and sorry, So yeah, exactly. one is way more flexible and allows countries and the buyer and the seller to have a lot more flexibility to decide again what they’re going to trade.

And Article 6.4, because you have that centralized UN body, which is called supervisory body, then it’s basically you have to follow the rules that this body sets. So I think just some countries might want to move faster and want have more flexibility, might choose to go with Article 6.2. Other countries want that standardized credit with a UN stamp, that hopefully get where guarantees quality. So they might go with Article 6.4.

How Paris differs from Kyoto

Arvid Viaene: And that leads me to the next question is that think the prior interview Ben Probst, he was looking at carbon offsets under the Kyoto Protocol. Now we’ve got the Paris Agreement., what has changed in this Paris Agreement versus the Kyoto Protocol with the clean development mechanism?

Beatriz Granziera: There are a few very big shifts there since Kyoto. So first, right, Kyoto was just one centralized system, the Clean Development Mechanism, very similar to what I just mentioned around Article 6.4. At the time, we also had this centralized UN body controlling everything related to the operationalization of the Clean Development Mechanism. But under the Paris Agreement, as I mentioned, countries have a lot more flexibility to decide how to engage in markets, for example, through just signing a bilateral deal under Article 6.2.

Second, and I think this is a really key difference here, that under the Kyoto Protocol, only developed countries had binding targets for climate. That means that developing countries could then sell carbon credits without that really affecting their national accounting. So as a result, double counting was not really a concern back then. But this is different now under the Paris Agreement because every country has a mitigation target or an NDC, and that basically changes everything. So If a country sells a carbon credit today, it has to adjust its own emission balance to make sure that the same emission reduction is not counted in another country at the same time. Because if you’re counting one emission reduction twice, that won’t help as the goals of the Paris Agreement. And then that has some major implications that we get can get more into later. But now developing countries have to really think what kind of credits they are selling and what quantities and at what price.

And just, I’ll say that the third big difference here, a little bit related to what I’ve already mentioned, is that the landscape of carbon markets today is way more complex than what we had under Kyoto.

Now you have more than a decade of experience with voluntary carbon markets and a lot of lessons learned from what worked and what really did not work. You have large scale forest programs generating credits for the first time. and on top of that, there are today over 70 regulated carbon pricing systems around the world, including carbon taxes and emission trading systems. So with countries, for example, like Brazil now entering the space. So Article 6 is both shaped by and shaping all of these markets as well. And the rules are also hopefully learning from all this experience that happened in the past couple of decades.

Arvid Viaene: Thank you. And I think it’s also worthwhile pointing out that this is something I learned that I wasn’t aware of is that exactly under the Kyoto Protocol, there were no targets for some of these countries. So they could sell credits without it impacting their goals. But now that has changed with the Paris Agreement. So the double counting topic that you can only use it once becomes really important. And I was even kind of surprised that this used to be the case. You could just buy credits that the other person then didn’t need to account for. So, yeah, first when I read that, I’m like, huh? But it makes sense that is now a goal. So, and then this double counting is, as I understand it, addressed in Article 6.4, which is kind of the centralized system, if I can call it that.

Arvid Viaene: Is that also there in Article 6.2 in this bilateral system?

Beatriz Granziera: Yes, it is. Article 6.4 and Article 6.2 both need tools in place to avoid double counting. This may sound simple and obvious, but it was one of the main sticking points in the negotiations for years. Article 6 is one of the many articles of the Paris Agreement, and it took countries almost a decade to finalize rules. Almost all other articles were largely agreed in 2018 in COP 24, but Article 6 is really complex and that issue around how you really address the double counting was at the core of very heated debates throughout all these years.

Arvid Viaene: Why was it so heated?

Beatriz Granziera: Because we were coming from the Kyoto Protocol. So developing countries, a lot of them still had some expectations that they could still sell credits without really that affecting their own climate commitments under the Paris Agreement. So, and I think there is, Kyoto was divided between developing countries and developed countries. So it took a lot of time for countries to transition to this new Paris universe.

And I think addressing the double counting for all countries is a key point of Article 6 and really the core of why this system can work. Because unless you have, all countries moving towards reducing emissions, the system just, it doesn’t make sense in this new reality that we have right now.

Arvid Viaene: Exactly. So, and I can also, imagining that the EU exactly has this as a big condition that you want to have this double counting or otherwise it won’t reduce global emissions. So...

How big is the Article 6 market today?

Beatriz Granziera: Yes, exactly.

Arvid Viaene: Just to get like a sense of what the market is before we dive into the further technicalities, could you just give us an idea of the size of these carbon offsets, like how have been generated over the past or the past five years? And I know might get complicated with like those issued under Kyoto and now, but just kind of getting a sense of the landscape.

Beatriz Granziera: Now, I think that’s actually a really important question because there’s a lot of buzz around Article 6 right now. But when you look at the actual market and what’s happening, you realize very fast that we’re just at the very, very beginning. Just to break it down, you have around Article 6.2, So the bilateral agreements, you actually have a lot of momentum. There are over 80 bilateral agreements that have been signed between countries to date. But then when you look at the actual trades between countries, the number falls to two. So only two trades have happened. One was between Switzerland and Thailand back in 2024. And the second one happened a few months ago between Switzerland and Ghana.

So this is a market that hasn’t really even started yet. So there are a lot of reasons why that’s the case. So first of all, after a decade or almost a decade of negotiations, a lot of countries are still regulating Article 6 domestically. And that’s complicated. That requires sometimes congressional approvals, different legislations, different, negotiations. So that just takes time. The second [reason] is that there’s a lot of uncertainty now about how countries will get to their climate targets. Just to explain, climate targets under Paris Agreement, they are updated every five years. And then the next target to 2030, it’s coming up, but countries are not absolutely sure yet where they’re going to be there. So they have to be careful about how many credits they want to sell under Article 6, because these credits will not be able to use for them to meet this climate target. So this is a very big component. And the third thing is that demand for Article 6 credits is still small and quite fragmented. So overall, Article 6 is up and running, but it hasn’t really turned into a liquid market yet. So to your question, like how many credits we’re talking in terms of supply, we don’t know yet.

And there are very few countries that have, the legal framework in place, the institutions in place and a pipeline of carbon credits that could qualify for Article 6.

Arvid Viaene: Thank you. And then I think that does stand in contrast to the voluntary carbon market, where I think one of the big things that I’m learning is this course, yeah, like the aviation is like a big source of demand for credits.

Could you maybe speak a little bit more to that? Because even in your projected demand for 2030, they were in there.

Beatriz Granziera: Yes, absolutely. So I was talking before about supply of Article 6 credits and how that is slowing happening. But then another huge component of any market is where the demand is coming from, right? Who is going to buy in the end Article 6 credits? So today, as I mentioned, Article 6 demand is not there yet. It’s fairly small, but it’s slowly emerging. So demand for Article 6 comes basically from two sides. One, you have buyer countries, mostly developed countries like Switzerland, Singapore, Sweden, South Korea, Norway and Japan. They want to use Article 6 credits to meet their own climate targets.

So these countries have announced some demand, and this is by 2030 200 million tons of CO2. But as you very correctly mentioned, the bulk of Article 6 demand comes from CORSIA, which is the aviation sector where companies would be purchasing credits to meet their own goals under this Corsia market. But I think there’s one thing that is important to mention here, that this is just, the numbers that I mentioned are just a photo of what we have today, and they will for sure change in the future. So as we get closer to 2030 and also closer to 2040, more and more countries might rely on Article 6 to meet their own climate targets.

And I think one of the biggest examples that we have is the European Union that announced just in December of last year, 2040 target, which allows of 5% of Article 6 credits. So that 5% might not sound a big number, but it’s actually a huge game changer for Article 6 demand. And just the EU alone could double all the current Article 6 demand that we have today to 2030. So that’s definitely going to be a big deal in how the market progresses.

Arvid Viaene: Could we talk about the EU demand just for a second? Because one of the things I was surprised by when I read your article is the timeline of the EU demand. So could you maybe talk about how they’re thinking of implementing this?

EU 2040 target and the return of international credits

Beatriz Granziera: Yes, absolutely. So, as I mentioned just last month, the EU finally agreed on their 2040 targets, and that’s a 90% reduction in emissions compared to 1990 levels. The big novelty here, as you mentioned in your introduction, is that for the first time in many years, the EU will allow 5% of this target to come from the use of international credits, and that’s basically Article 6 credits.

Arvid Viaene: Article 6.4, right?.

Beatriz Granziera: Article 6 in general,

Arvid Viaene: Got it

Beatriz Granziera: Yes, the EU, from what the EU has been announcing, it’s not yet clear. And I can talk a little bit more about the uncertainties that we have coming up in 2026 and the following years. But just in terms of timing, the use of international credits would be available from 2036 onward. And before that, you’d have a pilot phase running from 2031 to 2035. There’s not a lot of clarity on how the pilot phase is going to work. But that’s that’s just how the EU is structured. That’s the target.

And again, I think I want to emphasize this many times because, when you hear 5%, that might sound small, but politically it’s actually a big shift for the EU. Because for a long, long time, the EU has been very clear that it wanted to meet its its climate targets only with domestic mitigation inside the EU. So this decision to reopen the door to international creditS has definitely made the waves here in Brussels and well beyond.

Beatriz Granziera: And I can talk a little bit about the different positions here.

Arvid Viaene: Yeah. and Did it surprise you? Had you seen something coming?

Beatriz Granziera: Actually, it did surprise me when it first came. So these discussions, the first announcement came in July of this year. And we are used to see the EU in the Article 6 negotiating rooms, very clear that they won’t use these credits for, maybe, a decade of negotiation. So that was that was actually a surprise. But at the same time, the EU has been one of the main negotiators and decision makers in this process. The EU has been around the negotiation since the Kyoto Protocol. So on the other side, it makes sense that you might want to use, that is one of the flexibility mechanisms.

Arvid Viaene: Maybe we then, know, because they announced that some people were surprised and some people were against the use saying, we should keep all reductions domestic. I think there’s a case to be made to use credits from just a theoretical point. If you want, can reduce them somewhere cheaper. But there are then, of course, some worries. And I think one of the worries we talked about with Ben in his episode is what I would call flooding of past low quality credits.

Because under the Kyoto Protocol, you had these credits that sometimes were of lower quality or sometimes might have not mitigated CO2 or might have not reduced CO2. and now there’s this whole discussion as I get it about how do we transition those prior credits, if at all. So maybe could you talk about what the transition mechanism could you talk about what the transition mechanism is. Because I imagine those are also intense discussions.

Can old Kyoto credits flood the market?

Beatriz Granziera: Yes, absolutely. And you’re right. That has also been another important seeking point. So I think your question has two points there. one the criticism about the EU being open to the use of Article 6 credits in general. And the other thing, how this old Kyoto Protocol credits, and a lot of them, don’t have the same quality standards, would get into this mechanism. So I’ll just break it down and start talking about the criticism that we have been hearing here in process.

So I think one of the major concerns is whether relying on international credits would weaken climate ambition inside the EU or even risk increasing emissions domestically. Right. And I think that’s a very valid concern and definitely deserves serious attention, but I think this is only part of the picture because using Article 6 isn’t automatically good or bad, and it doesn’t decrease or increase ambition. What really matters it’s like are the details, right? And many of these details haven’t haven’t been decided yet. And this is what the Commission is going to start doing this year now.

So big questions that are still unanswered are: which sectors are going to be allowed, which methodologies? Is the EU going to use Article 6.2 Article 6.4 only? What safeguards will be in place? How will member states participate in the decision of how to purchase these credits.And, I think very importantly, what kind of buffers and quality controls will ensure that the credits coming in the EU are actually high quality and real and additional and verified.

And I think there’s also another point that I feel that is often overlooked in this discussion as well. By entering this market, EU is not only benefiting from the credit credits, but because the EU represents such a huge demand, it will also shape how the supply of credits will develop.

And right now, I mentioned before, we’re just at the beginning of the market. So supply has not yet been locked in. So the fact that EU is entering the market represents a big opportunity for Europe to shape how developing countries are developing the credits at what quality criteria with what ambition. And I think this is a very rare and timely opportunity that the EU have in the end, the EU participation could really drive more global ambition of this market, depending on how it’s done.

Arvid Viaene: Yeah. And in some sense, it’s because they then represent such a big potential demand, they can also have potentially more influence on the rules that go into it.

Beatriz Granziera: Yes, absolutely. Because, developing countries are looking at demand. So if there’s a clear demand signal to use, certain standards and, to have certain ambition, that’s how, where the market’s going to evolve. And the EU is one of the very few players in the market that has, the size and and scale to really shape all of this.

So I think this is, and this is like the side that I don’t feel it’s being talked about in Brussels that much, that the EU could have a huge influence on the quality of carbon credits that could then be developed in the future.

Arvid Viaene: And then we have the transition of the old credits.

Beatriz Granziera: Yes. So you’re right. The Clean Development Mechanism, some Clean Development Mechanism credits could transition to Article 6.4, but that’s there is one catch there. For most product projects, the deadline has already passed. So it was established in 2021 that like old projects from the Clean Development Mechanism could request transition until 2023, with the exception of afforestation and afforestation projects, which extended the deadline until 2025.

But then even when the project developer requests the transition, it’s up to the host country to decide if they will allow the transition. So this is a very important point. And this is one thing that was very discussed at COP30 in Bellin just a few months ago or couple months ago. That deadline for countries to approve the transition was extended by six months until June 2026. Without that approval, the transition won’t happen.

So if you look just in terms of how many projects requested transition, you have around 1,400 projects that could lead to, in the higher end, maybe a billion credits entering transition. maybe flooding at the Article 6 market. But in reality, the number of projects and credits that we transition will transition will be much lower because you require that host country approval.

Arvid Viaene: I think I read somewhere it’s like of the billion around 300 million would be allowed to enter or do I get that wrong?

Beatriz Granziera: Yes, I think that there are some estimates. I think the World Bank has come up with estimates around that number. But for me, when I talk to countries that are going through the very bureaucratic process of approving, the projects and people that have on their desks just a pile of projects that they are deciding to approve, I feel that this is still quite uncertain. Because a lot of countries, they still don’t know if they want to approve the projects for the reasons that I mentioned before.

If they approve the transition with a corresponding adjustment, that means that they cannot use these credits to meet their climate targets. So countries are being very careful. And I think it’s very hard to estimate how many credits are going to enter the market. The other important issue here is that it’s a market, right? So even if some credits from the CDM are allowed to transition, it’s up to the buyers to decide to buy them.

So if the EU, as you mentioned, like that concern that the EU would then be, buying CDM credits, that’s up to the EU. The EU can decide what kind of credits they will buy. And I think there is a big concern around quality on the CDM project. So I’m very curious to see how the market reacts to them and how much demand for these credits are and what price.

Quality control under Article 6.4

Arvid Viaene: So maybe that’s a good point to transition to Article 6.4 and the quality control on credits. Because as the way I read your explainer, it seems like there’s a lot of stringent quality control going on with the supervisory board. Could you talk more about what that supervisory board is doing and what the status is?

Beatriz Granziera: Yes, absolutely. And I think 2025 was a big year for Article 6.4 and the supervisory body. And everyone there worked really, really hard, including the UNFCCC Secretariat. So we had some very big milestones. For example, the first ever methodology eligible under Article 6.4 was approved just back in October for landfill methane. The first projects also started to transition.

Arvid Viaene: Just when you say it’s been approved for landfill methane, that means that every project in landfill methane meets all these requirements, it can officially enter in Article 6.4. There’s no more need for approval or like you would need some verification. Just what does that actually mean that now it’s been approved?

Beatriz Granziera: Oh, there’s a lot of approval. let me clarify: I think 2025 was a very big year for the Paris Agreement crediting mechanism or Article 6.4, with some very important milestones that the supervisory body and the UNFCCC secretariat achieved. Just to mention some of them, there were, for example, some very important rules that were draft. These are overarching rules around technical issues on permanence and additionality, leakage, baselines and all of that. Very important and very technical issues on how the market will work.

On top of the super broad and overarching rules, now they are also working to approve specific methodologies. So methodologies are basic, like, activity tailored rules that every project would have to apply to be eligible for Article 6.4. This will take time. The first methodology has been approved already. It was approved in October of 2025. And it’s just for landfill methane.

But now for 2026, the supervisory body will likely consider a lot more methodologies. So more projects and more types of activities can also be considered under Article 6.4. And then the other milestone is that projects already started to transition. So far, we don’t have any new project because we didn’t have methodologies until October, but we have some of those CDM-old projects that were that transitioned to Article 6.4. So definitely some very big moments for Article 6 right now.

And I think in terms of quality, this is a very key component because most of when you look at who is making these decisions, a lot of them were around making the same decisions under the CDM. So they, they [experienced the difficulties of the CDM quality control]. In fact, in many aspects, the quality issue was a big problem there. So you see that like quality control is a really big focus, as it should be. I think in general, it was a deliberate decision that one way to control quality is that to make very stringent rules. And with that, of course, you’re going to reduce the supply of credits that would be available to be generated.

So I think this is where we are right now. But I think there are other points to be considered in these discussions as well that were very, very evident and very important in 2025, because what you’re actually developing is a market, right? And a market needs to be feasible and needs to work if you want to deliver the goals of the Paris Agreement.

So if you implement rules that are really good on paper, but just they don’t work in practice, the system just won’t deliver mitigation and scale to meet the goals of the Paris Agreement. So I feel that right now you have that this tension between two sides. One side pushing to make rules very, very stringent and as they should be. But also some questions around to what point you pushed too much in a sense that you actually don’t deliver any of the goals that you are intended to deliver within a carbon market mechanism.

Arvid Viaene: So it’s like the balance between too stringent, it won’t generate any credits and then to lose you, you get a big concern about the quality. But right now, it sounds like if the rules get too stringent, there might just not be any, not, if the rules get too stringent, there might not be any credits. If, that’s a summary.

Beatriz Granziera: Just to give you an example, I think one of the biggest discussions of last year was around the role of nature-based credits within this market and how that would work. So, I think starting in the summer until the very end of last year, that was one of the biggest and most heated topics that I think it really went from, the super technical like policy nerd discussion to become a very big political issue. We had, Forbes, Reuters covering this issue. So it really became important. But basically, the supervisory body was drafting rules around permanence and the risk of reversals. And hundreds and hundreds of stakeholders in many countries raised concerns that these roles were so stringent that they would basically exclude nature from Article 6.4 altogether. And, as I was mentioning, this is not only about Article 6.4, because now all these markets are interconnected.

So this would really mean that nature would be affected in other markets as well, such as the voluntary carbon markets and other compliance markets. So I think this is an example of how, rules that might sound good on paper, in the end, could exclude one of the most important sources of supply. And nature is not only about reducing emissions, you have very important co-benefits for communities, for water, for so many other things. So, again , I think there are concerns around quality are important and they needed to be addressed. But I think risks should be addressed with risk management mechanisms, not only simply excluding full sectors from the market.

Arvid Viaene: It sounds like the rules might even get too stringent.

Beatriz Granziera: What I think is that the supervisory body developed some very important rules that are looking at quality controls. And as I mentioned many times, you cannot have a market if you don’t have very stringent quality control. So this is for sure important and this is what is wanted. But to your question on whether the supervisory body went too far, I think we don’t know yet because there are still a lot of rules that are going to be discussed in 2026, some very important components as well.

And I think to answer your question, we’re really going to have to wait until the methodologies are approved. So, as I mentioned, you have overarching rules, but like these discussions will come back over and over again when you when you approve methodologies.

All methodologies need to be approved by the supervisory body and all projects also need to be approved by the supervisory body. So these discussions will come back over and over again. And I think only then we will have a real sense of, how the market’s going to work.

Arvid Viaene: So, It sounds like the Article 6 is really like taking off like 6.4, the landfill methane was approved. Next year, we’re going to look at other projects. I think that’s my sense and takeaway is that this is all starting. This is all happening right now. Like it took a long time until COP29 to kind of agree on the things. And now it’s like starting to kick off for Article 6.4.

Beatriz Granziera: Yes, exactly. For Article 6.4, it has been a very slow development. So Article 6.4 is just now becoming operational for the first time. So, you haven’t had any trades yet. And this is, I think we only see how the market evolves when you actually have the trades. We will only see how stringent or how, feasible the market is when you actually start to have trades.

So I think I agree with you. This is a very exciting time to see how things evolve for, again, for a market that has the potential to be, a very big deal within the landscape of carbon markets and that is already influencing, how other markets consider high quality.

Arvid Viaene: Perfect, thank you for coming on. I think this is going to really help people get a sense of Article 6 instead of the abstract to actually get to know it. So thank you so much.

Beatriz Granziera: Awesome. That works. Great. Thanks, Arvid. It was really a pleasure to meet you and thanks So much for the invitation. It was great to participate here.

Arvid Viaene: When we think about tackling climate change, and given my training as an economist, I tend to think we should use either a cap-and-trade system or a carbon tax. But I recently read a paper that made me realize I might not be fully aware of the criticisms against pricing instruments coming from other disciplines.

So today I’m joined by Jeroen van den Bergh to discuss those criticisms—especially the idea that people might be boundedly rational. Jeroen is the author of a paper called Pricing Instruments in Environmental and Climate Policy when Polluters are Boundedly Rational.

Jeroen van den Bergh is an environmental economics professor. He is an ICREA research professor at ICTA-UAB in Barcelona, and an honorary professor at Vrije Universiteit Amsterdam. He leads ICTA-UAB’s Environmental and Climate Economics group, was Editor-in-Chief of Environmental Innovation and Societal Transitions from 2011 to 2021, and has received major honors, including the Shell Sustainability Research Prize, two ERC Advanced Grants, and an honorary doctorate in 2019. Welcome to the podcast.

Jeroen van den Bergh: Thank you for having me.

Arvid Viaene: This is a question I generally ask my guests: what’s the number one thing you’d want listeners to take away from your paper?

Jeroen van den Bergh: I guess that carbon markets—or emissions trading systems—are better than carbon taxes. Many people put them in the same category: they either like “pricing” or they don’t. But they’re actually quite different.For a long time, many colleagues were in favor of carbon pricing through taxes. Then I became rather indifferent. And now, after seeing the evidence for many years, I’m strongly in favor of carbon markets.

One main reason is that the biggest carbon market—another word is “emissions trading system,” or “cap-and-trade”—is the European one, which covers 30 countries. That’s already a big advantage. We don’t know any carbon taxation system, let alone other climate policies like standards or subsidies, that is harmonized among 30 countries.

In fact, it’s quite easy to extend the number of countries. It’s basically a technical “button” that can be activated and countries can be included. There have also been carbon markets across borders between Canada and the U.S.—different states and provinces have had joint carbon markets—which shows that country boundaries don’t matter very much.

And that’s great. You could not imagine a tax being shared across borders, because taxes are really national. They involve legislation, and rules about how revenue should be used. That’s very difficult to extend beyond borders.

2. Another reason I think carbon markets are successful is that they’re an institution outside the direct control of governments. Take the EU ETS—the European Union Emissions Trading System. When Russia invaded Ukraine, many energy taxes across Europe (and elsewhere) were lowered, cut, delayed—whatever.

The only system that remained intact, as designed, was the European ETS. At the national level, politicians couldn’t touch it. Also, many right-wing politicians who may not like climate policy were not even very aware of it, because it has been there for years. It’s a bit “hidden.” And that’s good—that’s what we need.

3. High prices: That leads to a third advantage.The ETS is the only system we’ve had so far that has achieved high prices. The carbon price in the European system has already exceeded €100 per ton—which is the order of magnitude we need. Maybe we need €200, €300, €400, but the order of magnitude is there. That’s very promising.

With carbon taxes, that’s very difficult to achieve. And if you look at carbon taxes around the world—maybe a dozen or so—and compare them with carbon markets, it’s clear carbon markets generally reach higher prices.

4. That’s probably because you plan the system: the cap goes down over time; the permits become scarcer and more expensive; and therefore the price goes up. That’s a big stimulus to reduce emissions, because polluters then face a choice: either emit and pay the carbon price, or reduce emissions. If the price is higher, they’ll adopt more expensive alternatives for abatement—and that’s how it works. But it also leaves freedom. Not every firm has to reduce in the same way. In some industries or subsectors, it may be very difficult and expensive to reduce emissions, so the system drives reductions toward those activities where it’s cheapest.

That’s a fourth advantage: it makes emissions reduction cheaper for society. It means the average cost increases in products and services will be less if you do it through carbon pricing. This point holds for carbon taxes too.

5. Automatic adjustments of the price: A final advantage is that we have economic growth and rebound effects. People may save energy, but then through behavioral and systemic effects they don’t save as much as expected; somewhere else energy use goes up; emissions go up. That puts pressure on emissions targets. With a tax, you’d have to raise the tax—which is politically difficult, if not impossible. Maybe you can raise a carbon tax once every few years, but if you do it too often you get voter and stakeholder resistance. Parties that don’t like the policy will use that to create resistance, win elections, and then get rid of the tax.

With carbon markets, if there’s more pressure on the system, the price automatically goes up—because it’s determined by demand and supply for permits. If there’s more demand, the price rises. Nobody has to decide it; no politician has to vote for it. The system arranges it itself.

So even with economic growth and rebound effects, the system responds. With taxation—and also with subsidies or standards—you don’t automatically control additional emissions from growth and rebound. They perform worse in that regard.

So my conclusion is: carbon markets are really the way forward. I know many people don’t like the word “market,” just like many people don’t like the word “tax.” So you can use the term “cap-and-trade.” Many environmental organizations accept that, because “cap” means you put a limit on total emissions, which aligns with a precautionary perspective. And it’s getting more support from environmental NGOs.

Arvid Viaene: Thanks for that. That was really helpful—and there was a lot in there. Let me process it. One thing your explanation made me realize is that with cap-and-trade, a lot is automated. Like you said: there’s no need for politicians to raise the tax because of shifts in the economy or circumstances; it just happens automatically through supply and demand.

And the second thing I took away is that it can be more “hidden,” in the sense that people are less aware it’s there—even though for a given price it can have a similar impact as a carbon tax. Is that right?

Jeroen van den Bergh: Yes, you’re right. A carbon market is an automated system, in the sense that politicians don’t need detailed information about emissions, technologies, or the costs of different abatement options.

If politicians try to decide, for example, “this sector must reduce X and that sector must reduce Y,” they need to know a lot: where are the emissions, what are the alternatives, how expensive are they? Historically, governments sometimes decided that sectors should contribute proportionally to their size or emissions share. That might feel “fair,” but it’s not a wise way to solve climate change—economists agree on that.

For instance: suppose agriculture is 5% of emissions, so you say it should do 5% of reductions. But if emissions reductions in agriculture are very difficult and expensive, why force that? You’d make food extremely expensive, and products depending on agriculture and forestry would become more expensive too. Society would see big cost increases, and that would reduce support.

With the ETS, we started by including big emitters. But it doesn’t mean they all contribute equally to reductions; it depends on their opportunities and costs. This increases the costs of things like metal, paper, fertilizer. We don’t know exactly how it affects final goods and services—and we don’t need to know every detail.

But if you had a carbon tax that was very visible in consumer products at the end of the chain, firms might start advertising: “We’re not responsible for this part of the price increase.” That’s not what we want.

Now, bounded rationality is also important—this is what we focus on in the paper. I think few people have realized this, so it’s quite innovative. If you have a carbon tax and you don’t get a good response because people are habitual, or they’re not very rational, or they don’t really notice the cost, then you get less emissions reduction than hoped.

But if you have a carbon market, and the response is insufficient—meaning emissions pressure pushes up against the cap—then the price goes up until the cap is respected. So the market automatically corrects for bounded rationality that would otherwise weaken emissions reductions.

That’s interesting because across the social sciences—including economics—bounded rationality is not the exception; it’s the rule. There’s a lot of talk about behavioral responses: defaults should be green; people should be nudged; car shops should show electric cars first, and only later combustion engines. I’m perfectly in favor of these things. But in my view, carbon pricing is the essence of the solution. The key question is: which type of carbon pricing is more robust to bounded rationality? For me, that’s carbon markets.

I already mentioned five advantages of carbon markets—this is a sixth. It’s a convincing list.

Arvid Viaene: I really agree with you that behavioral economics has become very popular—nudges, defaults, information campaigns, telling people how to reduce electricity use—but ultimately cap-and-trade handles a lot of that because you’ve set the cap. No matter how people behave, the cap is an upper limit for firms and there’s a limited amount of emissions permitted. So it affects the price such that the cap is maintained.

And in your paper you point to examples where giving people information doesn’t necessarily stick. There can be a lot of work in behavioral interventions, without a clear return.

Jeroen van den Bergh: Yes. I find it interesting because I’m looking back at an older paper where we discussed behavioral interventions and we identified six types of behavioral problems. I even have an idea for a new paper, because we didn’t really connect those six behavioral problems to carbon pricing—yet I think there could be a link.

In that older work, one category was inattention. You can use energy-efficiency labels and lifecycle information to create attention. But if you have a sufficiently high carbon price, that will draw attention—price information dominates behavior. If the price is very low, people ignore it. But if price differences between clean and dirty alternatives become large, attention will be there.

Another category is mental accounting: people have mental “budgets” for environment, energy efficiency, cars, and so on. Again, a higher carbon price can change that mental accounting, because people realize they’re hitting limits and must rethink.

Defaults are also important. But if the default is dirty and it becomes relatively more expensive because of carbon pricing, attention shifts toward the cleaner option.

Then you have present bias: people invest in an efficient car or heating system, but the benefits are in the future. With a carbon price, the energy bill is higher, and they more clearly see that future savings will be meaningful—so present bias is reduced somewhat.

Finally, there’s peer influence: people are influenced by others. Some see this as bounded rationality; others say it’s rational to rely on others when information is hard to obtain. Peer influence can complement carbon pricing. If pricing changes behavior for, say, the first 30%—the “first movers”—and others are socially sensitive, then social examples can reinforce the price signal. At some point you could get more than 50% changing behavior, which triggers a quicker transition. We have a paper on that. The advantage is you can need a lower carbon price if social interactions reinforce behavior change; we call it a social multiplier.

I also have a recent paper—published last week—extending this idea to a cultural multiplier. Social interaction is one thing, but sometimes people see themselves as apart of subcultures. (like seeing neighbors install solar PV). Cultural multiplier is broader: you’re part of a community or subculture—vegan eating, no holiday driving, low-carbon initiatives—so you’re influenced culturally.

That can also reinforce the effects of carbon pricing and allow lower carbon prices, which helps with political support.

The Use of Cap-and-Trade Revenues

Arvid Viaene: That’s a really good explanation of how those biases can interact. I also wanted to ask about something else I found interesting in your paper: how revenues are used. A lot of attention goes to whether we should do cap-and-trade or a carbon tax, and then revenue use is often an afterthought—even in textbooks.

If I summarize: if you set the price correctly, you’ve accounted for the externality, so you don’t necessarily need to subsidize green energy. But there may still be a role in developing new technologies. Could you elaborate on your thoughts on how revenues should be used?

Jeroen van den Bergh: Yes, it’s very relevant, because carbon pricing generates revenue. Carbon taxation clearly generates revenue. With carbon markets it’s not always as obvious, but in the initial phase permits are sold by governments, which creates revenue. You can also arrange the system so that permits must be renewed periodically—every year, every two years, every five years—possibly with a base price. That can create an additional revenue element.

Then the question is: what do you do with it? Surveys show people say they are concerned about inequality—people are inequality-averse. But when you ask people concretely how to allocate revenues, they don’t prioritize compensating inequality as much as you might expect. Instead, they tend to choose what we call environmental or climate projects. They like the idea: “use the money for climate projects.” Often they mean renewables. But it’s ironic: most renewable projects are done by private partners because they’re extremely expensive. People underestimate this. Tax revenues from carbon pricing wouldn’t be sufficient to fund massive renewable buildouts.

People sometimes point to cities like New York investing in renewables and say, “Look.” But compared to future needs, it might be a small share—maybe 5% of energy needs—so it’s not that impressive.

So why do people want “climate projects”? We haven’t fully sorted it out, but our guess is that many respondents think the main purpose of carbon pricing is to raise revenue and then use that revenue to solve climate change. But that’s not necessary. Carbon pricing already creates a price gap between clean and dirty alternatives, which stimulates firms, investors, and consumers to shift toward low-carbon options. That has an immense effect, and people underestimate that. People talk about “radical change,” but carbon pricing produces many gradual changes throughout the economy, and they add up to a radical transformation. Radical change is often many changes happening quickly. But somehow, people want to use that money to reinforce more change, and I understand that.

Now, subsidies can sometimes be useful, but not generally. Subsidies also create a gap, but differently: carbon pricing punishes the dirty alternative; subsidies reward the clean alternative. And we’ve seen subsidies don’t always work so well. There’s a study in Nature Energy that looked at 50 years of renewable energy in many countries. It found that only about 15–25% of renewable energy actually substituted for fossil fuels—depending on whether you look at electricity or broader energy categories. The rest largely met rising energy demand. That’s shocking. Some of that is due to demand growth. But it’s also because we don’t punish fossil fuels—we reward the clean alternative, which doesn’t guarantee substitution.

Carbon pricing would do better. I’m not against subsidies, but I’m critical of them. I think subsidies should be used to create a good market in early stages. Take Germany: it subsidized renewable energy over the last two decades—estimates vary, but on the order of €50 billion. Many experts now say: if we had spent that money on innovation, we’d be much further. What happened was: with good intentions, we tried to diffuse an immature solar PV technology to a large population too early.

Of course, it’s also not good to only innovate and not build markets. Markets have barriers too: production, sales, building integration, local government acceptance—many issues. If you have perfect technology but no market, you get delays. So you need to create a small market with subsidies. But we’re beyond that now—far beyond that—so I think subsidies are not necessary anymore.

Arvid Viaene: That helps a lot. I think you may have solved one of my open questions: why revenues from carbon cap-and-trade often go to renewable projects. It sounds like politicians do it because that’s what voters expect. People think the revenue is for funding the transition, instead of realizing the cap-and-trade mechanism is the solution.

In Europe, for example, EU ETS revenues used to be split—something like 50/50, where states could use some portion flexibly and some for climate projects. But I think it changed so that now it’s more like 100% must be used for climate transition purposes.

Jeroen van den Bergh: Yes, indeed. I think that requirement comes from frustration that we’re not solving climate change.The best way would be to raise the price more. But the EU is limited because it’s an open region; it can be competed away by other regions if it doesn’t protect itself. That’s why it’s working on the border tariff—the CBAM, the Carbon Border Adjustment Mechanism—which is not fully in place yet; it’s being experimented with.

Just to add to what you are saying, from a traditional economics perspective, revenues from carbon pricing should be returned to taxpayers neutrally, like a lump sum. “Lump sum” is a technical term: it means it doesn’t change behavior.

In practice, pure lump sums are difficult. But you could return revenues through income taxes, proportionally. If you give everyone the same amount, it becomes redistributive: poorer households get relatively more than rich households. You could do that if you want redistribution; if you don’t, you’d do it differently.

But we’re far from that way of thinking in policy. That economic principle—returning revenues neutrally—is not really followed. And that’s how society works: you need political and public support. And many people in parliaments don’t know this theory.

Arvid Viaene: I recently read a paper discussing everything about the ETS—framing, setup, and so on—and it barely said anything about how revenues are used. It surprised me.

Jeroen van den Bergh: There is good thinking on this. There’s a good paper in Nature Climate Change on how to make carbon pricing acceptable for citizens—“citizens” is in the title.

They present a scheme suggesting that revenue use should depend on country conditions: is the country prosperous or in crisis, is there unemployment, and so on. You could choose revenue recycling options that fit the economic and political situation and help build support. So there’s no single general advice. A pragmatic approach can make sense.

The potential progressiveness of Cap-and-Trade or Carbon taxes

Arvid Viaene: That connects to another point you raise: most people think a carbon tax is regressive. But you point out that in some countries it might be progressive. Could you talk about that?

Jeroen van den Bergh: Yes. This progressive nature is especially relevant for poorer countries, where a small share of the population has a luxury lifestyle and uses a lot of energy, while many people don’t even have access to electricity. Some households burn stoves using collected wood. Those people won’t be affected by carbon pricing directly.

There is a risk: people who use some electricity might reduce electricity use if it becomes more expensive, and switch to burning more wood. That could have negative environmental effects. Wood also emits a lot of CO₂ per unit of energy—if you rank fuels by emissions intensity, wood can be worse than coal. So developing countries are a special situation.

For rich countries, it’s more complicated. Studies for Europe found carbon pricing was not as regressive as expected. Maybe richer households don’t consume dramatically more energy than poorer ones, or maybe “poor” is relative and basic needs are still met. This leads to a difficult debate. Sometimes we say we must protect poor households—but poverty is a relative concept. Does everyone have a right to drive a car? Two cars? A flight every year, or multiple flights? If someone can only afford one car and one flight, are they “poor” in rich societies?

If someone truly can’t pay more, then with a carbon price it may become impossible for them to do some things. People then say carbon pricing is regressive. But is that what we should worry about most? These are sensitive ethical issues, and subjective. I don’t have a strong opinion, but I see people are afraid to touch them.

Arvid Viaene: Going back to criticism of pricing instruments: the EU ETS has been in place for a while, EU ETS 2 and CBAM are coming in. In Europe we seem to be moving toward more pricing. What do you think has shifted the narrative? Have papers convinced politicians, or is something else behind that trend?

Jeroen van den Bergh: Europe is different from other parts of the world, and Europe as a whole is also different from member states.

At the EU level, there’s a strong embrace of the carbon market. In all contexts, it is presented as the core pillar of European climate policy. Other studies show it’s the strongest element in national policy outcomes too. In some countries, you see small carbon taxes alongside the ETS, but they’re often low, and sometimes they replace existing energy taxes like fuel taxes. That’s good, but it doesn’t necessarily mean stronger behavior change, depending on design. I would invite all governments to replace existing energy taxes with carbon-based taxes or prices.

Many people don’t understand the difference. For example, fuel taxes aren’t proportional to carbon content. Different fuels—gasoline, diesel, others—are taxed in ways not directly linked to their carbon content. Diesel, for instance, can be slightly cleaner in CO₂ per kilometer because it’s more efficient—maybe around 5% cleaner than gasoline in emissions, depending on assumptions and lifecycle considerations.

The problem with diesel is local pollution: particulate matter, black soot. In cities, that’s not good. On highways, diesel can be better than gasoline. Diesel has a bad reputation now, and I don’t think it’s fully justified—but that’s a separate issue.

CBAM and Climate Clubs

Arvid Viaene: Right—and it’s like you say: if you change a general tax not related to carbon into one related to carbon, then these things get internalized. I’ve been following the CBAM, and it seems intellectually challenging: you have to estimate emissions embedded abroad along value chains. It’s a massive exercise, but once done, a lot happens automatically.

Jeroen van den Bergh: Absolutely. What the EU is doing—creating a protective border around its system through CBAM—is not perfect, because you need to estimate emissions from production of imported goods. You can’t know that perfectly. Companies importing goods are asked to get information from producers abroad, and they often don’t know exactly either. So there’s biased and imperfect information being used. But it’s a second-best approach—we knew that. The better solution is that the EU expands and invites other countries to join its system. This has already happened in a limited way: some countries that are not EU members are part of the EU ETS system, because the system allows it. There’s no real limit.

These are close countries: Liechtenstein, Norway, and I think Switzerland. You could go further: you could ask the UK. You could even go as far as certain U.S. states. The U.S. as a whole isn’t possible at the moment, but states bordering Canada, and states on the East and West Coast, are more progressive and trade a lot with the world. The EU is a major trade partner.

For them, it could be economically logical to join rather than pay carbon border tariffs. My proposal in some papers is that the EU invites other countries and also puts pressure through political channels. This is sometimes called a climate club or climate coalition that expands. I think this is the only way to solve climate change.

The Paris Agreement is not really an agreement in the strict sense. We don’t have a uniform harmonized policy; there are no punishment mechanisms. It’s more like a collection of voluntary bids. It’s good for communication, but every year at the COP meetings you see frustration that it doesn’t achieve what’s needed.

Big international agreements rarely start big. Trade agreements like the GATT and the WTO evolved over time. The EU itself didn’t start as a big organization; it started small—with the Benelux. Belgium, the Netherlands, and Luxembourg were the beginning. I could cross from the Netherlands to Belgium without a passport my whole life. That’s fantastic—and it’s where Europe started. We should learn from that: we won’t solve climate change with one big agreement. The Paris Agreement is fine, but it is not sufficient. We need in parallel, a coalition of countries with similar ambition that joins policy and expands over time. If China joined, for example—China has an ETS too, though it’s different—if China and the EU linked systems, that could make a big difference globally.

Arvid Viaene: Absolutely. It might also address a concern I’ve heard from Jos Delbeke: we might get short on liquidity in the EU ETS over time because we’ve used up lower-cost abatement options, and now we’re moving to harder-to-abate reductions. So we might get short on liquidity. Expanding could be in the EU’s interest.

Jeroen van den Bergh: Let’s do five or ten minutes more.

Arvid Viaene: Is there anything else you’d like to highlight about the paper, or anything we haven’t covered?

Jeroen van den Bergh: Not so much. I think we went through a lot of it.

Arvid Viaene: Then I do have one more question. What criticism do you hear most from non-economists—what are the common resistances to pricing instruments?

Jeroen van den Bergh: Good question. One thing people often stress—and economists are a bit at fault here—is that the main advantage of carbon pricing is efficiency or cost-effectiveness: it reduces the cost of emissions reduction. That’s true, but it can only be true if it’s also effective. If an instrument isn’t effective—if it doesn’t reduce emissions—then it can’t be cost-effective either.

But for me, something even more important is that carbon pricing, if done well, puts a price on fossil fuels proportional to carbon content. Coal becomes very expensive; oil less, but still a lot; gas less, but still. That creates a strong shift away from coal, and also from oil. Low-carbon alternatives like nuclear and renewables don’t have the extra charge, so they become more attractive.

Then, across the whole production chain and lifecycle, it stimulates movement away from high carbon. If you buy a product at the end of a long supply chain, it becomes more expensive if production didn’t shift away from high-carbon inputs. That becomes a strong incentive not to buy it. At the end of having implemented carbon pricing well, you can expect that cheap things tend to be low-carbon. “Cheap is good to buy.” Right now, it’s often the reverse: cheap is dirty. We shouldn’t make it too difficult. I don’t believe altruism alone will drive people to sacrifice a lot. People might buy green electricity at a slightly higher price, but not much—because your computer doesn’t run better on green electricity than on gray electricity. People will pay a lot for phones because they do new things. Green electricity doesn’t create a new function—it’s just a different production process.

And people have a limited willingness to pay. For me, the effectiveness of carbon pricing is guaranteed in a way that standards and subsidies are not. If you subsidize solar PV, people may buy it—but they’ll try to buy cheap ones, often from China, which can be “dirty” if there’s no carbon price. In China, production can rely on coal-based electricity.

Years ago, I tried to buy solar PV from Germany because studies suggested it was cleanest in production. It was very hard to find; much of what was sold in Spain was ultimately produced in China. I ended up buying mine from South Korea, which is based on nuclear energy, which is low-carbon. I don’t have a problem with that. So effectiveness is guaranteed by carbon pricing; not by standards; not by subsidies.

Arvid Viaene: That would be a great way to conclude.

Jeroen van den Bergh: I have one more point, related to free riding.

I stress in lectures that it’s extremely important to understand why climate change is so difficult to solve. Climate change is hard for many reasons. It’s abstract—nobody has “seen” CO₂. We have to trust scientific experts. I have that trust, but for citizens it can be difficult.

It’s also hard because our energy system is still largely dependent—85% to 90% worldwide—on fossil fuels, and there’s no quick way to replace them. Renewable energy is not problem-free either; much renewable energy is still produced using fossil fuels. But the most important problem, often neglected, is that climate is a free-riding problem.

Climate is what economists call a public good: many people can enjoy it; one person enjoying it doesn’t reduce others’ enjoyment; and if you don’t contribute, you can still benefit. If you don’t reduce emissions and others do, and the climate improves, you still enjoy the better climate.

That invites free riding. Individuals aren’t willing to sacrifice too much. People say they recycle and buy ecological products, but they won’t give up their car; they won’t give up flying for holidays. Carbon pricing counters free riding by putting a cost on the dirty alternative for everyone. It becomes easier to move away from it because you have an incentive.

Many alternatives suggested by people critical of pricing—subsidies, voluntary behavior, industrial policy—don’t guarantee reduction of free riding. And if you don’t reduce free riding, you don’t solve climate change.

Arvid Viaene: That was really good. I think I’ll clip that out too.

I want to give you a big thanks. I really enjoyed this conversation and learned a lot—not just from the paper, but from all the thought behind it. Thank you for coming on.

Jeroen van den Bergh: Thank you very much, Arvid, for your good questions—and your deep knowledge. It’s nice to have an interviewer who is well prepared and understands the issues. That helped me give good responses. Thanks very much.

Arvid Viaene: Thank you.