Carbon pricing is not a silver bullet but faith endures in this market approach to climate action

I recall asking my PhD supervisor Dennis C. Mueller in the 1990s why, despite empirical support to the contrary, articles in leading economics journals reflect an almost unquestioned belief in markets as efficient allocators of resources. It felt to me almost theological. Perhaps the alternative in the form of government direction was more frightening? In any case, work challenging the orthodoxy was treated as heretical rather than debatable.

Mueller’s response, characteristically measured, was that neoclassical models were elegant. They allowed optimization and produced clean results. Profit maximizing firms and utility maximizing consumers, represented by rational agents, delivered tractable outcomes. The models worked, even if the world did not seem to cooperate.

This criticism is neither new nor profound. So, why revisit it now? Because another article of faith has quietly taken hold in global policy discourse: the belief that carbon pricing is the most efficient and therefore most appropriate way to address climate change. The regulation in question is the EU’s carbon pricing policy to control global emissions, known as its Carbon Border Adjustment Mechanism (CBAM).

Implemented from 1 January, CBAM aims to check carbon leakage and level the playing field for emission-intensive goods such as steel and aluminium by putting a carbon price on imports based on the emissions embedded in their production. This ensures that imported goods face a similar carbon cost as those produced in the EU under its Emissions Trading System (ETS).

The price of carbon under the ETS is market-driven and is currently in a range of €85-90 per tonne. Countries were given time to adjust because transitions are difficult. Yet, there is little tolerance for alternative approaches that might achieve similar outcomes. Again, the thought is that markets should do the heavy lifting through carbon pricing.

The EU’s CBAM is designed to prevent carbon leakage and protect the integrity of its ETS. Its stated goal is environmental: to ensure that European producers subject to carbon pricing are not disadvantaged by imports from countries with weaker climate policies.

In Ricardian terms, this implies that laxer environment standards should not become a source of comparative advantage. What’s more, environmental goals, according to the EU, are best achieved through a market-determined price on carbon, while other methods are implicitly dismissed as inefficient.

Thus, climate-friendly measures such as levies on coal and mining, renewable energy purchase obligations and industry emission standards are tolerated, but not given the legitimacy they deserve.

The use of carbon pricing as the preferred option reflects its theoretical elegance. By internalizing the social cost of carbon, a uniform price is determined to ensure that emissions are reduced where abatement is cheapest.

This logic has shaped decades of climate economics and rests on a critical assumption: that markets function reasonably well. Mounting evidence, however, shows that import demand for carbon-intensive goods is highly sensitive to carbon prices. Even moderate price increases lead to sharp declines in volumes, especially for products with high embedded emissions. Yet, the impact on total emissions in countries that export these products is limited.

This result matters. If the CBAM were primarily an environmental instrument, one would expect meaningful emission reductions in exporting countries. Instead, it appears more effective at redirecting trade flows than reducing emissions. Thus, concerns have arisen around its use as a protectionist measure in green guise.

The relevant question, therefore, should not be whether a country has an economy-wide carbon tax, but whether its policy mix delivers comparable emission outcomes. Regulatory standards, technology mandates, sector-specific interventions and subsidies are good candidates. Ignoring these tools while penalizing trade by using default carbon values only makes trade costlier without commensurate climate gains.

Globally, only about 23% of emissions are covered by explicit carbon pricing. India’s are not covered so far because we have adopted other means. We use standards, renewable energy mandates, technology support and sectoral policies that implicitly limit emissions.

Even if carbon pricing makes clean technologies cheaper over their lifetime, the upfront investment is often unaffordable for small firms and households. Higher energy prices intensify affordability and equity concerns.

Economic theory offers a useful lens. The theory of the second-best reminds us that when multiple distortions coexist, fixing just one may worsen outcomes. Carbon pricing works best when markets are competitive, information is available and distributional concerns can be managed. In their absence, insisting on first-best solutions can be counterproductive.

Markets are powerful yet imperfect tools. Let’s not abandon them, but use them with greater humility.

These are the author’s personal views.

The author is dean, school of humanities and social sciences and professor of economics, Shiv Nadar University.