Balancing Efficiency and Fairness: Kaldor-Hicks Improvement?

Abstract

This chapter mainly discusses two issues related to achieving carbon neutrality: innovation and fairness. We believe that innovation (efficiency enhancement) is critical to carbon neutrality, and the attendant fairness-related issues need to be addressed. To efficiently achieve carbon neutrality, we believe the following measures should be simultaneously taken: (1) internalizing external costs by raising carbon prices; (2) fundamentally altering the mode of production by expediting eco-innovation; and (3) improving the social governance system by encouraging low-carbon lifestyles, and reaching a consensus on environmental protection among the general public. Among these measures, we believe innovation is the key, as it can help reduce carbon emissions per unit of energy consumption as well as energy consumption per unit of GDP. In the long term, we believe innovation is also the major driving force for economic growth. In retrospect, we find that each technological revolution has led to a reshaping of the global economic landscape, and countries with an early start to innovation usually achieved economic advances in the end. Eco-innovation is a general-purpose technology innovation that has a greater effect in terms of improving productivity. Nevertheless, innovation does not happen overnight or without hindrances. Eco-innovation features double externality, and as a result sees slower progress and faces more barriers than general innovation. Public sector policies and capital investment (green finance) need to be coordinated, in our view, to inspire innovation among enterprises and to remove the systemic obstacles to innovation. Carbon neutrality may cause fairness issues both domestically and internationally. Globally, principles of fairness and each country’s stage of development should be taken into consideration to avoid unfair distribution of rights, responsibilities and interests among different countries. Domestically, emission reduction may lead to fairness problems between different social classes, generations, sectors, and regions. Hence, fiscal policies should play a more important role in income distribution and cross-cycle adjustments to prevent worsening imbalances in residents’ income distribution and regional development.

The COVID-19 pandemic that swept the world in 2020 shows that an unexpected crisis related to public health and climate issues is no longer a challenge that is far away from us. Such challenges will cause substantial economic losses and endanger human life, health, and safety. In the past decade or so, carbon emissions in Europe and the US have shown a downward trend, while China’s carbon emissions were still growing, which means that it is increasingly important for China to reduce carbon emissions (Figs. 2.1, 2.2 and 2.3).

Fig. 2.1

Source Our World in Data, CICC Research

GDP per capita and carbon emissions in the US.

Fig. 2.2

Source Our World in Data, CICC Research

GDP per capita and carbon emissions in the EU.

Fig. 2.3

Source Our World in Data, CICC Research

GDP per capita and carbon emissions in China.

How to achieve carbon neutrality? What effects will this process have on the economy? What challenges will we face? What are the policy implications? We will answer these questions in the following sections.

2.1 Three Approaches to Achieving Carbon Neutrality: Innovation is the Key

2.1.1 Carbon Neutrality Cannot Be Achieved Through “zero-sum game”

The first approach people most likely have in mind to achieve carbon neutrality is adjusting the structure of industries. For example, policy guidance can reduce the proportion of high-emission industries (usually high-energy-consuming manufacturing industries) in the economy and vigorously develop low-emission industries (usually service industries). This is also the experience of European countries and the US. However, historical experience suggests that high-emission industries usually do not disappear but will only move to other countries without such policy interventions and with lower production costs. In the end, products produced by high-emission industries will return to their home country in the form of imports, and the country’s “carbon emissions trade deficit”¹ would widen.

In the US, the amount of carbon emissions contained in the country’s imported goods grew over 1990–2008. Therefore, the country’s “carbon emissions trade deficit” also widened (Fig. 2.4).

Fig. 2.4

Source Our World in Data (based on Global Carbon Project), CICC Research

Carbon emissions trade deficit/surplus.

From a global perspective, moving high-emission industries to other countries is a “zero-sum game”, and this is a process of transferring carbon emissions rather than achieving carbon neutrality. This cannot fundamentally solve the issue of greenhouse gas emissions because the damage to the environment is determined by the total amount of emissions rather than where the emissions came from. Therefore, it is not enough to just adjust the structure of industries and we must find a way to get to the root of the problem.

2.1.2 Approach 1: Raising Carbon Price to Internalize External Costs

The externality of environmental pollution is at the root of the carbon emission problem. To cope with the negative externalities of carbon emissions, the key is to introduce a carbon pricing mechanism and raise carbon prices. Carbon pricing means setting a price for carbon emissions (carbon price) to link the external costs of carbon emissions with emitters’ private costs. Carbon pricing does not specify who should reduce emissions, where to reduce emissions, or how to reduce emissions. Instead, it provides an economic signal to emitters and allows them to decide whether to take measures to reduce emissions or continue to emit carbon dioxide and pay for their emissions. Carbon pricing works via two mechanisms: First, under the constraint of the carbon price, companies begin to regard emission permits as a factor of production, which could help to manifest the hidden costs of carbon emissions and internalize external costs. Second, carbon price could promote innovation in energy conservation and emission reduction technologies. Studies have found that higher carbon prices drive innovation in low-carbon technologies and increase companies’ incentive to develop and adopt low-carbon technologies. The European Union (EU) is more experienced in carbon pricing at present.

2.1.3 Approach 2: Accelerating Innovation to Fundamentally Alter Mode of Production

Another way to achieve carbon neutrality is to fundamentally change the way companies operate, and specifically, (1) by reducing the carbon emission intensity per unit of energy consumption, or (2) by reducing the energy consumption intensity per unit of GDP. In this case, we have the following formula:

$$ \frac{{{\text{CO}}_{2} }}{{{\text{GDP}}}} = \frac{{{\text{CO}}_{2} }}{{\text{E}}} \times \frac{{\text{E}}}{{{\text{GDP}}}} $$

CO₂ represents carbon dioxide emissions, E represents the consumption of the energy, the first term on the right-hand side of the equation is carbon emissions per unit of energy consumption, and the second term is energy consumption per unit of GDP.

Innovation is crucial to reducing the two parts of intensity. Environmental protection-related technological innovation is usually called “eco-innovation” in the academic world. For example, the development of new emission reduction technologies and carbon capture technologies can reduce carbon emissions per unit of energy, while the use of clean energy can reduce energy consumption per unit of GDP. When promoting development of the low-carbon economy, many developed countries would focus on how to promote environmental technological advancement, and encourage and facilitate innovation.

In the longer term, innovation can not only solve the problem of carbon emissions but is also the major driving force for economic growth. Each technological revolution has reshaped the global economic landscape, and countries with an early start to innovation eventually achieved economic advances.

Unlike innovation in regular technologies, eco-innovation is a general-purpose technology innovation that has great effects on improving the productivity of the human society. The core feature of general-purpose technologies is the wide range of applications, and they could often be used as inputs by downstream industries, promoting innovation in the field where they are used. In addition, this type of technology also has large potential for improvement. Therefore, when innovation in general-purpose technologies emerges, it tends to be more conducive to the improvement of total factor productivity of the whole economy than regular technologies (Fig. 2.5). It is believed that eco-innovation, just like the invention of the steam engine and electric motor, could also trigger an important technological revolution in the history of human development (Fig. 2.6).

Fig. 2.5

Source Gartner, CICC Research

General-purpose technologies drive other innovations.

Fig. 2.6

Source NASSCOM Insights, CICC Research

Eco-innovation has potential for leading a new round of technological revolution.

2.1.4 Multiple Barriers to Eco-Innovation

Although innovation could help to achieve carbon neutrality, technological progress could be relatively slow and face considerable uncertainty. If history is any guide, the development of a new technology usually traces an S-shaped curve from the stage of invention to the stage of application. That is to say, the development process of a new technology would accelerate from a low level first before it gradually slows down. It seems that the process of eco-innovation is slower than the development of regular technologies. In the early 1990s, some scholars believed that eco-innovation and internet technology represent the most promising directions of technological development in the future. In the past three decades, internet technologies have experienced exponential growth, but the overall progress of eco-innovation has been slow.

The slow development of eco-innovation could be due to the issue of double externality. The externality of environmental issues lies in the fact that the benefits from releasing pollutant emissions are enjoyed by companies, while the costs are borne by the whole society. The externality of innovations lies in that new technologies and products developed by companies can be easily imitated by their competitors so that the latter can gain the benefits of R&D, but the developers bear the R&D costs. As eco-innovation is both environmentally friendly and innovative, it features double externalities. Under the market mechanism, this would ultimately lead to insufficient investment in eco-innovation, which slows down the development of eco-innovation. Polzin (2017)² did in-depth research on barriers to eco-innovation. Specifically, eco-innovation faces multiple barriers such as technological, institutional, financial, economic, political and transformation barriers (Table 2.1).

Table 2.1 Barriers to capital support for eco-innovation along the innovation process

2.1.5 Innovation-Related Policy Suggestions

How to remove the barriers above? One could address this issue from the following perspectives.

First, compared with developed economies, financial support channels at the innovation stage are not well-developed in China, so it is imperative to promote green finance. Second, promoting eco-innovation requires policy intervention, and policy departments should collaborate to form a joint force. Third, from a global perspective, removing political barriers requires the international community to reach a consensus, identify a more consistent development direction and vision, and then systematically promote eco-innovation policies under the framework of intergovernmental cooperation. In general, in order to accelerate eco-innovation, the government needs to introduce a series of tools and policy mechanisms, including government-enterprise R&D partnership, goal-driven public investment, demand stimulation, and tax system reforms to break the “lock-ins” and path dependence that hinder eco-innovation. Policies should be introduced to eliminate the advantages of traditional energy sources under the free price system, achieve the internalization of externalities, and encourage the transfer of social resources from conventional technologies to a green economy.

2.1.6 Approach 3: Improving the Social Governance System and Encouraging Emission Reduction Among the General Public

Innovation is very important for achieving carbon neutrality, but eco-innovation faces multiple barriers and does not happen overnight. Therefore, to achieve carbon neutrality, efforts must also be made to improve social governance. Such efforts include formulating corporate governance standards compatible with a low-carbon world, building an environmentally friendly financial system, improving carbon tax and carbon market systems, encouraging low-carbon lifestyles, and advocating new consumption concepts. These efforts could help reach a consensus on environmental protection and promote carbon neutrality among the general public. For example, garbage classification, shared mobility services, and reducing electricity use at home can help to cut carbon emissions. Such efforts do not necessarily require new technologies and may simply require emitters (mainly consumers) to adopt low-carbon lifestyles. Therefore, improving the social governance system and raising public awareness of environmental protection will play an essential part in promoting carbon neutrality (Fig. 2.7). We will elaborate on it in the following sections.

Fig. 2.7

Source CICC Research

In addition to innovation, efforts must be made to improve social governance.

2.2 Issues Related to Fairness

2.2.1 Distribution of Income

Carbon neutrality also has global negative externalities. If only a single country strives to achieve carbon neutrality, energy consumption intensity may be negatively impacted in the short term. A single country’s efforts to reduce emissions often cannot offset the unrestricted emissions of other countries. Instead, this could push up costs and damage the competitiveness of related industries in the country, while other countries may benefit. Domestically, fairness regarding carbon neutrality is related to the issue of income distribution, including the distribution of income between different income groups and between different generations.

Distribution of carbon neutrality cost between different income groups: Carbon tax is “regressive” and may add burden to the low-income group. Given the low elasticity of demand for fossil fuels and the high proportion of direct and indirect spending on fossil fuels by the low-income group, the low-income group may bear a higher proportion of cost when prices of fossil fuels rise driven by carbon prices. Carbon tax “regressivity” is related to consumption baskets of different income groups, but a deeper reason is that carbon taxes are indirect taxes and could be easily passed on. As for solutions, one method is to reduce the use of carbon tax and rely more on carbon trading to raise carbon prices. However, carbon trading also can be regressive as it essentially adds constraints on production. The other method is to increase tax rebates and compensate low-income groups with the carbon taxes collected. For example, 15% of the Regional Greenhouse Gas Initiative’s (RGGI) proceeds from the auction of carbon dioxide allowances are used to subsidize low-income groups’ energy expenditures to mitigate their economic pressure from rising energy costs.

Distribution of carbon neutrality cost between different generations: The present generation may bear the majority of the cost of carbon neutrality, while the previous generation and the next generation could benefit more. If carbon neutrality is achieved, the next generation will benefit more from the improving environment and economic growth. However, the investment to achieve carbon neutrality will be mainly made by the present generation. The present generation may bear the majority of the cost of carbon neutrality. Therefore, the next generation is likely to benefit more than the present generation on the road to carbon neutrality (Fig. 2.8). To balance the costs and benefits between the two generations, the government should transfer payment across different periods. For example, the government could issue green bonds to finance carbon neutrality-related public investment, and the present generation and the next generation could jointly repay the interest and principal of the bonds.

Fig. 2.8

Source CICC Research

Next generation to benefit more than present generation on the road to carbon neutrality.

The fairness issue also exists between the present generation and the previous generation. For example, the majority of the environmental pollution today is related to the production and life activities of the previous generation. We have calculated the ultimate distribution coefficient (the consumption of a product to produce a unit of another final product) for the electric power, heat generation and supply industries that contributes most to carbon emissions. We find that the residential property construction sector has the highest distribution coefficient (Fig. 2.9). In other words, the real estate industry consumes the most electric power and heat. Therefore, property owners should bear more “historical responsibility” to reduce carbon emissions. In this regard, perhaps a proper amount of taxes should be levied on property owners with “high-carbon assets.”

Fig. 2.9

Note Coefficient value on the y-axis. Source Input–output tables of China (2018), CICC Research

Ultimate distribution coefficient of the electric power, heat generation and supply industries.

2.2.2 How to Share the Cost of Emission Reduction Among Industries and Regions?

Carbon neutrality also involves the issue of cost sharing among different industries and regions within a country, and the issue of direct and indirect carbon emissions. In 2017, eight major industries accounted for nearly 90% of carbon emissions in China. The power industry (mainly thermal power) accounted for the largest share (44.4%), followed by the steel industry (18.1%), the construction materials industry (12.6%), the transportation³ industry (7.8%), the chemicals industry (2.6%), the petrochemicals industry (1.5%), the nonferrous metals industry (0.7%), and the papermaking industry (0.3%). Power and steel industries are major contributors to the overall growth in the proportion of carbon emissions by the eight major industries, while the proportions of carbon emissions by other industries among the eight industries have been relatively stable. So, should these eight industries bear the majority of the cost of emission reduction? Obviously, these eight industries are only industries with high levels of direct carbon emissions, and the output of these eight industries is mainly used as intermediate input by other industries. Without the output of these industries as intermediate input, other industries may not be able to operate normally. Thus, the eight major industries should not be responsible for the entire cost.

From the perspective of geographical regions, China’s fossil energy supply is more concentrated in the north of the country. Fossil energy production in China is mainly concentrated in provinces such as Shanxi, Inner Mongolia, and Shaanxi. Specifically, coal production is mainly concentrated in provinces such as Inner Mongolia, Shanxi, and Shaanxi; crude oil production is mainly concentrated in provinces and municipalities such as Shaanxi, Heilongjiang, and Tianjin; and natural gas production is mainly concentrated in provinces and municipalities such as Hebei, Shanxi, and Shandong. Historical experience suggests that restrictions on fossil energy sources often lead to employment problems. For example, the number of employees in China’s mining industry has rapidly decreased from the peak level of 6.36mn in 2013 to 3.68mn in 2019 due to environmental protection-related production restrictions. Although the rapid growth of emerging service industries in the past several years can create new employment opportunities, it is often difficult to achieve stable employment transfer due to different technical thresholds between new and traditional industries, and the mismatch in regional distribution of industries.

Fig. 2.10

Source China Taxation Yearbook 2018, CICC Research

Provinces with high reliance on taxes from mining and power industries.

The impacts of emission reduction on local government finances also should not be ignored. Fiscal revenues are highly dependent on mining and power industries in provinces such as Shanxi, Inner Mongolia, and Shaanxi, indicating that carbon neutrality may have a larger impact on these provinces (Fig. 2.10). On the one hand, fiscal policies should play a role in transferring part of fiscal revenues generated by carbon pricing to these provinces to prevent their fiscal revenues from falling sharply (which may affect people’s livelihood and debt repayment in these provinces), supporting the green transformation of industries in these provinces, and developing low-carbon and decarbonization technologies for industries in these provinces to promote carbon emission reduction. On the other hand, industrial policies should play a role in transforming and upgrading industries in coastal areas, and supporting and encouraging some industries to move to provinces with abundant fossil energy to prevent the hollowing out of industries and population outflows in such provinces. In addition, the ability to absorb and store carbon in China’s terrestrial ecosystems may be underestimated. Economies in the southwest and northeast of China are less developed. In our view, carbon sinks could play an important role in alleviating poverty, promoting carbon emission reduction, and facilitating the rebalancing of income distribution among different regions.