The Oil Price Opportunity

The sharp drop in the price of crude oil since late June has been grabbing headlines worldwide – and producing a lot of contradictory explanations. Some attribute the fall largely to declining global growth expectations. Others focus on the expansion of America’s oil and gas production. Still others suspect a tacit agreement between Saudi Arabia and the United States aimed at, among other things, weakening political rivals like Russia and Iran.

Regardless of the reason for the price drop – probably to be found in some combination of these factors – the consequences are the same. Though, as International Monetary Fund Managing Director Christine Lagarde has noted, lower oil prices may boost overall global growth, with the oil-importing advanced economies gaining the most, the impact on efforts to combat climate change could be devastating.

Indeed, a sustained decline in oil prices would not only make renewable energy sources less competitive now; it would impede their future competitiveness by discouraging research and investment. More generally, it would reduce the incentive for consumers, companies, and governments to pursue more energy-efficient practices.

Even if we remained on our current trajectory, keeping temperatures from rising more than 2º Celsius above pre-industrial levels – the threshold beyond which the most disruptive consequences of climate change would be triggered – would be next to impossible to achieve. As the Intergovernmental Panel on Climate Change’s most recent report reinforced, we cannot afford a slowdown in progress.

Of course, climate science is not precise; instead, it works in terms of probability ranges. But uncertain estimates do not mean that the risk is any less acute.

World leaders increasingly seem to recognize this in theory, including at the just-concluded climate-change meeting in Lima, Peru. But they continue to depend on non-binding commitments – leaving the world on a dangerous climate trajectory.

A sharp decline in oil prices does, however, provide a rare political opportunity to introduce more carbon pricing. After all, one of the major arguments against a “carbon tax” has been that it would make energy more expensive. Even assurances that the revenue from such a tax would be refunded to taxpayers were inadequate to overcome political resistance, particularly in the US.

But, with declining oil prices now exerting downward pressure on oil substitutes, a carbon tax could be introduced without raising the price of energy for consumers. Policymakers must simply be willing to forego some of the short-term stimulus effects of cheaper energy. In fact, with low enough prices, consumers could still benefit from lower energy costs – just not quite as much as they are now.

The structure of a carbon-pricing scheme remains up for discussion. One option would be to introduce flexible pricing, tied to the price of oil. For example, for every $5 decline in the price per barrel, the carbon tax could be raised by a specified amount; for every $5 increase, the tax could be lowered by, say, two-thirds of that amount.

The carbon price would thus increase over time – the optimal outcome, according to growth models that account for climate constraints. At the same time, it would buffer consumers from oil-price volatility, thereby stabilizing their energy spending. Finally, and perhaps most important, such an approach would be more politically attractive than a fixed carbon tax, especially if it is introduced at a time of sharply declining oil prices.

In short, world leaders must take advantage of falling oil prices to move beyond indirect carbon pricing – achieved through the prices of carbon-emitting substances – to an explicit carbon tax that can help steer the world onto a more sustainable growth path. Crucially, in order to make a real impact, carbon-pricing schemes would have to be introduced in all major economies.

Of course, given the multitude of existing taxes, fees, and subsidies on energy products in various countries, the goal of aligning the effective cost of carbon with its most economically efficient level would take time to achieve. But introducing a modest, flexible carbon tax in major economies would be an important first step.

Today’s environment of falling oil prices enables the world to take that step. It should be modest, so that it is politically feasible; flexible, so that it helps stabilize user prices; and it should increase over time, to place the global economy on a more sustainable path. Most important, it should be implemented quickly. After all, this window of opportunity will not remain open for very long.