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Sentiments of Ethical Leviathan

Anna Matveeva - Sony Pictures

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The conversation on the role of the state reoccurs in all ages of history for all generations.  It is a central piece in understanding of the moral philosophy constructs of liberty and tyranny.  It is the definitive piece in examining of the political philosophy ideas of democracy and autocracy.  Because of its centrality this conversation expands inevitably outside of utilitarian and into ethical grounds.  On such grounds the role of the state in society has been under diligent examination from the times of the Reformation for restricting the religious liberties of the individual.  From the 17’th century onwards the state has been under continuous assault for restricting the economic and civic liberties of the individual.  Evidently the state has endured, not so much because of its virtues, but simply because of the lack of alternatives.  The strategy of surviving by simply being irreplaceable has prevailed over various reductionist and nihilistic tendencies.  Nonetheless the debate of the moral justification of the role of the state in society has not withered away.  In a new age of global and interconnected risks of climatic, pandemic and financial nature the ethical justification for the intervention of the state in society aimed to protect or restrict its liberties becomes of critical importance. This essay revises some aspects of contemporary understanding of the moral judgement of the state in context of anglophone experiences and philosophical tradition.

Sound the Retreat

In the first quarter of the new century this debate continues to engage vigorously both the academic and the wider public domains.  This expansion of intensity of thought and discourse today is driven by the conditions of four systemic and entangled crises – in credit worthiness, population displacement and migration, climate change vulnerability and human health.  In all of these calamities the state has stepped into a different degree to regulate, remediate, compensate and sanction.  This renewed vigor of activity comes after some notable retreats and most prominently from its role of economic activity manager and regulator.  From the late 1970’s the ability of the state to regulate and restrict the economic liberty of the individual and the corporation has come under intellectual and political offensive by the proponents of liberal market philosophy.  At its core this is an ideological contest on the optimal approach to protecting and promoting the concepts of individual liberty and of the public good.  The critical proposition of the philosophy of liberal markets is twofold.  Firstly, it maintains that the economic liberty of the individual is a necessary and irreplaceable condition for realization of their civic liberty. Secondly, the economic liberty of the individual is a major creative and constructive force which enhances the protection of the public and societal good. When undesirable externalities and conflict may occur as a result of such arrangements of economic liberties, then such issues are always secondary and manageable through the risk redistributive forces of the market. Furthermore, restricting and regulating the creative forces of economic liberty is detrimental to all individual civic liberty and to the societal good in general.  On the opposite end of the thought spectrum the statist philosophical tradition of economic intervention maintains that the economic liberties of the individual are optimally ensured and protected by the institutions of the state.  This tradition further claims that the economic endeavors of the private citizen will inevitably and eventually enter into conflict with the wider public good.  As a rational and self-interested party, the individual operating in this framework, will maximize and retain their benefits and externalize their cost into the social domain. In a society with finite natural resources and capabilities to absorb and remediate negative externality a conflict of burden and shortage emerges. The state with its tools and mechanics of remediation, regulation and sanction is the only fair arbitrator, the only entity capable and equipped to protect the societal good.  The configuration of political and intellectual forces in the late 1970’s was such that it drove into retreat the doctrine of the economic role of the state in society.  The prevailing understanding of the utility of this role was in practical and ideological retreat for 30 years until the arrival of the first shocks to the sovereign, corporate and personal credit markets in the first decade of the new century.

Systemic Interdependence and Transformation

The arrival of systemic economic shocks from 2008 onwards bucked the trend of the retreat of the state from its involvement in market management and regulation. The distributive properties of the liberal market system were clearly not sufficient to prevent the concentration of risk and ruin in some well-established corporate and sovereign institutions. These institutions were significantly large and deeply interconnected in economic networks such that their collapse would threaten wide spread social damage. At times of regular economic growth, of smooth and undisturbed operations of markets and corporate institutions the riskiness of interdependence does not seem evident or essential. At such a time interdependence serves as a mechanism, which channels and allocates risk and resources in what is clearly an efficiently operating market system. This quickly changed during the economic shocks and the extreme and catastrophic developments in the financial system taking place by the end of the first decade of this century. Systemic interdependence rapidly transformed into a source of risk contagion across all aspects of civic life.  The fragility of social networks during shocks severely restricted the economic and civic liberties of the individual in aspects of credit worthiness, wage earning potentials, purchasing power and entrepreneurial initiative.  The financial crisis itself with all of its impacts across the socio-economic fabric of society became the overwhelming violator of the economic liberty of the individual and the corporation – a charge which traditionally was levied on the restrictive and regulatory actions of the state. The full exercise of economic liberty by a small group of individuals and financial firms in its most exuberant form had produced a systemic externality in the form of a large accumulation of risk and ruin in critical corporate and sovereign institutions.  This externality of a most dangerous and undesirable kind deeply suppressed and severely restricted economic activity and by association economic liberty across all sections of society.  The extreme fragility of the system was evident and threatening to drive already existing societal fractures into a full systemic collapse.  At this moment and arguably and literally in the 11’th hour, the state entered the fray and lend its resources to prevent such a fully catastrophic eventuality. There are many technical stories and definitions of the intervention of the state in the financial and economic events of 2008 – 2013.  The definition which allows for examination of the ethical judgement of the state is that of corporate and sovereign debt mutualization.  The ethical intervention of the state is quite evident.  The state explicitly redistributes a negative externality of economic ruin concentrated within one small group of individuals and corporate actors across all of society by means of its fiscal and monetary mechanisms.  This is an explicit moral judgement openly executed by the state on behalf of the wider societal good.  From the perspective of the state as a civic actor, the redistribution of the ruinous burden of excessive debt across society becomes a preferable outcome than a deep societal fracture and collapse.  Stability and preservation of social order become paramount. This is an undeniable ethical judgement which the body of the state has explicitly embraced and exercised on behalf of society.  The threat associated with the role of the state in socio-economic activity in these circumstances is now entirely transformed and is has transgressed from fear of overreach and of restricting liberty to fear of failure to engage and to provide support.  The risk emerging in society at this moment is no longer that the economic liberty of the individual and corporation are being restricted by the state.  It is rather that the state may fail to act in time or that its action may not be sufficient to prevent a complete economic collapse.  The ethical judgement of the state and the state’s intervention based on this judgement are now demanded and fully welcomed by social consensus. It is then only the commitment to the common good, and to its pure survival as part of this concept, which drives the formulation of the ethical judgement of the state and consequently of its actions.  Since economic and civic liberty of the individual are two of the key components of the societal good, the actions of the state are now fully inversed from curtailing of economic liberty to protecting and promoting this human condition.

A Moral Sentiment Revised

The intervention of the state on moral and common good ground and the consensual acceptance of such actions by society create an apparent contradiction with the classical theory of liberty, which cannot be left unrecognized.  Two fundamental schools of thought – of Thomas Hobbes and of Adam Smith define the classical tradition.   The liberty of the individual is at the fulcrum of contention.  The moral philosophy proposition of Hobbes is that the only action which the individual could take to ensure his liberty, both civic and economic, is to fully submit to the state.  It is the state’s task and destiny to protect and ensure the freedom, rights and dignity of the individual.  Individual actions of civic and democratic nature, pursuits of economic and entrepreneurial substance cannot improve on these three essential human conditions. In fact, they are likely to create only discourse, conflict and rupture among social classes, which are to the detriment of the whole of society. The state on the other hand is the only civic institution, which is both entitled by its contract with society and capable by virtue of its resources to improve upon these human conditions.  Adam Smith is no less concerned with the civic and economic liberty of the individual. This is his primary passion and project.  He questions not the entitlement of the state and its contract with the individual in particular and with society in general, nor the resources of the state.  The concerns raised by Smith are about the depth of knowledge of the state, of its intellectual know-how, which if insufficient, would severely impair the effectiveness of its intervention to enrich the liberty of the individual. Much more than this, such intervention may prove to be detrimental to the cause of civil liberty. The concern raised by Smith is towards what extend such intimate and detailed knowledge accompanied by moral judgement could possibly be possessed by a single person, and by association by the body of the state. On the other hand, Smith observes that the actions of the common entrepreneur through the free flow and exchange of goods, services and ideas create social conditions under which the civic liberty of the individual is most thoroughly guaranteed.

In the last quarter of the 18’th century craftsmen, manufacturers, traders and entrepreneurs or more generally – the middle classes were the champions of civic and economic liberty.  They contended with the formidable powers of the state and of the landed aristocracy.  Their ingenuity in producing goods and their inexhaustible energy in distributing and trading them provided these social classes with incomes and position in society, which ensured their economic and civic liberty in a system, where they were by far not the dominant political force.  It was unimaginable to scholars and moral philosophers of the time that the economic actions of the common entrepreneur would cause a deep and degradative crisis in society.  Rather the opposite, Adam Smith was convinced that vigilance was needed to guarantee that the encroachment of the state and of the large land owners does not threaten the survival of the goods’ producing and trading middle class.  The preservation of economic liberty – a foundation for all civic liberties was at stake. 

The effectiveness of a socio-economic system and the robustness of civic liberty, which it enables matter not only in time of prosperity and growth but also in a time of crisis and threat.  A systemic catastrophe and economic collapse with massive impoverishment and dislocation of populations would destroy all foundation of civil liberty. In our own time, entangled and interdependently destructive forces of financial and credit ruin, health, pandemic and climate vulnerabilities have the potential to bring about such catastrophic futures. When preventing or remediating such outcomes proves to be beyond the powers of market forces the institutions of the state are called upon to intervene. The thrust of such intervention upon society in modern times is impossible without an explicit moral judgement by the state on assumption of its role as guardian of the public good.  The concept of the greater public good once again is at the center of ethical provisioning among private and public actors and institutions. The dual nature of the state precipitates the need for explicit definition of its moral judgment and for examination of the justification of its actions. By its Hobbesian nature the state would be willing to offer protection to the individual from calamity, in return it will require a full surrender of their liberties.  This is a contractual relationship between the state and the individual, or more generally between the state and society, but clearly it is of an unequal nature.  The State in a Hobbesian framework assumes that all civic good and liberty equates with the stability and the health of its institutions and thus that all civic good flows from its own deliberations.  In this paradigm, more relevant to the continental European experiences, the interests of the state and society merge seamlessly and perfectly, while the state holds the definitive prerogative of formulating these interests.

By its duality and by its liberal nature, in parallel the state would recognize that the traditions of Adam Smith and the forces of economic liberty, entrepreneurship and trade are the ones to create the true conditions for material and moral prosperity as core premises of civic liberty. This is the paradigm closer to the political experience of the Anglo sphere.  Yet in the last 70 years, we have many examples and occasions of both traditions failing the common good of society.  The hard, theoretical application of statist or of liberal markets’ principles in dogmatic manner may not be sufficient to address the formation and emergence of multiple and dependent societal risks today.  The notion that institutional tools, mechanisms and policies need to be selected and implemented upon their merit and upon their fitness for purpose for solving particular civic problems rather than on pure ideological grounds is not new.  The critical question though remains if the state with its network of institutions is capable to make such selection and deliberation effectively on behalf of the societal good.  We have come full circle as this is the same question which Adam Smith posed in the Wealth of Nations nearly 250 years ago.  The historical reality and the ethical grounds of the question however have changed entirely.  In its originality Adam Smith initiated the conversation in order to encourage the individual drive for economic and civic liberty and to caution the intervention of the institutions of the state on the premise of their insufficient knowledge to act on behalf of the common good.  Smith doubted the cognitive ability of the Hobbesian state to be an effective moral arbitrator of the societal common good. Some 250 years later the frailty of cognition is not limited to the institutions of the state.  The recent catastrophic events of the sovereign credit and financial crisis were not the first banking and economic crisis to decent upon society.  Despite a rich historical experience, well studied and well documented, the corporate financial sector, as well as some sovereign borrowers found themselves fully unprepared to shore up a multi sector-wide economic meltdown. At that time the charge of failure of cognition, sound business reasoning and moral judgement can be effectively leveled at both private and state economic actors and institutions with the same validity.  Deeper inside the decision-making processes of economic actors – individual, corporate and sovereign, such decisions, which prove to be detrimental to the wider civic good, may be due entirely to lack of knowledge and to information sparsity and asymmetry. Such decisions may very well be fully optimal and well informed from the perspective of a single economic agent. Economic action also comes about as a result of setting of priorities, defining hierarchies of expected and desirable outcomes, based on hierarchies of values of all critical actors involved. Rather than an issue of information asymmetries and market inefficiencies the argument revolves more intensively to organizing priorities of moral sentiment, hierarchies of values in the perception of the public good. The task of structuring and organization of priority of moral sentiments and ethical values would be more equally met if it were to be taken on not only by the institutions of the state but by the wider civic orders. After all recent events and historical examples show that this task is too important to be left to one order of society. When such singular formation of priority of values occurs, whether we rely on the mechanisms and channels of the markets or on the prerogative power of the state the outcomes are often times less than desirable. The institutions of the state, the corporate sector and civil society can work in synchronicity on this hierarchy of moral sentiments only within a stable and democratic political framework conducive to this purpose. A framework which will allow the various orders of society to raise the definition of the public good to the top of the agenda of a revitalized and ethical Leviathan.

Ivelin Zvezdov is a financial and insurance economist by training. He has masters' degrees from the Universities of St. Andrews and Oxford. He works on natural and man-made catastrophe modeling and product development for the (re)insurance industry. His research interests include climate change and environmental risk, contagion and propagation of systemic risk, sustainable and ecosystems approaches to managing natural resources. Mr. Zvezdov has published research papers on financial and insurance quantitative methods for risk management, and on environmental and biodiversity risk estimation.

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Economy

Reforms Key to Romania’s Resilient Recovery

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Over the past decade, Romania has achieved a remarkable track record of high economic growth, sustained poverty reduction, and rising household incomes. An EU member since 2007, the country’s economic growth was one of the highest in the EU during the period 2010-2020.

Like the rest of the world, however, Romania has been profoundly impacted by the COVID-19 pandemic. In 2020, the economy contracted by 3.9 percent and the unemployment rate reached 5.5 percent in July before dropping slightly to 5.3 percent in December. Trade and services decreased by 4.7 percent, while sectors such as tourism and hospitality were severely affected. Hard won gains in poverty reduction were temporarily reversed and social and economic inequality increased.

The Romanian government acted swiftly in response to the crisis, providing a fiscal stimulus of 4.4 percent of GDP in 2020 to help keep the economy moving. Economic activity was also supported by a resilient private sector. Today, Romania’s economy is showing good signs of recovery and is projected to grow at around 7 percent in 2021, making it one of the few EU economies expected to reach pre-pandemic growth levels this year. This is very promising.

Yet the road ahead remains highly uncertain, and Romania faces several important challenges.

The pandemic has exposed the vulnerability of Romania’s institutions to adverse shocks, exacerbated existing fiscal pressures, and widened gaps in healthcare, education, employment, and social protection.

Poverty increased significantly among the population in 2020, especially among vulnerable communities such as the Roma, and remains elevated in 2021 due to the triple-hit of the ongoing pandemic, poor agricultural yields, and declining remittance incomes.

Frontline workers, low-skilled and temporary workers, the self-employed, women, youth, and small businesses have all been disproportionately impacted by the crisis, including through lost salaries, jobs, and opportunities.

The pandemic has also highlighted deep-rooted inequalities. Jobs in the informal sector and critical income via remittances from abroad have been severely limited for communities that depend on them most, especially the Roma, the country’s most vulnerable group.

How can Romania address these challenges and ensure a green, resilient, and inclusive recovery for all?

Reforms in several key areas can pave the way forward.

First, tax policy and administration require further progress. If Romania is to spend more on pensions, education, or health, it must boost revenue collection. Currently, Romania collects less than 27 percent of GDP in budget revenue, which is the second lowest share in the EU. Measures to increase revenues and efficiency could include improving tax revenue collection, including through digitalization of tax administration and removal of tax exemptions, for example.

Second, public expenditure priorities require adjustment. With the third lowest public spending per GDP among EU countries, Romania already has limited space to cut expenditures, but could focus on making them more efficient, while addressing pressures stemming from its large public sector wage bill. Public employment and wages, for instance, would benefit from a review of wage structures and linking pay with performance.

Third, ensuring sustainability of the country’s pension fund is a high priority. The deficit of the pension fund is currently around 2 percent of GDP, which is subsidized from the state budget. The fund would therefore benefit from closer examination of the pension indexation formula, the number of years of contribution, and the role of special pensions.

Fourth is reform and restructuring of State-Owned Enterprises, which play a significant role in Romania’s economy. SOEs account for about 4.5 percent of employment and are dominant in vital sectors such as transport and energy. Immediate steps could include improving corporate governance of SOEs and careful analysis of the selection and reward of SOE executives and non-executive bodies, which must be done objectively to ensure that management acts in the best interest of companies.

Finally, enhancing social protection must be central to the government’s efforts to boost effectiveness of the public sector and deliver better services for citizens. Better targeted social assistance will be more effective in reaching and supporting vulnerable households and individuals. Strategic investments in infrastructure, people’s skills development, and public services can also help close the large gaps that exist across regions.

None of this will be possible without sustained commitment and dedicated resources. Fortunately, Romania will be able to access significant EU funds through its National Recovery and Resilience Plan, which will enable greater investment in large and important sectors such as transportation, infrastructure to support greater deployment of renewable energy, education, and healthcare.

Achieving a resilient post-pandemic recovery will also mean advancing in critical areas like green transition and digital transformation – major new opportunities to generate substantial returns on investment for Romania’s economy.

I recently returned from my first official trip to Romania where I met with country and government leaders, civil society representatives, academia, and members of the local community. We discussed a wide range of topics including reforms, fiscal consolidation, social inclusion, renewably energy, and disaster risk management. I was highly impressed by their determination to see Romania emerge even stronger from the pandemic. I believe it is possible. To this end, I reiterated the World Bank’s continued support to all Romanians for a safe, bright, and prosperous future.

First appeared in Romanian language in Digi24.ro, via World Bank

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US Economic Turmoil: The Paradox of Recovery and Inflation

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The US economy has been a rollercoaster since the pandemic cinched the world last year. As lockdowns turned into routine and the buzz of a bustling life came to a sudden halt, a problem manifested itself to the US regime. The problem of sustaining economic activity while simultaneously fighting the virus. It was the intent of ‘The American Rescue Plan’ to provide aid to the US citizens, expand healthcare, and help buoy the population as the recession was all but imminent. Now as the global economy starts to rebound in apparent post-pandemic reality, the US regime faces a dilemma. Either tighten the screws on the overheating economy and risk putting an early break on recovery or let the economy expand and face a prospect of unrelenting inflation for years to follow.

The Consumer Price Index, the core measure of inflation, has been off the radar over the past few months. The CPI remained largely over the 4% mark in the second quarter, clocking a colossal figure of 5.4% last month. While the inflation is deemed transitionary, heated by supply bottlenecks coinciding with swelling demand, the pandemic-related causes only explain a partial reality of the blooming clout of prices. Bloomberg data shows that transitory factors pushing the prices haywire account for hotel fares, airline costs, and rentals. Industries facing an offshoot surge in prices include the automobile industry and the Real estate market. However, the main factors driving the prices are shortages of core raw materials like computer chips and timber (essential to the efficient supply functions of the respective industries). Despite accounting for the temporal effect of certain factors, however, the inflation seems hardly controlled; perverse to the position opined by Fed Chair Jerome Powell.

The Fed already insinuated earlier that the economy recovered sooner than originally expected, making it worthwhile to ponder over pulling the plug on the doveish leverage that allowed the economy to persevere through the pandemic. The main cause was the rampant inflation – way off the 2% targetted inflation level. However, the alluded remarks were deftly handled to avoid a panic in an already fragile road to recovery. The economic figures shed some light on the true nature of the US economy which baffled the Fed. The consumer expectations, as per Bloomberg’s data, show that prices are to inflate further by 4.8% over the course of the following 12 months. Moreover, the data shows that the investor sentiment gauged from the bond market rally is also up to 2.5% expected inflation over the corresponding period. Furthermore, a survey from the National Federation of Independent Business (NFIB) suggested that net 47 companies have raised their average prices since May by seven percentage points; the largest surge in four decades. It is all too much to overwhelm any reader that the data shows the economy is reeling with inflation – and the Fed is not clear whether it is transitionary or would outlast the pandemic itself.

Economists, however, have shown faith in the tools and nerves of the Federal Reserve. Even the IMF commended the Fed’s response and tactical strategies implemented to trestle the battered economy. However, much averse to the celebration of a win over the pandemic, the fight is still not through the trough. As the Delta variant continues to amass cases in the United States, the championed vaccinations are being questioned. While it is explicable that the surge is almost distinctly in the unvaccinated or low-vaccinated states, the threat is all that is enough to drive fear and speculation throughout the country. The effects are showing as, despite a lucrative economic rebound, over 9 million positions lay vacant for employment. The prices are billowing yet the growth is stagnating as supply is still lukewarm and people are still wary of returning to work. The job market casts a recession-like scenario while the demand is strong which in turn is driving the wages into the competitive territory. This wage-price spiral would fuel inflation, presumably for years as embedded expectations of employees would be hard to nudge lower. Remember prices and wages are always sticky downwards!

Now the paradox stands. As Congress is allegedly embarking on signing a $4 trillion economic plan, presented by president Joe Bidden, the matters are to turn all the more complex and difficult to follow. While the infrastructure bill would not be a hard press on short-term inflation, the iteration of tax credits and social spending programs would most likely fuel the inflation further. It is true that if the virus resurges, there won’t be any other option to keep the economy afloat. However, a bustling inflationary environment would eventually push the Fed to put the brakes on by either raising the interest rates or by gradually ceasing its Asset Purchase Program. Both the tools, however, would risk a premature contraction which could pull the United States into an economic spiral quite similar to that of the deflating Japanese economy. It is, therefore, a tough stance to take whether a whiff of stagflation today is merely provisional or are these some insidious early signs to be heeded in a deliberate fashion and rectified immediately.

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Carbon Market Could Drive Climate Action

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Authors: Martin Raiser, Sebastian Eckardt, Giovanni Ruta*

Trading commenced on China’s national emissions trading system (ETS) on Friday. With a trading volume of about 4 billion tons of carbon dioxide or roughly 12 percent of the total global CO2 emissions, the ETS is now the world’s largest carbon market.

While the traded emission volume is large, the first trading day opened, as expected, with a relatively modest price of 48 yuan ($7.4) per ton of CO2. Though this is higher than the global average, which is about $2 per ton, it is much lower than carbon prices in the European Union market where the cost per ton of CO2 recently exceeded $50.

Large volume but low price

The ETS has the potential to play an important role in achieving, and accelerating China’s long-term climate goals — of peaking emissions before 2030 and achieving carbon neutrality before 2060. Under the plan, about 2,200 of China’s largest coal and gas-fired power plants have been allocated free emission rights based on their historical emissions, power output and carbon intensity.

Facilities that cut emissions quickly will be able to sell excess allowances for a profit, while those that exceed their initial allowance will have to pay to purchase additional emission rights or pay a fine. Putting a price tag on CO2 emissions will promote investment in low-carbon technologies and equipment, while carbon trading will ensure emissions are first cut where it is least costly, minimizing abatement costs. This sounds plain and simple, but it will take time for the market to develop and meaningfully contribute to emission reductions.
The initial phase of market development is focused on building credible emissions disclosure and verification systems — the basic infrastructure of any functioning carbon market — encouraging facilities to accurately monitor and report their emissions rather than constraining them. Consequently, allocations given to power companies have been relatively generous, and are tied to power output rather than being set at absolute levels.

Also, the requirements of each individual facility to obtain additional emission rights are capped at 20 percent above the initial allowance and fines for non-compliance are relatively low. This means carbon prices initially are likely to remain relatively low, mitigating the immediate financial impact on power producers and giving them time to adjust.

For carbon trading to develop into a significant policy tool, total emissions and individual allowances will need to tighten over time. Estimates by Tsinghua University suggest that carbon prices will need to be raised to $300-$350 per ton by 2060 to achieve carbon neutrality. And our research at the World Bank suggest a broadly applied carbon price of $50 could help reduce China’s CO2 emissions by almost 25 percent compared with business as usual over the coming decade, while also significantly contributing to reduced air pollution.

Communicating a predictable path for annual emission cap reductions will allow power producers to factor future carbon price increases into their investment decisions today. In addition, experience from the longest-established EU market shows that there are benefits to smoothing out cyclical fluctuations in demand.

For example, carbon emissions naturally decline during periods of lower economic activity. In order to prevent this from affecting carbon prices, the EU introduced a stability reserve mechanism in 2019 to reduce the surplus of allowances and stabilize prices in the market.

Besides, to facilitate the energy transition away from coal, allowances would eventually need to be set at an absolute, mass-based level, which is applied uniformly to all types of power plants — as is done in the EU and other carbon markets.

The current carbon-intensity based allocation mechanism encourages improving efficiency in existing coal power plants and is intended to safeguard reliable energy supply, but it creates few incentives for power producers to divest away from coal.

The effectiveness of the ETS in creating appropriate price incentives would be further enhanced if combined with deeper structural reforms in power markets to allow competitive renewable energy to gain market share.

As the market develops, carbon pricing should become an economy-wide instrument. The power sector accounts for about 30 percent of carbon emissions, but to meet China’s climate goals, mitigation actions are needed in all sectors of the economy. Indeed, the authorities plan to expand the ETS to petro-chemicals, steel and other heavy industries over time.

In other carbon intensive sectors, such as transport, agriculture and construction, emissions trading will be technically challenging because monitoring and verification of emissions is difficult. Faced with similar challenges, several EU member states have introduced complementary carbon taxes applied to sectors not covered by an ETS. Such carbon excise taxes are a relatively simple and efficient instrument, charged in proportion to the carbon content of fuel and a set carbon price.

Finally, while free allowances are still given to some sectors in the EU and other more mature national carbon markets, the majority of initial annual emission rights are auctioned off. This not only ensures consistent market-based price signals, but generates public revenue that can be recycled back into the economy to subsidize abatement costs, offset negative social impacts or rebalance the tax mix by cutting taxes on labor, general consumption or profits.

So far, China’s carbon reduction efforts have relied largely on regulations and administrative targets. Friday’s launch of the national ETS has laid the foundation for a more market-based policy approach. If deployed effectively, China’s carbon market will create powerful incentives to stimulate investment and innovation, accelerate the retirement of less-efficient coal-fired plants, drive down the cost of emission reduction, while generating resources to finance the transition to a low-carbon economy.

(Martin Raiser is the World Bank country director for China, Sebastian Eckardt is the World Bank’s lead economist for China, and Giovanni Ruta is a lead environmental economist of the World Bank.)

(first published on China Daily via World Bank)

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