Today, when still more than 80 percent of our world energy needs are met by fossil fuels, it is hard to believe that it has already been more than twenty years since the international community signed the International Framework Convention on Climate Change (UNFCCC) to recognize and address the threat of extensive greenhouse gas (GHG) emissions. Although there exists plan to make a fast transition to a low-carbon economy, in order to cap the global temperature increase at two degrees Celsius in comparison to the pre-industrial level, the challenges are tremendous.

Although the last eight presidents of the United States of America each proposed their own promising energy policy, the unattainable goal to guarantee a reliable, affordable and clean supply of energy stayed the same. In this quest for affordability, and in the context of naturally increasing oil and general energy production prices, Congress has never asked its citizens to pay a price that reflects the true costs of their energy consumption.

Over the last few decades it has become increasingly clear that the actual costs of energy production and consumption in the United States are much higher than the current market prices. The consumption and production of energy creates negative externalities that damage the health of Americans, the environment and the global climate system, creating risks that go beyond any possible liability scheme.

It is this surprisingly large price distortion in energy prices that led to a system in which well over 40 percent of energy is produced by coal, a fuel that not only creates very high GHG emissions but also pollutes the air, leading to higher lung cancer rates and acid rain. It is estimated that the prices of coal do not reflect even half of the environmental and human health costs that the fuel is inflicting. When the National Academy of Sciences tried to quantify the costs, they found the total non-climate change-related damages associated with energy consumption in the United States of America in 2005 to be higher than $120 billion. The climate change-related damages are likely to be much higher if one adopts the conservative U.S. government estimations of $21 of social costs for each unit of carbon dioxide GHG emission.

Furthermore, it seems clear that energy prices would be significantly higher if the energy sector was required, as nearly every other sector is, to shoulder the full liabilities associated with its operations. By providing legal caps on the liability of energy firms in the event of nuclear disaster ($12.6 billion), onshore oil spills ($350 million) and offshore oil spills ($75 million), the real risks connected to American energy consumption are obscured and lead eventually to a higher chance of disaster.

Historical experience illustrates how large-scale energy transitions usually occur gradually over the span of many decades, as technological improvements were implemented little by little. In the face of climate change, issues like energy security, international competitiveness and the previously discussed social costs, there is a great need to accelerate the transition towards alternative energy. Such a shift requires major investments in intelligent grids, energy storage and new power plants in order to move technology innovations from niche markets to industry-wide application.

The challenge lies not only in the gigantic scale of innovation needed but also in moving capital away from traditional fossil fuel business into renewable energy projects. Although a great share of energy technology innovation is in one way or another subsidized by the government, it is clear that eventually the lion’s share of this transition has to be driven by the private sector. This is exactly where the main challenge lies.

This situation, in which high-risk venture capital cannot provide enough capital for the translation and adaptation phases and big private equity investments are too risk-averse to be involved, defines the challenge of the commercialization gap. The appeal of higher energy prices that reflect their social costs is apparent. Growing profitability of alternative energy projects may narrow or even close the commercialization gap and thus catalyze the transition towards alternative energy.

Most government initiatives to tackle the issue of the commercialization gap of alternative energy were defined by traditional command-and-control regulations. The following three examples illustrate the main disadvantages of command-and-control regulations in comparison to market-oriented energy policies.

In 2007, in the quest to support the development of alternative energies, Congress expanded the definition of subsidy-eligible alternative fuels to including a wide range of petroleum fuels containing biomass products. As a result, the U.S. paper industry figured out that their so-called “black liquor” waste could be made eligible for the subsidy by simply adding diesel. Consequently, the originally estimated cost of $100 million of the subsidy soared to about $8 billion with the taxpayer funding the burning of diesel.

Although, the black liquor scandal is arguably the most prominent case, the 1978-2011 ethanol subsidy was certainly much more wasteful. This subsidy for ethanol used in gasoline oscillated between 40 and 60 cents per gallon. The idea of complementing and eventually replacing traditional fossil fuels with biomass products was certainly well-intended. However, when the Congressional Budget Office estimated the actual benefits in 2009, it found that the ethanol subsidy cost around $1.78 for every gallon of gasoline saved and around $750 for every ton of carbon dioxide emission saved.

Nevertheless, the problem is not a few cases of bad or wasteful subsidies; even the most successful regulations exhibit a high degree of economic inefficiency. The Corporate Average Fuel Economy (CAFE) fuel-efficiency standard, for instance, is often regarded as one of the most effective conservation measures. However, it is estimated that a simple carbon tax on gasoline of 25 cents per gallon could have saved just as much oil but at one-third of the costs to the economy.

These three cases exemplify not only the limited cost-effectiveness but also the challenge of additionality, winner picking and the predisposition to favoritism that can be associated with command-and-control and subsidy regulations. It is clear that subsidies and tax-credits are usually not able to differentiate desirable efforts, which happen only as a result of the subsidy, from efforts which would have happened anyways. It is this challenge of additionality that often transfers large shares of the overall subsidy into private pockets without having any impact. By subsidizing specific technologies or projects, the government chooses the winning technology without leaving the possibility of developing more cost-effective alternatives or unexpected new innovations.

Market-oriented energy policies operate quite differently. By internalizing the externalities of energy production and consumption, market-oriented energy policies aim to make the market prices reflect their social costs. Thus, with the signal function of the energy prices is restored, it is left to the market to determine the most cost-effective technologies to minimize the social costs of energy production and consumption.

The basic idea of carbon taxing is straightforward. Every business in the economy has to pay a tax proportional to its contribution to the overall carbon dioxide emissions. Such a carbon tax could be applied upstream on fossil fuel suppliers based on the carbon content of the fuels or downstream on the final emitters. By focusing on the upstream sector, about 98 percent of the U.S. carbon dioxide emissions could be captured in a relatively small number of firms. The required monitoring would be small and would be similar to already existing taxes that fuel suppliers already pay. The revenues of such an economy-wide carbon tax would not only eliminate the price distortions of today’s low energy prices but could also be used for the reduction of other taxes on labor and capital. Thus, the significantly higher energy prices for the consumer could not only be compensated but could also stimulate the economy. A carbon tax of $15 to $20, for instance, could could be used to reduce other tax burdens.

In contrast to a carbon tax, emission-trading schemes operate not on a maximization principle, but on a minimization principle: A given amount of GHG emissions should be reduced with the smallest possible costs to the overall economy. Emissions-trading schemes are therefore often referred to as cap-and-trade systems. The “cap” refers to the predefined budget of GHG emissions for which the government distributes emissions allowances. Firms face the choice of either reducing their emissions or acquiring emissions allowances for every ton of carbon dioxide they are emitting. As these emission allowances would be traded, the emissions allowances would concentrate in the firms with the highest reduction costs and push firms with lower reduction costs to undertake these changes.

On the basis that exactly the right amount of allowances are handed out, the price of the emission allowances would reflect the actual social cost of every ton of carbon dioxide emission. Although the current state of the European Trading Scheme with the devastating drop-off in allowance prices to only five euros provides a negative example, there are several situations in which cap-and-trade systems have proved themselves to be successful and cost-effective. In the U.S. Clean Air Act 1990, a cap-and-trade system helped to save businesses more than half of the costs of complying with energy standards for coal plants  — approximately $3 billion a year. Similarly, with the help of an emission-trading scheme, the celebrated Montreal Protocol successfully phased out Chlorofluorocarbons in order to prevent the destruction of the ozone layer.

A more global perspective elucidates that strong, isolated moves in the direction of carbon pricing in single nation states will not only fail to meet the global emission budget of 2 degrees Celsius but will also significantly undermine the international competitiveness of their domestic economies. Although it is certainly true that carbon-import tariffs can be a useful tool in incentivizing individual nation states to enter an international climate change agreement, isolated carbon tariffs cannot alter the rules of the underlying prisoners’ dilemma of climate change: the undeniable need for collective action.

With the current international climate change negotiations and their effort for an ambitious, comprehensive post-Kyoto Protocol at the world climate change conference in Paris in 2015, the widespread application of market-oriented policies, even in the international theatre, seems to be the right way towards serious, cost-effective climate change mitigation.

It seems like we have the right tools in our hands. Are we able to organize the necessary political willingness?