Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix

Abstract

This report presents a review of the theory and practice of carbon pricing and a quantitative analysis of alternative options for a carbon pricing instrument mix to help Mexico meet its Nationally Determined Contribution under the Paris Agreement.

Full text

is document was published in May 2017.
is publication presents the results of the study Achieving
the Mexican Mitigation Targets: Options for an Effective
Carbon Pricing Policy Mix, which was elaborated by Michael
Mehling and Emil Dimantchev.
Its contents were developed under the coordination of
the Ministry for the Environment and Natural Resources
(Secretaría de Medio Ambiente y Recursos Naturales,
SEMARNAT), and the “Mexican-German Climate Change
Alliance” of the Deutsche Gesellschaft für Internationale
Zusammenarbeit (GIZ) GmbH on behalf of the German
Federal Ministry for the Environment, Nature Conservation,
Building and Nuclear Safety.

Achieving the Mexican
Mitigation Targets: Options
for an Effective Carbon
Pricing Policy Mix

e coordinating institutions for the publication of
Achieving the Mexican Mitigation Targets: Options
for an Effective Carbon Pricing Policy Mix
would like to thank the Ministry of Finance and
Public Credit (Secretaría de Hacienda y Crédito
Público, SHCP) for its valuable contribution and
content review.

Contents
Abbreviations 7
1. Introduction 10
2. Definitions and eoretical Considerations 12
2.1. Carbon Pricing: Rationale and Alternative Approaches 12
2.2. Carbon Pricing in the Climate Policy Mix 14
2.2.1. Prices vs. Quantities: eory and Practice 14
2.2.2. Aligning Prices and Quantities in the Policy Mix 17
3. Options and International Experiences 20
3.1. Options for a Carbon Pricing Mix 20
3.2. Carbon Pricing Mix as a Transition Mechanism 21
3.3. Carbon Pricing Mix as a Flexibility Option 22
3.3.1. Voluntary Opt-in 22
3.3.2. Compliance Alternative 24
3.4. Carbon Pricing Mix as a Price Management Option 25
3.4.1. Improving Cost-effectiveness 25
3.4.2. Driving Low-carbon Investments 26
3.4.3. Revenue Certainty 26
3.4.4. Curtailing Regulatory Uncertainty 27
3.4.5. Enhancing Co-benefits 27
4. Carbon Pricing in Mexico 30
4.1. Socioeconomic Parameters 30
4.1.1. Macroeconomic Context 30
4.1.2. Emissions and Emission Trends, by Sector 30
4.1.3. Emissions Abatement Cost, by Sector 32
4.1.3.1. Societal Abatement Costs 32
4.1.3.2. Private Abatement Costs 33
4.2. Regulatory Framework of Carbon Pricing 34
4.2.1. Economy-wide Mitigation Targets 35
4.2.2. Carbon Tax: Sectoral Coverage and Rates 35
4.2.3. Emissions Trading System: State of Discussion 36
5. Quantitative Analysis 38
5.1. Emission Projections 39
5.1.1. e Reference Case 39
5.1.2. How Likely Is the Reference Case? 40
5.2. Carbon Price 42
5.3. Government Revenues 44
5.4. Policy Costs 47
5.5. Implications of Future Uncertainty for Policy Choice 48
6. Conclusions and Recommendations 51
6.1. Qualitative Analysis 51
6.2. Quantitative Analysis 52
7. Bibliography 54
7.1. Legal and Policy Documents (in reverse chronological order) 54
7.2. Other Sources (alphabetically) 55

List of Figures
Figure 1: GHG Emissions by Sector, 1990 and 2010 32
Figure 2: Marginal Abatement Curves for 2030 by Sector 34
Figure 3: Reference Case Emission Projections by Sector 40
Figure 4: Range of Reference Case Emissions 41
Figure 5: ETS Carbon Prices by Scenario 44
Figure 6: Total Government Revenues, 2017-2030, by Scenario 45
List of Tables
Table 1: Variations in a Carbon Pricing Mix 20
Table 2: Mexico Carbon Tax Rates in 2016 (MXN$) 35
Table 3: ETS Carbon Price Projections by Scenario (Units in Constant MXN/t) 43
Table 4: Revenues per Year, Full Auctioning (Units in Constant Billion MXN) 46
Table 5: Revenues per Year, Free Allocation to Industry (Units in Billion MXN) 47
Table 6: ETS Policy Costs in 2030 by Sector (Units in Million Pesos) 48

Abbreviations
AF: Assistance Factor
BAU: Business as Usual
CDM: Clean Development Mechanism
CER: Certified Emissions Reduction
CICC: Comisión Intersecretarial de Cambio Climático
ENCC: Estrategia Nacional de Cambio Climático
ETS: Emissions Trading System
EU: European Union
EU ETS: European Union Emissions Trading System
GDP: Gross Domestic Product
GHG: Greenhouse Gas
GS: Gold Standard
IEA: International Energy Agency
IMF: International Monetary Fund
INDC: Intended Nationally Determined Contribution
IPCC: Intergovernmental Panel on Climate Change
LGCC: Ley General de Cambio Climático
LIEPS: Ley del Impuesto Especial sobre Producción y Servicios
Mt: Million metric tons
NAFTA: North American Free Trade Agreement
OECD: Organisation for Economic Co-operation and Development
OTA : Office of Technology Assessment
PECC: Programa Especial de Cambio Climático
SEMARNAT: Secretaría de Medio Ambiente y Recursos Naturales
t: Metric ton
UNCED: United Nations Conference on Environment and Development
UNFCCC: United Nations Framework Convention on Climate Change
UNPD: United Nations Population Division
VCS: Verified Carbon Standard
WEF: World Economic Forum

8
Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing
Policy Mix
Key messages
• As climate policy tools, neither a price set through a carbon tax nor quantity rationing through an
emissions trading system is clearly superior to their alternative under all circumstances; considering
economic advantages under uncertainty and political economy constraints, real tradeoffs can be miti-
gated by hybrid approaches.
• A combination of emissions trading and a carbon tax can leverage synergies if properly aligned. Impor-
tantly, the coverage of a tax should be equal to or exceed that of a concurrent trading system to avoid
leakage between both instruments.
• Aside from uncoordinated coexistence, different coordinated combinations are possible based on the
degree of synchronicity and the symmetry of application, allowing it to serve as a flexibility option, a
transition mechanism, or a price-management mechanism.
• International experience has shown that the increased flexibility offered by a carbon pricing mix is
welcomed by compliance entities. Likewise, the use of a carbon pricing mix to manage price extremes
and excessive volatility in the carbon market can help avoid adverse effects, such as bounded rationality
in investment decisions and carbon lock-in.
• Mexico’s emissions are currently on a pathway to nearly achieve its unconditional 2030 contribution,
equal to a 22% reduction in GHGs relative to business as usual. Achieving Mexico’s unconditional tar-
get with an emissions trading system may result in a carbon price of MXN 74/tCO2e (USD 3/tCO2e)
in 2030. Reducing emissions further, to 26% below projected business as usual emissions, may result in
a carbon price of MXN 495/tCO2e (USD 23/tCO2e) in 2030.
• Mexico can implement an emissions trading system while maintaining a stable inflow of carbon pricing
revenue by including a carbon price floor. Depending on the level, revenue could then remain consistent
with current carbon tax proceeds, even if some allowances are allocated free of cost.
• e uncertainty analysis presented in this paper suggests approximately a one-in-four chance that an
emissions trading system would result in a carbon price of MXN 21/tCO2e (USD 1/tCO2e) or less in
2030. A hybrid approach with a carbon price floor would mitigate the risk of adverse effects and avoid
a decline in government revenue.

Introduction

10
Part 1: Conceptual Framework and International Experiences
1. Introduction
Mexico is the world’s 13th largest emitter of greenhouse
gases (GHGs), yet at the same time a pioneer among
emerging economies in its transition towards a compet-
itive, low-carbon economy. At present, Mexico’s policy
framework for energy and climate change is undergoing
a comprehensive reform towards greater sustainability,
competitiveness and security of supply. But Mexico also
shares many of the challenges faced by other emerging
economies, with a political and social context favoring
policies that promote economic growth and develop-
ment. Consequently, Mexico’s legal framework sets a
clear obligation to give priority to the least costly miti-
gation actions while promoting and sustaining the com-
petitiveness of the vital sectors of the economy (INDC,
2015). Economic instruments that afford flexibility in the
location and timing of abatement measures have proven
– in both economic theory and international practice – to
offer such a least costly approach to correcting the various
market failures underlying climate change (see Section
2.1 below).
Mexico’s General Law on Climate Change (LGCC)
reflects this by including an entire chapter on econom-
ic instruments (Chapter IX) and requiring the Federal
Government, the States, and the Federal District, within
their respective authority, to “design, develop, and apply
economic instruments that provide incentives for meet-
ing the objectives of national climate change policy”
(LGCC, 2012: Art. 91). Exercising this mandate, Mexico
introduced a carbon tax on certain fossil fuels starting in
2014 (see Section 4.2.2 below), and is now considering
the option of establishing an of an emissions trading sys-
tem (ETS) for one or more emitting sectors. Although
an ETS would be in line with Mexico’s strategy of pursu-
ing economically efficient climate policies, and is indeed
expressly mentioned in the LGCC (LGCC, 2012: Art.
94; see also Section 4.2.3 below), it remains unclear how
these two approaches to carbon pricing – one based on
fixed prices, the other on specified quantities – will op-
erate alongside each other. What this analysis therefore
sets out to explore are alternative pathways towards an
instrument mix that combines both the carbon tax and a
potential future ETS, including the economic and envi-
ronmental implications of different combinations.

Definitions and
Theoretical
Considerations

12
2. Definitions and Theoretical Considerations
(1) In the presence of enforced property rights and sufficiently low transaction costs, the ‘Coase eorem’ postulates that bargaining will lead to an efficient
outcome when trade in externalities is allowed (Coase, 1960). For common-pool resources and public goods (Samuelson, 1954), where property rights are
typically not defined, this will require creation of institutions such as common property protocols (Ostrom, 1990) or formation of clubs (Buchanan, 1965).
(2) Note, however, that the emission of GHGs is often accompanied by other pollutant emissions, notably air pollutants discharged during the combustion
of fossil fuels. High concentrations of such pollutants may set limits to the flexibility afforded to GHG emitters under any form of policy constraint.
2.1. Carbon Pricing: Rationale and
Alternative Approaches
Concern about the cost of environmental policy, coupled
with a broader trend towards deregulation and market
liberalization, has contributed to the diffusion of concepts
from economic theory into environmental policy (Kneese
et al., 1975; Pearce et al., 1989; Stavins, 1988). Econom-
ic theory commonly ascribes environmental challenges
to different market failures, such as positive or negative
externalities (Buchanan et al., 1962; Meade, 1952), the
bounded rationality of economic actors, or information
asymmetries. For economists, such market failures denote
an inefficient allocation of goods and services by the mar-
ket (Bator, 1958. One school of thought calls for public
policy intervention to correct such market failures, for
instance to internalize the social cost of pollution in the
private cost of underlying economic activity (Baumol et
al., 1988: 155; going back to Pigou, 1920). An alternative
approach focuses on the role of institutions in allowing
markets to correct themselves: because rational individ-
uals may fail to take collective action in the common in-
terest (Olson, 1968: 2; Hardin, 1968), properly defined
institutions – including property rights – are necessary
for the market to achieve an efficient outcome (Coase,
1960; Ostrom, 1990: 15)(1).
Although different policy instruments are available to ad-
dress the market failures underlying environmental pol-
lution (e.g. OTA, 1995: 81–89), economic instruments
are widely considered to achieve effective outcomes at the
lowest economic cost (Opschoor et al., 1989). Economic
instruments are defined as “instruments that affect costs
and benefits of alternative actions, open to economic
agents, with the effect of influencing behaviour in a way
which is intended to be favorable to the environment”
(OECD, 1991: 117).
A subset of these economic instruments includes those
that introduce an explicit price on environmental harm,
be it through a corrective price set in the form of tax-
es, charges, and other levies (Baumol, 1972, drawing
on Pigou, 1920), or through quantity controls based on
a market for tradable permits (Crocker, 1966; Dales,
1968; Montgomery, 1972; drawing on Coase, 1960). By
increasing the economic cost of harmful behavior, these
instruments create a continuous incentive to reduce envi-
ronmental harm: polluters will abate whenever they can
do so at a cost below the price of pollution, but pay the
applicable price when abatement is costlier, in line with
the principle that “the polluter should pay” (UNCED,
1992: Principle 16). Abatement decisions are thus decen-
tralized, helping overcome the information asymmetry
between policy makers and polluters, and thereby reduc-
ing efficiency losses through rent seeking and regulatory
capture (Helm, 2005: 215; on the underlying concepts,
see Buchanan et al., 1975; Krueger, 1974). Ultimately,
both instruments should result in an equilibrium where
marginal abatement costs are equalized across all regu-
lated entities, and abatement occurs where it yields the
largest net benefit to society (Baumol et al., 1988: 177).
Policies that generate an explicit price on pollution are
considered particularly useful to address climate change
(Aldy et al., 2012; Bowen, 2011: 5-6; Krupnick et al.,
2012: 1; OECD, 2013b: 14-15; Rydge, 2015), which has
been described as “the greatest market failure the world
has ever seen” (Stern, 2006: viii). e unique nature of
climate change calls for policies that are flexible, scal-
able, and cost-effective. GHGs are not in themselves
toxic, and the damage function of their accumulation
in the atmosphere is likely to be shallow in the short
run (Helm, 2005: 223), both of which allow for a more
flexible policy approach(2). Scale thus becomes critical
to any viable policy solution, because the causes of cli-
mate change originate in diffuse, widely heterogeneous
and virtually ubiquitous activities, with the boundless
geographic scope of emissions matched only by the long
time horizons of their accumulation in the atmosphere.
So does the economic cost of a policy response: although

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 13
the avoided impacts of climate change – such as extreme
weather events, flooding, crop losses, vector-borne diseas-
es, and biodiversity loss (IPCC, 2014; World Bank: 2014)
– and the co-benefits of mitigation, such as energy sav-
ings, reduced health impacts, or improved energy securi-
ty (IPCC, 2015: 1152), suggest that a carefully designed
mitigation strategy will generate benefits that outweigh
costs in the long term (Stern, 2006), abatement actions
divert resources and capital away from the production
of conventional goods and services, and can thus have a
detrimental effect on economic growth in the short term.
Aside from scale, therefore, cost effectiveness becomes an
overriding concern when addressing climate change.
For these reasons, introduction of a price on GHGs –
commonly described as “carbon pricing” – has been re-
ferred to as the “logical foundation of any policy regime
for clean energy” (WEF, 2009: 39). Unlike policies tar-
geting specific solutions, carbon pricing is able to harness
all available potential mitigation opportunities, provid-
ing scalability and avoiding potentially costly path de-
pendencies in technological innovation (Anadon et al.,
2016). By equalizing marginal abatement cost across all
covered entities, it also minimizes the negative welfare
impacts of mitigation. As the economic cost of climate
action rises over time – with cheap abatement options
being, by design, exhausted first (Stern, 2006: 63, 191)
– the cost-effectiveness of carbon pricing will become
increasingly critical to sustain any policy regime in the
long run.
Another advantage of carbon pricing is its ability to
generate public revenue to address distributional effects,
reduce other distortionary taxes, or invest in research, de-
velopment and deployment where the price signal alone
is insufficient to alter behavior and channel finance to
sustainable technologies and infrastructure. But although
elegant in its conceptual simplicity, carbon pricing can be
challenging to implement in practice, especially as part
of an instrument mix alongside other policy instruments,
where interactions can have multiple and unintended ef-
fects. Such interactions are the focus of the next section.
Definition: Carbon Pricing through Prices and Quantities
Policy makers seeking to address the causes and effects of climate change can take recourse to a portfolio of policy
instruments, including corrective pricing and quantity rationing, performance standards, subsidies, agreements,
and informational instruments (IPCC, 2015: 1155; OECD, 2008: 18-22). As mentioned earlier, both pricing and
quantity controls deliver an explicit price signal on GHG emissions, better known as a “carbon price” (Aldy et al.,
2012). Other policy instruments will also incur a cost of compliance and abatement, and therefore can be said to
have an implicit, “effective”, or “shadow” carbon price (OECD, 2013a; see generally Posner, 1971); but although
this price can be estimated, it will vary widely among compliance entities, and – not being revealed like an explicit
carbon price – will fail to send a price signal to the economy.
A pricing approach is implemented by way of fiscal instruments, commonly through what is called a “carbon
tax”. At a general level, taxes are compulsory, unrequited payments to a government where public benefits pro-
vided to taxpayers are not normally in proportion to their payment (OECD, 2001: 15). Other fiscal instruments,
such as charges and fees, are payments in return for services received, limiting their suitability for climate policy.
Functionally, a carbon tax can pursue various objectives individually or simultaneously, and focus on influencing
behavior, financing specific expenditures, or generating public revenue. As for the taxable object and the point of
regulation, the tax can be levied upstream on products and natural resources, based on their embedded carbon
content, or on GHG emissions discharged in connection with certain activities along all stages of the value chain.
A quantity rationing approach involving a market, by contrast, is based on units conferring the right to discharge a
specified quantity of GHGs for a specified duration of time, and includes both emissions trading systems based
on a technological baseline or an emissions ceiling, and crediting systems based on mitigation efforts at project,
sectoral or economy-wide level.

14
All these approaches – collectively referred to as “carbon markets” – have in common that they are based on a
quantity limitation which generates demand for carbon units, and that they enable parties to purchase or sell car-
bon units at the respective market price, signaling the opportunity costs of pollution as determined by the forces
of demand and supply. Following the initial issuance of units, thus, their distribution is left to market forces. As
prices for units rise in response to growing scarcity, the demand for them will gradually decrease, along with the
associated emissions (Tietenberg, 2006). Like a carbon tax, emissions trading can be implemented at different
stages of the value chain, upstream, mid- or downstream.
(3) In most sectors, GHG mitigation will be achieved by improving the efficiency with which energy is used or by reducing its carbon intensity (OECD,
2008: 11), but in agriculture, forestry, and certain chemical and industrial processes where emissions are not related to energy use, other actions – such as
input substitution, process changes, and stabilization or expansion of carbon sinks – will be necessary.
2.2. Carbon Pricing in the Climate Policy
Mix
As Mexico transitions to a sustainable economy, it will
have to consider the policy instruments it chooses as
part of a balanced and coordinated mitigation strategy.
In practice, climate policy instruments are applied alone
or in varying combinations to different sectors, such as
electricity generation, industry, transport, buildings, and
land use (Krupnick et al., 2010: 8-9)(3). With this diver-
sity of policy options comes a need for reliable criteria to
guide and justify selection processes between contend-
ing instruments. While no universal framework serves to
evaluate policy instruments across all settings, a number
of criteria have been proposed in academic literature that
focus on the environmental effectiveness, the cost effec-
tiveness, and the distributional impacts of alternative pol-
icy approaches (Goulder et al., 2008; IPCC, 2015: 1156;
Keohane et al., 1998).
A first subsection below discusses the application of these
criteria to price controls and quantity rationing in climate
policy, illustrating the limitations of a purely theoretical
approach to instrument choice. Experience also suggests
that carbon pricing will rarely, if ever, be introduced into
a policy void, emerging instead alongside existing and
evolving policy frameworks dedicated to climate change
mitigation and adaptation, environmental protection
more generally, and other social and economic concerns.
Because the inevitable interactions with other policies
can undermine both the environmental and the cost ef-
fectiveness of mitigation efforts, the following subsection
introduces the concept of an instrument mix, and the
current state of knowledge about successful policy align-
ment. Finally, a third subsection focuses specifically
on alternative ways in which a carbon tax and an ETS
can exist alongside each other, distinguishing a range of
options based on the symmetry and synchronicity of ap-
plication.
2.2.1. Prices vs. Quantities: Theory and
Practice
Much theoretical debate has focused on the relative mer-
its of pricing and quantity controls, focusing largely on
a key difference between both approaches: the manner
in which prices are determined. Under a carbon tax, it
is set exogenously by administrative fiat, whereas in a
carbon market, the price is discovered in the market at
the meeting point of demand and supply, the latter be-
ing determined by the regulator (Goulder et al., 2014).
Under idealized conditions of perfect information, both
pricing and quantity rationing should equalize marginal
abatement cost at a level that reflects the marginal en-
vironmental damage of pollution and therefore yields
identical welfare outcomes (Baumol et al., 1988). When
the marginal costs and benefits of policy intervention are
uncertain, however, this assumed identity no longer holds
true, and the welfare implications become contingent
on whether the marginal costs or the marginal benefits
of abatement rise faster with growing policy ambition
(‘Weitzman eorem’, after Weitzman, 1974). Climate
change is driven by aggregate GHG concentrations in
the atmosphere, prompting some commentators to argue
that anthropogenic emissions will only result in a mar-
ginal increase in the overall “carbon stock”, whereas the
abatement costs – although also uncertain – are likely
to grow more steeply; in other words, the global climate
might be less sensitive to short-term changes in emis-
sions than abatement costs (Hoel et al., 2002; Newell et
al., 2003; Tol, 2014: 56).

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 15
Applying the foregoing theorem, the flat damages from
climate change would suggest favoring a carbon tax be-
cause a quantity set at the wrong level will result in great-
er deadweight loss than a wrong price (Weitzman, 2015).
Empirical research on the accuracy of emission forecasts
and its impact on policy design seems to underscore this
conclusion (Wara, 2015). Importantly, however, uncer-
tainty about the damages function of climate change
over longer timeframes – and especially the possibility of
climatic discontinuities and catastrophic outcomes (Pin-
dyck, 2013; Weitzman 2014, 2011, and 2009) – can shift
the preference towards quantity controls and the emis-
sions certainty they offer (IPCC, 2015: 1167; Hepburn,
2006: 238; Pizer, 2002: 415; Pollitt, 2015: 8).
Indeed, as an influential commentator has suggested, the
theoretical debate about prices and quantities might thus
be one of “second-order importance” (Tirole, 2012: 124),
prompting instead a focus on considerations of political
economy. And in effect, experience to date suggests that
political economy dynamics may favor emissions trad-
ing over taxes (Goulder, 2013: 99; Keohane et al., 1998:
315; Mehling; 2012: 278; IPCC, 2015: 1167). Different
factors have been suggested to explain this observation,
from the deliberation focused on a science-based tar-
get rather than a politicized price, the emergence of net
beneficiaries under an ETS – including the financial
services sector – as supportive constituencies (Paterson,
2012), and a proactive role of invested business coalitions
(Meckling, 2011), to greater flexibility in distributing the
economic burden of mitigation efforts through free al-
location of units (Tirole, 2012: 124; Helm, 2005: 216;
Hood, 2010: 12)(4).
Still, reasoned disagreement exists on the political econ-
omy of various aspects of instrument design and im-
plementation. In terms of the administrative capacities
required for carbon taxes and emissions trading, both
approaches will require mechanisms to determine carbon
emissions or content, and to monitor and enforce compli-
ance at the point of regulation; but only an ETS will also
require the establishment of a registry to track issuance,
possession and transfers of units, and market infrastruc-
ture to allow for trading (Goulder, 2013: 99; Goulder et
(4) Unlike tax revenue returned to a compliance entity, which affects the net incentive to reduce emissions, free allocation of units under an ETS does
not alter the overall quantity, or ‘cap’, and therefore the environmental outcome. It does, however, have distributional impacts and limit the ability to use
auctioning revenue to reduce other distortionary taxes, which would increase aggregate welfare (Goulder et al., 2010; Parry et al., 2010), and some forms of
free allocation – notably grandfathering – can significantly favor incumbents, creating a barrier against new entrants (Helm, 2005: 216).
al., 2013: 11). Some commentators additionally cite the
ability to use existing tax levying structures in defense of
a pricing approach, reducing the overall administrative
burden (Cramton et al., 2015; Helm, 2005; IPCC, 2014;
Wara, 2014). Others, meanwhile, point to the greater
transparency of outcomes in an ETS relative to domestic
fiscal flows as an advantage of quantity rationing (Gollier,
2015; Tirole, 2012). As for revenue generation, empir-
ical research shows that a larger share of revenue from
ETS auctions has been allocated to environmental ex-
penditures, whereas carbon tax revenue more commonly
accrues to the general budget or is refunded to taxpayers,
some authors would suggest reduced flexibility for policy
makers under a pricing approach (Carl et al., 2016). Both
instruments also interact differently with complementary
policies in an instrument portfolio, affecting cost and, in
some cases, environmental outcomes (see below, Section
2.2.2).
Once introduced, carbon taxes and emissions trading
may also differ in their resilience against political change.
Revenue generated by a carbon tax should incentivize
governments to protect or even strengthen tax rates over
time (Weitzman, 2015), although recent experience has
also shown how the countercyclical tendency of carbon
prices to fall during an economic downturn lessens the
compliance burden in an ETS (Goulder, 2013: 95), in-
creasing its resilience precisely at a time when pressure
to weaken climate policies makes taxes more vulnerable
(Doda, 2016; Pollitt, 2015). An argument can also be
made about the opportunities each approach offers for
international cooperation. While some commentators
have argued in favor of international carbon tax harmo-
nization (Cramton et al., 2015; Weitzman, 2015), sci-
ence-based quantity targets have proven far easier to ne-
gotiate in international arrangements (Helm, 2005: 212).
To date, emissions trading has also resulted in greater
harmonization and linkage across jurisdictions (Mehling,
2016), however, it has been argued that the accompany-
ing cross-border financial transfers may contribute to po-
litical vulnerability (Weitzman, 2015: 39).

16
Perhaps the most important difference relates to the con-
sistency of the price signal under each instrument, where
a carbon tax, by default, will be more stable and predict-
able than the price discovered by market forces within an
ETS. Some observers have countered that tax rates will
usually require frequent adjustment, whereas quantity
targets can be set for the medium and long term, pro-
viding a longer policy horizon (Tirole, 124; Gollier et al.,
2015: 20). Still, experience has shown price volatility to
be considerable in markets for tradable carbon units, with
potential ramifications for the achievement of intended
policy objectives.
While this may not have implications for static cost ef-
fectiveness, it can affect the dynamic efficiency of car-
bon pricing over time (Görlach, 2014: 735). Volatility
may prompt risk averse firms to engage in fewer trans-
actions under an ETS (Baldursson et al., 2004), reduce
incentives to innovate (Cramton, 2015; Hepburn, 2006;
Johnstone et al., 2010), and increase financing cost for
low-carbon investments (see below, Section 3.4.2). Under
extreme volatility or extended periods of very low prices,
market participants are more likely to focus on available
mitigation options and hold off on innovation, which
may promote unsustainable path dependencies and risk
locking in carbon emissions (Bertram et al., 2015a; Seto,
2016; Unruh, 2000). Still, while carbon taxes avoid such
volatility by offering price certainty, the rates set in most
jurisdictions – as well as prices revealed in most carbon
markets – are far from approaching even the low end of
estimates of the social cost of carbon (OECD, 2016). A
price in line with such estimates would be necessary for
optimal outcomes, but may be precluded by binding po-
litical constraints (Jenkins et al., 2016).
Pursuit of an optimal outcome may be unrealistic in sit-
uations of incomplete information, limited resources, and
various contending objectives (Simon, 1955). What that
may instead justify is a pragmatic focus on reasonable,
second-best solutions, with greater attention afforded to
policy design rather than a futile pursuit of theoretical
optimality (Labandeira et al., 2012). One important de-
sign option available to harness the relative advantages of
pricing and quantity rationing while limiting their short-
comings is the introduction of a hybrid carbon price (see
text box below), obviating much of the debate about the
theoretical merits of pure pricing or quantity rationing.
Carbon Pricing Hybrids
Price uncertainty and volatility in an ETS can be reduced by combining its emissions certainty with some degree
of price predictability through market interventions, resulting in a hybrid between pure pricing and quantity ra-
tioning. One way to manage prices is the introduction of a price floor, price ceiling, or both, by either setting prices
directly or by manipulating unit supplies. A price ceiling, for instance, can be created by injecting additional units
into the markets whenever the price reaches or exceeds a designated threshold, or by allowing compliance entities
to pay a fixed tax in lieu of compliance. A price floor, by contrast, can be implemented by setting a minimum price
for the initial sale of units (e.g. an ‘auction reserve price’), by removing units from circulation whenever prices fall
below a specified threshold, or by introducing a minimum tax that compliance entities must pay whenever the
price of units drops below the tax (Goulder, 2013: 95; Wood et al., 2011). More complex mechanisms that inter-
vene in the supply of units pursuant to sophisticated rules, such as market stability and cost containment reserves,
have been established in several ETS (Golub et al., 2012; Murray et al., 2009). Such hybrid approaches have been
thoroughly researched (Goulder et al., 2013; Grüll et al., 2011; Hepburn, 2006; Pizer, 1997 and 2002; going back
to Weitzman, 1978), offer a viable means to secure predictable price signals for investors (Brauneis et al., 2013),
and are also increasingly established features of carbon pricing systems currently in operation (Holt et al., 2015;
Kollenberg et al., 2015). At the same time, they come with a tradeoff, as the presence of a price ceiling removes the
constraint on overall emissions and thus compromises certainty about the environmental outcome. Some authors
have suggested alternative ways to compensate for emission increases, for instance by using revenues from ceiling
price sales or taxes to purchase offsets (e.g. Stavins, 2008).

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 17
2.2.2. Aligning Prices and Quantities in the
Policy Mix
Different market failures contribute to anthropogenic
climate change, from the negative externality of GHG
emissions and the positive externality of innovation spill-
overs, to information asymmetries, bounded rationality,
and principal-agent problems. Accordingly, policies ad-
opted to correct these market failures can pursue objec-
tives other than GHG emissions abatement, such as pro-
moting innovation, inducing structural transformation,
or increasing energy security (Helm, 2005: 214; Knudson,
2009: 308). A widely accepted precept, the ‘Tinbergen
Rule’, states that each policy target requires at least one
policy instrument for all policy goals to be achieved (Tin-
bergen, 1952; Johansen, 1965: 12), thereby providing the
theoretical justification for climate strategy harnessing a
variety of policy instruments in an instrument portfolio.
In keeping with this rationale, and despite the theoretical
benefits of carbon pricing outlined earlier (see Section
2.1), there is growing recognition that a price on carbon
by itself will prove insufficient to address climate change
(IPCC, 2014: 1173; ITD, 2015; Stern, 2006: 308). So far,
political constraints have mostly prevented the adoption
or emergence of a carbon price sufficient to compensate
the negative externality of GHG emissions (Jenkins et
al., 2016; OECD, 2016). In such cases, additional policy
measures will be indicated to correct the market failure,
as reliance on the carbon price alone may delay necessary
action and significantly increase welfare costs (Açemoglu
et al., 2016).
Even where the carbon price reaches or exceeds median
estimates of the social cost of carbon, additional barriers
and distortions justify introduction of complementary
policy instruments. In particular, policies that foster re-
search, development, demonstration, and market deploy-
ment of low-carbon technologies are considered vital to
drive innovation and bring forward the range of technol-
ogy options needed to make deep emissions cuts (Açe-
moglu et al., 2012; Bertram et al., 2015b; IPCC, 2014:
1174; Stern, 2006: 308). Additionally, barriers to behav-
ioral change – such as information failures, bounded ra-
tionality, and lacking availability of finance – can require
targeted policies (Labandeira et al., 2011). Over time, the
innovation and efficiency improvements spurred by such
policies may even foster a more favorable political context
for strengthened carbon pricing efforts (Wagner et al.,
2015).
Transitioning to a low-carbon economy – a trajectory
Mexico has committed to – will therefore likely require a
balanced and coordinated strategy that leverages a com-
bination of policy approaches. But in practice, concurrent
policy objectives and instruments are not always clearly
defined or easily distinguishable (Tinbergen, 1952: 37).
Moreover, the positive theory of government suggests
that political and institutional dynamics result in poli-
cy accretion (Helm, 2005: 213-214), where some policy
instruments are introduced for purely symbolic reasons
or concealed motivations. Negative policy impacts, for
instance on low-income households or vulnerable indus-
tries, may require additional policy interventions, further
increasing the number of instruments in the mix. In the
end result, policy portfolios are not necessarily the result
of a rationally conceived and fully coordinated process
(Görlach, 2014: 735).
With simultaneous operation of different policy instru-
ments, however, comes an increased likelihood of inter-
actions (OECD, 2007: 27), especially where instruments
pursue more than one objective or undermine other pol-
icy objectives and therefore necessitate tradeoffs (Knud-
son, 2009: 309-311). Depending on the instrument type,
objectives, and context, such interactions can be positive
or negative. ey are more likely to be beneficial when
each of the affected instruments addresses a different
market failure with sufficient specificity, whereas adverse
interactions are more likely when multiple policies seek
to correct the same market failure (IPCC, 2014: 1181).
When combined with other policy instruments, carbon
pricing will also interact along the same logic. Synergies
can arise from the simultaneous operation of a carbon
price, which aims to compensate the negative external-
ity of emissions, and policies targeting a different mar-
ket failure. Examples include financial incentives to in-
ternalize the positive knowledge spillover of innovation
in renewable energy technology, where the combination
with carbon pricing has been shown to allow emissions
mitigation at lower cost than either policy would achieve
alone (Fischer et al., 2004; Oikonomou et al., 2010;
Schneider et al., 1997), or policies to overcome behav-
ioral barriers, such as bounded rationality or information
failures (Goulder et al., 2008; Gillingham et al., 2009).
Given its economic rationale of promoting mitigation
at least cost, however, carbon pricing is also vulnerable
to adverse interactions and even outright redundancies
when implemented alongside other instruments that ad-
dress the same market failure. Performance standards tar-
geting particular technologies, for instance, will interfere
with the ability of carbon pricing to equalize abatement

18
cost across the economy and identify the most cost-effec-
tive abatement options. If the carbon price is higher than
the marginal abatement cost under such complementary
policies, it becomes redundant (IPCC, 2014: 1182); if the
carbon price is lower, however, the simultaneous appli-
cation of directed technology mandates will curtail the
compliance flexibility of emitters and increase the cost
of achieving the same environmental outcome. With a
pricing approach, such as a carbon tax, the interaction
should not compromise the environmental effectiveness
(de Jonghe et al., 2009; Goulder et al., 2011); but with a
quantity rationing approach that involves tradeable units,
such as an ETS, the introduction of complementary pol-
icies can result in undesirable emissions leakage, as de-
scribed in the text box below.
Quantity Rationing and the ‘Waterbed Effect’
In the presence of an ETS, introducing additional instruments such as a performance standard might yield no
further reductions in overall emissions. Because the overall emissions level is determined by the number of units
in circulation, emissions reductions achieved under the complementary policy will displace units that can be used
to offset emissions elsewhere under the ETS, effectively only shifting the location and timing of emissions under
the determined limit (Burtraw et al., 2009; Fankhauser et al., 2010; Goulder and Stavins, 2011; Goulder, 2013).
Additionally, the increase in unit supply will, ceteres paribus, exert downward pressure on unit prices until all units
in circulation are again demanded (Goulder et al., 2013: 16), thereby weakening the price signal in the market.
Although observers have countered that such an effect will not occur whenever unit supply exceeds emissions
(Whitmore, 2016), an imbalance observed in most existing ETS, it still has an important bearing on the design
of climate policy portfolios.
Occasionally described as the ‘waterbed effect’ because of how pressure in one location leads to expansion in an-
other, the foregoing phenomenon will occur when the coverage of an ETS overlaps with that of a complementary
policy at the same jurisdictional level, or when a policy introduced at a lower jurisdictional level is integrated
within an ETS implemented at a higher jurisdictional level (IPCC, 2014: 1180, 1182; see also the Case Study
on the United Kingdom, below). With relevance for a carbon pricing policy mix, such interactions can also arise
when a carbon tax is introduced in the presence of an ETS (Böhringer et al., 2008; Fischer and Preonas, 2010),
provided the fixed price is introduced only for a subsection of entities participating in emissions trading; when-
ever coverage of both instruments is identical, however, the tax will assume the role of a price floor (see below,
Section 3.4).
For climate policy makers exploring the adoption of
multiple climate policy instruments – including carbon
pricing – as part of an instrument portfolio, the foregoing
observations translate into a number of important rec-
ommendations. A starting point can be derived from the
Tinbergen Rule: just as each target requires its own poli-
cy (Tinbergen, 1952), each policy should seek to address
a different market failure, and do so with the greatest
level of specificity possible. Policies adopted to promote
climate mitigation should avoid the simultaneous pursuit
of other policy objectives, such as labor or industrial poli-
cy goals (Görlach, 2014: 736). Because political economy
considerations may nonetheless require that individual
instruments invoke concurrent policy priorities, limiting
the overall number of instruments may also be indicat-
ed (Knudsen, 2009: 309). Level of governance and sec-
toral coverage of complementary policies both have an
important bearing on interactions, which, in the case of
carbon pricing, suggests a preference for either full or no
policy overlap: to avoid the “waterbed effect” described
above, concurrent pricing through a carbon tax and quan-
tity rationing with an emissions trading system requires
that both instruments have identical coverage, or that the
carbon tax have broader coverage, including all sectors
and activities covered by the ETS. In the next section,
these guiding principles are assessed in greater detail,
with a view to specific case studies drawn from interna-
tional experience.

Options and
International
Experiences

20
3. Options and International Experiences
3.1. Options for a Carbon Pricing Mix
A carbon tax and an ETS can exist alongside each other
without any degree of coordination, or can form part of
a coordinated instrument mix. Concurrent application
without coordination will result in an aggregate effective
price signal for sectors and activities covered by both in-
struments, but not offer the opportunity to leverage their
coexistence for specific design purposes. Additionally,
lack of coordination risks incurring leakage of emissions
between policies described as the “waterbed effect” above.
A coordinated carbon pricing mix, by contrast, can help
avoid unintended interactions and offers additional op-
tions for policy makers to introduce specific design
features. Each of the following subsections outlines a
conceptual option for the inclusion of pricing and quan-
tity rationing in a coordinated carbon pricing mix, and
provides case studies drawn from international practice.
Alternative approaches to a carbon pricing mix are dis-
tinguished by the scope and timing of their application,
described in terms of the ‘symmetry’ and ‘synchronicity’
of coverage.
Where a carbon tax and an ETS are fully symmetrical
in coverage, they will apply to all the same activities and
sectors; where they are partially symmetrical, there will be
some, but not full overlap; and where they are asymmetri-
cal in coverage, they will apply to entirely different sectors.
Likewise, a carbon tax and an ETS will be synchronous
if they apply at the same time, and asynchronous if one
applies first, and phases out or transitions into the other.
Depending on the degree of symmetry and synchronicity,
a portfolio of options emerges to combine pricing and
quantity rationing, as described in the following table.
Table 1: Variations in a Carbon Pricing Mix
Synchronous Asynchronous
Symmetrical Price Floor and/or Ceiling Transition/Phase-In
Compliance
Alternative No Overlap
Asymmetrical No Overlap
No Overlap
Each of these possible combinations will be described in
greater detail below, with reference to international ex-
periences in the form of case studies where available. It
bears noting, however, that the boundaries between some
options – such as the compliance alternative and the pos-
sibility to opt into an ETS – are blurry, and different op-
tions can also be combined. For instance, the case studies
on Switzerland and the United Kingdom describe both
an opt-in scenario as well as a transition from voluntary
to mandatory participation in the respective ETS. Con-
ceptually, moreover, using a floor or ceiling price to man-
age volatility and price extremes in an ETS is, in some
ways, a mirror image of using offset credits as a com-
pliance alternative in a carbon tax regime. Rather than
offer precise definitions and sharp conceptual boundaries,
therefore, the following sections are meant as a heuristic
approach to categorizing different combinations of pric-
ing and quantity rationing in a carbon pricing mix.
Timing
Coverage

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 21
3.2. Carbon Pricing Mix as a Transition
Mechanism
One option for lawmakers is to implement price-based
and quantity-based carbon pricing sequentially. An ex-
ample of this approach would be to put a price on carbon
emissions that is initially fixed, but eventually allowed to
float through an ETS. Australia offers an example of how
such a transition can work (see text box below).
e advantage of starting carbon pricing with a fixed-
price period is that it provides stakeholders with relative
certainty over policy costs. Such certainty can ease the
lawmaking process. e history of lawmaking in the en-
vironmental and health arenas shows that policy costs
have been far more often overestimated than underesti-
mated (Harrington et al., 1999; Goodstein and Hodges,
1997). We conjecture that it is more likely for stakehold-
ers to overestimate the costs of a quantity-based instru-
ment than to overestimate the costs of an equivalent
price-based instrument. is is because it is impossible
to predict what carbon price will emerge from the for-
mer, which leaves greater room for error in analyses that
seek to estimate policy costs. Since errors tend to be on
the side of overestimation, we think that the greater cost
uncertainty associated with quantity-based instruments
may result in greater exaggeration of these costs. Indeed,
our experience with constructing long-term ETS carbon
price forecasts has shown us that it has been more com-
mon to overestimate than to underestimate future car-
bon prices. For these reasons, fixed-price instruments are
likely to lead to cost expectations that are closer to actual
costs than those resulting from quantity-based instru-
ments. us, fixed-price instruments can mitigate the po-
tential for cost exaggeration and help lawmakers secure
the support of the companies that are to be regulated.
A disadvantage of this approach is that a fixed carbon
pricing instrument focuses the political debate on a spe-
cific price (rather than an emissions target), which may
reduce its political appeal and burden the instrument
with the political economy context of other fiscal mea-
sures. In Australia, a sustained, and eventually effective,
opposition to the nation’s carbon pricing system was
founded on the notion that the carbon price was a tax
(see text box below).
It is also worth recalling that a fixed-price instrument
does not allow for a cap on emissions. Given that the
primary objective of carbon pricing is to cost-effective-
ly reduce greenhouse gas emissions, policy makers may
therefore have a rationale to eventually transition from a
fixed price period to an ETS that can ensure that emis-
sion reduction targets are met.
Case Study: Australia’s Carbon Pricing Mechanism
Australia implemented carbon pricing when it enacted the Clean Energy Act of 2011. e act introduced the
Carbon Pricing Mechanism, which became operational in the fiscal year 2012-2013. e mechanism operated
until 1 July 2014, when it was repealed by the newly elected government formed by the center-right Liberal party
under Prime Minister Tony Abbot. Despite its short existence, Australia’s Carbon Pricing Mechanism holds
lessons for policy makers due to its unique integration of price-based and quantity-based instruments. e mech-
anism required that liable emitters surrender a permit for each ton of CO2 emitted.
It covered emissions from power, industry, waste management, and fugitive sources, capturing around 60% of
Australia’s emissions. A unique feature of the mechanism was that it introduced carbon pricing in a sequential
manner.
For the first three years of the program, emitters could purchase permits from the government at a fixed price.
e mechanism stipulated that the price level would start at AUD 23/t CO2e for the 2012-2013 fiscal year, and
gradually rise to about AUD 25/t CO2e in 2014-2015.
e design of the fixed price period allowed a broad coverage of sectors, while mitigating competitiveness con-
cerns. e program covered politically sensitive sectors such as energy-intensive industries, but gave them permits
for free to protect them from any adverse effects of the carbon price. Companies could sell free permits back to
the government, which provided them with an incentive to reduce emissions.

22
e Carbon Pricing Mechanism stipulated that an ETS would come into force in 2015-2016. ough the carbon
price was to be determined by the market, the government decided to maintain some level of price management
by including provisions for a price floor and a price ceiling. e transition was to be facilitated by virtue of that
fact that some of the prerequisites for emissions trading had already been put in place for the fixed-price period,
such as systems for the monitoring, reporting and verification of emissions.
However, the ETS never entered into operation. Politically, the fixed-price period incurred significant challeng-
es for the government. Opponents to the carbon price, led by the Liberal Party, assailed it as an economically
harmful carbon tax, implying that Prime Minister Julia Gillard had reneged on an earlier campaign promise not
to implement any new taxes. e ensuing controversy caused damage to Gillard’s approval ratings and played a
part in the Liberal Party’s victory in the 2013 elections, ultimately resulting in the repeal of the Carbon Pricing
Mechanism.
3.3. Carbon Pricing Mix as a Flexibility
Option
Pricing and quantity rationing can be implemented
alongside each other to offer compliance entities in-
creased flexibility in meeting their obligations. Two al-
ternative approaches have been deployed in practice, al-
lowing entities liable under a carbon tax the option to
voluntarily become participants in an ETS, or affording
them the opportunity to comply with the tax obligation
through use of emission offset credits. Both approaches
are described through case studies below.
3.3.1. Voluntary Opt-in
Being able to voluntarily opt into an ETS offers enti-
ties flexibility in their compliance with climate policy
objectives and related carbon constraints. Typically, the
decision to opt into the ETS is voluntary, but once it has
been exercised, participation becomes mandatory, with
affected entities either subject to an aggregate cap or in-
dividual mitigation targets. Different motivations may
underlie such a choice, including reputational benefits or
a desire to participate in the carbon market for specula-
tive or other purposes, but most commonly the driver will
be a desire to avoid having to comply with costlier policy
alternatives.
In Switzerland and the United Kingdom, for instance,
the default policy at one point in time was a carbon tax,
but taxable entities were given the option to adopt a mit-
igation target and participate in an ETS in lieu of servic-
ing their tax liability. Both cases saw significant uptake
of the opportunity to opt into the ETS, reflecting the
cost-savings expected from participation in the market
and from having access to offset credits. In both cases,
however, participation in the ETS eventually became
mandatory for entities exceeding certain emission or ca-
pacity thresholds. While the advantages of a voluntary
opt-in are readily apparent for compliance entities, the
uncertainty it introduces also curtails the ability of pol-
icy makers to predict and control emissions outcomes,
possibly explaining why this option has often remained
a temporary one.

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 23
Case Study: Switzerland
In 1999, Switzerland adopted an Act on the Reduction of Carbon Dioxide (CO2) Emissions (Federal Council,
1999) to help achieve the quantified emission reduction commitment entered under the Kyoto Protocol to the
UNFCCC. Included in the 1999 CO2 Act was a mandate to adopt a CO2 levy if alternative instruments proved
insufficient to achieve the Swiss climate commitment. is mandate also specified the earliest launch date, the
scope, and the maximum rates for such a levy. Starting in 2008, Switzerland exercised this mandate by imposing a
levy on all fossil thermal fuels, such as heating oil, natural gas, coal, petroleum, and coke, used to produce heat, to
generate light, in thermal installations for the production of electricity or for the operation of heat-power cogen-
eration plants. Rates under the levy have gradually risen from CHF 12/tCO2 (USD 11.9/tCO2) in 2008 to CHF
84/tCO2 (USD 82/tCO2) in 2016 (Federal Council, 2007: Art. 3; Federal Council, 2012: Art. 94).
Up until 2012, energy intensive and trade exposed entities had the option to seek an exemption from the tax,
provided they voluntarily adopted an absolute GHG emissions target and subjected themselves to specified trans-
parency obligations (Federal Council, 1999: Art. 9). Exempted entities were assigned allowances at no cost and
could sell surplus allowances to other compliance entities, or cover a shortfall in their compliance obligation by
purchasing allowances or international offset credits. In essence, thus, the CO2 levy functioned as a de facto price
ceiling for covered entities, and the option to participate in the ETS afforded entities flexibility to potentially
comply at a lower rate than the levy (Dahan et al., 2015c).
Approximately 1,900 companies were affected by the levy or participated in the ETS during this period (Dahan
et al., 2015c: 3). Starting in 2013, participation for approximately 50 installations with emissions exceeding spec-
ified thresholds became mandatory (FOEN, 2014: 13). Large emitters set out in an Annex to the Ordinance on
the Reduction of CO2 Emissions (Federal Council, 2012) are subject to an aggregate emissions cap, which started
at 5.63 Mt CO2 in 2013 and declines 1.74% annually thereafter. Small and mid-sized emitters not included in
the Annex may continue to opt-in voluntarily in order to avoid payment of the CO2 levy (Dahan et al., 2015c).
Case Study: United Kingdom (2002-2004)
In 2000, the United Kingdom adopted a Climate Change Programme outlining ways to achieve its quantified
emission reduction obligation under the Kyoto Protocol to the UNFCCC, as well as a stringent unilateral ob-
jective of reducing GHG emissions 20% below 1990 levels by 2010. With this Programme, it introduced various
flexible instruments, including a new tax on industrial energy use, the Climate Change Levy (CCL); negotiated
arrangements with large emitters, so-called Climate Change Agreements (CCAs); and a voluntary ETS, which
became the first comprehensive trading system for GHG emission allowances upon its launch in 2001 (Dahan et
al., 2015d; Smith et al., 2007). 34 entities became direct participants in this ETS, allowing them to bid for support
from an incentive fund in return for committed emissions reductions.
Moreover, entities that had voluntarily entered CCAs with the government in order to obtain an 80% discount
on their CCL payment obligation were able to use allowances from the ETS for compliance. Entities in over 40
energy-intensive sectors took on such quantitative energy efficiency targets in exchange for discounts on their
CCL liability.
According to a study of the UK ETS, it incentivized substantial abatement in its first two years, achieving emis-
sion reductions of 4.62 million tCO2e against the target reductions of only 0.79 million tCO2e in 2002 (Smith
et al., 2007).
When the mandatory EU ETS was introduced in 2005, most participants in the UK ETS became subject to the
larger system by virtue of their inclusion in the annex listing covered activities and coverage thresholds. e UK
ETS ended in December 2006, with the final reconciliation completed in March 2007 (Dahan et al., 2015d).

24
3.3.2. Compliance Alternative
Conceptually similar to the opt-in approach described in
the previous section, a quantity rationing approach can
also provide a compliance alternative for affected enti-
ties. Instead of opting to participate in an ETS, however,
this option is characterized by the original compliance
obligation remaining in place, but offering compliance
entities an additional means to satisfy their obligation.
It is particularly suited for carbon tax regimes, affording
taxable entities the option to meet their tax liability by
surrendering allowances or offset credits in lieu of pay-
ment. For affected entities, this will normally be attractive
only when allowances or offset credits can be obtained at
lower cost than the equivalent tax liability. To determine
whether that is the case, however, the mechanism to cal-
culate equivalence first has to be determined. One option
applied in the case of South Africa, described in great-
er detail below, is to base equivalence on the amount of
GHGs represented by an allowance or offset credit – typ-
ically one metric ton of CO2e – and accepting these units
in lieu of payment of the tax for the equivalent amount
of GHGs. An alternative option would be to base equiv-
alence on the nominal or market value of allowances and
offset credits, in which case, however, the economic ra-
tionale of choosing compliance by way of such emission
units is less clear.
Case Study: South Africa
Following its submission of a climate pledge under the Copenhagen Accord, South Africa began exploring policy
options to achieve its mitigation objectives. An analysis of a carbon tax presented by the South African National
Treasury in 2010 surveyed the advantages and disadvantages of a carbon tax versus an ETS. In an updated version
of May 2013, the National Treasury ultimately supported the implementation of a carbon tax (National Treasury,
2013). In November 2015, it released a draft Carbon Tax Bill for comments (National Treasury, 2015), which
envisioned introduction of a carbon tax on 1 January 2017 covering fossil fuel combustion emissions, industrial
processes and product use emissions, and fugitive emissions. Nominally set at ZAR 120 (USD$ 8.77) per tCO2e,
the tax would be phased in over time and allow for a number of exemptions and tax-free thresholds to avoid
impacts on vulnerable industries and households.
Additionally, it would establish a carbon offsets tax-free allowance of 5 to 10 per cent of the tax liability. Offset
credits from mitigation projects in South Africa would be eligible for use up to this limit, with the expectation
that this flexibility will enable mitigation at a lower cost and therefore lower the tax liability of affected entities,
while also incentivizing abatement measures in sectors that are not directly covered by the tax (Dahan et al.,
2015b).
More specific details about the offset mechanism and its design, including eligible offset crediting standards,
project types and methodologies, have yet to be published; in the meantime, a number of international verification
standards, including the CDM, Verified Carbon Standard (VCS), and CDM Gold Standard (GS), should be
eligible (Dahan et al., 2015b).

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 25
3.4. Carbon Pricing Mix as a Price
Management Option
Lawmakers can also use price-based and quantity-based
policies in conjunction to create a hybrid carbon pricing
instrument. Such an approach policy uses taxes or fees as
tools to manage the floating carbon price generated by
an ETS. Countries have used such approaches to incor-
porate both price floors (see the UK Case Study, text box
below) and price ceilings (see New Zealand Case Study,
text box below) into their carbon markets.
e reason lawmakers may want to consider carbon price
management is the instability of carbon prices generat-
ed by an ETS, as introduced in Section 2.2.1. Histor-
ical experience has shown that ETS policies that lack
meaningful price controls have produced carbon prices
that are highly variable. Carbon prices in the European
Emissions Trading System (EU ETS), for instance, have
fallen precipitously from their initial levels. In 2013, the
EU carbon price hovered around an annual average value
of 4.5 EUR/t CO2e (4.8 USD/t CO2e), 80% lower than
its average value in 2008.
Another common concern for lawmakers has been a ten-
dency for ETS policies to result in carbon prices lower
than what they had initially expected. e reason behind
this phenomenon is that, across all ETSs, emitters have
needed fewer permits than lawmakers have allocated (Fer-
dinand and Dimantchev, 2015). Such permit surpluses
have stemmed from overestimations of future emissions
and unanticipated emission reductions caused by comple-
mentary policies such as renewable energy mandates and
incentives. Against this background, price management
provisions can help lawmakers mitigate the risk of low
carbon prices. In the following subsections, we discuss the
specific ways in which price management has been shown
by historical experience to improve carbon pricing.
3.4.1. Improving Cost-effectiveness
eory and practice suggest that stable carbon prices de-
liver long term emission reductions at a lower cost than
variable ones. In ETSs with no price management in
place, carbon prices largely follow short-term changes
in the supply and demand for permits. is occurs be-
cause market participants generally pursue a short-term
orientation and because they apply higher than socially
optimal discount rates, leading them to either ignore or
heavily discount information about the long-term sup-
ply and demand for permits. As a result, carbon prices
may not reflect the costs of meeting long-term climate
targets and send misleading signals to the private sector.
In such cases, businesses can overinvest in high-carbon
assets, causing “carbon lock-in” that makes emission re-
ductions costlier (Seto et al., 2016). Carbon-intensive fa-
cilities may later become “stranded assets” and be forced
to close prematurely so that climate targets can be met
(Bertram et al., 2015a; on the concept of carbon lock-in,
see Unruh, 2000).
A testimony to these dynamics is the history of the EU
ETS. e sharp decline of the European carbon price af-
ter 2009 hurt the profitability of low carbon investments
which the EU needed to achieve its long-term target
to reduce emissions by 80% from 1990 levels by 2050
(COM(2014)20, 2014). While the European Commis-
sion estimated that the long-term target would require
a 2050 carbon price between 100 EUR/t CO2e and 370
EUR/t CO2e (in real 2008 euros), the carbon price hov-
ered around 6 EUR/t CO2e (7.9 USD/t CO2e) in 2014.
Out of concern for high-carbon lock-in, the European
Commission proposed a measure to increase and stabilize
the carbon price, called the “Market Stability Reserve”,
which was eventually adopted in 2015 (Decision (EU)
2015/1814, 2015).

26
As discussed in Section 2.2.1, the academic literature also
suggests that – all things being equal – a fixed carbon
price may be more cost-effective than a variable one in
the short-term, unless the risk of climate change discon-
tinuities and non-linear impacts is significant. Likewise,
studies have shown that a mix of climate policies that in-
cludes a carbon tax is more cost-effective than a mix that
includes emissions trading without price management;
the main reason is that complementary climate policies
induce price variability in emissions trading systems (see
the text box on the “Waterbed Effect” in Section 2.2.2),
which in turn can lead to suboptimal investments and a
carbon lock-in effect (Bertram et al., 2015b). As discussed
earlier (see Section 2.2.1), political economy constraints
may nonetheless favor emissions trading as the more vi-
able instrument. But policy makers can still capture the
foregoing advantages of a carbon tax while retaining the
benefits of emissions trading by implementing an ETS
with a price floor (Grubb, 2012; Burtraw et al., 2013; see
also text box on carbon pricing hybrids in Section 2.2.1).
3.4.2. Driving Low-carbon Investments
A number of studies have found that uncertainty with re-
gard to the future CO2 price decreases the ability of car-
bon pricing to induce low-carbon investments (Yang et
al., 2008; Fuss et al., 2009; Oda and Akimoto, 2011). In-
vestors in capital-intensive and long-lived assets such as
low-carbon technologies require a relatively large degree
of certainty over their future profitability. Carbon prices
that swing from one year to the next make investing in
low-carbon technologies a riskier venture. Uncertainty
leads to higher financing costs, which can be particular-
ly challenging for renewable technologies, which require
most funding upfront. Consequently, some authors argue
that the variable European carbon price proved to be in-
effective as a driver of investments in renewables (Grubb,
2012).
One solution for investors in capital-intensive assets that
has been applied in electricity markets is hedging risk
through long-term contracts. However, willingness to
engage in long-term contracts is likely to be insufficient
in carbon markets characterized by significant variability
in price. Indeed, such lack of interest is demonstrated by
the low liquidity of futures contracts for EU carbon al-
lowances for delivery in the long-term on their most liq-
uid trading platform (Intercontinental Exchange, 2017).
An additional challenge is the fact that low-carbon in-
vestments are often irreversible, which generally leads in-
vestors to adopt a “wait and see” approach in the presence
of uncertainty (Dixit and Pindyck, 1994). Such delays to
low-carbon investments make decarbonization more ex-
pensive overall (Altamirano et al., 2016).
erefore, a cost-effective transition to a low-carbon
economy requires carbon prices that are predictable
(Stern, 2006; Global Commission on the Economy and
Climate, 2014). A carbon price floor will likely acceler-
ate investments in low-carbon technologies (Brauneis et
al., 2013, Wood et al., 2011). is rationale led the UK
to implement such a tax in 2013 (see UK Case Study
below).
3.4.3. Revenue Certainty
Variability in carbon prices can also diminish the predict-
ability of the associated government revenues generated
from the sale of carbon permits under an ETS. A lack of
revenue certainty complicates budget planning for gov-
ernments. Inability to rely on variable revenues interferes
with the ability of governments to reliably plan expen-
ditures funded through emissions trading revenues. For
example, Germany set up a special fund that channels
revenues from allowance sales toward climate related ini-
tiatives, but it raised less revenue than expected when the
price of carbon in the EU ETS fell substantially, forcing
the government to seek alternative financing to fill result-
ing gaps in already committed expenditures (Esch, 2013).
Where revenues are directed toward specific programs
such as energy efficiency, their effectiveness is limited
if funding is volatile. Such programs are most effective
when they can provide a consistent stream of financing
that incentivizes businesses to invest in research and de-
velopment (R&D), develop supply chains, and provide
labor force training. In the UK, inconsistent funding for
energy efficiency prior to the implementation of the price
floor hindered the ability of the energy efficiency sector
to maintain a skilled workforce (Vaze, 2014).

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 27
A carbon price floor in the form of a top-up tax within
the ETS alleviates this problem. It makes revenue from
emissions trading more reliable, and allows regulators to
plan how to spend it most effectively.
3.4.4. Curtailing Regulatory Uncertainty
Carbon price floors and ceilings can in some cases reduce
regulatory uncertainty for market participants. In their
absence, there may be times when carbon prices deviate
too much from expected or desired levels, leading reg-
ulators to take discretionary actions to adjust them. In
2014, for instance, the EU responded to the crash in the
European carbon price with an intervention to adjust the
projected supply of CO2 permits (an initiative known as
“backloading”). e legislative debate leading up to this
decision led to periods of excessive volatility in the mar-
ket and uncertainty among traders about the possibili-
ty of such discretionary actions (on the adverse effects
of such volatility, see above, Section 2.2.1). To reassure
market participants, the EU stipulated in its backloading
decision that it would never pursue such interventions
again. Carbon price floors and ceilings would largely ob-
viate the need for such regulatory interventions.
3.4.5. Enhancing Co-benefits
Price management can also enhance certain co-benefits
of emissions trading. For example, in the absence of a
price floor, an economic downturn may substantially re-
duce the carbon price in an ETS, thus making coal more
competitive relative to alternative generating technolo-
gies, which in turn will increase concentrations of dan-
gerous air pollutants such as PM 2.5 (see UK Case Study
below).
Another co-benefit that can be compromised by carbon
price variability is energy security. As noted above, vari-
able carbon prices generally fail to drive investments in
renewable generation. is can make it more difficult for
regulators to increase or diversify domestic energy pro-
duction capacities (HM Treasury, 2010).
Case Study: United Kingdom (Since 2013)
e UK has implemented a carbon pricing policy that combines emissions trading and a carbon tax. e country
participates in the European ETS (the EU ETS), which applies to emissions from power, industry and aviation.
In addition, the UK charges a domestic top-up carbon tax on fossil fuels used in electricity generation (called
“Carbon Price Support”). e tax is referred to as a top-up because companies only have to pay it when the EU
ETS price is below a certain target price level defined by the government. e amount of tax they pay is equal to
the difference between the EU ETS price and the target price. Hence, the target price acts as a floor for the price
of carbon.
e rationale for the price floor was to provide businesses with a stable incentive to invest in low-carbon power
generation. e government argued it was necessary because the carbon price produced by the EU ETS was too
variable and unpredictable to drive low-carbon investments (HM Treasury, 2010). e UK chose a price floor
trajectory that started at GBP 16/t CO2e (USD 25/t CO2e) in 2013 and was initially set to rise to GBP 30/t
CO2e (USD 46/t CO2e) in 2020 and GBP 70/t CO2e (USD 110/t CO2e) in 2030, a trajectory that was eventually
revised (see below). Under the original policy framework, the government was mandated with determining the
annual top-up tax rate twelve months before the start of each fiscal year. is system would provide UK businesses
upfront certainty about the amount of the top-up tax.
However, it still left companies with some uncertainty about their overall carbon price obligation, because the
calculation of the top-up tax used a one-year historical average of the EU ETS price. When the EU ETS price
later declined from this level, the final carbon price was slightly lower than the government’s target price.
e government estimated that the tax would increase low-carbon generation capacity by 7 GW, mainly from nu-
clear and carbon capture and sequestration (CCS), by 2030. Its analysis also calculated co-benefits in air pollution
abatement valued at 400 million pounds. Ex-post analyses of the carbon price floor have shown that a short-term
effect has been a switch in power generation from coal to gas (Carbonbrief, 2016). Meanwhile, ex-post evalua-
tions of the expected long-term effects have yet to be performed.

28
A prominent issue that surrounds the UK’s carbon price floor is the burden it imposes on British energy-intensive
industry (HM Treasury, 2011). Some businesses expressed concern that the UK’s carbon price floor would harm
their competitiveness compared to rivals in mainland Europe which only have to comply with the lower carbon
price generated by the EU ETS. e UK managed to minimize such risks by limiting the scope to power genera-
tion. Since electricity costs are a relatively minor component of costs for energy-intensive industry, the price floor
is unlikely to harm their competitiveness (Grover et al., 2016). e government further assuaged such concerns
by introducing the tax in conjunction with other tax reforms that lowered taxes on capital and income (HM Trea-
sury, 2011). In 2014, the UK government decided to cap the top-up tax at a maximum GBP 18/t CO2e (USD
29/t CO2e) until 2020 (HM Treasury 2014). is was partly a reaction to the fact that the EU ETS carbon price
continued to decline, expanding the gap between the carbon prices paid by UK producers and mainland ones.
UK’s policy experience provides a proof of concept of how top-up carbon taxes can be used to provide a price
floor in emissions trading systems, improving predictability for investors. Britain’s experience of combining its tax
with the EU ETS also demonstrates that such a top-up carbon tax does not categorically prevent countries from
participating in linked carbon markets, retaining the opportunity to meet domestic policy goals while cooperating
with others on carbon pricing.
Politically, the willingness to embrace greater climate policy ambition through a carbon floor price might even
signal leadership and incite other jurisdictions to adjust their carbon pricing regimes.
But at the same time, given its integration in the larger EU ETS, the UK carbon floor price has also given rise
to criticism for merely shifting emissions to other EU Member States, where allowances displaced by the higher
carbon price in the UK will be used to offset an emissions increase and also exert downward pressure on EU
carbon prices (Fankhauser et al., 2010; Sartor et al., 2011; Goulder, 2013).
Although this “Waterbed Effect” (see also text box in Section 2.2.2) is greatly dampened by the current allow-
ance surplus in the EU ETS, making for a flatter supply curve and thus lowered demand (and price) sensitivity
(Whitmore, 2016), the UK carbon floor price will nonetheless alter the equilibrium of demand and supply across
Europe, exacerbating the current imbalance.

Carbon Pricing
in Mexico

30
Part 2: Application to the Mexican Context
4. Carbon Pricing in Mexico
4.1. Socioeconomic Parameters
4.1.1. Macroeconomic Context
In the design of climate policy, one of the most import-
ant considerations is its impact on the economic system.
e economic literature suggests that mitigating climate
change does not have to come at the expense of eco-
nomic prosperity, and that carbon pricing plays a role in
cost-effective climate policy (Global Commission on the
Economy and Climate, 2014). As Mexico prepares to ex-
pand carbon pricing, two issues will likely be particularly
prominent in the national conversation: industrial com-
petitiveness and government revenues.
Mexico derives as much as 34 percent of its Gross Do-
mestic Product (GDP) from industry (compared to an
OECD average of 24%). is includes both energy-in-
tensive industries, which may feel the impact of a carbon
price, and industries that are not energy-intensive, which
will very likely suffer no impacts. Mexico is also a rela-
tively open economy, with trade as a percent of GDP at
73% (compared to an OECD average of 56%). e econ-
omy derives competitive advantage from relatively low
labor costs and its proximity to the United States. In that
context, lawmakers designing a carbon pricing system
will have to consider how such a policy may influence
Mexico’s international competitiveness.
A price on carbon can both help and hinder international
competitiveness, depending on how it is designed. Carbon
pricing can strengthen competitiveness by giving Mexi-
co a head start in the development of the technologies
and capabilities that will be increasingly demanded in a
future low-carbon global economy, spurring a structural
shift towards higher value-added industries and sectors.
At the same time, it can also raise manufacturing costs
for carbon-intensive Mexican firms, which can harm
their competitiveness if other nations do not implement
comparable climate policies. International experience has
shown that carbon pricing can be designed in a way that
minimizes this risk by including exemptions or favorable
allocation provisions for sectors deemed particularly vul-
nerable due to their energy intensity and exposure to in-
ternational trade (Bolscher et al., 2013).
Carbon pricing also has important implications for the
national budget. Mexico has recently seen growing levels
of debt as a percentage of GDP, due in part to the slump
in oil prices. Public budges are coming under addition-
al strain from the rising costs of extreme weather events
associated with climate change (PECC, 2014). An ETS
that incorporates auctioning of allowances can generate
revenues for the state, as we discuss below (see Section 5,
“Quantitative Analysis”).
4.1.2. Emissions and Emission Trends, by
Sector
Analyzing the sources of greenhouse gas emissions can
help regulators determine the scope of a carbon pricing
policy. e potential of carbon pricing will be maximized
if it is targeted toward high-emitting sectors. As shown
in Figure 1, Mexican greenhouse gas emissions are con-
centrated in three sectors: industry (27% in 2010), trans-
port (22%), and power (15%). Based on Mexico’s more
recent emissions inventory of 2013, which uses an up-
dated methodology, these sectors contribute 29%, 26%,
and 19% to overall Mexican greenhouse-gas emissions.
ough Figure 1 displays data calculated based on an
older methodology, it provides a look into how sectoral
emissions have changed over time. e industry, trans-
port and power sectors have seen growth in emissions
since 1990 as a result of rising energy demand, which is
itself a result of economic growth and a relatively small
change in energy intensity per unit of GDP (IEA, 2016).
ey have also come to represent higher shares of Mexi-
co’s overall emissions, as emissions in other major sectors
have decreased significantly (LULUCF), or stayed rela-
tively unchanged (agriculture). Emissions in these sectors
will likely continue to rise with economic growth and
continued increase in energy demand (IEA, 2016), mak-
ing them a prime target for carbon pricing policy.

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 31
Carbon pricing will be most cost-effective when it covers
sectors with a relatively small number of large emitters.
Such sectors include industry and power. In contrast,
policy costs may be higher for sectors with many small,
diffuse and remote emission sources (such as forestry,
agriculture, and waste), where administrative costs per
entity are higher and emissions measurement potential-
ly more uncertain. A solution to the problem of diffuse
emission sources is the implementation of an upstream
carbon price on fossil fuel producers or importers. Cal-
ifornia’s ETS has demonstrated that such a policy can
effectively capture the transport sector, a large but highly
diffuse source of emissions. An upstream carbon price on
fossil fuels can also cover the combustion of fossil fuels
in smaller sectors such as the residential and commercial
buildings sector. Burning of fossil fuels in this sector led
to the emissions of 24 Mt of CO2e in 2013.
A comprehensive coverage of Mexican emissions would
likely require a combination of upstream and downstream
carbon pricing, with an upstream point of regulation par-
ticularly suited to capture carbon emissions from fossil
fuel combustion by diffuse sources, such as households
and transport, and downstream regulation a more direct
way to target emissions from large point sources in the
power sector and in industry. An important consideration
is the significant amount of non-fossil fuel emissions in
the industry sector. Emissions from industry arise not
only from fossil fuel combustion, but also from industrial
process emissions. Fossil fuel combustion, and processes,
respectively contributed 57% (66 Mt CO2e in 2013), and
43% (49 Mt CO2e) to the sector’s emissions. is split
indicates that a carbon price imposed solely on fossil fu-
els will exempt significant emissions from industrial pro-
cesses. Another consideration is that downstream carbon
pricing applied on emitters is theoretically likely to be
more salient to company managers, and may therefore
have a higher potential of effecting a change in behav-
ior (PMR and ICAP, 2016). Interviews with companies
liable under the EU ETS show a shared belief that the
market raised environmental awareness among company
managers and employees (European Commission, 2015),
which may be due to the fact that the EU ETS applies to
downstream emissions at the point of combustion.
e overarching takeaway is that carbon pricing can apply
to a broad share of Mexico’s emissions, the extent of which
regulators can adjust through various design parameters.
e optimal sectoral coverage of carbon pricing in Mexico
is beyond the scope of this section and will depend on a
number of additional factors such as the ability of vari-
ous points along the supply chain to pass through carbon
costs, measure emissions, and comply with regulations.

32
Figure 1: GHG Emissions by Sector, 1990 and 2010
Source: Inventario Nacional de Emisiones de Gases de Efecto Invernadero 1990-2010
4.1.3. Emissions Abatement Cost, by Sector
ere are two categories of abatement costs: societal and
private. e first category represents the monetary costs
that accrue to society when it reduces a certain amount
of emissions. e latter measures the costs that firms and
individuals bear when they reduce their emissions. Both
have important implications for designers of carbon pric-
ing policy. In this section, we provide a broad review of
societal abatement costs and compile estimates of the
private marginal abatement costs, which we will use later
in our economic analysis in section 5.1.
4.1.3.1. Societal Abatement Costs
Regulators can use societal abatement costs to determine
the overall costs of climate policy at varying levels of strin-
gency, and to decide what level of stringency is desired.
Studies have found that Mexico can achieve substantial
emission reductions at a net negative cost (an economic
gain). is is because many of the ways Mexico can re-
duce emissions – such as industrial efficiency standards,
vehicle fuel economy standards, gas flaring abatement,
waste recycling – yield savings that over time exceed their
initial costs. McKinsey & Co., an international consul-
tancy, estimate that Mexico will benefit financially if it
meets its target to reduce emissions by 30% below Busi-
ness-as-Usual (BAU) levels by 2020 (McKinsey, 2013).
Earlier calculations by McKinsey & Co found that Mex-
ico can reduce 2030 emissions from BAU levels by over
500 Mt CO2e at a net economic gain (McKinsey, 2009).
ese results suggest that Mexico can exceed both its
conditional and unconditional commitments to the Paris
Agreement in a profitable manner (Section 4.2 explains
these targets in detail). Similarly, an analysis authored by
the World Resources Institute found that Mexico can
meet its unconditional and conditional targets while ac-
cruing net economic savings of 500 and 200 billion pesos
respectively by 2030 (Altamirano et al., 2016).
ree caveats are worth noting. First, these analyses do
not account for the opportunity costs of abatement. ey
do not compare the profitability of abatement compared
to other investments. Economic analyses using general
equilibrium models find that a climate mitigation sce-
nario lowers GDP compared to a BAU scenario (Veysey
et al., 2016). Yet, such models likely overestimate climate
policy costs because they make the unrealistic assump-
tion that all resources are used efficiently in their BAU
scenarios.

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 33
Second, the quoted marginal abatement costs do not fac-
tor in the substantial co-benefits that accompany climate
change mitigation, such as air pollution mitigation (Al-
tamirano et al., 2016) and energy security. Despite these
first two caveats, the evidence on abatement costs does
demonstrate the fact that Mexico has ample cost-effec-
tive opportunities to reduce emissions.
A third caveat regarding the above estimates is that they
do not reflect the costs that individual firms bear when
they implement a given abatement option. e analyses
use relatively low discount rates of around 3%-4% to cal-
culate the present value of future costs and savings. Pri-
vate decision makers typically use higher discount rates,
one reason being that businesses face a higher cost of
capital. e values above also take no account of non-fi-
nancial barriers, which in practice prevent private firms
from implementing otherwise profitable abatement op-
tions such as energy efficiency improvements.
4.1.3.2. Private Abatement Costs
Private abatement costs can help regulators answer two
questions: under a given carbon price, how many emis-
sions will be abated; and for a given abatement require-
ment, what will the carbon price be? Figure 2 displays the
total private marginal abatement costs curve for Mexico
and the respective curves for each sector, based on data
from the Energy Policy Simulator for Mexico.
ese abatement curves include the costs of reducing
emissions by changing production levels or material us-
age, changing the efficiency of newly purchased equip-
ment (in buildings, transport) and the efficiency of newly
built power plants, and early retirement of power plants.
Additionally, we constructed the marginal abatement
curve for industrial process emissions by combining data
from the Energy Policy Simulator model for the costs of
clinker substitution in the cement sector as well as for
the costs of abatement through worker training for bet-
ter equipment maintenance (Altamirano et al., 2016),
and data from the EPA for the costs of abatement of
non-CO2 process related emissions (EPA 2013), which
includes abatement cost data for methane capture in the
oil and gas sector and abatement in nitric and adipic acid
production.
e curves presented here are used below in our econom-
ic analysis (see section 5.1). When interpreting results, it
is important to keep in mind several simplifying assump-
tions. A key assumption is that these abatement curves
represent the implementation of carbon pricing without
any other change in climate policy relative to the BAU,
which includes Mexican policies enacted as of 2014.
us, the numbers presuppose that regulators do not take
any additional steps to eliminate barriers to abatement.
In reality, additional policies may eliminate such barriers.
For example, an increase in transmission relative to BAU
will allow the carbon price to deliver additional emission
reductions. Another important assumption is that these
curves exclude several major abatement options includ-
ing industrial energy efficiency improvements. erefore,
they underestimate the emission reductions associated
with a given carbon price, particularly in the industry sec-
tor. Similarly, these simplifying assumptions likely lead to
a certain overestimation of the carbon price for a given
level of abatement.
Figure 2 suggests that, under these assumptions, an emis-
sions trading policy will have the most potential to reduce
emissions in the power and industry sectors. e trans-
portation and building sectors show modest abatement
potential under a carbon price of USD 100/t tCO2e,
which reflects the fact that there are various non-financial
barriers that make reductions difficult.

34
Figure 2: Marginal Abatement Curves for 2030 by Sector
Source: Energy Innovation LLC. We derived this data from the Energy Policy Simulator for Mexico, an open-source system
dynamics model developed by Energy Innovation LLC. e tool allows users to model the impacts of a given 2030 carbon tax
on GHG emissions. Carbon prices are assumed by the model to rise linearly from 0 in 2016 to the specified value in 2030. We
generated the curves above by iteratively increasing the 2030 carbon price from 0 to 100 in $5/tCO2 increments. Process related
emissions were derived from EPA data (EPA, 2013) and Energy Innovation LLC data (Altamirano et al., 2016).
(5) Covered gases are: carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), sulphur hexafluoride (SF6), perfluorocarbons (PFCs), hydrochloro-
fluorocarbons (HCFCs), and nitrogen trifluoride (NF3).
4.2. Regulatory Framework of Carbon
Pricing
In 2012, Mexico became the first developing country to
adopt comprehensive climate change legislation when its
Congress unanimously passed the General Law on Cli-
mate Change (LGCC, 2012), which mandates the Fed-
eral Government with strengthening institutions and ex-
ploring suitable instruments to reduce GHG emissions.
A landmark act of legislation, the LGCC is complement-
ed and operationalized by a number of ancillary laws
and policies, such as the National Strategy on Climate
Change of 2013, which sets the vision for the next 10, 20
and 40 years (ENCC, 2013), as well as the second Spe-
cial Program on Climate Change for 2014-2018 (PECC,
2014) and further legislative and regulatory measures
implementing the reform of the Mexican energy system.
Importantly, the LGCC requires giving priority to the
least costly mitigation actions which also promote and
sustain the competitiveness of the vital sectors of the
economy, including an entire chapter on economic in-
struments (Chapter IX). Already, exercising a mandate
under the LGCC, Mexico has implemented a National
Emissions Registry (RENE), which requires all entities
emitting in excess of 25,000 tCO2e/year to submit annual
reports on their emissions of seven categories of GHGs(5)
and black carbon, subject to verification every three years.
Extending to direct and indirect emissions from station-
ary and mobile sources, RENE covers all major sectors
including energy, transport, agriculture, services, industry,
construction, tourism and government, and thereby pro-
vides a critical basis of information for carbon pricing.

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 35
4.2.1. Economy-wide Mitigation Targets
Mexico was the first major developing country to sub-
mit an Intended Nationally Determined Contribution
(INDC) in March 2015, committing itself to uncondi-
tional GHG emission reductions of 22 percent, and a re-
duction of soot emissions – a Short-Lived Climate Pol-
lutant – of 51 percent by 2030, each relative to expected
business-as-usual (BAU) emission levels. BAU has not
been explicitly defined. On the one hand, a graph illus-
trating the path of a constant economic growth and con-
stant carbon intensity of GDP is presented, although in
the text the objective of reducing the carbon intensity of
GDP is highlighted. According to a series of interviews,
the interpretation of the BAU seems to be more along
the lines of the latter, while the graph appears to be used
to provide a tangible set amount of tons to reduce for the
argumentation of the efforts to be carried out.
Subject to a number of conditions, Mexico intends to
strive for even more ambitious emission mitigation ef-
forts of 36% GHG and 70% soot emission reductions by
2030, again relative to BAU. ese contributions build on
previous targets set out in the LGCC, mandating emis-
sions reductions of 30% below BAU by 2020 and 50%
relative to a 2000 baseline by 2050, and to source 25% of
electricity from clean energy sources by 2018, rising to
35% by 2024, conditional on international technical and
financial support.
4.2.2. Carbon Tax: Sectoral Coverage and
Rates
In 2013, Mexico introduced a carbon tax on selected fos-
sil fuels as part of a broader fiscal reform, implementing it
by way of an amendment of the Excise Tax Law (LIEPS,
1980). From 2014 onwards, fossil fuels – with the ex-
ception of natural gas – are subject to a carbon tax set
at MXN$ 39.80 (US$ 3.50) per tCO2e released during
combustion, translated into volumetric or mass-based
rates for individual fuels (see Table 2 below).
Tax rates were modified from the original initiative to
implicitly cap them at 3% of the sales price of fuel that
year, and the tax is expected to yield revenue of approxi-
mately US$ 1 billion a year (Dahan et al., 2015a). Pend-
ing adoption of further implementing rules, taxable en-
tities will have the option of complying with Certified
Emission Reduction (CER) based on the market value
of these credits at the time the tax liability is paid, and
provided the credits have been issued under the Kyoto
Protocol to the UNFCCC for offset projects implement-
ed in Mexico (LIEPS, 1980: Art. 5 Para. 8). Interestingly,
this alternative compliance option would create a hybrid
carbon pricing regime combining elements of price set-
ting and quantity rationing, allowing greater compliance
flexibility. A voluntary carbon exchange, MexiCO2, was
established in 2013 to facilitate trading of credits, includ-
ing CERs (Dahan et al., 2015a).
Table 2: Mexico Carbon Tax Rates in 2016 (MXN$)
Timing Coverage Synchronous
Natural gas 0
Propane 6.29 ¢/l
Butane 8.15 ¢/l
Gas (Regular & Premium) 11.05 ¢/l
Jet Fuel 11.05 ¢/l
Turbosine & other Kerosene 13.20 ¢/l
Diesel 13.40 ¢/l
Fuel Oil (Heavy & Regular 15) 14.31 ¢/l
Petroleum Coke $16.60/ton
Coal Coke $38.93/ton
Mineral Coal $29.31/ton
Other fossil fuels $42.37/ton of carbon content
Source: LIEPS, Art. 20 lit. h)

36
4.2.3. Emissions Trading System: State of
Discussion
Under the LGCC, the Ministry of the Environment
(SEMARNAT), involving the Inter-Ministerial Com-
mission on Climate Change (CICC) and the Council on
Climate Change, is authorized to explore and implement
an ETS “with the objective of promoting emissions re-
ductions that can be achieved at the least possible cost
and in a measurable, reportable, and verifiable form”
(LGCC, 2012: Art. 94). e relevant provisions read as
follows:
Article 94: e Secretary, with the participation of
the Commission and the Council, will be able to es-
tablish a voluntary system of emissions trading with
the objective of promoting emissions reductions
that can be accomplished at the lowest cost possible,
in a measurable, reportable and verifiable way.
Article 95: ose interested in participating in a
voluntary manner in emissions trading will be able
to carry out operations and transactions that link
the emissions trading in other countries or that can
be utilized in international carbon markets under
the terms provided by applicable legal provisions.
Although exploratory work is underway, no substantive
arrangements or draft legislation have been adopted as
of now under this mandate. Important aspects, including
the timing, scope, stringency, and legal nature of a future
ETS, still need to be determined, rendering it difficult to
evaluate alternative carbon pricing scenarios combining
the existing or an amended carbon tax with the future
ETS. In the following section, therefore, the quantitiative
analysis will be based on a set of hypothetical outcomes,
based on the likelihood of implementation and the use-
fulness to illustrate possible interactions between carbon
pricing regimes.

Quantitative
Analysis

38
5. Quantitative Analysis
In this section, we quantify the potential economic im-
pacts of alternative carbon pricing mixes for Mexico.
First, we outline the general framework of the analysis
and several of the main assumptions. Specifically, our
analysis evaluates four options for a carbon pricing mix,
incorporating a subset of the combinations outlined in
Section 3 above based on early indications of likely policy
trajectories, the political viability of the scenarios, and the
demonstration value of their quantitative assessment:
1. “Limited ETS”: e current carbon tax continues
to apply and an ETS is introduced to cover process
emissions in the industrial sectors. Limited ETS
represents a possible instrument mix, in which
Mexico uses both a carbon tax and an ETS, which
cover different sectors. is approach combines
synchronous and asymmetrical application of a car-
bon tax and ETS.
2. “ETS Only”: An ETS is introduced to cover all
GHG emissions from energy-related and pro-
cess-related activities in the power, steel, chemical,
oil & gas, cement, lime, glass, and ground trans-
portation sectors, as well as emissions from “other
combustion” as defined in Mexico’s 2013 inventory,
which includes sectors such as pulp and paper, car
manufacturing, plastics, metals, and others. e car-
bon tax is discontinued. is approach reflects an
asynchronous and partially symmetrical application
of a carbon tax and ETS, and would incorporate
elements of the transition scenario described above
in Section 3.2.
3. “Overlapping Tax & ETS”: e current carbon tax
continues to apply and an ETS is introduced with
the same coverage as in the “ETS Only” scenario.
is approach combines synchronous and partially
symmetrical application of a carbon tax and ETS,
but does not represent a price management mech-
anism as outlined above in Section 3.4 because the
fixed carbon price component does not apply to all
sectors included in the ETS.
4. “Hybrid ETS”: Finally, an ETS is introduced to-
gether with a carbon tax in the form of a “top-up”
carbon price floor. is hybrid instrument is as-
sumed to apply to the same sectors as the above two
scenarios. e carbon tax is discontinued. e top-
up price floor is set at the current carbon tax level of
$3.5/t (75 MXN/t). is approach represents a syn-
chronous and symmetrical application of a carbon
tax and ETS, and therefore constitutes a genuine
price management mechanism as described above
in Section 3.4.
All policy changes implied by these scenarios are assumed
to take place in 2017 for the purposes of this analysis.
While this may not be practical, the results presented
here are also applicable to policy changes introduced at
a later point.
e impacts of an ETS depend to a large extent on the
stringency of the emissions cap. All four ETS policies are
assumed to have a cap on emissions stringent enough to
allow Mexico to meet a given emission reduction target
for 2030. e targets being analyzed cover only GHG
emissions (Mexico’s targets for black carbon are exclud-
ed from the analysis). For this purpose, we first make a
Reference Case projection for total Mexican emissions
out to 2030 in the absence of an ETS and compare this
to a given 2030 emission target. is way, we derive an
estimate for the emission abatement necessary for the
achievement of the target. Next, for each ETS being an-
alyzed, we calculate a cap on emissions by subtracting the
required emission abatement effort from the 2030 Ref-
erence Case emissions. us, the analysis assumes that all
of the reductions necessary for Mexico to close the gap
between its Reference Case emissions and its target will
be met by the ETS-participating sectors.

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 39
Below, we present results for Mexico’s unconditional tar-
get of 22% reduction from Mexico’s BAU projection for
2030. Second, to allow additional comparison between
the four different instrument mixes, we show results for
a more ambitious ETS cap, which is set at such a level
that allows Mexico to meet a target equal to a 26% re-
duction from BAU in 2030. is “26% reduction” case
was selected for the simple fact that it represents a reduc-
tion in emissions that is twice as large as that required to
achieve the unconditional target (see Section 5.1 below
on Emission Projections). is case allows us to quantify
the sensitivity of our results to the level of cap stringency.
An important purpose of carbon pricing can be the
generation of government revenue. For each scenario,
we calculate revenue under two different policy design
options that refer to the balance between free allocation
and auctioning of permits. We model a system of full
free allocation to sectors that participate in international
markets (industry) and auctioning in sectors less exposed
to international competition (power and ground trans-
portation), and a system with full auctioning of permits.
e former scenario reflects the approach to distribution
of allowances used in many ETSs currently in operation,
including the EU ETS and the Californian ETS. e lat-
ter presents a case in which the government has opted to
maximize the revenue potential of the ETS.
5.1. Emission Projections
In order to measure the impacts of new carbon pricing
policy, we construct a Reference Case projection for fu-
ture greenhouse-gas emissions (see below, Section 5.1.1).
In this scenario, emissions are only influenced by Mexi-
co’s current policies.
It is important to note that this scenario is only one way
that future emissions may evolve. ere are many other
pathways that emissions may follow. And if emissions do
turn out to be substantially different from the Reference
Case projection, the impacts of any new policy will also
differ from what the Reference Case suggests. Policy
makers that are aware of possible alternative develop-
ments can plan ahead and design better policies, which
can better accommodate the uncertainties of the future.
at is why, in Section 5.1.2, we lay out a range of pos-
sible future emission pathways. We discuss probabilities
of various emissions outcomes and their implications for
policy makers.
5.1.1. The Reference Case
In the Reference Case, we estimate that Mexico’s GHG
emissions grow from 665 Mt in 2013 to 793 Mt in 2030.
Emissions thus grow at an average of 1 percent per year.
Figure 3 presents the resulting emission projections by
sector.
To derive this estimate, we combine historical 2013 emis-
sions data per sector with projections for emissions cal-
culated by previous modeling exercises. Specifically, we
assume that emission growth rates in sectors with ener-
gy-related CO2 emissions (power, industry, transport, and
buildings) equal the growth rates projected by the Inter-
national Energy Agency (IEA) in its Current Policy Sce-
nario as featured in the Mexico Energy Outlook (IEA,
2016). IEA’s Current Policies Scenario is an appropriate
representation of the Reference Case, as it accounts for
Mexico’s current climate mitigation efforts, including the
two major CO2 reducing policies: the Special Program
on Climate Change (PECC, 2014) and the clean energy
targets inscribed in the LGCC. For process emissions in
the industry sector and for emissions in the “other” sec-
tors, which include waste, agriculture and forestry, we use
the emission growth rates from the BAU scenario con-
structed by the World Resources Institute and Energy
Innovation LLC (Altamirano et al., 2016).
ese results suggest that Mexico’s emissions in 2030
may not be far from the illustration for the unconditional
target laid out in Mexico’s INDC to the Paris agreement.
Mexico’s unconditional target of 759 Mt is 34 Mt, or 4
percent, lower than the 793 Mt emitted in the Reference
Case. For the purposes of comparing instrument mixes
in the analysis below, we also analyze a 2030 target of 26
percent below BAU, equal to 725 Mt. Meeting this target
would require an emission reduction of 69 Mt, represent-
ing a doubling of policy ambition.

40
Figure 3: Reference Case Emission Projections by Sector
Source: Baseline 2013 emissions numbers are derived from Mexico’s 2013 emissions inventory (INECC, 2013).
5.1.2. How Likely Is the Reference Case?
e difficulty of accurately projecting future emissions
makes it advisable for policy makers to consider the un-
certainty involved in such projections. To quantify the
uncertainty related to future emissions, we constructed
a Monte Carlo model. is statistical method allows us
to use information about the historical variation of Mex-
ico’s emissions to project how future emissions may vary
around the expected trajectory of the Reference Case (see
Text Box “Monte Carlo Model for Mexico’s Emissions”
below for details). Using this model, we ran a large num-
ber of simulations of future emissions, where each simu-
lation represents a possible pathway for future emissions,
to represent the full range of possible future trajectories.
e range, for which we ran 20,000 simulations, is dis-
played in Figure 4. It is important to note that, due to a
number of simplifying assumptions (see Text Box), the
range shown is not necessarily an all-inclusive represen-
tation of all possible future scenarios, but an approxima-
tion thereof.
As displayed, this analysis shows that future emissions
are highly uncertain. Mexico’s emissions in 2030 could
be as low as 470 Mt or as high as 1,177 Mt. e emis-
sion level in 2030 has a standard deviation of 87 Mt (the
mean 2030 emissions among our simulations equal 790
Mt). Based on our model, we estimate that there is about
a 68 percent probability that Mexico’s emissions will be
between 706 Mt and 880 Mt in 2030 (68 percent of the
simulations of our model fell in this range). And there is
a 95 percent likelihood that emissions fall between 627
and 960 Mt.
It is noteworthy that Mexico’s unconditional target of
759 Mt in 2030 lies well within the 68 percent prob-
ability range. is suggests that there is a considerable
chance that Mexico meets its target without an addition-
al carbon pricing policy. According to our model, this
may occur with a 36 percent likelihood. Similarly, there
is a considerable chance that emissions turn out higher
than in the Reference Case, and thus necessitate more
emission reductions.

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 41
Figure 4: Range of Reference Case Emissions
Source: Own calculations
Such significant variation in future emissions means that
the performance of a future Mexican ETS is vulnerable
to uncertainty, a challenge faced by all ETS designers.
Wide fluctuations in future emissions could result in sub-
stantial variation in the level of the carbon price, with
important implications for policy predictability, govern-
ment revenues, and policy efficiency. How well such risks
are managed is critically dependent on policy design. e
following analysis will discuss the implications of this
uncertainty for Mexico as it considers alternative policies
and instrument mixes (see Section 5.5).
Monte Carlo Model for Mexico’s Emissions
e Monte Carlo method employed here estimates the distribution of future emissions based on the assumed
distribution of the relevant inputs. e inputs in our emission projections are the annual growth rates in emis-
sions since 2013 (as well as the amount of emissions in 2013) as discussed in Section 4.1.1. For a given sector, the
emission projection can be described by the following equation:
〖Emissions〗_2030=〖Emissions〗_2013×g_2014×g_2015×g_2016⋯ ×g_2030
Where: gi denotes growth in emissions for year i.

42
Our Monte Carlo model repeats the above equation over a very large number of simulations. For each simulation,
the model selects different emission growth rates, with each growth rate picked randomly from the distribution
of possible growth rates. We assume that growth rates are normally distributed around the expected growth rate
value (the average growth rate of the Reference Case equal to 1 percent per year). e model uses a standard de-
viation of 2.8 percent, which we derived from historical Mexican emission growth rates for the period for which
data was available: 1991-2010.
A key assumption is that the standard deviation of historical emissions is a good representation of the variation
of future emissions. Another important methodological input is the choice of distribution type. Our choice of the
normal distribution may somewhat overestimate the chances of emissions being higher than the Reference Case
and underestimate the chances of emissions being lower. e normal distribution passed common goodness-of-fit
tests such as the Kolmogorov-Smirnov and Chi-squared tests, but other distributions did so as well. In particular,
it is possible that emission growth rates follow a skewed distribution, whereby deviations from the expected value
tend to be rather on the low side than the high side. Indeed, the historical data was to an extent skewed toward
the low side. However, it is unclear whether we can assume that this will continue to be the case, given that the
historical record consisting of 20 data points may not be an accurate representation of the future. Consequently,
we opted for the normal distribution. is assumption is conservative as it likely underestimates the possibility of
emissions being lower than the Reference Case, and therefore underestimates the possibility of policy costs being
lower than implied by the Reference Case.
5.2. Carbon Price
We estimate carbon prices in each policy scenario by
comparing supply and demand for emission reductions.
e supply curve for emission reductions is equivalent
to the marginal abatement cost curve. e demand for
emissions is represented by the emission reduction effort
necessary for emissions in the ETS-covered sectors to
equal the emissions cap (as explained above, this is equiv-
alent to the difference in emissions between the Refer-
ence Case emissions in 2030 and a given climate target,
such as Mexico’s unconditional INDC target).
As we estimated above, for Mexico to meet its uncondi-
tional target, the demand for emission abatement would
equal 34 Mt in 2030. e supply, represented by the mar-
ginal abatement cost curve, depends on the scope of the
ETS. In the “Limited ETS” scenario, abatement poten-
tial is constrained by the emission reductions options that
exist in the industrial process sector. As suggested by the
industrial process abatement curve we presented in Fig-
ure 2, an abatement of 34 Mt would require a 2030 car-
bon price in excess of MXN 2,148/t (USD 100/t). is
suggests that in the “Limited ETS” scenario, the carbon
price may be greater than USD 100/t, a level that may
pose considerable political challenges, and, therefore, is
likely to be infeasible. For the remainder of the analysis,
we exclude this scenario.
For the remaining scenarios, we use a marginal abate-
ment cost curve derived from abatement options in the
power, industry, industrial processes, and ground trans-
port sectors, as presented above in Section 4.1.3.2. As ex-
plained above, these abatement curves reflect the carbon
price level required in 2030 for a given amount of abate-
ment to take place (given the simplifying assumptions
explained in Section 4.1.3.2). e curves further assume
that the carbon price would rise linearly from 0 in 2016
to the respective level by 2030. Given these assumptions,
we can construct projections for carbon prices under the
different ETS scenarios (Table 3). e carbon price levels
for 2030 are uncertain and should be seen as our best-
guess approximations for what the carbon price will be
in each scenario, based on the available data and resourc-
es. We note that the price trajectories between 2017 and
2029 are even more uncertain. In reality, carbon prices
will fluctuate based on variation in emissions and the
availability of abatement options over time. ese tem-
poral effects have not been taken into account. us, the
presented set of projections is mainly a tool to compare
different policy options.

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 43
Table 3: ETS Carbon Price Projections by Scenario (Units in Constant MXN/t)
2030 Cap = Unconditional target 2030 Cap = 26% below BAU
ETS Only Overlapping
Tax & ETS Hybrid ETS ETS Only Overlapping
Tax & ETS Hybrid ETS
2017 5 5 75 35 33 75
2018 11 10 75 71 65 75
2019 16 15 75 106 98 106
2020 21 20 75 141 131 141
2021 26 25 75 177 163 177
2022 32 31 75 212 196 212
2023 37 36 75 247 228 247
2024 42 41 75 283 261 283
2025 47 46 75 318 294 318
2026 53 51 75 353 326 353
2027 58 56 75 389 359 389
2028 63 61 75 424 392 424
2029 68 66 75 459 424 459
2030 74 71 75 495 457 495
Source: Own calculations
is analysis suggests that the “ETS Only” scenario with
a cap based on the unconditional target will result in a
2030 carbon price of MXN 74/t (USD 3/t). is carbon
price is a reflection of the fact that demand for abate-
ment is relatively low, and that enough relatively cheap
abatement options exist, mainly in the power sector and
in industrial processes, to achieve the necessary emission
reductions.
e “Overlapping Tax & ETS” scenario results in a sim-
ilar, but slightly lower price, according to this analysis, at
MXN 71/t (USD 3/t) in 2030. e lower price is a result
of the fact that the existence of the carbon tax reduces
emissions, creating less demand for ETS permits. We as-
sumed that Mexico’s carbon tax reduces 1.8 Mt per year
based on previous work (Muñoz-Piña, 2016). For the
“ETS Only” and the “Hybrid ETS” scenarios, where the
carbon tax is discontinued, we assumed that the emission
reduction driven by the ETS would have to be 1.8 Mt
higher, which creates additional demand for ETS permits
and leads prices to be slightly higher in these scenarios.
Comparing the “ETS Only” scenario with the “Hybrid
ETS” scenario reveals the effect of the top-up price floor.
e two scenarios are identical with one exception: the
“Hybrid ETS” contains a top-up carbon tax that acts as a
price floor in the carbon market. While low-cost abate-
ment options lead to a low ETS price in the “ETS Only”
scenario, the price floor of the “Hybrid ETS” scenario
prevents the price from falling below MXN 75/t (USD
3.5/t).
A stricter cap would result in higher prices, as shown in
Table 3 and Figure 5. An ETS cap in 2030 consistent
with a 26% emission reduction from Mexico’s 2030 BAU
results in a carbon price of MXN 495/t (USD 23/t) in
the “ETS Only” and “Hybrid ETS” scenarios, according
to our model, and in a price of MXN 457/t (USD 21/t)
in the “Overlapping Tax & ETS” scenario. e reason for
the extent of the difference in the carbon prices projected
here compared to those projected under the uncondition-
al target is that a 26% reduction would require twice as
much emissions abatement. Such an amount of abate-
ment would exhaust the relatively low-cost abatement
options featured in our marginal abatement cost curves
and require the most costly reductions.

44
As displayed in Table 3, even such a more ambitious pol-
icy may result in a carbon price lower than the current
carbon tax in the “ETS Only” scenario during the first
years of implementation (2017-2018). Meanwhile, the
top-up price floor featured in the “Hybrid ETS” scenario
maintains a carbon price at the current carbon tax level
at all times. As long as the ETS carbon price is above the
price floor, the Hybrid ETS generates the same carbon
prices as the “ETS Only” design.
Figure 5: ETS Carbon Prices by Scenario
Source: Own calculations
5.3. Government Revenues
Figure 6 presents a comparison of the total government
revenues generation from 2017 to 2030 by scenario. Ta-
ble 4 and Table 5 below present the annual results. We
show results for two different options available to policy
makers when it comes to distributing ETS permits. A
system of full auctioning generates the maximum possi-
ble revenue by selling all permits to participating compa-
nies. e other policy design we have modeled is a system
whereby some of the ETS allowances are given for free
to industrial companies to cover their energy- and pro-
cess-related emissions, while the remaining permits are
sold to the other ETS participants, namely, the power
and ground transport sectors.

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 45
Figure 6: Total Government Revenues, 2017-2030, by Scenario
Source: Own calculations. Revenues are based on the projected carbon prices and sector-level emissions in each scenario. Sector
emissions in each scenario were estimated based on the projected carbon price and the respective marginal abatement cost curve.
e “Overlapping Tax & ETS” scenario generates the
most revenue, as companies pay both the ETS carbon
price and the carbon tax. e tax is assumed to gener-
ate MXN 21 billion (USD 1 billion) in 2016, which we
scaled up every year until 2030 based on projected emis-
sions growth. A noteworthy result is that the “Hybrid
ETS” generates revenues that are not far from the “Over-
lapping Tax & ETS” scenario in the case of full auction-
ing, with the cap equal to the unconditional target. is
result stands out at first glance because companies partic-
ipating in the “Hybrid ETS” pay only one carbon price,
while those in the “Overlapping Tax & ETS” scenario
pay two different carbon prices (the carbon tax and the
ETS-generated price). However, government proceeds
are similar because revenues from the ETS featured in
the “Overlapping Tax & ETS” scenario are lower than
those generated by the “Hybrid ETS” scenario, due to
the lower ETS carbon price, which is caused by the lack
of a price floor. In addition, the “Hybrid ETS” scenario
covers a greater amount of emissions than the carbon tax
included in the “Overlapping Tax & ETS” scenario, re-
sulting in additional revenues.

46
Table 4: Revenues per Year, Full Auctioning (Units in Constant Billion MXN)
2030 Cap = Unconditional target 2030 Cap = 26% below BAU
ETS Only Overlapping
Tax & ETS Hybrid ETS ETS Only Overlapping
Tax & ETS Hybrid ETS
2017 3 24 36 17 37 36
2018 5 27 36 34 53 36
2019 8 29 36 50 68 50
2020 10 32 36 67 84 67
2021 13 34 36 83 99 83
2022 15 37 36 99 114 99
2023 18 40 36 116 129 116
2024 20 42 37 132 144 132
2025 23 45 37 148 159 148
2026 26 48 37 164 175 164
2027 28 50 37 180 190 180
2028 31 53 37 196 204 196
2029 34 56 37 212 219 212
2030 37 59 37 227 234 227
Source: Own calculations.
ese results also show that free allocation of ETS per-
mits comes at a cost of foregone revenue. Yet, this policy
design is frequently employed in ETSs around the world
as a way to assuage concerns about any adverse impacts
a carbon price might have on industrial competitiveness,
and, thus, to secure political support. Our results show
that even when permits are allocated for free to indus-
trial participants, an ETS can still generate significant
government revenue. e “Hybrid ETS” scenario with a
cap at the unconditional INDC target generates revenues
in line with the current carbon tax revenues of roughly
MXN 21 billion (USD 1 billion) per year (Table 5).
e “ETS Only” scenario shows that replacing the cur-
rent tax with an ETS without a price floor may lower
government revenues. Especially in the case of freely
allocating allowances to industry, revenues generated by
the “ETS Only” scenario are lower than current carbon
tax revenues when the ETS cap equals the unconditional
target (Table 6). However, even the ETS Only scenario
can generate substantial revenues if the ETS cap is made
more stringent.
As shown in the last three columns of Table 4 and Ta-
ble 5, a cap that achieves a 2030 reduction of 26% from
Mexico’s BAU is estimated to more than double the cur-
rent carbon tax revenues (of MXN 21 billion per year)
by 2020, and to increase them by more than six-fold by
2030, across all three ETS scenarios. ese results reflect
the significance of the level of the ETS cap.

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 47
Table 5: Revenues per Year, Free Allocation to Industry (Units in Billion MXN)
2030 Cap = Unconditional target 2030 Cap = 26% below BAU
ETS Only Overlapping
Tax & ETS Hybrid ETS ETS Only Overlapping
Tax & ETS Hybrid ETS
2017 2 23 22 10 31 22
2018 3 25 22 20 40 21
2019 5 26 22 30 50 30
2020 6 28 21 40 59 40
2021 7 29 21 50 68 50
2022 9 31 21 59 77 59
2023 10 32 21 69 86 69
2024 12 34 21 78 94 78
2025 13 35 21 87 103 87
2026 15 37 21 96 111 96
2027 16 38 21 105 120 105
2028 18 40 21 114 128 114
2029 19 42 21 122 136 122
2030 20 43 21 131 144 131
Source: Own calculations.
5.4. Policy Costs
We estimate policy costs by using the quoted marginal
abatement cost curves and approximating the area under
the curve for a given carbon price level. Table 6 displays
estimated policy costs in 2030. We estimated costs con-
servatively by assuming linear marginal abatement cost
curves. Rather than as forecasts of future impacts, the
costs are best seen as a way to compare impacts across
scenarios and sectors.
Costs are concentrated in the power and industrial pro-
cess sectors in the cases where the ETS cap equals Mex-
ico’s unconditional target. is results from the fact that
most abatement occurs in these sectors. Particular indus-
trial process sub-sectors that deliver significant emission
reductions are the oil and gas sector, where methane cap-
ture is a relatively low-cost abatement option; and the
cement sector, where clinker substitution supplies sizable
reductions.
A higher policy ambition, represented by the 26% reduc-
tion case, result in higher costs, as well as a higher pro-
portion of costs being born by industrial energy-related
activities. is occurs as a growing share of emission re-
ductions come from these sectors.
Turning to instrument mix options, we observe that the
“Hybrid ETS” scenario results in slightly higher costs than
the “ETS Only” case, due to the 2030 carbon price being
slightly higher as it is bolstered by the price floor. In the
“Overlapping Tax & ETS” scenario, the costs of the ETS
are lower because of the slightly lower carbon price and
because fewer emission reductions take place in the ETS.
It is worth making clear that these costs refer to ETS costs
only and do not include costs related to the carbon tax.
Nor do these numbers include the expenses companies
will bear when they purchase ETS permits. e costs of
purchasing permits are equivalent to the revenues that ac-
crue to the government, which we discussed above.

48
Table 6: ETS Policy Costs in 2030 by Sector (Units in Million Pesos)
2030 Cap = Unconditional target 2030 Cap = 26% below BAU
Power Industry
(energy)
Industry
(process) Transport Power Industr y
(energy)
Industry
(process) Transport
ETS Only 598
(0.2%) 106
(0.003%) 628
(0.02%) 15
(0.002%) 6691
(2%) 4722
(0.1%) 6043
(0.2%) 773
(0.1%)
Overlapping
Tax & ETS 560
(0.2%) 99
(0.003%) 565
(0.01%) 14
(0.001%) 6106
(2%) 4031
(0.1%) 5572
(0.1%) 658
(0.1%)
Hybrid ETS 624
(0.2%) 111
(0.003%) 670
(0.02%) 16
(0.002%) 6691
(2%) 4722
(0.1%) 6043
(0.2%) 773
(0.1%)
Source: Numbers in the parentheses denote costs as a percent of value added of the relevant sector. Value added is for 2013 and was
derived from Producto interno bruto trimestral por sector – Inegi. Sector 22 (power generation and transmission) was used for the
power sector; A sum of sectors 23 and 31-33 (construction and industrial manufacturing) was used to calculate percentages for both
industrial energy and process costs; and sector 48-49 (transport) was used for the transport sector (Inegi, 2013).
5.5. Implications of Future Uncertainty
for Policy Choice
e results presented here are based on a number of simpli-
fying assumptions and projections about the future, which
may not materialize as described in this analysis. As the
future is inherently uncertain, there is a limit to the abil-
ity of any modeling exercise to accurately estimate future
policy impacts. Climate policy is particularly uncertain be-
cause it lies at the intersection of many complex systems,
including the economy and energy markets, two areas in
which accurate predictions are especially rare. Climate
policy designers have experienced substantial surprises,
as exemplified by virtually all operating ETS becoming
“oversupplied” with permits (Ferdinand and Dimantchev,
2016). An oversupply of permits can harm the long-term
efficiency of emissions trading, a risk that prompted the
European Commission to take action to reduce the permit
surplus in the EU ETS (COM(2014)20, 2014).
Our Monte Carlo model allows us to explore probabil-
ities of various potential outcomes based on the uncer-
tainty of one of the main inputs to our analysis: namely,
projected future emissions. Given the assumptions made
for that projection, we estimate that the “ETS Only”
scenario with a cap equivalent to the unconditional
INDC target has about a one-in-four chance of result-
ing in a carbon price at or less than MXN 21/t (USD
1/t) in 2030, and about a one-in-six chance of resulting
in a 2030 carbon price of MXN/USD 0/t. is would
mean that there is a one-in-four chance that the govern-
ment raises 84 billion pesos or less for the whole period
2017-2030 (assuming full auctioning), or roughly a third
of what we projected above; and a one-in-six chance of
no revenues at all. e “ETS Only” scenario underscores
the sensitivity of an ETS to uncertainty. As we discussed
above, such unpredictability of future policy makes it diffi-
cult for compliance entities to plan strategically, and dulls
any incentives for low-carbon investment. ese risks are
mitigated in the “Hybrid ETS” scenario, where the top-up
carbon tax acts as a price floor and thus provides greater
predictability.
Similarly, a consideration of contingent possibilities re-
veals a risk that emissions turn out higher than initially
expected, leading to higher carbon prices and policy costs
than initially foreseen. is can be an important consid-
eration for lawmakers, depending on the range of pol-
icy costs that they may implicitly or explicitly consider
feasible. Based on our Monte Carlo model, we estimate
that there is about an 8 percent chance that the “ETS
Only” scenario results in a carbon price of MXN 2,148/t
(USD 100/t) or more. As we mentioned in the earlier
Text Box describing the model, we have made conserva-
tive assumptions that likely overestimate the chances of
emissions being higher rather than lower. Nevertheless,
there is a possibility that policy costs are higher than ex-
pected. is may provide an argument for a carbon price
ceiling in addition to a carbon price floor to mitigate such
risks. However, it is worth noting that a price ceiling can
undermine the environmental purpose of an ETS if it
results in the emissions cap being breached.

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 49
In addition to bolstering arguments for price manage-
ment through price floors and, potentially ceilings, fu-
ture uncertainty suggests that policy makers will benefit
from an adaptive management approach. Mexico’s car-
bon pricing should be structured around a system of pe-
riodic reviews. Such procedures for periodic assessment
have been built into many carbon pricing policies, one
example being the EU ETS (COM(2014)20). ETS poli-
cies are typically organized according to temporal phases,
with each phase offering an opportunity for a change in
regulations. Such phases, combined with a periodic as-
sessment of the effectiveness of policy, can lead to more
effective policy making in the face of uncertainty. e
case of the United Kingdom’s climate policy serves as an
example. As our Case Study explained (see above, Section
3.4), the government, as part of its annual budget assess-
ments, proposed to implement a carbon price floor after
its assessment reached the conclusion that the variability
of its carbon price was hampering investment in clean
energy (HM Treasury, 2010).

Conclusions and
Recommendations

Achieving the Mexican Mitigation Targets: Options for an Effective Carbon Pricing Policy Mix 51
6. Conclusions and Recommendations
6.1. Qualitative Analysis
Due to its ability to equalize marginal abatement cost
across covered emitters, carbon pricing offers a highly
cost-effective policy instrument to internalize the social
cost of GHG emissions, and thereby correct one of the
principal market failures contributing to climate change
(see Section 2.1). is feature, combined with its scalabili-
ty, flexibility, and ability to generate revenue, make carbon
pricing a favorable policy option for a rapidly growing
economy with ambitious climate targets such as Mexico.
Carbon pricing can be implemented through a price set
by the government, usually by way of a carbon tax, or
through quantity rationing with subsequent trading of
emission allowances (see Text Box “Definition: Carbon
Pricing through Prices and Quantities” in Section 2.1).
Neither approach is clearly superior, with certain theoret-
ical advantages of each approach offset by political econ-
omy constraints and uncertainties about the sensitivity
of the climate system and the scale and cost of climate
impacts (see Section 2.2.1). Moreover, hybrid approaches
combining pricing and quantity rationing can help har-
ness the advantages of a carbon tax and an ETS by com-
bining the price certainty of a price-based approach with
the certainty of mitigation outcome under a quantity-ra-
tioning approach.
Political economy considerations and administrative con-
straints will typically outweigh theoretical considerations
of instrument choice, with an ETS offering greater flex-
ibility to accommodate stakeholder concerns and secure
political support (see Section 2.2.1). International expe-
rience, including in the cases of Australia and the United
Kingdom surveyed in this report (see Sections 3.2 and
3.4), suggest that fixed-price approaches to carbon pric-
ing may be more politically vulnerable in certain contexts.
is observation may also prove important in Mexico,
where a high share of manufacturing industries will likely
spur debate about the competitiveness impacts of climate
policy, and where the general public has proven highly
sensitive to increases in energy cost.
Mexico has already introduced a carbon tax on certain
fossil fuels (see Section 4.2.2). A combination of the ex-
isting carbon tax with a future ETS can leverage syner-
gies if both instruments are properly aligned. Economic
theory, however, suggests that each policy instrument
should address a different market failure; uncoordinat-
ed coexistence of carbon pricing instruments can result
in adverse effects and significantly undermine both the
cost-effectiveness and environmental benefits of carbon
pricing. In particular, the sectoral and geographic cover-
age of a carbon tax should be equal to or exceed that of a
concurrent ETS to avoid emissions leakage between the
two instruments (see Section 2.2.2).
A carbon tax and an ETS can be combined in different
ways, based on the degree of synchronicity and the sym-
metry of application (see Section 3.1). Without claiming
an exhaustive list, the coordinated operation of a carbon
tax and ETS alongside each other or in sequence can
serve important design functions, allowing the introduc-
tion of greater compliance flexibility, facilitating a tem-
poral transition, or serving to manage price extremes and
volatility (see Section 3). Each of these approaches to a
coordinated carbon pricing mix has been introduced in
practice, with varying results.
Where jurisdictions, such as Switzerland or the United
Kingdom, have offered the option of participating in an
ETS as an alternative to paying a carbon tax, experience
has shown that affected entities will exercise this oppor-
tunity (see Section 3.3.1), reflecting a likely preference
among compliance entities for the perceived advantages
of emissions trading. Similarly, the ability to use offset
credits to comply with a carbon tax liability, as will be the
case in South Africa, has been generally welcomed due to
the increased flexibility it offers (see Section 0).
Use of a carbon pricing mix to introduce a carbon floor
price in an ETS – as applied, for instance, in the Unit-
ed Kingdom (see Section 3.4) – has also proven to offer
distinct benefits. By providing a more predictable carbon
price, a price floor helps avoid inefficiencies in investment
decisions and the resulting risk of carbon lock-in (see
Section 3.4.2), while also guaranteeing a steadier reve-
nue flow (see Section 3.4.3). In rapidly growing econo-
mies such as that of Mexico, where significant additional
energy, transport and other infrastructure will likely be
added in coming decades, this price predictability may
prove of particular importance. To avoid emissions leak-
age between sectors, however, the scope of the carbon tax
should be at least equal or larger than that of the ETS
(see Section 2.2.2).

52
Likewise, a carbon pricing mix can be used to introduce a
price ceiling. In a political economy context of high sen-
sitivity to increases in energy cost and other production
factors, which is the case in Mexico, a price ceiling may be
helpful to secure political passage of an ETS. As the case
of New Zealand has shown, a fixed payment obligation
in lieu of surrendering the requisite number of allowances
can be a practical solution (see Section 3.4), although it
comes at the expense of certainty of mitigation outcome.
Use of revenue for investment in mitigation can reinsert
a degree of control over the emissions outcome.
6.2. Quantitative Analysis
A central conclusion from the quantitative analysis is
that Mexico’s emissions are currently on a pathway that
nearly achieves the unconditional climate target of re-
ducing emissions by 22 percent below the government’s
“Business-as-Usual” scenario. Emissions in our Reference
Case, which uses inputs from highly regarded modeling
exercises, reach 793 Mt in 2030. is is only 34 Mt short
of the unconditional 759 Mt target, as stipulated in Mex-
ico’s INDC to the Paris Agreement.
is analysis shows how an ETS can help close this gap.
Based on a number of conservative assumptions taken,
we find that an ETS could lead Mexico to achieve its un-
conditional target at a carbon price of MXN 74/t (USD
3/t) in 2030, a relatively modest carbon price compared
to that of California, a major trading partner for Mexico,
where carbon allowances are around MXN 258/t (USD
12/t), and likely to rise further in the future. e relatively
low carbon price projected for Mexico is a result of the
fact that our projection for business as usual emissions
(our Reference Case) estimates 2030 emissions to be very
close to the unconditional target, thus requiring relatively
modest reductions to meet the target. e other reason
for the relatively low carbon price projection is the avail-
ability of relatively low-cost abatement options, mainly
in the power sector and in industrial processes. us, an
important assumption of this analysis is that both com-
bustion and process emissions would be included in the
ETS (see Section 5 for details on coverage).
Yet the design of a future ETS matters. As our analysis of
the “Limited ETS” scenario shows, an ETS that is con-
strained in scope to industrial process emissions, but still
stringent enough to meet Mexico’s unconditional target,
will result in a very high carbon price of above MXN
2,148 MXN/t ($100/t) in 2030. An ETS that is confined
to sectors outside of the scope of Mexico’s carbon tax will
come at a relatively high cost.
Due to the inherent uncertainty of future projections, any
given policy pathway may not result in impacts that had
been expected or desired. Mexico can increase the effec-
tiveness of its carbon pricing policy by implementing a
price management system, such as a carbon price floor.
As our uncertainty analysis shows, in the absence of a
price floor – represented, for instance, in the “ETS Only”
scenario – there is a considerable chance that lower than
expected emissions will cause a crash in the carbon price
and, in turn, government revenue. e possibility of such
an outcome will be a risk to low-carbon investors that
may preclude investments consistent with cost-effective
mitigation from taking place. In contrast, an ETS with a
price floor – as in the “Hybrid ETS” scenario – will pro-
vide a more stable and predictable carbon price and gov-
ernment revenues. Uncertainty about policy costs may
also seem to make the case for carbon price ceilings, but
such instruments can undermine the ability of an ETS
to meet its original environmental purpose of emission
reductions if they compromise the cap on emissions.
As we show above, an “Overlapping Tax & ETS” instru-
ment mix can help generate stable government revenue
and meet environmental outcomes. However, it comes at
the expense of imposing two carbon prices at the same
time, leading to a regulatory regime that may be seen as
redundant and overly complex.
Out of the scenarios considered, a hybrid ETS with a
carbon price floor in the form of a top-up tax emerges
as a suitable carbon pricing mix for Mexico. is policy
option allows for the continuation of carbon pricing rev-
enues, and for the introduction of an ETS that introduces
higher certainty of achieving climate mitigation goals.
Due to the limited ability of any modeling exercises to
predict the future, Mexico can enhance the effectiveness
of a future ETS if it implements a system for periodic re-
views. Such an adaptive management approach would in-
clude a process for monitoring policy effects and poten-
tially amending policy parameters in the face of changing
circumstances.

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54
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is document was published in May 2017.
is publication presents the results of the study Achieving the Mexican Mitigation
Targets: Options for an Effective Carbon Pricing Policy Mix, which was elaborated by
Michael Mehling(1) and Emil Dimantchev(2).
Its contents were developed under the coordination of the Ministry for the Environment
and Natural Resources (Secretaría de Medio Ambiente y Recursos Naturales,
SEMARNAT), and the “Mexican-German Climate Change Alliance” of the Deutsche
Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH on behalf of the
German Federal Ministry for the Environment, Nature Conservation, Building and
Nuclear Safety.
Editorial design and creative direction by:
Edgar Javier González Castillo
and La Estación de Servicio.
Published by:
Deutsche Gesellschaft für
Internationale Zusammenarbeit (GIZ) GmbH
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F +49 228 44 60-17 66
Dag Hammarskjöld-Weg 1-5
65760 Eschborn, Deutschland
T +49 61 96 79 0
F +49 61 96 79 11 15
E info@giz.de
I www.giz.de
Project:
Preparation of an Emissions Trading
System in Mexico (SiCEM)
Av. Insurgentes Sur No. 826, PH
03100 Col. del Valle, CDMX México
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Secretaría de Medio Ambiente y Recursos
Naturales (SEMARNAT)
Avenida Ejército Nacional 223, piso 19
Del. Miguel Hidalgo, Col. Anáhuac
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E mexico.ets@semarnat.gob.mx
(1) Deputy Director, MIT Center for Energy and Environmental Policy Research (MIT CEEPR), Cambridge,
Mass., USA; eMail: mmehling@mit.edu.
(2) Research Assistant, MIT Selin Group and MIT Joint Program on the Science and Policy of Global Change;
Graduate student, MIT Technology and Policy Program; Cambridge, Mass., USA; eMail: emild@mit.edu.