AIQ - The climate edition

‘Sticking’ it to carbon

The pros and cons of taxing emissions

With governments urged to do more to tackle climate change, carbon taxes are being touted as a politically expedient solution.

In his 1984 book Managing the Global Commons: The Economics of Climate Change, Yale economist William Nordhaus said the burning of fossil fuels and release of carbon dioxide and other greenhouse gasses created significant externalities. Moreover, he believed markets would be unable to correct them on their own.

In the intervening years, Nordhaus’s pioneering work – which began in the mid-1970s and led to him being awarded the Nobel Prize in Economics in 2018 – has become widely accepted. There now seems little doubt the world economy is facing significant risks from unabated climate change. Furthermore, while households and businesses have an important role to play, it seems almost certain greenhouse-gas emissions will hit perilous levels if economies are left to operate freely.

Consequently, many economists believe governments must step up their efforts to address the situation. Although subsidies to encourage the development of clean technologies are one option, their cost can be prohibitive. As a result, policymakers have primarily focused less on the carrot, and more on the stick.

Polluter pays

To date, countries that have attempted to apply the polluter-pays principle and put a price on the emission of carbon dioxide and other greenhouse gasses have done so via a carbon tax (known as a price instrument); a cap-and-trade scheme (a so-called quantity instrument); or a combination of the two.

A carbon tax imposes a tax on each unit of greenhouse-gas emissions and gives economic actors an incentive to reduce pollution whenever doing so would cost less than paying the tax. The tax is set by assessing the cost or damage associated with each unit of pollution and the costs associated with controlling it.

By contrast, a cap-and-trade system sets a maximum level of pollution and distributes emissions permits among firms. Companies must have a permit to cover each unit of pollution they produce, and can obtain these permits either through an initial allocation or auction, or through trading with other firms.

Economists such as Nordhaus prefer the former option, on the basis higher prices will encourage firms and consumers to find alternatives to carbon-based products as well as encourage new technologies to make those substitutes competitive. While this has become the mainstream view among environmental economists, the profession continues to debate the relative merits of price and quantity instruments. For instance, Harvard professor Martin Weitzman was not alone in arguing quantity instruments were likely to work best, at least under certain conditions.1

Government inaction

Unfortunately, beyond keeping some members of the economics profession occupied, the debate has been of little practical consequence since government action has been woefully inadequate. It is true a growing number of jurisdictions have implemented a carbon tax or an emissions trading system. As of June 2019, the World Bank reported 57 initiatives, up from 51 a year earlier, a number it expects to grow.2 However, they have been devised in piecemeal fashion, if at all, meaning they have struggled to significantly dent emissions.

Just 20 per cent of global emissions are covered by a carbon price

A September 2018 report from the Organization for Economic Cooperation and Development found the average carbon price across 42 major economies was around US$8 per tonne.3 The following month, the Intergovernmental Panel on Climate Change, a body that assesses the science related to climate change in order to guide world leaders, estimated that to be effective any tax would have to range from $135 to $5,500 per tonne in 2030, and from $690 to $27,000 per tonne by 2100.4

All told, the World Bank reckons just 20 per cent of global emissions are covered by a carbon price and less than five per cent of those are currently priced at levels consistent with reaching the temperature goals of the Paris Agreement. It called on all countries to go further and faster in using carbon-pricing policies, which it believes to be the most effective way of reducing emissions.

$40 per tonne: The carbon tax advocated by leading US economists

In 2018, a record number of US-based economists called for a carbon tax of around $40 per tonne.5 Raised over time by more than the rate of inflation, they said this would be the most effective and immediate way of tackling climate change. Led by former Federal Reserve chiefs Janet Yellen and Ben Bernanke, the 3,300 members of the Climate Leadership Council said such a tax would be “very effective” at reducing emissions and would “more than meet the Paris commitment”.

How high is high enough?

Lawmakers face two main issues in taxing domestic polluters. First, since taxes are generally unpopular with businesses and, more importantly, electorates, politicians have found it difficult to set a price high enough to bring about sufficiently deep reductions in carbon emissions. This explains why governments have had most success in reducing emissions through regulations, such as imposing fuel-economy standards on vehicle manufacturers or simply closing coal-fired power stations.

Regulations tend to be a more palatable political solution than carbon taxation

Although Nordhaus showed raising prices through taxation was more economically efficient, regulations tend to be a more palatable political solution since their true cost tends not to be evident. A policy that requires electricity providers to build more renewable energy facilities has visible benefits – more wind and solar – and hidden costs. But a carbon tax that directly increases the price of petrol at the pump or electricity bills brings more obvious pain, and hence is more likely to stir opposition. After all, the soaring cost of everyday necessities, including petrol, have in recent years sparked protests that spiralled into major movements in countries including France, Lebanon, Sudan and Chile.

Second, since pollution is a global externality that does not respect national boundaries, there is a perverse risk that taxes in one country or region might cause global emissions to rise due to “carbon leakage”. Faced with stringent climate policies in their domestic market or home region, polluting companies might simply shift production to countries with less ambitious climate measures for fear of losing out to international rivals.

Putting up borders

As a result, a growing number of economists believe carbon border taxes are needed. Discussing what is essentially a form of tariff, Dieter Helm, a professor of economics at the University of Oxford, tells AIQ: “If you want to tackle carbon leakage, border taxes are the only way.”

The European Commission is considering applying a carbon border tax on imports

While the idea has been around for more than a decade, it is only in recent months it has begun to make headlines after the European Commission said it was considering applying a carbon border tax on imports should “differences in levels of ambition worldwide persist, as the EU increases its climate ambition”.6 Under pressure following a big swing to Green parties after climate issues leapt up the political agenda, it said the aim would be to ensure the price of imports more accurately reflected their carbon content.

It might be only a matter of time before other countries take the idea of a carbon border tax more seriously. Helm believes such a tax could have “deep political appeal” in Washington given US attitudes towards China and bipartisan support for reshoring heavy industries such as steel.

“From both a US and European perspective, what is the point in cutting emissions if you are going to import the stuff from China and other countries which are increasing their pollution fastest?,” he says.

Devising a carbon border tax that meets WTO rules will not be straightforward

Interestingly, the Climate Leadership Council’s proposal also envisaged a carbon border tax. The plan drew backing from across the political spectrum. Other signatories included former US Treasury Secretary Larry Summers, former Clinton economic adviser Alan Blinder, and Marty Feldstein, a prominent Republican economist and former chief economic adviser to Ronald Reagan.

Aside from dealing with carbon leakage, a carbon border tax should also incentivise big polluting countries such as China and India to do more to curb their own emissions.

Although the EU says any border tax would be designed to comply with World Trade Organization rules, that is unlikely to be straightforward. For instance, putting a fair carbon price on a product as complex as a car would be immensely difficult. Nonetheless, according to Helm, that is not to deny the merit of taxing a small number of energy-intensive products, which is where Brussels is likely to start.

“It need not be fantastically complicated. If you take steel, cement, aluminium, fertiliser, petrochemicals; that’s a huge proportion of the carbon footprint of total trade,” he says.

The other main drawback of a carbon border tax is that the price of goods with high-carbon contents would be likely to rise

The other main drawback of a carbon border tax is that the price of goods with high-carbon contents, in this case imported ones, would be likely to rise. However, most economists agree there is no way of shifting from an almost entirely carbon-intensive economy to one that has virtually no carbon in it, and to do it in a very short space of time, without incurring significant expense.

While the price of a wide range of goods would be likely to rise, in some cases sharply, a tax with the potential to bring back long-lost heavy industries at the same time as tackling climate change might seem like too good an opportunity for politicians to pass up. As questions over the benefits of globalisation grow ever louder, could it be that the world is stumbling upon a politically expedient way of tackling climate change?

Either way, what seems beyond doubt is that whether countries ultimately opt for subsidies for clean energy or some form of carbon taxation, they have to do far more if the world is to have hope of avoiding drastic climate change. As Nordhaus told the Nobel committee, policies are lagging “very, very far – miles, miles, miles – behind the science and what needs to be done”.

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