What is Carbon Tax?
- In Economics
- 12:20 PM, Dec 17, 2015
- Anirban Paul
We have seen before the global warming has a price. This gives an option to take an economic approach to the problem. Economists such as William Nordhaus and Dieter Helm have done so.
Just to recap what we discussed in my previous articles published here , if global warming was not happening, the world would be about $14.5 trillion richer. Thus, the cost of global warming can be estimated at $14.5 trillion. Stabilizing the temperature rise to 4.5 deg F would reduce temperature rise by 0.86 deg F than it would otherwise have been, but at a cost of $ 15.8 trillion. Thus, the cost of a partial solution is higher than the cost of the entire problem. Alternative proposals – a carbon tax that starts at $ 2 per ton and gradually rises to $ 27 per ton towards the end of the century. Total climate impact is small – it reduces the temperature increase by 0.2 deg F by the end of the century. It costs about $ 600 billion but creates twice that in benefits.
What is Carbon Tax? Dieter Helm has done considerable work on Carbon Tax. His 'The Carbon Crunch' explains why the tax is worth looking into and what could be a pathway towards implementation. Let us examine Helm’s arguments.
Demand for carbon is indirect. It is the goods and services that contain carbon which really count. Some activities require carbon-intensive fuels – or carbon intensive inputs – e.g.; steel and cement. If there is long term carbon price, Helm explains, it makes sense to invest in low carbon technologies.
But possibly Helm’s most important insight is on fixing the price. In our view he nails the case for Carbon Tax.
As Helm says, there are two ways of fixing carbon price – with a carbon tax or via emissions trading.
First case – the price of mercury pollution in a river could be fixed based on the estimates of pollution discharged by factories in the river bank. If the factories discharge more than the estimate, even a slight mistake has severe consequences as mercury is very poisonous. The damage function has a very steep curve. Thus the policy solution should target strict permits, tradable permits, or outright bans.
Second case – we get the amount of carbon emitted wrong. It does not matter at the margin, as a few extra tons of carbon would not make a drastic difference to the climate. If, however, the costs of reducing emission are underestimated, the extra costs may be very large. Large power projects may have significant cost overruns. Thus, at the margin, getting the costs right should have a higher priority than getting the quantity right.
Thus, Helm says, as a general principle: fix the quantity when the slope of the damage function is steep relative to that of the cost function; however, fix the price when the slope of the cost function is steep relative to the damage function.
Since carbon emission falls in the latter category, it is preferable to have a fixed carbon tax; the practicalities of carbon emission permits may also mean that the permits are short term. The carbon tax may have a long term certainty, and could be utilized for R&D.
If there is a price on carbon, firstly, there is a substitution effect. There is a substitution from high carbon to low carbon; the substation also encourages efficiency gains. Secondly, there is an income effect. As the price of fossil fuel and chemicals, cement and steel goes up, consumers have less disposable income. In the short run the impact of the income effect is likely to be higher than the impact of the substitution effect. We cannot immediately shift to a low carbon economy.
Now, there is a problem with emission reduction targets that is often overlooked. It’s common to look at the emissions in China which is often called the factory of the world. However, China emits in the process of manufacturing – its manufacturing output is exported to the US and the EU countries. The output of China’s carbon intense manufacturing activities is often consumed in the EU. Thus, on the surface, it appears the EU countries have cut emissions. But, in reality they may have outsourced their emission to countries such as China. The phenomenon is called Carbon leakage. For a sensible policy solution to carbon emission this aspect must be addressed.
The problem for emission is that industrial production is increasing in countries such as China, which produce emission, but consumption takes place in the richer North America and Europe. Since carbon consumption is the root cause behind our carbon footprint, a policy design needs to contain an incentive to reduce carbon consumption.
However, calculating each and every consumer item for its carbon content may be a computational nightmare. Helm suggested - the EU and the North American countries could start by taxing coal, oil and gas, steel and cement etc.
An alternative is to use the existing database of EU ETS and to start taxing those plants that are already covered in EU’s LCPD, and then gradually expand the number of companies covered. The move to include aviation for its environmental footprint could be a step in the right direction, though the move has generated protests from China and the US. There is room for improvement in the EU. In Britain, petrol is taxed, but not coal.
However, not just carbon production, but carbon consumption needs to be targeted for reducing environmental footprint. Otherwise, carbon leakage takes place, as production of consumer goods takes place in countries that have low or non-existent carbon tax. However, there is the practical problem of taxing each and all imported goods for their carbon content – this may result in an implementation nightmare.
Experts recommend that we should apply concepts similar to Pareto principle and focus on a small number of items which are responsible for bulk of carbon imports: steel, chemicals, aluminum, cement, and fertilizers. The guiding principle should be to estimate a rough cut estimate so that implementation is relatively simple.
This policy design should also give an incentive to exporting countries to implement carbon tax domestically. The domestic carbon tax could be offset at the borders of importing countries for “carbon tax credit”. This general principle has worked in car manufacturing, where Japanese car manufacturers incorporated the EU emission standards.
A common carbon price would make the import credit transparent and simpler to implement, but separate trading schemes in each country would produce their own prices as a result of exogenous factors such as the economic growth and business cycles in each country.
In his work in the early 2000s, David Pearce argued that the social cost of Carbon may be less than GBP 10, and could be as low as GBP 3-6 per ton. It could be advisable to start with a lower cost of carbon. In the short run, income effects of carbon will subsume the substitution effects of carbon. There could be a significant popular backlash if the price is too high. However, an expectation should be created that the price of carbon would go up in future. If the reduction in emission is less, the price could be gradually increased, as the central bank interest rates are increased. Essentially the price should be set so that the CO2 level in the atmosphere stabilizes at 450 PPM, which is the current consensus among scientists.
A tax of one dollar on a ton of CO2 will increase gasoline price by about one cent per gallon. But, a one-dollar tax on CO2 will lead to an overall drop of emission by 2%. Also, 1% increase in energy efficiency comes every year due to incremental improvement in engineering of household goods.
With a $30 tax per ton of CO2, we can reduce emission by 40% - however there could be a huge popular backlash and it may be counterproductive.
As we have seen before, sacrificing economic growth is one of the biggest mistakes we can make. For starters it may be sensible to look at the 3% reduction in emission per year – 1% from incremental energy efficiency that anyway takes place, and another 2% drop in emission that would result in a small one-dollar per ton tax on carbon.
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