Putting a price on carbon: Why not a carbon tax?

In Australia there has never really been a debate about the merits of particular policy instruments available to governments – price-based or quantity-based ones – to mitigate the effects of climate change.

Climate change mitigation involves reducing GHG emissions, reducing the rate and magnitude of global warming. Many of the impacts of climate change can be reduced or delayed by mitigation. The main economic requirement for effective mitigation is to put a price on carbon.

At the moment we don’t generally pay for the current and future costs of our emissions. Thus, Lord Stern refers to a climate change ‘market failure’. As one economist puts it,

we need to correct this market failure by ensuring that all people, everywhere, and for the indefinite future face a market price for the use of carbon that reflects the social costs of their activities. Economic participants [governments, firms, people] … need to face realistic prices for the use of carbon if their decisions about consumption, investment, and innovation are to be appropriate.

Qantity or price-based instruments?

The question is whether to rely on quantity-based or price-based instruments. A price-based instrument is a carbon tax. A tax sets a price on carbon, and emitters choose how much to emit; an emissions trading scheme (ETS) sets a total quota for emissions; emitters – the market – work out the price.

An ETS is a quantity-based instrument, the most common example of which is a cap-and-trade system. The Carbon Pollution Reduction Scheme (CPRS), a proposed Australian ETS which was to have begun on 1 July 2011, was never implemented. And national ETS legislation – the Clean Energy Act – has been repealed with effect from 1 July 2014.

Given the failure of emissions trading at the national level and its (now) near-absence at the state level in Australia, we set out here how a carbon tax could work and some of its advantages. New research confirms additional carbon tax advantages.

A carbon tax could begin at a relatively low level (so as to avoid disruption) and would increase steadily, and predictably, over time, providing incentives to affected corporations to lower emissions, and encouraging those corporations to use energy more efficiently – encouraging the move to lower emissions technology.

And while there are a number of points at which to impose a carbon tax, there is some agreement that the most simple, efficient way is for it to be introduced as close to the source of the fuel as possible – that is, as far upstream in the energy supply chain as possible.

One result of an upstream approach is that increased costs would be passed along by suppliers and would be borne, ultimately, by consumers; they would be passed into downstream prices of electricity, for example.

It is argued by those on both the left and the right that a carbon tax would provide government revenue which could then be used to reduce or offset other forms of taxation, primarily corporate and personal income taxes, thus making a carbon tax ‘revenue neutral.’ Revenue from a carbon tax could also be used to subsidise alternative fuel industries and projects.

Arguments for a carbon tax

Arguments that can be made for the imposition of a carbon tax, both in isolation and as against an ETS, include the following:

 1.         Taxation is a proven instrument. Countries have used taxes for centuries, and their properties are well understood. For Yale University’s Nordhaus, such advantages are even clearer when compared to the operation of an international ETS. As he says,

tax systems are mature and universally applied instruments of policy … By contrast, there is no experience – as in zero – with international cap-and-trade systems [although that’s not quite true now] … [I]t would be … perilous for the international community to rely on an untested system like international cap-and-trade to prevent dangerous climate change …

2.         Taxes capture revenue more easily than quantitative instruments, and are less costly. Tax infrastructure is in place; pre-existing collection mechanisms exist. Taxation has lower administrative and compliance costs than does carbon trading.

3.         Taxation is more direct and transparent than emissions trading (so it’s said), and affords less opportunity for corruption; money moves from polluters directly to the government. And a carbon tax provides price certainty and stability (as opposed to permit price volatility) and a fixed price for carbon emissions across all economic sectors and markets.

The argument for carbon taxation is concisely made by Harvard economist Richard Cooper:

Decisions to consume goods and services made with fossil fuels are made by over a billion households and firms in the world. The best and indeed only way to reach all these decision makers is through the prices they must pay. If we are to reduce CO2-emitting activities, we must raise the prices of those activities. Levying a [tax] … does that directly.

New research – why taxes are better

Recent research from Stanford Law School shows that vital information necessary for the design of cap and trade systems is unavailable to those making climate policy and that, while accurate emissions forecasts are needed to set the cap, energy models ‘are not up to the task.’

This is not the case with regard to carbon taxes. The Stanford research shows that such taxes ‘don’t require the same level of information about future emissions in order to create real policies.’ Further,

[c]arbon taxes are likely to produce emissions reductions relative to baseline emissions with greater certainty than a cap-and-trade because a real carbon tax will always create incentives to lower emissions while real cap-and-trade may not.

There is also news from the United States for adherents of emissions trading schemes. Representative Chris Van Hollen of Maryland plans to introduce legislation in the US House of Representatives that would result in permits purchased by coal, oil and natural gas corporations for each tonne of carbon in the fuels they sell being auctioned. All of the proceeds would be ‘returned straight to the American people as equal dividends for every woman, man and child.’

The New York Times asks whether the bill ‘stand[s] a snowball’s chance in the partisan hell of Washington.’

The answer is no.