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Carbon Tax - a proposal for a direct tax on the amount of emissions

June 18, 2020 2:19 PM
By Julian Hawkins

Julian Hawkins (Julian Hawkins)Introduction to Carbon Taxes

An increasing number of technologies and behavioural changes are available to combat climate change, with varying effectiveness and costs. Technically, it looks as if the world can be saved without impairing people's lives much. For example, the Committee for Climate Change proposed that the UK could achieve Net Zero emissions by 2050 (for territorial emissions only) at a cost of about 1% of GDP.

Carbon Taxes are being discussed at the
GLD 2020 Vision virtual conference
7.00pm - 8.30pm Tuesday 30th June

Introduction to Carbon Taxes

However, the changes are being implemented far too slowly, even in countries that have committed to net zero. So, how can we motivate people and corporations to make the right changes in good time?

One possible means is to apply the Polluter Pays Principle - make those who emit greenhouse gases pay for the impact of their emissions. There are two main ways to do this:

This article is about the second.

A carbon tax is widely regarded by economists as the most cost-effective way to motivate emission reductions, using market forces to incentivise emitters to change their behaviour. This article:

Finally, the GLD are currently considering a proposal to implement a carbon tax and re-distribute the revenue to people as a "dividend", so that the net effect helps rather than harming people on low incomes. This article isn't specific to that proposal, but mentions it when relevant.

Carbon Tax in Theory

Tragedy of the Commons

Climate change is an example of the "Tragedy of the Commons".

This can occur for a finite shared resource if individual resource users maximise their short term profits by taking too much. The idea was originally applied to over-grazing on common lands, where individual herders put more cattle on a fixed piece of land than it could support, but applies to many environmental issues.

This does not mean that common resource ownership is bad. The original author (William Foster Lloyd, 1833) later remarked that he should have called his pamphlet "The Tragedy of the Unregulated Commons".

Solutions include government actions, such as privatisation, regulation, and internalising externalities ("Pigovian Taxes"). Non-government solutions involving individual and community self-restraint are also possible, such as social rules on exploiting common grazing land and fishing stocks. Informal rules can work well in stable communities where most individuals value long term outcomes, including their own children's future.

Externalities and Pigovian taxes

In economics, an externality is a cost or benefit which affects a third party to a transaction:

A Carbon tax is an example of a Pigovian tax - a tax on transactions which generates "negative externalities". These taxes pass the cost of the externality on to the parties to the original transaction. They were originally aimed at social issues, such the behavioural impact of alcohol, but are now applied increasingly to environmental issues.

These taxes also raise revenues which can be used for desirable goals, such as reducing taxes, increasing welfare, or facilitating transition to a sustainable economy.

Free Markets and Perfect Competition

The term "free market" is widely used, but in two very different ways:

This discussion is about the second - perfect competition. Of course, there is no perfect market in reality, but some fruit and vegetable markets may come close.

Some theoretical analysis shows that a perfectly competitive market can be the most efficient way of allocating resources. These markets have a number of requirements, including:

(More information - https://en.wikipedia.org/wiki/Perfect_competition )

So it could be argued that Pigovian taxes are necessary to achieve perfect competition, by eliminating or compensating for the effects of externalities.

Competition is never perfect, but it can be good enough to do the job. This requires suitable rules, including limitations on monopolies, and publishing accurate product specifications and prices. These don't involve direct state control over people and corporations. Instead, the state sets up a market framework that applies to all people and businesses, reducing the risk of cronyism and corruption.

This doesn't just need to benefit privately owned businesses: social enterprises should be able to engage in fair competition on equal terms.

Carbon Tax in practice

Carbon Tax Mechanics

The tax is based on the amount of carbon used to create a product, which depends on the quantity, type and source(s) of the product. This information has to be captured by the authority that levies and collects the tax at some point in the supply chain:

One of these approaches should be used consistently throughout a particular tax jurisdiction, to ensure the tax is levied once and only once on each taxable item.

There are several reasons to tax as far upstream as possible. Extracting fossil fuels is generally a closely monitored process run by a limited number of corporations, so it should be fairly easy to get data on the quantities and types of specific fuels. One shipment of crude oil could be split into many components in a refinery, or used in non-fuel ways, but that doesn't matter if the tax has already been paid.

Each fuel has a specific carbon content per unit mass, though exact amounts vary based on source. Once extracted from the ground, we can calculate how much carbon will eventually be released into the atmosphere without having to know exactly how it will be used - apart from a few exceptions such as Carbon Capture and Storage (CCS).

Capturing the tax revenue early also minimises the risk of failing to tax some fuels due to losses during refining and physical leakage, also tax evasion and bankruptcy.

Fossil fuels are not the only source of CO2, and there are other greenhouse gases:

However, 81% of UK territorial emissions are due to CO2 as of 2018 according to the latest figures from the BEIS, so taxing fossil fuel is the obvious place to start. Source figure 2 in

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/862887/2018_Final_greenhouse_gas_emissions_statistical_release.pdf

Impact on prices and incomes

In theory, a carbon tax can be passed forward, increasing prices paid by consumers, or passed backwards, reducing prices paid to producers, or a bit of both.

In practice, most of the tax will probably be paid by consumers through higher prices. However, where consumers won't pay higher prices, the tax could force price reductions on producers. This can affect payments to suppliers, profits received by corporations, and income paid to workers.

In either case, this will incentivise the people affected to reduce emissions in cost-effective ways, such as buying similar but cheaper products from low-carbon sources.

It is sometimes claimed that the effect will be regressive, but this isn't necessarily correct. In any case, many Carbon Tax supporters propose that the tax revenue is redistributed to people, particularly to those on low incomes.

Example of how this could influence prices - steelmaking

Consider two different approaches to making steel:

(For other options, see https://www.green-alliance.org.uk/resources/The_case_against_new_coal_mines_in_the_UK.pdf )

The first approach releases a lot of CO2 for both heating and chemical reduction. A carbon tax will add significantly to the price of domestic steel by increasing the price of the coal.

The second approach releases no CO2 directly, but some CO2 will have been released in generating the electricity. For a generic feed from the grid, this might contain a significant element of carbon tax, and the price of electricity would reflect this directly for electricity generated in the UK.

So this would incentivise recycling scrap, though by how much depends on how the electricity is generated. As the UK increases the proportion of power generated from no/low carbon sources, the price of electricity used to melt the scrap should decline as the tax declines. This might be further reduced by preferentially running the furnace on sunny days and windy nights, when emissions are much lower because the grid is mainly powered from renewables.

Imported steel would need a border carbon adjustment applied to compete on fair terms - more details below.

Issues and solutions

I identify four main risks in implementing a Carbon Tax:

Carbon Leakage

The analysis above explains how a carbon tax could work in a single country, but what happens when we introduce cross-border trade?

Carbon leakage occurs when actions taken to reduce emissions in one country lead to increases elsewhere. Causes include:

The amount of leakage is usually less than the emissions reduction in the country which levies the tax, so the overall impact is a smaller net global reduction. However, it is theoretically possible for carbon leakage to actually increase total global emissions in an extreme case.

A solution is border carbon adjustments - levying a tax on imported goods based on their "embedded emissions". These are the total life cycle emissions from manufacturing and distributing these goods, up to the point of import. This could include mining the raw materials, transport and leakages, in addition to direct emissions from the factory where the goods were made. A border tax could be applied to all goods, or just high energy ones (iron and steel, chemicals, paper, aluminium, cement and bulk glass).

This is particularly relevant to the UK, because we import large quantities of goods with a high level of embedded energy: our emissions based on consumption are substantially higher than territorial ones -

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/882939/Consumption_emissions_March_20_v9.pdf

There are other reasons to implement these border taxes:

Relevant issues to be addressed include:

Transaction costs and administration

Administering a carbon tax could be anywhere from simple to complex, depending on its scope.

A direct tax on fossil fuels (domestic production and imports) would require fairly simple reporting of fuel quantities by type and source. These are already monitored in some detail, so the additional effort should not be large.

Calculating embedded emissions on complex goods such as imported cars accurately would require data on all the components that went into building the cars. In practice we would need a simpler approach, such as estimating the emissions required to create the total quantities of metal, plastics and other materials in it, plus allowances for forming individual parts, assembly and transport.

Another source of data would be to look at domestic car and component manufacturers' emissions in detail - if there are any left by the time this tax is implemented!

Some data on greenhouse gas emissions is already collected internationally, to calculate territorial and consumption emissions. DEFRA publish general statistics on UK embedded emissions, based on data collected by the Norwegian University of Science and Technology (NTNU).

The imposition of excessive costs on trade can cause significant harm, by reducing the benefits of cross-border trade. These arise due to the law of comparative advantage, which explains how specialising in what they do best enables all countries engaging in genuinely free and fair trade to benefit overall. This is a non-zero-sum game, so one country's gain is not always another country's loss. Examples:

It is worth noting that there is a complex set of taxes and subsidies affecting UK energy prices now, including the EU ETS (Emissions Trading System), Carbon Price Support, Climate Change Levy, and Fuel Duty. A well-designed carbon tax combined with the removal of existing schemes which were no longer needed might reduce overall administrative costs for businesses.

Unintended consequences

Things don't always go according to plan. This is sometimes known as the law of unintended consequences, and is well known in social sciences and economics.

Here are two relevant examples, one bad (but fixable), the other good.

Biofuels sound like a good replacement for fossil fuels, because the plants should grow back, re-absorbing the carbon emitted when the fuel was burned. However, some of these fuels are, allegedly, not produced from sustainably managed crops and forests. If so, the carbon emitted might not be re-absorbed for decades, if ever.

Also, some of these biofuels attract substantial subsidies.

A carbon tax on fossil fuels alone might encourage unsustainable biofuels by giving them an unfair price advantage. We could avoid this with accurate reporting of biofuel sources and methods, taxing them on the percentage of carbon that was not re-absorbed reasonably quickly. This would discourage unsustainable practices. It might also encourage genuinely sustainable biofuels - if that is possible.

Potential solutions:

We could do both. A fair carbon tax on all fuels, including any emissions from biofuels, should reduce/eliminate the need to subsidise no/low emission fuels, as the tax will give them a competitive advantage.

Second, an example of a widely anticipated problem which can be avoided.

One of the obvious problems with new taxes is that there are losers. It is often claimed that carbon taxes will be regressive, tending to take from the poor and give to the rich. Actually it is not clear that this will happen overall, but some people on low and middle incomes who use a lot of fuel could lose out.

The proposal before the GLD therefore includes a "dividend" that should prevent or mitigate this problem - an equal per capita redistribution, which would mean that the people with modest life styles should more than recover any price increases arising from carbon tax. Without going into detailed life style choices, this system is likely to reward the poor, be neutral for those on middle incomes and penalise the rich.

Adverse publicity

Climate change deniers and delayers are looking for propaganda material, as are some organisations and nation states who stir up trouble for its own sake, such as using social media to incite people on both sides of racial arguments in the US.

If we give the bad guys free ammunition, it could hurt our country through damaging confrontations. The gilets jaunes are a clear example of what could happen. Also, the global impact could be negative, by discouraging other countries from implementing effective policies against climate change.

It is worth looking at other aspects of the tax carefully, both the implementation and how it is "sold" to people. We can't guarantee that everything will work perfectly, but careful planning and implementation can mitigate the risk of problems.

Case Study - British Columbia Carbon Tax

As of 2019 there were 56 carbon pricing schemes around the world, 28 carbon tax and 28 carbon trading. In summary:

For more details see https://www.carbonbrief.org/guest-post-what-the-uk-can-learn-from-carbon-pricing-schemes-around-the-world

One particular scheme has achieved considerable public acceptance by re-distributing tax revenues.

British Columbia implemented a Carbon Tax on fossil fuels in 2008, covering about three quarters of all greenhouse gas emissions in the province. It is charged at the point of sale to retail customers, e.g. at the petrol pump for vehicle fuels. It was originally set at 10 Canadian Dollars (about £6) per tonne (Carbon equivalent), rising to $30 in 2012 and $40 now.

Note that much of British Columbia's electricity comes from hydropower, and their electricity costs are relatively low.

In January 2013, the carbon tax was collecting about $1 billion each year, which was used to reduce other taxes. The tax shift has enabled BC to have one of Canada's lowest income tax rates, though revenues have increasingly been used to support particular industries.

The tax was originally unpopular, but is now widely supported. It has some exemptions, including exported fuels, agriculture and forestry. Greenhouses were exempted because the tax made their operations uncompetitive with the US and Mexico.

There is a survey of various studies on the effectiveness of the British Columbia carbon tax over the period 2008 to 2015 -

https://nicholasinstitute.duke.edu/sites/default/files/publications/ni_wp_15-04_full.pdf

Overall conclusions in the survey based on the amalgamation of multiple studies:

These studies do need to be interpreted with some care. For example, some evidence indicates a moderate drop in fossil fuel consumption compared to the rest of Canada, but there have been suggestions that some of this might be an artefact of cross-border shopping.

My conclusions based on this are:

The tax appears to work pretty much as one would expect by applying classical economic principles. That is comforting, though there is always a risk with finding what you expect to find.

The lack of studies on carbon leakage is a weakness. Some leakage would be expected from the policy, even just people driving across the border to fill up on petrol. If the tax caused large amounts of leakage, it could be significantly less effective.

However, this doesn't prove that the tax is a failure - in fact it appears to be reasonably successful.

Finally, several references to this tax mention BC's high use of hydropower. I am not aware of any specific evidence on this point, but it seems likely that this limits any adverse impact on the domestic economy, because the price of electricity is little affected by the tax. This is potentially relevant to the UK, which now relies heavily on fossil fuels, but is steadily increasing the use of non-dispatchable renewable energy.

My assessment and recommendations

First, here is my view of our objectives:

To achieve these, we need to avoid/minimise:

A well-designed and implemented carbon tax can help to achieve the above objectives while avoiding the risks, but a badly designed one could make things worse. To illustrate this, compare three "green" energy subsidies, one good and the others bad:

These are not free: the first two are funded by higher electricity prices, the last by general taxation. The growth in offshore wind power is almost certainly worth the cost, but the others are worth little - possibly less than nothing.

So we need to get the details right.

A carbon tax can't do everything. For example, perfect competition could in theory improve insulation in new homes, because it is clearly in the financial interests of home buyers over the life of the properties. However, so long as the market is dominated by a few large builders who are not required to provide accurate information on housing energy costs, nor to give the customers a clear choice, it is easier to tackle this problem through building regulations.

Also, energy markets are significantly distorted by existing taxes and subsidies. Replacing these with an efficient carbon tax should make these markets work better.

So my recommendations are:

The Carbon Tax should progressively replace existing carbon pricing schemes and start at a similar level for two reasons:

The tax can start at a moderate level and rise over time. If it sends a clear signal to the people who make long-term economic decisions and they expect the rate to rise, then they will adjust investment plans appropriately.

This tax will create some losers, but it needs to be the right losers. We should identify genuine impairment to ordinary people and legitimate commerce, and mitigate where appropriate. We don't need to compensate everybody - such as people forced to trade down from SUVs to normal sized cars.

Some sectors will need sensitive handling, both due to risk of immediate adverse impact when the change is implemented, and to avoid stirring up needless hostility.

We might choose to adjust the fuel duty so as to leave the price of petrol unchanged when the carbon tax is first introduced, and to leave the tax exemption on diesel for agriculture in place temporarily. Also some industries facing foreign competition may need temporary arrangements to compete on equal terms. However, these and other exemptions would need to be phased out over time.

Without a border adjustment, any carbon tax is likely to lead to significant carbon leakage and other problems. This needs to be done fairly, not as a protectionist measure, in order to provide a reasonable justification under WTO rules.

This will lead to threats from some countries, possibly a trade war. We should avoid needless conflict, but must combat global warming by the most effective means available. Countries and corporations who use the environment as a dumping ground to reduce their direct costs are getting a free ride at everybody else's expense, and a carbon tax without a border adjustment can give an advantage to the polluters where there is direct competition with domestic industries.

A full emissions tax plus border adjustments across the entire economy will be complex. This can be mitigated in two ways:

It would also be easier for a well-organised group of like-minded countries to benefit from cross-border trade which taxes emissions fairly, and to stand up to countries that object to this.





And finally

This article was written by Julian Hawkins. This version (1.1) is for publication by the GLD, dated 28 June 2020.

Thanks to Stewart Reddaway, Steve Bolter and Russell Ellis for their comments.

Some of this article is based on a rather useful report published by the Carbon Pricing Leadership Coalition -

https://www.carbonpricingleadership.org/highlevel-economic-commission-1/

This recommended a Carbon price of USD 50 to 100 per tonne by 2030, in a report published 29/05/17 -

https://static1.squarespace.com/static/54ff9c5ce4b0a53decccfb4c/t/59b7f2409f8dce5316811916/1505227332748/CarbonPricing_FullReport.pdf

Also, there are several points where I quote from UK government statistics. I plan to publish a separate guide to the information available, which is generally well-organised and useful.

Other references:



Julian Hawkins