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Tax vs Regulation

November 17, 2020 10:09 PM
By Julian Hawkins

Green Emblem scales from wikimedia (https://commons.wikimedia.org/wiki/File:Green-emblem-scales.svg)Introduction

I recently spoke in favour of carbon taxes at two GLD events: a session at the GLD conference in the Summer, and a fringe meeting during the main party conference. Both times, the meeting agenda was somewhat changed at the last minute, taking the focus away from the advantages of Carbon tax and onto other people's concerns.

Despite that, I found both events quite positive. It is important to hear different views sometimes, to avoid the dangers of living in a "filter bubble". Both meetings made me think, and I have modified my views on carbon tax implementation (but not principle) following the second one.

Context

A lot of green campaigners and NGOs believe that we need carbon pricing (usually a carbon tax) to reduce emissions in time to avoid severe global warming. This view is particularly popular among economists.

Also, some GLD members feel that the national party should be moving more quickly on environmental issues.

The party's position

Liberal Democrat policy on reducing emissions is set out in Policy Paper 139 "Tackling the Climate Emergency" and the accompanying policy motion F29.

The policy paper is a good set of proposals for reducing emissions. In particular, sections 7 to 12 list practical policy actions across the main carbon-emitting sectors.

Paragraph 4.3.2 has been criticised by some green Lib Dems -

"Proposals are often made for an economy-wide carbon tax in the UK. The combination of the Carbon Price Floor, the Climate Change Levy and road fuel duty already raise the prices of the bulk of fossil fuel use; the proposals that we outline above would tilt the balance further towards renewables and electric vehicles. However, there remain parts of the economy where carbon emissions are not priced. Given the urgency of the climate crisis, the need for clear economic incentives for the transition to net zero to take place in a cost-effective and equitable way, and the need to raise government revenue for net-zero investments, we would review the potential for the more consistent application of carbon pricing in the UK. No major reform would take place, however, until our energy efficiency policies have been effective in addressing fuel poverty (see Chapter 7)."

Taken literally, this paragraph appears to put additional carbon pricing on hold for the foreseeable future, as fuel poverty (a serious problem for some people) doesn't look likely to disappear soon.

The GLD Conference and after

Some months back, a few GLD members (including me) came together to propose a pro Carbon Tax and Dividend motion to the 2020 Autumn Conference. I spoke in favour this at a session at the GLD Conference last summer.

The meeting was somewhat hijacked by a speaker from Extinction Rebellion, who proposed radical solutions to Climate Change. I don't entirely agree with his views, but he was speaking in good faith, and made me think about what policies would work.

In parallel, the GLD leadership pressed for a related motion covering a wider range of issues, including a carbon tax.

After both policy motions were rejected, the GLD leadership brought us together to propose some amendments to the motions that were proposed for conference - also rejected.

The Autumn Conference Carbon Pricing Fringe Meeting

The GLD organised a series of fringe events, including one to discuss two alternative forms of Carbon Pricing: Carbon Taxes and Emissions Trading Schemes (ETS). I gave a short speech to promote a carbon tax, dividend and border adjustment in preference to an ETS.

However, the meeting was actually dominated by comments from Duncan Brack (party activist and expert on environmental matters) and Hannah Dillon (Head of the Zero Carbon campaign). They expressed concerns about implementing a carbon tax throughout the entire economy, and Hannah introduced a report calling for a sector-based approach to a carbon tax.

Also interesting was the informal Zoom call afterwards, where ordinary GLD members expressed their views on a range of subjects:

What struck me

Why I am writing this paper

The fringe meeting and after call, particularly Duncan and Hannah's comments, made me re-evaluate my own views on carbon taxes. I am writing this paper to:

A summary of the arguments

The case for a carbon tax

A universal carbon tax can, in theory, motivate efficient and cost-effective reductions in emissions across the whole economy, by using the power of genuinely competitive (not laissez-faire) markets.

A dividend can return the revenue raised to the people, achieving political acceptability and ensuring the net effect is progressive. The British Columbia Carbon Tax shows that this can work.

A Border Carbon Adjustment which taxes imports based on the carbon emitted to manufacture them can ensure that emissions are reduced globally rather than just moving them around, and also encourages other countries to impose their own carbon taxes. If levied fairly, it could be compatible with World Trade Organisation (WTO) rules.

Carbon taxes are much simpler and more transparent than rules-based approaches, so less vulnerable to lobbying by special interest groups. They use the power of the market, so can be very efficient. They are also, potentially, universal - affecting all economic activity without needing to draw up detailed rules for every part of the economy.

Projections from an IPCC report and other independent evidence suggest that a Tax plus Dividend can achieve 70-90% of the emissions reductions required.

A carbon tax implements the polluter pays principle, giving it moral authority.

Carbon tax concerns

  1. Some people suggest that carbon taxes won't change behaviour quickly enough.

  2. Some people claim that carbon taxes will harm the poor, because people on low incomes spend a lot of their income on domestic heating.

  3. They are potentially very unpopular, such as the French Gilet Jaunes movement response to proposed increases in fuel prices.

  4. Some markets have limitations which will make it hard for them to be effective - see "Productive role for regulation" which mentions cases where the tax doesn't directly affect the problem, or where market barriers such as lack of information inhibit the effect of the tax.

  5. The case for a carbon tax depends in part on modelling its cost effectiveness. Can we rely on these models?

  6. There are a lot of existing carbon pricing mechanisms in the UK, including the EU's Emissions Trading System (ETS), Carbon Price Support, Climate Change Levy, Fuel Duty. There are also subsidies, such as tax breaks on North Sea oil and gas. This potentially complicates implementing carbon taxes, by requiring the old system to be dismantled in parallel, and complicates the analysis of consequences (including winners and losers).

There are full or partial answers to all points.

(1) A carbon tax should change price-sensitive purchasing decisions almost immediately. It should also start to influence long term investment decisions, as investors adjust their plans for the cost impact over project and asset lifetimes.

(2) A number of studies suggest that a tax and equal per head dividend should combine to benefit the poor overall. If these studies are accurate, then this objection is unfounded. And even if there are a few special cases, those people could be given additional financial and/or practical support.

(3) The British Columbia Carbon tax shows that these taxes can be reasonably popular.

Also, some of the people using arguments 2 and 3 may be climate change deniers, just looking for excuses to block or delay any action on emissions.

(4) Market limitations do not mean that carbon taxes will never work, just not always. Consider domestic heating. Home owners with reasonable incomes should be able to adjust to rising fuel bills with better heating and insulation, but poor tenants may have no good options for reducing their heating (though they would still receive the dividend).

I am, therefore, sceptical about claims that a carbon tax alone could produce most of the emission reductions that we need quickly, because too many markets are imperfect. However, it should do a substantial part of the work.

(5) Mainstream economics provides a good window on how economies work. Mainstream economic models give a useful indication of the likely consequences of particular policies and events. They can't give accurate predictions, just a rough idea.

Models can produce inaccurate results if the underlying assumptions are incorrect, which is likely if the modellers are trying to prove a point, rather than seeking accurate information.

Full disclosure - I am not a trained economist.

(6) Finally, dealing with the existing carbon pricing mechanisms don't mean that a carbon tax won't work, they just make it more complicated to implement.

So, none of these arguments suggest that a well-designed and implemented carbon tax won't reduce emissions, nor that it will necessarily cause other serious problems.

The case for regulation

Good regulations can sometimes get things done very quickly - where there is a really good plan with widespread support.

One good example is the phase-out of incandescent light bulbs. This has led to a significant reduction in global emissions. Impact in the UK appears to be roughly halving total energy used for lighting from 2008 to 2018 as shown in "Energy Consumption in the UK 2019" published by the Department for Business, Energy & Industrial Strategy. The statistics imply continuing reductions as existing incandescent bulbs burn out, and are replaced by low energy ones.

So, why could we not achieve a similar impact by increasing the price of electricity? After all, fluorescent and LED lamps are much cheaper over the lifetime of the bulb, and also reduce the effort involved in changing lightbulbs because they last so much longer. The main answer is that many people will just look at the immediate price of the lamp, unless (or even if) you publish lifetime costs for each alongside the lamps being sold. Also, some people are influenced by black propaganda on social media.

This isn't an argument against carbon taxes, but it shows that good regulations can sometimes work better in imperfect markets.

Problems with regulation

There are several potential problems with using regulations to force emission reductions:

  1. It can be relatively expensive to dictate personal and corporate behaviour, compared with motivating them to achieve reductions through the cheapest process.

  2. There is a risk of industrial and political lobbying leading to bad regulations which are ineffective and/or favour particular interests.

  3. There may be no obviously right solutions in a particular sector.

  4. We need to address the issue of imports with high levels of embedded carbon, without protectionist policies.

For example, "Diary of a Wimpy Carbon Tax" uses "MIT's Emissions Prediction and Policy Analysis (EPPA) Model to calculate the carbon tax required to replace the major federal climate change policies that existed as of 2016: Corporate Average Fuel Economy (CAFE) Standards on light-, medium-, and heavy-duty vehicles; the Clean Power Plan (CPP); and the Renewable Fuel Standard (RFS)." It finds that it is much cheaper to use carbon taxes to achieve equivalent emissions reductions.

To be fair, these are not good regulations. In particular, the Renewable Fuel Standard (RFS) which requires US petrol/diesel fuel to contain a minimum volume of renewable fuels is an appallingly bad regulation driven by political lobbying, due to the very low efficiency in converting solar energy into usable fuel, compared to directly powering electric vehicles.

Another interesting example is steelmaking, which produces a significant amount of the world's emissions. Various technical options for reducing emissions are being trialled by various companies, globally. But which?

Any attempt to tell steelmakers what process to implement faces the problem that nobody knows the best option right now. However, price pressure through a carbon tax could motivate companies to find out by experimenting, in both the UK and countries that export steel to us.

And that's important to point 4. If we tax or regulate our own industries while allowing unchecked imports from overseas polluting industries, we could damage our economy, help polluters, and move emissions to other countries instead of reducing them. But applying regulations to imports could easily break WTO rules, and be influenced by domestic politics. A well-designed border adjustment avoids these issues, and incentivises other countries to reduce their own emissions.

This is particularly important to the UK, due to the high level of embedded emissions in our imports: our consumption emissions (which include imports) are far higher than territorial emissions alone.

This means that there are serious limits to regulatory solutions in some markets.

So which is better?

Sometimes carbon taxes will work well, other times not so well. The same is true of regulation.

Carbon taxes can work well when:

Regulations can work well when:

The argument for market-based solutions is that pricing carbon will always make things better quickly and efficiently by solving a key market problem - externalities - and that regulations won't do this. In my view, the tax will work well when externalities are the main problem, but less well where there are multiple problems with a particular market.

There is a name for this - the theory of the second best. Essentially, where multiple market problems tend to cancel each other out, fixing one could lead to a worse situation overall.

I am also concerned about the possibility that some poor people might be worse off under a carbon tax and dividend. I suspect the studies showing that they will be generally better off are correct for most people, but there might be a few outliers. The party should review these studies while developing our policy.

And consider our opponents. Even if we have umpteen academic papers showing that poor people should generally benefit from this, there is an obvious propaganda line.

Another sensitive sector is agriculture. There are obvious issues with market-based solutions here: competition for land use with other environmental needs, unpredictability of harvests, and the need to eat. This has driven a high level of intervention in agricultural markets since the Second World War, even if not always well designed intervention.

This sector is also politically sensitive.

A way forwards

Policy Paper 139 and the Zero Carbon report

Paper 139's statement on carbon pricing (4.3.2) is a holding position, intended to avoid detrimental political effects and other adverse consequences. I now think that Duncan's explanation for this approach just before the last general election made sense - at the time.

This is my biggest issue with policy paper 139. It appears to say that we should not implement carbon tax anywhere until we have a solid policy on domestic heating. I disagree:

It doesn't have to be all or nothing. The Zero Carbon report proposes a range of solutions for different sectors, not necessarily all at once. I don't necessarily agree with every detail, but the overall message makes a lot of sense.

Listening to Duncan and Hannah did not make me think that a carbon tax is wrong, just that we need to be careful how we do it.

The Big Bang approach

The ultimate aim should be a universal carbon tax plus border adjustment, combined with finding a positive way to use the funds generated (maybe but not necessarily a dividend). However, we shouldn't try to do it all at once.

A carbon tax may be relatively simple, but implementing one across the whole economy in one go must be very complicated, because of the wide range of impacts on businesses and people, and the need to unwind a lot of existing carbon pricing schemes - unless we accept double taxation, which would distort markets further.

Dropping existing taxes is fairly easy, apart from loss of revenue. Without trying to perform a detailed analysis on ETS, Carbon Price Support, etc., it seems likely that:

A fair border adjustment would also be difficult to implement across all sectors at once, due to the need to provide reasonable computations of embedded carbon in the huge range of products imported, especially given that the importers will be motivated to pay as little as possible.

My experience from decades working in the Financial IT sector is that large, complicated plans tend to go wrong. The industry is now changing over to a different approach ("Agile") involving small teams making lots of small changes quickly. This can work very well, and I think it is the right approach in many situations, not just for IT projects.

If we were starting from scratch, I would prefer to go straight for a low carbon tax at source, rising gradually over time. But we aren't. In the real world, this is a large and complex project, and splitting it into many smaller changes is a good way to reduce risk.

So, I now prefer a sector-based transition which converges on a universal carbon tax, rather than implementing the tax in one go.

Prioritised implementation by sector

There are good reasons to believe that a carbon tax will sometimes work very well, but not always. Let's pick the easy wins, prioritising sectors where:

For example, the iron and steel sector should be relatively easy to tax:

Domestic heating policy could combine progressively taxing domestic fuels with obviously popular policies for improving home heating and insulation, also aimed at helping tenants, and those leaseholders who are heavily constrained by their contracts. Most people who are concerned about climate change are also concerned about the poor and powerless, and would understand and support policies which tackle both climate change and fuel poverty.

Agriculture is another sector with multiple objectives, where we should combine reducing emissions with increasing food security, protecting the natural environment, and ensuring that responsible farmers can earn a reasonable living. Any solution should include a carbon tax along with other appropriate measures.

Principles, not ad hoc

A series of ad hoc solutions risks lobbying and political interference: one of the reasons for preferring a carbon tax over regulation or an ETS. Instead, we should identify key principles and use them intelligently, including:

Cooperation and other options

Regulations and carbon pricing aren't our only weapons. We can also facilitate cooperation between reasonable people working on reducing emissions, encourage good behaviour, and use non-financial rewards.

We do need to build support on the centre left - this policy isn't going anywhere unless we can work with other political parties.

And we shouldn't focus exclusively on reducing emissions. We live in an increasingly dangerous world. We should increase our resilience against natural disasters by generating all our power renewably. And let's not forget pressure from other countries, likely to become an increasing issue when authoritarian rulers have to deal with the consequences of global warming.

Finally, we can fix a range of other problems using similar principles. For example, using Pigovian taxes to reduce waste, road charging, etc.

End notes

This article was written by Julian Hawkins. This version (1.0) is for publication by the GLD, dated 7 November, 2020. Some of this material is recycled from other things I have written.

Thanks to Stewart Reddaway and James Collis for their comments on earlier versions.

There are a number of campaign groups which advocate a carbon tax. For example -

https://citizensclimatelobby.org/ (based in the US but operates globally) and related -

https://citizensclimateinitiative.eu/

And another good source of information is https://www.carbonbrief.org/guest-post-what-the-uk-can-learn-from-carbon-pricing-schemes-around-the-world

Green Emblem scales from wikimedia (https://commons.wikimedia.org/wiki/File:Green-emblem-scales.svg)