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Though many questions remain about the extent and pace of global
warming—its affects on sea level rise, polar ice melt, severe storms,
droughts, floods, diseases and economic losses—the important debate has
now shifted to economic policy. Specifically, putting a price on carbon
emissions, to signal world markets that the long free ride is really
over.
What is the most feasible, effective, fair and efficient
way to price carbon, in order to reduce greenhouse gas (GHG) emissions
before they reach levels where the damages go beyond the ability of
humans to adapt? Where the natural systems underlying the economy of
nations could collapse? Or where abrupt and catastrophic climate
changes occur?
Not easy questions, because both the point of no return
and how the costs of abatement change as the overall stocks of carbon
emissions in the atmosphere grow are imperfectly known. Also, the pace
of innovation to low-carbon technologies, which is of course the most
important factor in long-term carbon emissions reduction, depends upon
effective policy choices.
In short, this is not about whether to believe Al Gore or George W. Bush. It’s about good old risk management.
Broadly speaking, two economic policy tools are available to reduce GHG emissions: a carbon tax on greenhouse gas emissions and a carbon cap on emissions with allowances and trading, like the European Trading Scheme (ETS) launched under the Kyoto Treaty caps.
Private sector trading schemes are already at the heart of international carbon finance, according to British economist Sir Nicholas Stern (a third tool, regulation by central governments, has been rejected by most thinkers as too unwieldy and costly: a government agency sets carbon emissions reduction targets and makes every sector of the economy conform equally; consequently, everyone sues everyone else, and after approximately 100 years of litigation, the courts throw up their hands and it’s too late to prevent runaway climate change). The United States pioneered the cap-and-trade system in the 1980s to reduce sulphur emissions causing acid rain. But the Bush administration and the U.S. Congress reviled the cap-and-trade system called for under the Kyoto Treaty, arguing that unless developing economies like China and India were included, economic damage to the U.S. economy would outweigh assumed benefits to the environment. Developing countries argued, on the contrary, that the industrialized countries had done the vast majority of the global warming, so it was only fair they start the emissions cutting. Instead of using diplomacy to find a solution, the United States threw in its cards and walked away from Kyoto. The practical effect of this rejection was years of delay in addressing global warming. At the same time, American industries gained a competitive advantage over Europe and Japan by free riding through the first phase of carbon capping and trading.
Now, however, American public opinion is catching up with climate science, and there is growing political pressure for the U.S. to make a serious effort to curb carbon emissions. Choosing the right method of coping with GHG emissions will have vast consequences for the future, in its actual affect on carbon emissions levels, in the costs to the economy, in post-Kyoto diplomacy, and in directing capital toward a sustainable, low-carbon, global energy future.The choice is complicated by the risk management aspects of carbon emissions policies, which are like buying insurance: the benefits will be felt decades from now, while the costs (premiums) must begin to be paid as soon as possible.The following comparison of carbon tax/carbon trading was culled from the thinking of advocates on both sides to give TEI readers a reasonably objective understanding:
Policy Goal: To establish a price mechanism for industries to internalize the costs of greenhouse gas emissions in the least harmful and most economically efficient way, in order to stabilize the concentration of greenhouse gases in the atmosphere and thereby limit the risks of catastrophic damage to the Earth’s environment.
Cap and Trade
How it Works: First, a quantitative target for emissions reductions is set up and a timetable for achieving those reductions. That's why you hear that the Kyoto Treaty established a reduction to 1990 emissions levels by 2012. After emissions are capped, the system then allows countries and companies to buy and sell the rights, permits or allowances, usually measured in equivalent units of one metric ton of CO2, up to the target or cap.
Advantages: A cap and trade system directly limits the quantity of emissions, and reduces the uncertainty involved in setting emissions targets. If a cap and trade system is designed with broad participation across countries and economic sectors, it provides great flexibility for reducing emissions at the lowest cost, because it lets the market determine where emissions can be reduced most cheaply. The market aspect of carbon trading appeals to the modern globalization mentality that everything can be a commodity with a speculative price attached. You cannot discount the advantage that carbon trading has already won the backing of Wall Street, many big corporations and what might be called the Neo-Liberal wing of the environmental movement, which first came up with the idea in the 1980s.
Drawbacks: There are three main slams against cap and trade. One is that the availability of excess permits for trading weakens incentives to invest in alternative fuels and more efficient technologies. A second drawback is the price volatility associated with permits trading. Under a strict cap, the price of permits is driven to whatever level is necessary to bring emissions under that cap. An unexpected spurt of economic growth or a cold winter can produce spikes in permit prices, which increase the volatility of energy prices as they work through the economy and can affect consumption and business investment. In the same way, an economic slowdown, good weather or choosing a baseline year for the cap that distorts the price of emissions permits can all result in no real reduction of GHG emissions. Under the first cap and trade system implemented in the U.S. to reduce acid rain emissions, permit prices over time have moved up and down an average of 43 percent a year. Price volatility has been even more severe in Europe’s ETS under Kyoto, with permit prices shifting an average of 17.5 percent per month. Third, emissions trading in markets is far more vulnerable to evasion, corruption, manipulation and cheating, not to mention political and diplomatic compromise. Europe, for example, planned its allocations of permits in concert with industry behind closed doors. Germany exempted its coal industry, the country’s largest greenhouse gas producer, in part because Kyoto used 1990 as the baseline year, when German reunification closed down old-line, heavily polluting industries, creating an excess of permits.
Experience so far: The European Trading Scheme was established to meet Europe’s Carbon cap under Kyoto. ETS began in 2005 covering CO2 emissions from 11,400 major sources owned by 5,000 companies in electricity, steel, cement, glass, brickmaking and paper, which account for about half of EU carbon emissions. As of now, the ETS is expected to have virtually no affect on GHG emissions, because too many allowances were allocated by national governments and because Russia and Eastern Europe had excess permits to sell as a result of their industrial recession in 1990, the year Kyoto chose as the baseline.
The Regional Greenhouse Gas Initiative by nine Northeast American states, also provides carbon allowances to electric utilities by allocation (that is, for free) rather than by auction or sale. Critics of cap and trade say that handing out carbon permits for free only delays carbon pricing. As in all markets, no scarcity, no demand.
Affect on revenues/public finances: Carbon permit trading raises revenues only where corporations must purchase some or all permits from the government in an auction or by direct sale. Setting up a new administration and enforcement system under cap and trade would be costly.
Politics: Cap and trade has a long lead over Carbon taxing at the current time. Politicians instinctively avoid new taxes, and cap and trade has been effectively sold as a “market-based” approach. Corporations that want to manage risks associated with climate change find the creation of commodities as allowances conducive and convenient—not to mention a way to profit from a new derivative financial instrument with almost unlimited growth possibilities. Environmental advocates justify cap and trade by its political feasibility, as well as by its economic utility. All climate change bills currently introduced in the U.S. Congress take the cap and trade approach.
Something to keep in mind: One of the advantages of cap and trade, it is argued, is that it allows investment in low-carbon technologies to flow from developed countries to developing countries, where carbon emissions reductions are relatively cheaper. In order for this to happen, however, cap and trade systems and markets should specifically provide access to the purchase of emissions reductions permits in developing countries, including the five so-called Threshold Countries, China, India, Brazil, South Korea and South Africa. A national cap-and-trade system lacking such global clean development mechanisms would be very limited in its actual effects on global carbon emissions. China’s absolute rejection until now of trading carbon allowances is perhaps cap and trade’s biggest challenge.
Carbon Tax
How it Works: A uniform carbon tax would raise the cost and price of goods and services that result in GHG emissions by taxing the fossil fuels that produce emissions. By embedding the environmental costs in the market price of fuels, carbon taxing directly assesses the environmental costs of fossil fuels emissions. By making the carbon tax as broad-based as possible, marginal rates could be set low, and all people and economic activities would be affected equally. International agreement and collaboration could lead to a tax regime that takes into account each country’s existing energy taxes, subsidies and preferences to calculate a harmonized, net carbon tax.
Advantages: Industry gets a clear price signal and can integrate the certain costs of GHG abatement into financial planning. Countries and companies that can reduce their emissions for less than the cost of the tax would likely do so, so the carbon tax provides a constant incentive to reduce the cost of abatement. A well-designed carbon tax could thus provide an efficient way to drive investment into low carbon technologies as a tax-avoidance strategy and, in developing countries, for the government to invest carbon tax revenues in low-carbon infrastructure, education or business development. Perhaps the greatest advantage of carbon taxes is the so-called double dividend: while the taxes act to reduce carbon emissions over the long term, governments can use the revenues in the short term to reduce other unpopular taxes (for example, the payroll tax) or to finance popular social programs (for example, universal health care or Social Security). Finally, carbon taxes would significantly enhance public spending on research, development and demonstration of low-carbon energy technologies, spending which has fallen significantly in the last two decades and is now low relative to other industries.
Drawbacks: Most arguments against carbon taxes focus on how hard it would be to sell politically in the United States, and how difficult it would be to get the world community to harmonize their tax structures. Given the Boston Tea Party as one of America’s crystallizing cultural moments, you might need a Barack Obama on steroids to achieve a global Kyoto-like treaty based on carbon taxation. The main economic problem with carbon taxes is that you cannot predict how large a tax will achieve how much reduction in GHG emissions. Overshooting, as economists call this phenomenon, would incur higher costs and more economic harm for the same benefits. A carbon tax regime would require adjustment of the rates according to new scientific information about global climate change, though this should not be a deal breaker. A second drawback is that taxes collected and spent on a national basis, even if under a global harmonization agreement, would tend not to flow easily across nations and sectors, where carbon emissions reductions may be more economical.
Experience so far: Scandinavian nations Norway, Sweden, Finland and Denmark all put national carbon taxes in place in the 1990s. Norway’s tax was proposed to cover 90 percent of carbon-emitting activities, but full or partial exemptions were granted to a host of industries, including electric production (which was nearly all from hydroelectric sources), natural gas, domestic aviation, shipping, fisheries and pulp and paper. Despite exemptions, the tax reduced carbon emissions slightly more than 2 percent in the 1990s and substantial revenues were raised. Significantly, Norway’s Gross Domestic Product grew by more than 20 percent in the same period, demonstrating that emissions growth can be decoupled from economic growth. At the same time, Norway’s carbon tax helped provide incentives for technological innovation. For example, high emissions from a state-owned North Sea natural gas provider impelled investment in a commercial carbon capture system that has made an important contribution to the understanding of carbon sequestration. On the downside, the Scandinavian countries have been unable to harmonize their carbon tax regimes, showing the tough challenges of international agreement on carbon taxation. I mean, if Scandinavia can’t do it…
Affect on government revenues/public finance: Carbon taxes would raise substantial revenues with which governments could subsidize research, development and deployment of new technologies; offset other taxes; and pay for popular social programs and environmental cleanup. Every country has a tax authority in place and most governments already tax energy, so there would be low costs involved in administering and enforcing carbon taxes.
Politics: Taxes are taboo to politicians who lack the courage to look straight at climate change and decide that carbon taxes may provide the best option to reduce carbon emissions over the long term with the least harm to the economy.
Something to keep in mind: Although setting a carbon price through taxation appears at the moment a very high mount, don’t count carbon taxes out quite yet. For one thing, Al Gore has called for a tax on heavy GHG polluters. The review process of the early phase carbon trading under Kyoto could convince economists, policymakers and Greens of the necessity of carbon taxes either instead of, or in addition to, the European Trading Scheme. It is possible that carbon trading and carbon taxing could be combined in a hybrid system that allows the economic efficiency of the former and the certainty and stability of the latter.
Resources:
Shapiro, Robert: "Addressing the Risks of Climate Change: The Environmental Effectiveness and Economic Efficiency of Emissions Caps and Tradable Permits, Compared to Carbon Taxes." [link is directly to a PDF file of the article]
Chameides, William, and Oppenheimer, Michael, "Carbon Trading over Carbon Taxes," Science Magazine, March 23, 2007.
Bernd Hansjürgens, Introduction to Emissions Trading for Climate Policy US and European Perspectives, Cambridge University Press, 2007.
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