Carbon Taxes to Replace Carbon Trading?

At the UN Climate Change Summit (COP 15) in Copenhagen, a leading climate scientist from NASA, Dr James Hansen, has claimed that “cap-and-trade schemes are a terrible idea”. He went on to say  that “…a carbon tax, which is simple and honest, is a much easier task...all you have to do is get the major players to agree to put a carbon price on.”

Therein lies the rub. Hansen is a scientist and not an economist.

Three good economic reasons exist for not favouring a carbon tax over a cap-and-trade solution:

A “one size fits all” tax would require an impossible calculation of the average cost of reducing emissions over a given period of time.  Compare this to an emission trading system that works on the free floating marginal cost of emission abatement;

Taxes are levied locally and so are impossible to properly administer on a global scale. A global carbon market price is perfectly pervasive;

Tax cannot guarantee a reduction in greenhouse gas emissions: emitters could opt to pay the tax and continue emitting at will. Conversely, a cap-and-trade solution introduces an absolute carbon ceiling and the price acts as no more than a useful barometer of how close we are to achieving that goal: prices will tend to zero as the requisite level of emission reductions are achieved.

The latter point dispels the political myth that “we need to establish a carbon price”.

Why does it matter if we achieve the necessary quantity of emission abatement at $2USD per ton of CO2 or at $50USD per ton of CO2?

In fact, our objective ought to be to achieve the environmental goal at the lowest unit cost. This goal can only be accomplished through the flexibility of emission trading.

Politicians should not be focussing any attention on carbon pricing. All focus at the summit should be on setting a satisfactory carbon cap: the price will determine itself.

Analysis of Carbon Taxation

Under a system of carbon taxation, a company possessing no economically viable emission abatement opportunity would be burdened with a penalty tax for emitting too much. The imposition of such an inequitable financial penalty, on a company with no alternative course of action available to it, would bring about absolutely no natural benefit to the environment. The sole beneficiaries of a carbon tax would be the Government Treasury Departments.

Meanwhile, a company with access to low cost emission abatement opportunities would receive absolutely no encouragement under a carbon taxation system to achieve any more than that which was legally required of it. Moreover, it may not be financially viable for a company to invest in large scale emission abatement opportunities without the ability to share the cost of such an investment with other companies. As such, many of the biggest and lowest cost emission reduction opportunities may be passed by.

Finally, under carbon taxation system a company is deprived of the ability to properly hedge long term investments in emission abatement projects. Revenue intensive projects require investment to be amortised over several years and without a market in which to hedge such investments the risk of undertaking the investment would be considered too high resulting in yet more high-quality emission reduction opportunities being ignored.

The net result of the imposition of a carbon tax is the achievement of sub-optimal emission reductions at a higher marginal unit cost to the economy as a whole.

Analysis of Carbon Trading

By contrast, a cap-and-trade system encourages any company with a low cost emission abatement opportunity to exploit that opportunity to the full. Such a company will take comfort in the knowledge that, through the open market, it is able to sell any over-achievement to a company with no economically viable means of reducing its own emissions.

A priori, all manner of emission abatement opportunity will be exploited to the maximum, no matter how large or small. Additionally, it is perfectly possible to properly assess the viability of an investment over the many years of life of a carbon abatement project and to hedge that risk through the sale of carbon allowances in the futures market.

The net result is optimal emission abatement at the lowest unit cost to industry: entirely in keeping with the principles of the Kyoto Protocol.

Hypothecation of taxes

Carbon taxation would result in leakage of money away from the environmental cause of tackling climate change. By taxing emitters, money would flow away from industry and into the Government’s coffers. Once appropriated by the national Treasury, these funds will be applied to budgets for defence, healthcare, education, infrastructure, welfare and perhaps a very small proportion will find its way back to the environmental objective. Moreover, funds that are hypothecated for environmental purposes may then be misapplied by politicians in such a way that no immediate environmental benefit is gained: perhaps investments will be made into research around Carbon Capture and Storage technology which is not currently a cost effective solution and, while it may or may not provide a solution in the future, it does nothing to curb greenhouse gas emissions today.

By contrast, the cap-and-trade solution encourages money to flow from those with poor opportunities to reduce their emissions to those with the ability to make a difference to the environment. Carbon trading provides a company with the absolute flexibility of reducing its own emissions or else paying another company to make an emission reduction on its behalf.

The carbon market is the conduit through which money being invested will find its way to the best (lowest cost) emission abatement technologies and therefore provide the most efficient mechanism for tackling the climate change problem. Cap-and-trade is a zero sum game in economic terms as the money that flows through the system remains within industry and is entirely applied to the environmental cause.

Pricing a tax

The final arrow through the heart of the archaic argument in favour of carbon taxation is the question of what level at which to impose carbon tax to bring about the desired emission reductions. If the taxation level were set too low then companies would simply view the tax as a means of buying itself out of its obligation to curb its emissions, to the detriment of the environment. If the level were set too high then it would bring unnecessary strain on the economy. The perfect level for a tax would be the level of the marginal cost of emission abatement for the desired quantity of emission reductions. However, this is a moving target dependent on multiple variables including industrial output, relative fuel prices and the weather.

It is this issue above all else that distinguishes carbon trading as the best available mechanism for tackling climate change. The open market creates a floating price for the emission of one metric tonne of carbon dioxide equivalent determined by the forces of supply and demand. Over the course of the past eighteen months, this free floating pricing mechanism has seen EU Carbon Allowances trading in a very wide range from €8 to €30. At each moment in time the market price represents the marginal cost of the requisite level of emission abatement necessary to achieve the emission caps prescribed by governments. With such wild fluctuations in the marginal cost of emission abatement the task of setting a “one price fits all” carbon tax is quite impossible.

Conclusion

The carbon tax argument is as out of date and extinct as the dinosaurs. Let it rest in peace. Long live carbon trading.