The price of carbon

11 December 2012

Portrait of Tim Kruger

by Tim Kruger
Programme Manager

Tim leads a group across the university exploring proposed geoengineering techniques and the governance mechanisms required to ensure that any research in this field is undertaken in a responsible way. He has investigated in detail one potential geoe...

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Democrats and Republicans seem to be re-enacting the scene in “Rebel Without a Cause” in which the protagonists race their cars towards a cliff in a game of chicken. The fiscal cliff is speeding towards them and failure to reach a deal will send the US economy plummeting back into recession. But the lines drawn in the sand by the two sides do not seem to intersect. Is tragedy inevitable?

It is certainly probable. But perhaps there is a way for the US to cut its fiscal deficit in a way that is acceptable to both sides – putting a price on emissions of carbon dioxide. It is an idea that is gaining traction amongst think tank wonks in the US on both the left and the right. Bob Inglis, a former Republican representative from South Carolina and backer of such pricing, says “I think the impossible may be moving to the inevitable without ever passing through the probable.”

The concept is to charge a flat rate for CO2 emissions that would achieve two ends – impose on polluters a charge for the negative externalities that they are currently imposing on society and to raise revenue. Such Pigovian taxes (as they are known after their inventor, Arthur Pigou) are liked by conservatives who see them as a way to make markets more efficient by pricing in negative externalities, and by liberals who see them as an effective and moral way to raise revenue. Oh, and they would also help to reduce CO2 emissions – it’s not just a fiscal cliff we are heading towards.

They stand in counterpoint to the way that the EU has decided to limit CO2 emissions – a cap and trade scheme. Instead of a flat rate, in the EU system the price floats with the balance of supply and demand of credits. Unfortunately for the EU system, the supply of credits is a function of political will and a combination of oversupply, free credits for existing polluting industries (grandfathered rights) and the deindustrialisation of the east of the continent has led to a price for carbon that was at first highly volatile and has now pretty much collapsed.

In terms of what is produced within the EU, emissions have reduced, but in terms of what is consumed by the EU, emissions have actually increased – we have outsourced our pollution to other parts of the world which do not have any restrictions on emissions. This would have probably happened anyway as we de-industrialise and other countries develop, but the move has been accelerated by the difference in the price of carbon in the EU (something, if not very much) and China (nothing).

To avoid such ‘carbon leakage’ – where production flows to jurisdictions with a lower cost of carbon – it would be necessary to impose border adjustments that impose a levy on goods imported from countries that do not have a comparable charge for emissions. Whether such border adjustments are within WTO rules is a moot point, but many believe that it would be possible.

Consider the situation: the US decides to impose a price for emissions and simultaneously imposes border adjustments on goods imported from countries that do not have a similar charge on their domestic industries. This would raise revenue, reduce emissions of CO2 and it would not harm US-based industries that would otherwise find themselves at a price disadvantage.

How might other countries react? They might retaliate by raising tariff barriers of their own or they may decide to impose a similar carbon price on their own industry – in that way revenue would flow to their own exchequer rather than bolstering US customs revenue. If the US and EU acted together and set identical carbon prices then it would impel other nations to do the same. In short order one could see the establishment of a de facto global carbon price.

Pigou observed that it is in practice very difficult to accurately determine the cost of externalities. There are a wide range of estimates as to the damage done by emissions of greenhouse gases. There is both a huge degree of uncertainty as to the sensitivity of the climate system to any given level of emissions and disagreement as to how damage done to people in the future should be considered.

So at what level should the price be set? Pragmatists say that the price for emissions should be low to begin with and mandate a steady increase with time. This would allow businesses certainty in their investment decisions and time to adapt, while making it clear that the long-term future is a decarbonised one.

However, the experience with the tax revolt against the UK’s fuel-duty escalator would seem to indicate that Pielke’s Iron Law – that “when policies on emissions reductions collide with policies focused on economic growth, economic growth will win out every time” – seems to hold. As Pielke continues, “Climate policies should flow with the current of public opinion rather than against it, and efforts to sell the public on policies that will create short-term economic discomfort cannot succeed if that discomfort is perceived to be too great. Calls for asceticism and sacrifice are a nonstarter.”

The Iron Law may be corroded by time and rising understanding of the impacts of climate change, or be brittle to the impact of a series of startling events, but it would be foolish to expect its repeal any time soon. Being aware of the social acceptability of a measure that will impose a burden on the economy (even if it reduces the burden on society in general) is key to whether or not it can actually be implemented.

The pricing of carbon dioxide is often referred to as a ‘carbon tax’. This may be how it feels, but in reality it is not a tax – rather, it is a reduction in a subsidy. With carbon dioxide producers not paying the cost of the pollution that they are causing, they are in effect being subsidised by society – a transfer of wealth from society to polluters.

Whether framing a carbon price as a reduction in a subsidy, rather than as an imposition of a tax, is sufficient to win bipartisan support in the US seems optimistic. The fact that there is a mechanism that could rescue us all from plunging over cliffs - both fiscal and climatic - is no guarantee that there will be an outbreak of seasonal bonhomie in the Houses of Congress.

The grim reality is that they are so entangled in their own rhetoric that it is highly likely that they will be unable to make the conceptual leap to freedom in sufficient time.