Emission Trading and Carbon Tax

By: Bikal Dhungel 

This was also a part of an assignment I wrote but I put here as well because it is relevant for developing countries and international development. Climate change is no more an isolated science, it has been incorporated to development because of its huge impact on development. The essay will highlight two instruments used to mitigate Green House Gas emissions, one being Carbon Tax ( in this essay a possible Global Carbon Tax ) and Carbon Emission Trading and compares them. The EU's emission trading system is used. 

Introduction

Climate Change is a global phenomenon which has already been one of the most important issues in global political arena. It is a global issue because no single country can escape the consequences caused by global warming or avoid it. This can be in the form of rising sea levels, changing landscapes, risk of drought, fire and floods, stronger storms, emergence of more heat related illnesses, crop failures, deaths of many species, ozone layer depletion etc (NRDC,2008) which will place immense economic burden and to many developing countries it is going to be a matter of life and death. Hence, it has been generally agreed that countries in the whole world have ‘common but differentiated responsibilities’ to tackle this problem. However, the series of climate negotiations since the previous decades have shown that, this is everything but a simple negotiation between the nations. Developing Countries (DCs), Small Island Nations and Developed Countries differ with their views about the climate change itself, the ways to mitigate this and the extent of cost bearing. The milestone of reducing the global warming by limiting GHGs emissions was the Kyoto Protocol which set the target of internationally binding treaty by its parties. After second commitment, it was agreed to reduce at least 18% GHG emissions in the period between 2013-2020 compared to the level of 1990 (UNFCCC-2014) To reduce or limit the emissions, various policies were brought either in country level or globally. Two of the important instruments are ‘Carbon Trading Scheme’ and ‘(Global) Carbon Tax’. There is no simple answer which one is better. Both Carbon Trading Scheme and Carbon tax have advantages as well as drawbacks and as Global Carbon Tax has not been implemented yet, it is unsure either it will be a reality. The aim of this Essay is to compare both approaches within the context of North-South divide.

The Essay is structured as follows: Following the introduction, few important terms will be defined. Arguments about the advantages and drawbacks of both approaches will be dealt briefly followed by a closer look into some scholarly evidences. Finally, a conclusion will follow.

Definitions:

Carbon Emission Trading: Aimed at reducing emission, Carbon Emission Trading (hereafter only ETS) is the major element of Kyoto Protocol (Article 17) and allows countries to trade the spare emission certificates they have based on market mechanisms (UNFCCC-2014). The fixed emissions (also called ‘cap’) are divided into transferable unit (like 20,000 permits for 2 tons of carbon) which can be used as tradable commodity (Baumert,1998) .

The European Union Emission Trading Scheme (EU ETS) – is one of the many such regional schemes worldwide but a largest of its kind which was adopted in 2003 to start operating in three phases, Phase I, 2003-2005 (learning by doing phase), Phase II from 2008-2012 and Phase III after that, covering roughly half of whole EU CO₂ emissions with 17% energy related CO₂ emissions globally (Ellerman and Buchner 2007). The main objective of this scheme is to reduce CO₂ emissions and realise the goal targeted by Kyoto Protocol significantly in the most cost-effective way (EC,2005). All 28 member states plus Iceland, Norway and Liechtenstein are included in the scheme and during the first year 2005, 320 million allowances worth about 6.5 billion Euros were traded (World Bank,2012). About 5000 operators with combined 12,000 installations are the participants of this scheme in mainly four sectors, energy, production or processing of iron and steel, minerals like cement, gas etc pulp and paper (Weishaar-2007) and recently to aviation sector. Other ETS exist in Australia, New Zealand, South Korea is planning to implement it and China is initiating a test phase in seven cities (Goulder,Schein-2013)

Carbon Tax: is simply a form of carbon pricing referring to a tax for the level of carbon dioxide emission which can be expressed as 'Value per tonne' CO₂ equivalent (World Bank-2013). In other words, it is simply a tax for consuming a fuel that emits carbon dioxide. This is also a method that taxes the externality directly and makes sense both environmentally and economically (Baumert-1998).

A Global Carbon Tax (hereafter GCT): is simply a tax but with global implementation. It has not been born yet but is a matter of huge debate. Considering the global consequences of Climate Change with huge burden placed on developing countries and the importance of economic growth, North-South division about climate change exist. Developing Countries (DCs) do not prefer the emission reduction fearing economic growth which is vitally necessary to eradicate poverty. Public intellectuals like Bjorn Lomborg and others are calling poor countries 'too poor to be green' and environment is a problem of tomorrow whereas poverty is of today. Other scholars call for 'grow and clean up later' approach pointing to Environmental Kuznets Curve¹. As a result there is a huge 'North-South' division regarding CO₂ emission. Hence, it has been advocated that, only with a GCT with financial support from industrial countries, DCs will play their role to tackle climate change (Klein,Moehner-2007).

Additionally, which instrument to choose to tackle the problem is still unsettled. The viability of EU ETS is yet to be seen but if proven effective it can be an example to the rest of the world. However, if successfully implemented, tax is a ‘simple and flexible’ way to internalize the GHG² emission cost (Nordhaus-2007). Scholars opt for two models, 1) Where only industrialized countries pay the tax and 2) where the burden is shared globally. Model 1 might not be a feasible strategy as the industrialized countries might not want to participate in such schemes which will hamper the abatement strategies (Biccheti et al-2010). However, with model 2, developing countries might not participate. Still, an important advantage of uniform global tax is that it will avoid the relocation of firms that opt to move to a country with lower taxes (Cooper-2004). The advantages and disadvantages of GCT are incorporated in the arguments below. While arguing, it is also assumed that GCT is implemented globally.

The aim of both instruments, ETS and CT is to reduce the CO₂ emission (Goulder and Schein 2013). However, there is a huge debate between which method is the best in terms of cost efficiency, emission reduction etc. Especially in multi-national entities like the European Union, it was everything but easy to reach an agreement about which approach to embrace. There is huge difference between the member states how they want to tackle the issue without hampering their economic growth. During the nineties, the EU Commission itself campaigned for carbon energy tax but failed to introduce it and consequently, withdrew the proposal in 1997 (Convery-2009). When it comes to global decision making process, the issue becomes more complex. The following part will compare ETS and GCT approach.

1. Administrative Costs: it would be simple and straightforward to administer GCT since it could be incorporated to current fuel-supply monitoring methods that already exist (Aldy,Stavins,2011). However, this argument is based on the fact that, tax would be set upstream³. Stavins (2007) mentions that, upstream scheme include about 2000 energy supply companies which should be regulated whereas the downstream scheme would involve millions of regulation points because even the emissions of every households should be taken into account. Hence, GCT is only advantageous in comparison to ETS if it would be set upstream.

2. Emission Reduction: Under a ETS scheme, firms have an incentive to reduce the emission by switching to low emission technologies or at least investing in research and technology whereas in GCT, since there is only a rate of tax based on emission level, firms have less incentive to reduce emission. It does not guarantee a reduction and can cross the emission level beyond the limit set by environmental agreements (Goulder, Schein-2013). However, the evidence here is mixed. Despite the trading scheme, during the first phase of EU ETS, the emission level rose (Lang,2013) and then only decreased. The decrease can also be partly attributed to economic recession. On the other hand, Aldy and Stavins (2011) found that northern European countries were successful in reducing the greenhouse gas emission despite having a Carbon Tax scheme. Still, a longer time horizon is needed to check the viability of each scheme.

3. Price Volatility/Uncertainty: In contrast to GCT, price volatility can be a serious issue for ETS. GCT could be set at a fixed rate but ETS is a market based mechanism where the price will fluctuate according to demand and supply levels. A lower price per ton of CO₂ emission would de-incentivise the firms to invest in low emission technologies which can jeopardize the climate project. The allowance price in Phase II of EU ETS remained volatile. In early 2008, it was €20/tCO2 then increased to €22/tCO2 in the second half. Beginning of 2009, it fell to €13/tCO2 and fell further down to €10/tCO2 in mid-2011 (Laing et al,2013). Developing new technology require price stability and a long time. With lower cost per allowance, firms prefer to continue using carbon intense technology and can halt the development of green technologies. However, the fall of allowance prices can also be due to macroeconomic turbulences like economic recession which can cause a decline of production output. Any macroeconomic instability in the future is likely to cause the price to fall which will make the society worse off in terms of environmental goals. Hence, in ETS, price is uncertain and in GCT, emission level is uncertain.

Drawbacks of Global Carbon Taxes (GCT).

Aldy and Stavins (2011) suggest that all countries should impose and enforce a uniform domestic tax. However, confusion arises how it should be determined, based on per capita GDP or population or fossil fuel production. Distributional equity is another issue that is complex to solve.

As the tax rate might vary between countries, Aldy and Pizer (2009) mention that energy-intensive companies may relocate to a new place where the tax is lower. Moreover, big companies also tend to lobby to get exemption from the tax justifying with the competition they face in the market. Contrary argument to this is, though firms could relocate, greater amount of emission is caused by non-tradable sector, (transportation, households etc) (Stavin,Aldy-2011) so, solely from environmental point of view, it would have lower effect. Under ETS, this problem might not arise.

Drawbacks of Emission Trading Scheme (ETS)

Nordhaus (2007) highlights the issue of governance capabilities in developing countries where dictators or corrupt politicians/administrators could tangle the carbon market 'undermining the legimacy of the process'. Similarly, ETS can also lead to wealth transfers to OPEC countries as they can manipulate the allowance scheme by exploiting their advantage as oil monopolists by reducing the supply of oil, hence raising the oil price until the price of allowance are zero (Schein,Goulder 2013). In carbon tax scheme, such transfer will not occur as the emission prices are exogenously set.

Information asymmetry is possibly the most important disadvantage of ETS. As many external factors also play role, it is extremely complex to regulate the scheme. It is often the case that the regulators lack information about companies marginal abatement cost schedules in order to determine the set of emission quota that lead to the equality of marginal abatement cost to set their own marginal cost (Schein,Goulder-2013) (Aldy,Stavins-2011). Challenges of increasing surplus of allowance remain due to reasons like economic crisis or inefficient allocation from regulatory authorities which is likely to depress the goal of emission reduction (EC,2005) Some analyses also claim about the superiority of CT because of its ability to maintain fair distribution of burden between firms and consumers which preserves international competitiveness and avoid the problem of emission offsets (Goulder,Schein 2013). With ETS, difficulties with offsets is a major problem (Hansen,2009).

Evidences

As advantages and disadvantages exist in both schemes, in this section we will look at the evidences based on two main areas:

1. Was the EU successful in reducing emission? - Ellerman and Buchner (2008) estimated that in Phase I, 120-300 MtCO₂ abatement could be attributed to ETS. Delarue et al (2008) estimated an emission reduction of about 150MtCO₂ in power sector. However, Declercq et al (2010) estimated a 150 MtCO₂ reduction of emission as an impact of economic recession due to lower electricity demand and fuel prices but another study by Carbon Finance Institute (2009) highlights that 40% fall in 2008 emissions compared to the previous year can attributed to EU ETS.
2. Was there more investment in Innovation and Technology ? - A survey of 800 manufacturing companies in six nations by Martin et al (2011) studied either firms have embraced lower carbon alternatives and taken measures for clean innovation. They found that majority of the companies have undertaken GHG saving measures and there have been some impact on investment and innovation. Calel and Dechezlepretre (2012) found that EU ETS encouraged innovation and investment in clean technologies in firms that were regulated compared to those who were not.

Evidences of Global Carbon Tax

Global Carbon Tax does not exist yet, so we cannot look for evidences but regional or national schemes exist. Bruvol and Larsen found that in Norway, despite having a very high Carbon Tax rate, the taxes contributed only 2.3% of total emission reduction. Elgie (2014) found that, in British Columbia, Canada, fuel use dropped by 16% compared to Canada's Kyoto Target of 6% reduction in 20 years. The Carbon emission also decreased in Australia. In Sweden and Denmark, carbon tax led to the reduction of per capita emission by 9% and 15% respectively from 1990 to 2006 (Breslow et al-2014). There is a gap in literature about the investment in climate friendly technologies and the effects on products and pricing under CT.

Conclusion

This paper has compared Carbon Emission Trading and Global Carbon Tax as measures to mitigate CO₂ emission. Although Global Carbon Tax can be a successful tool to reduce CO₂ emission, challenges exist to bring it into life. The issue of cost-bearing, the extent of cost and how the revenues are to be used plays an important role to meet a consensus internationally. Even it becomes a reality despite the challenges, the success of this scheme is yet to be seen though it has generated positive results in regional and national level. Differences between the two schemes are generally on administrative costs, level of emission reduction, price volatility, complications in implementation, information asymmetry, wealth transfer, good governance etc.

As the current CO2 emission was basically caused by industrialized countries, DCs alone would not bear the cost. Neither they are likely to sacrifice economic growth for the sake of climate change. But still, developing countries face the consequences of climate change over-proportionally. So, the issue can only be dealt collectively. It is an obligation of industrialised countries to support DCs financially and by other means for example the Clean Development Mechanisms (CDMs) and the choice of an instrument (either ETS or GCT or both in tandem) should be chosen based on cost-efficiency and long term feasibility.