Carbon Pricing 101

The issue has been on the public agenda for several years but it still seems that the differences between a carbon tax and an emissions trading scheme (ETS) are not fully understood. With too many commentators focussing on the details and neglecting the basics, this is perhaps understandable. So follow me, gentle reader, through some introductory environmental economics as I explain how carbon taxes and ETSs work — and how they differ. (Shane Wright has recently written an excellent overview of other aspects of the issue.)

The primary goals of taxes are usually one or more of the following: to raise revenue; to encourage or discourage certain forms of behaviour; to redistribute income or wealth; or to simplify the tax system. The goal of a carbon tax (or ETS) is primarily to discourage behaviour that generates emissions of carbon dioxide (and other greenhouse gasses (GHGs)) into the atmosphere.

The emission of GHGs is, in economic parlance, an “externality”: it’s a cost or benefit resulting from an action that directly affects someone external to (that is, not involved in) the action. When my neighbour, a bakery, bakes a pie, I enjoy its fresh smell from my balcony; when my other neighbour, a restaurant, fries something, I suffer through the fumes. In neither case do my neighbours take my welfare into account when baking or frying things; my costs or benefits are external to their decisions. 

Put another way, when there are external costs (or benefits), the private costs or benefits of those involved in an action are different to the costs or benefits for society as a whole. When private costs equal social costs, what is best for the individual is also best for society. With externalities, that’s not the case. 

GHGs affect society through their contribution to climate change. The costs to society are different — most probably greater — than the costs to the individual causing the emissions: there is therefore an externality. The individual makes decisions that are best for him or her (burning lots of petrol, using lots of coal-fired electricity), but not best for society. 

We can correct this problem by making the private costs equal the social costs again. There are several methods of doing so, one of which is to increase the private costs by taxing the offending behaviour. This is the thinking behind a carbon tax. 

However, it can be difficult to know precisely what the difference between private and social costs is — set the tax too low, and behaviour doesn’t change enough; too high, and it changes too much. Where the desired level of behaviour is better known than the cost difference, it can be easier to create permits — representing the right to engage in the behaviour — and, just like a sharemarket, let people trade permits between each other to determine the price. This is the thinking behind an emissions (permit) trading scheme. 

The fundamental difference between a carbon tax and an ETS is therefore whether you restrict behaviour using prices or quantities, respectively. The same outcome can be achieved using either mechanism, but, depending on the circumstances, one instrument can have advantages over the other. 

In 1974, the well-respected environmental economist Martin Weitzman compared price and quantity instruments (taxes and permit trading) when the costs and benefits are uncertain, and came to the conclusion that price controls for pollution are better when the costs of pollution reduction increase relatively faster than the benefits (and vice versa). 

Whether the costs or benefits of reducing GHG emissions rise faster is, literally, an academic debate, but if the climate has “tipping points” (such massively increasing costs when a certain level of GHGs is reached), then — economically as well intuitively — it would be better to restrict emissions to a level so that this tipping point is not reached, and let the market determine what the appropriate price for that quantity of permits is. (Weitzman wrote a further excellent, if technical piece on the economic uncertainties of climate change in 2007.) 

There are other relative strengths and weaknesses (pdf) of taxes and trading schemes. Taxes can be simpler as well as easier to implement and administer than trading schemes; all companies have established structures for dealing with tax requirements, but few are used to trading permits. Tax levels are generally stable and predictable, while permit prices can be volatile (though well-designed trading schemes avoid this: after initial turbulences, prices in the EU ETS (pdf) have been stable over the past two years). Domestic emissions trading schemes can be linked with foreign schemes to provide international price and quantity harmonisation, which is not possible with a tax. An ETS would also be counter-cyclical, with prices falling in a downturn (as production and demand for permits falls), and rising in an upturn (as production and demand for permits rises); taxes remain constant throughout. 

It’s important to note that choosing either an ETS or tax does not affect decisions about coverage or compensation. Industries can be excluded from either; they can receive free permits, lower tax rates, or tax-free thresholds (like the thresholds in income tax). In both cases the costs will initially fall on businesses, who will choose to absorb them or to pass them on to consumers. Again these choices are independent of the scheme selected. And revenues can be used to compensate those consumers under either scheme — provided permits are sold and not all given away. 

These are all details the Multi-Party Climate Change Committee (MPCCC) has yet to finalise for its carbon pricing framework. Increasing the cost of GHG emissions then compensating consumers for those costs can still change behaviour, since the prices of polluting goods and services will rise relative to the cleaner alternatives and influence consumers’ decisions about which to purchase in favour of the relatively cheaper, cleaner options. 

Both schemes have problems. In each case, they can be solved. It is extremely unlikely that, whichever instrument is chosen, the initial design will be perfect; in the first phase of the EU ETS, the permit price dropped to almost zero, and the Rudd-era Carbon Polluting Reduction Scheme (CPRS) contained far too much compensation for industries. There is quite a bit of learning by doing. 

In that sense, the MPCCC’s hybrid scheme isn’t such a bad idea; after a few years under a simple scheme, during which companies and the Government figure out how this whole carbon pricing thing works with a fixed price (and realise it isn’t the end of the world), we can move to a more complicated, but hopefully more effective ETS.

This post was first published on New Matilda.