GW: carbon tax v trading
If something needs to be done about greenhouse gases in Australia*, then the best approach is a carbon tax with revenue used to remove or decrease other taxes.
The goal of climate change policy should not be to reduce energy use, but to switch energy production from carbon-intensive energy (primarily dirty coal) to alternative energy sources (clean coal, nuclear, solar, wind etc). This could be achieved by “picking winners” (ie subsidising specific energy alternatives) and the government has already spent over $2 billion researching energy from pig waste, using biomass waste from sugar mills, cloud seeding for more hydropower, improved solar energy, exploring clean coal and many other alternatives. This is the exact wrong way to go about public policy at it required politicians and bureaucrats to make decisions about the future of the energy industry.
A better approach is to put a price on carbon, which makes alternative energies relatively more competitive and allows the market process to discover the best new energy sources. This can be achieved either through a carbon tax or a carbon trading system.
A carbon tax fixes the price of carbon and allows the quantity emmitted to fluctuate according to demand. A carbon trading system fixes the quantity of carbon emmitted and allows the price to fluctuate. Both approaches will have a negative effect on producers of fosil fuels (less demand) and energy consumers (higher prices) so these issues do not help to distinguish between the two approaches.
Some economists (Warwick McKibbon, John Quiggin, Joshua Gans) have argued that carbon trading is better than a carbon tax. The supposed benefits of trading include the fixed level of carbon emmissions (therefore fixed environmental impact), the subsidy to some energy businesses and the difficulty in removing a carbon trading system because of intrenched special interest groups.
However, all of these issues could be seen as arguments against a carbon trading system. Fixed carbon emmissions (as with any fixed quota) is less efficient than a tax because a quota does not allow production decisions to adjust to changing circumstances and a fluctuating carbon price creates uncertainty. As Prof Warwick McKibbon (an advocate for carbon trading) admits, “from an economic perspective, a carbon tax would be an ideal instrument for addressing climate change. It would be efficient given the uncertinties surrounding climate change, and it would definitely work”. Despite Howard’s strange comments that a carbon tax is crude, inefficient and pays no regard to maket forces, it is actually more flexible, efficient and responsive to the market than a carbon trading system.
With a carbon tax, money flows from polluters to the government. In a carbon trading system money flows from polluters to organisations with carbon credits. The allocation of carbon credits amounts to a subsidy and while this will be popular among the recipients of the subsidy it is likely to promote further inefficiencies by picking winners and creating perverse incentives (ie the incentive to pollute heavily in the base year to get more credits the next year).
Prof Warwick McKibbon prefers a carbon trading system because it will create a special interest group (carbon credit holders) who will lobby to make sure the system is maintained. His analysis is probably correct, especially if we consider the contemporary example of taxi licences and the successful lobbying of the taxi industry. However, there is no reason to think that a carbon tax would be repealed without a good reason and the continued existence of the fuel tax shows that the government is not generally inclined to abolish unpopular environmental taxes. Further, it is possible in the future that we would legitimately want to abolish the carbon price and so the certainty of the carbon trading system is potentially a cost.
Perhaps the strongest argument for a carbon tax over a carbon trading system is that the revenue raised from a carbon tax can be used to reduce or remove other taxes and therefore offset the economic cost of the carbon tax. With a modest carbon tax and appropriate offsets it is possible that a carbon tax might have no net negative economic effect… while this is impossible under a carbon trading system.
Other problems with the carbon trading system include significant administrative and compliance costs. These include search costs, negotiating costs, approval costs and insurance costs. There is also the possibility of State governments charging stamp duty on carbon credit trading, further reducing the efficiency of the trading system. And resources used in carbon trading are a net waste to the economy. The need to consistently re-assess the number of carbon credits means the trading system is more susceptable to rent-seeking and a trading system would require a larger bureaucracy, while a tax bureaucracy already exists.
Some of these costs of trading have become apparent in the EU carbon trading system, where the carbon price has fluctuated from $30/tonne down to $1/tonne co2 and the initial allocation of credits have lead to perverse incentives, picking winners and a highly political approach.
A carbon tax is not a good thing. It will have a negative impact on the Australian fossil fuel industry and on energy consumers. However these same costs also apply to carbon trading. The advantage of a carbon tax is that the revenue can be used to reduce/remove other taxes, it is more efficient, it will be easier to remove if/when the need arises, it provides more certainty about prices, it avoids picking winners, and it will have lower administration and compliance costs. If something must be done about climate change in Australia — let it be a small revenue neutral carbon tax.
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* To determine whether the government should act it is necessary to show that the benefit of action exceeds the cost. This post does not attempt to address the issue of whether the government should act, but starts with the assumption that the government will do something.
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Get ready for the flamewar… Yeah, I know you had a disclaimer, but that isn’t going to change anything.
I think you need to add another dimension to your analysis. Specifically you need to compare a purely domestic intitiative with a more international intitiative. eg:-
1. Domestic carbon tax.
2. Domestic carbon trading scheme.
3. International carbon trading scheme.
4. International carbon tax.
5. Some hybrid of the above.
In theory at least it may very well make sense to import credits from abroad and to have the cost of adjustment incurred elsewhere if it is lower there. This would suggest that an international scheme is going to have more merit than a purely domestic scheme.
Given that a carbon tax will favour production that is done off shore in carbon tax free regions I’m not sure that a purely domestic initiative is going to effectively achieve the supposed aim of reducing CO2. Not that I’m overly convinced by any of the alternate policy schemes on the table either.
“If something needs to be done about greenhouse gases in Australia…”
Right. Well stop right there.
Clearly nothing needs to be done. CO2 is a positive externality and the matter should end there. You should not be promoting this.
But see how you go onto talk nonsense about coal being DIRTY.
Coal-energy-production is not DIRTY.
What did you mean by coal being dirty?
We weren’t asking you to smear it all over yourself?
What a bizzare thing to say that coal is dirty?
Why did you say it?
“1. Domestic carbon tax.
2. Domestic carbon trading scheme.
3. International carbon trading scheme.
4. International carbon tax.
5. Some hybrid of the above.”
You forgot the only sensible option.. Hows that for a biased debate.
The only sensible option is not trying to reduce carbon use at all. Since CO2 is good.
This is looking like mass-crazed-behaviour here.
There does need to be debate and research on the tax/trade options, which we haven’t had yet. Terje’s comments are relevant. Three points: contra the main post, there is no particular virtue in energy use from whatever source-in general it is an intermediate good, the less used the better: one of the unsung advantages of energy efficiency and hence of higher prices, which encourage innovation. Second, although the focus at present is on the climate change related externality viz CO2, a tax system would allow the inclusion of other environmental externalities, eg, just one of the Hunter power stations uses about half as much water as Newcastle, and in addition there is much excess heat discharged into the local ecosystem. Third, we have a reasonable idea of how a tax system would work, but we still don’t have a feasible blueprint for trading.
The other externality is the radioactive fallout from coal fired power stations which is not insignificant. Ideally the cost of water used would be factored in separately via a water market. I recently commented on this blog that outside Brisbane (which is running short of drinking water) there are two coal fired power stations consuming large quantities of water from the city supply at zero charge. In a conversation outside this blog somebody indicated to me that the reason for this is that the power stations paid for the capital cost of the supply. I have not confirmed this but given that the power companies are government owned and given the nature of the water market there may still be some perverse incentives involved.
John is quite right in framing this issue in terms of an assumption that the government is going to do something. If doing nothing was a political possibility it may still be the better choise.
Given the high price differences between traditional energy supplies and the alternatives any meaningful tax needs to be quite high. The benefit of schemes such as MRET is that it provides a market for alternatives such that competitive technology development can occur without raising the cost of all energy. If the goal is to foster the development of alternatives in a competitive framework whilst still mostly using the cheapest source of energy (coal) I think MRET is better than a carbon tax. At least in terms of market segments such as electricity production.
A lot of this hinges on future intent. If you think that alternatives will compete head to head with coal in the long term then an MRET gives them a short term price advantage to foster commercialisation without raising the cost of all electricity. However if you think alternatives will never compete head to head and that we will ultimately criminalise most carbon emissions then a tax might offer a neat transition. I’m a techno optimist so I currently prefer MRET in many ways.
For example assume that:-
1. Traditional energy costs $1.00 per unit.
2. Alternate energy costs $1.50 per unit.
A tax would need to be set at 50% to encourage the commercialisation and development of alternatives. Anything below 50% and we get no change in production method. However an MRET of 10% (ie a tenth of all energy must be renewable) would raise the average price to $1.05 but still provide lots of commercial opportunity for alternatives. If it is assumed that the higher cost of alternatives will come down over time then it makes sense to avoid over pricing energy in the interum. However if it is assumed that renewables will never compete and we must have 100% renewables in the long term then maybe a tax is better.
The cost of non-dirty technology is coming down and will eventually be competitive. By introducing a tax we are simply bringing forward the time of the transition.
For example, McLennan Magasanik Associates (MMA) showed that we are likely to see 7000 MW of new gas-fired energy by 2030 under “do nothing” and an extra 8000 MW of gas and 2400 of renewable if there was a $30/t co2-e tax.
Internationally coordinated options are unlikely in the near future. We are more likely to be dealing with domestic policies, and perhaps later an international agreeement that helps co-ordinate the various domestic policies.
xenophon — I didn’t mean to imply that energy use was good for it’s own sake. It is obviously only good for the benefit that it brings the energy user. But it most certainly does bring a benefit to the user (otherwise they wouldn’t use it) and it should not be our goal to reduce this benefit. Also, using water is not pollution.
MRET also brings forward the time of the conversion but with a lower energy cost in the interum. See example above.
Where a tax does have a significant advantage over something like MRET is in shifting production from the likes of coal to the likes of natural gas. ie from high emitter to low emitter rather than from high emitters to zero emitters.
“The cost of non-dirty technology is coming down and will eventually be competitive. By introducing a tax we are simply bringing forward the time of the transition.”
What is meant by dirty technology Humphreys?
New Zealand ratified the Kyoto Protocol and has carbon trading. It has perverse incentives and is highly political. Even the farmers consider it is a crock.
I think Australia should wait until Russia, India and China implement their schemes and try to ensure our approach is compatible. We represent a tiny fraction of the world’s CO2 production.
[...] Humphreys tries to get libertarians involved constructively in the AGW debate with a thoughtful post on the respective costs and benefits of carbon taxes versus carbon trading as policy instruments. [...]
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David – I think we should wait also but as John has outlined this discussion is based on the assumption that the domestic political agenda won’t wait.
John – I think that a tax works if alternatives exist across a near continuous price spectrum. My initial assertions about an MRET included a presumtion towards zero emission technologies which currently include a significant cost premium. However if we include the low emission options like gas and oil (any fuel with more hydrogen bonds basically) then I think the price spectrum is more complete. As such I think you are probably correct to assert that a simple flat carbon tax is more optimal.
A domestic tax could still be compatible with Kyoto or whatever replaces Kyoto (assuming we sign). If the tax cuts domestic emissions more than our Kyoto commitment then the bank could sell our credits on the international market.
I meant “government” not “bank”
Actually, I’ll go for the opposite view here — that Australia should change as soon as practicle. One reason for this is just self greed — getting the edge on these sorts of technologies (which will hopefully have a greater chance of happening due to such laws) is going to be worth a lot of bucks. In addition, perhaps I’m wrong here, but waiting a few years to start changing is going to make very little difference given that a fair chunk of the costs are in the transferring, which is going to happen anyway.
Second, rich countries not doing anything simply gives relatively poor countries like China and India a good excuse for doing nothing. In addition, the argument that Australia is only a small overall producer of CO2 is a exceptionally poor arguement, and the only people convinced by it are people in small countries. I’m sure the average Chinese citizen thinks they have exactly as much right to produce exactly as much pollution as people in rich countries, no matter how sparse the population, and they are the ones that need convincing.
One way to manage the move is by starting with a super-low tax and slowly ramp it up over time. This also gives the advantage of allowing us to consistently re-assess the situation and potentially stop ramping-up the tax if appropriate.
For example, if we go for a $20/tonne co2-e tax we could introduce it in four lots of $5/tonne co2-e increments introduced a few years apart. This shows we are taking action, but taking a “slowly slowly” approach to allow better future information to inform our final structure. This also gives people more time to adjust and removes any sudden changes in electricity prices or coal industry profits.
Yes. Why not cut off your legs so you can get a head start in the prosthesis market.
Ahh. Like boiling frogs hey.
Graeme: “What is meant by dirty technology Humphreys?”
I’m referring to carbon-intensive energy production, primarily coal. There is a convention to refer to carbon-intensive coal as “dirty coal” to distinguish it from the idea of “clean coal” energy.
The term “dirty coal” previously applied to brown coal which has a lot more sulphur and impurity than black coal. Black coal was considered clean because it was almost pure carbon. Ironic isn’t it. Some might regard this rather recent “convention” as being a form of green propaganda. CO2 is the stuff of life and in pure form it is no more dirty than a bucket load of rain. When you next look apon a tree take a moment to reflect on the fact that more than 98% of it’s mass is composed of CO2 and water delivered from the atmosphere. A tiny seed takes in these atmosheric nutrients and quite literally sucks itself into existance. Nobody thinks trees are dirty.
Actually Terje, talking about “dirty coal” is a logical consequence of talking about “clean coal”, which is a semantic trick introduced by the coal industries to show that coal is part of future energy even in an anti-co2 world.
The greenies tend to oppose the dichotomy, insisting that there is no such thing as “clean coal”.
Nasty tricky buggers.
Well why adopt such ridiculous propaganda-driven technology?
I mean I’m not taken in by it.
But you may well be and would be advised to go for precision.
So lets not hear any more unscientific bullshit about dirty coal. Coal is a clean technology and furthermore its the GREENEST.
Since no other energy-source so powerfully stimulates the natural world.
Terminology. Why adopt such propaganda-driven TERMINOLOGY?
Clearly industrial-CO2 is a positive externality and you ought to admit such things when there is just no denying it.
In an interview with Bill Moyers, Ron Paul mentioned (I imagine from a fairly hardcore libertarian perspective) cutting subsidies to oil companies
I think that any serious policy approach to controlling carbon emissions has to look first at elliminating the government subsidies and grants to the fossil fuel sector as well as any special tax consessions that the sector receives.
A tax on coal could be as simple as increasing the royalties that the government demands. This would of course effect exports of coal as well as coal consumed domestically.
I’ve been revisting this topic. Just thought I’d throw about some figures. This is based in part on Johns CIS paper: http://www.cis.org.au/policy_monographs/pm80.pdf
From Johns paper a general carbon tax of $30 per tonne of CO2 applied to Coal and the like from the electricity sector as well as to petrol and the like from the transport sector would raise enough revenue to allow us to abolish the existing fuel tax. According to his paper the net effect would be to reduce petrol prices by around 30 cents per litre.
By my calculation given emissions of around 600 kg of CO2 for each 1.0 MWhr of coal based electricity a $30 per tonne carbon tax would increase the wholesale cost of electricity by about $18 per MWhr (1.8 cents per kWhr). Given that electricity currently retails for about 10 cents per kWhr this is a significant but tolerable increase for domestic consumers. For businesses it would depend on the extent to which electricity was a major input cost.
So a $30 per tonne CO2 tax thus applied would likely cause:-
a) Petrol prices to fall by 30 cents per litre.
b) Electricity prices to rise by 1.8+ cents per kWhr.
In political terms that does not seem like such a tough sell although obviously it creates winners and losers.
Given that it would push the cost of coal based power to $53 per MWhr ($35 + $18) it would make some coal alternatives cost competitive. The following suggests the following prices for alternatives.
http://www.geodynamics.com.au/IRM/content/hfr_hfrexplain_economics.html
# Solar Termal figures are not from the website but from some back of an envelope guessing on my part.