Why price carbon - and how?

Almost every activity we are involved in today—either directly or indirectly—demands the combustion of oil, gas, or coal. Our addiction to convenience has culminated in a strong reliance on fossil fuels. Given the well-established consequences associated with the current rate of global warming, there is an increasing focus and pressure on policy-makers to implement effective strategies that will prevent further irreversible damage. What is the optimal policy? Our approach needs to be ambitious in reducing greenhouse gas (GHG) emissions as well as fiscally responsible. So, what does our best solution look like?

What does an efficient solution look like?

Economists typically turn to one of two key forms of carbon pricing in the debate on effective climate policy:

• Cap-and-trade or Emissions Trading System (ETS): The government issues a fixed number of emission “allowances” (typically via an auction to the highest bidder) which are subsequently traded on secondary markets, thereby allowing the market to determine a price on carbon. 

• Carbon tax: Regulators directly establish a price on GHG emissions that companies must pay for every tonne of emissions produced. CCL Australia’s preferred ‘climate dividend’ is a special form a carbon tax (termed a carbon fee) that recycles the generated tax revenue and redistributes it to citizens in the form of a dividend.

Both of these policies act as instruments to capture the external costs of GHG emissions (on health, the environment, and the climate) and ensure businesses internalise the social cost of fossil fuel emissions in their decision-making. They are also generally considered to be less invasive than direct regulations since all players in the market are free to choose how best to reduce their emissions (Mankiw, 2009).

While both policies have advantages in encouraging the lowest-cost emissions reductions, incentivising low-carbon technologies and generating government revenue, evidence typically points to a carbon tax as the more efficient mitigator of emissions (Goulder & Schein, 2013). A tax avoids the potential problems of weak emissions caps, volatility in emission permit prices, and rent-seeking by special interests that are common in Australia’s current political environment. Moreover, a fixed, economy-wide carbon tax offers more transparency than the current safeguard mechanism, a form of ETS which – by allowing for repeated baseline re-adjustments – has seen emissions from Australia’s largest industrial polluters increase by 7% since inception rather than fall (Foley, 2022).  

What about a better pricing model?

Under a climate dividend, the revenue generated from the carbon fee would be redistributed evenly, to every eligible Australian. Modelling of the Australian Climate Dividend Plan by UNSW estimates the average Australian household to be approximately $585 per annum better off (Holden & Dixon, 2018). Border adjustments for traded goods would also ensure that Australian industry would not be put at a competitive disadvantage.

Promisingly, the purported efficacy of a carbon tax is not solely restricted to economic theory. Recent cross-country evidence using data from 142 countries over a two-decade period reveals that average annual growth rates of carbon dioxide (CO2) emissions are significantly reduced in countries with a carbon price relative to those without (Best et al., 2020). Of the countries included in this longitudinal study, 47 countries had adopted some form of carbon price by 2019, of which 25 had imposed a carbon tax. As Figure 1 demonstrates, countries without a carbon price experienced annual growth in CO2 emissions of almost 3 % between 2007 and 2017, while annual emissions fell by an average of 2% amongst those countries adopting some form of carbon price.

While this initial analysis admittedly reflects an unconditional relationship, Best et al. (2020)  demonstrate that the negative relationship between a carbon pricing scheme and emissions growth continues to hold even after controlling for several key covariates. More specifically, Best et al. (2020) estimate a cross-sectional and fixed-effects econometric framework to control for a host of potential drivers of emissions including other policies such as feed-in tariffs and renewable portfolio standards as well as structural variables such as GDP, population and the energy intensity of GDP. Based on their model, they estimate that average annual growth rates of CO2 emissions from fuel combustion have been approximately 2% lower in those countries with a carbon price. While perhaps small over a single year, these emission savings over a decadal timeframe may facilitate an overall decline in a country’s GHG emissions, contributing to an ability to honour 2030 and 2050 climate commitments.

Figure 1: Average annual CO2 emissions growth rate with and without the presence of a carbon pricing scheme.

Conclusion

Given the established and irrefutable benefits of a carbon pricing policy and growing support from economists, scientists, and even businesses, policy-makers can now return to carbon pricing with confidence. Now the climate wars have been blunted by the recent election it will be even easier for government to include a carbon price as a means to fulfil its 2030 target and beyond.

References:

Best, R., Burke, P. J., & Jotzo, F. (2020). Carbon Pricing Efficacy: Cross-Country Evidence. Environmental and Resource Economics, 77(1), 69-94. Springer Link website, accessed July 2022. https://link.springer.com/article/10.1007/s10640-020-00436-x 

Climate Change Economics, 04(03), 1350010. World Scientific Website, accessed July 2022. https://www.worldscientific.com/doi/abs/10.1142/S2010007813500103 

Economic Journal, 35(1), 14-23. Springer Link Website, accessed July 2022. https://link.springer.com/article/10.1057/eej.2008.43

Foley, M. (2022). What is Labor's climate change Safeguard Mechanism plan? SMH website, accessed July 2022. https://www.smh.com.au/politics/federal/what-is-labor-s-safeguard-mechanism-is-it-a-sneaky-carbon-tax-or-a-sensible-way-to-cut-emissions-20220427-p5agkd.html

Goulder, L., & Schein, A. (2013). CARBON TAXES VERSUS CAP AND TRADE: A CRITICAL REVIEW. 

Holden, R., & Dixon, R. (2018). A climate dividend for Australians. Australian Carbon Dividend Website, 2022. https://auscarbondividend.com 

Mankiw, N. G. (2009). Smart Taxes: An Open Invitation to Join the Pigou Club. Eastern Economic Journal, 35(1), 14-23. Springer Link Website accessed July 2022. https://link.springer.com/article/10.1057/eej.2008.43

Author: Josephine Auer (jo.a@ccl.org.au), 12 July 2022