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Chapter 7: Setting a price, version:2 CO2NNECTFor review in Berlin

7. Setting a price

7. Setting a price.............................................................................................................17.1 Why price matters..........................................................................................17.2 Pricing for energy security: gasoline taxes....................................................47.3 Pricing for pollution: the carbon dimension...................................................57.4 First steps first: reforming energy subsidies..................................................7

The good and bad of energy subsidies...........................................................87.5 Tax versus trade: which is more efficient?....................................................97.6 Pricing pollution in practice.........................................................................127.7 The politics of pricing..................................................................................177.8 Conclusions..................................................................................................20

Prices currently play an important part in determining energy intensity in the long-run, with the best evidence shown by comparing across countries. This evidence, along with economic theory helps to create a rationale to place a price on carbon. In order to do this we must first remove the negative prices that we place on carbon through various subsidies. Removing these subsidies, however, brings in a range of political issues and difficulties. In order to create a carbon price we have a choice of two different instruments, carbon taxes, or cap-and-trade schemes. In a simple world these two instruments are identical, however bringing in uncertainty and asymmetric information may favour either taxes or trading schemes, with a general overall conclusion favouring taxation. We have experience already of pricing pollution using either taxes or trading schemes. The US sulphur programme shows that emissions trading schemes can be effective, while the experience of the failures to enact a BTU tax in the US or a carbon tax in the EU highlight some of the difficulties in implementing taxation. This helps to highlight the fact that the choice between the instruments is essentially political rather than economic, with the ability to shift relative prices without requiring large redistributions of income one of the features that may lead us toward favouring trading schemes.

7.1 Why price matters

No-one likes paying higher prices. Yet economists often advocate them. Why?

Price instruments both raise money, and provide incentives for investors and consumers to use less. But as energy is such an integral commodity to so much of society can prices really shift behaviour and investment patterns?

At first glance the answer may appear to be no. Households need to heat and light their houses, and power their TVs and cars. Firms need to power their machines and industrial processes. Will price make much difference? Curiously, the answer appears to be in part, “it depends how long they have” – and therein lies one of the great paradoxes of energy economics.

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One way of getting at long effects is to compare different countries. Historically, some countries have had higher energy prices than others, a pattern exacerbated since the oil shocks of the 1970s. Most of the ‘old world’ industrial countries (Europe, Japan) let gasoline prices rise and then reinforced these with taxation as oil prices fell; North America maintained low prices; and the former Soviet countries mostly continued to subsidise energy. Figure 7.1 compares the result, plotting average energy prices against average consumption per unit of economic output.

This shows that countries with higher average energy prices produce wealth with less energy consumption. Specifically, it measures what economists call a “cross-elasticity” – the flexibility of national responses to price differences. The striking result is that the elasticity is around -1 – which means that for each 10% higher energy price, the country used energy 10% more efficiently. Japan, with prices twice those in the US, uses less than half as much energy per unit output; the Eastern European countries, where subsidies kept energy cheap, use twice as much. Russia and other former Soviet countries would be almost off the scale (we have left these and developing countries off the chart because so many other factors complicate meaningful comparison – but the general relationship holds. 1

1 The price elasticity of energy measures how much the energy intensity changes in response to a change in prices. Previous work such as Newbery, D. (2003). "Sectoral dimensions of sustainable development: energy and transport." Economic Survey of Europe 2: 73-93. have estimated an elasticity of -1 for the time period 1993-99, excluding transition economies. Including these economies and repeating the analysis with all economies gives an elasticity of -1.7 for the time period 1990-2005, while excluding the transition economies gives an elasticity of -1.2.Document last changed: 7/6/2010 10:47:00 PM

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One paradox therefore is that countries with higher energy prices do not end up paying more for energy - they just use it more efficiently.

The other paradox is that in-country measurements of response to price changes – “own elasticities” – seem to tell a different story, with much less measured response. Estimates vary, but are typically more like -0.2 to -0.5.

This difference probably reflects several things. One is that the ability to change in the short run is more limited, for example being constrained by existing capital stock (cars, houses, machinery) and habits; it takes time to adjust. Responding to higher prices with new investment in cleaner goods and facilities also, inevitably, takes time – and a belief that higher prices will persist. Energy prices can only play a limited role in the short-term.2 It also takes time for prices to feed through in intermediate and final goods, provoking responses through the supply chain as consumers and producers choose less energy-intensive products.3 Innovators will also respond – bringing more efficient products to market – thus higher energy prices can change the long-run direction of economies and their production.4

Thus in the longer-term both households and firms have more options to be more efficient and to buy cleaner goods. Economists have measured how the response to price changes through these various channels increase, given more time, increasing the overall energy efficiency of the economy.5 Finally, it reflects even deeper changes. Faced with higher prices, governments themselves are more likely to pursue policies to cut energy consumption (like stronger building standards, or high-speed rail networks, or other infrastructure), and consumers are more likely to support them when prices transmit the fact that energy is a valuable thing.

So the difference between short-run, “own-elasticity”, and the long-run, “cross-elasticity” is a measure of the cumulative response of individuals, economy, and society, and therein lies the challenge. If energy price rise, then in the short run, individuals do end up paying more, and they don’t like it. In the long run, society doesn’t; it just gets more energy-efficient, all round. Its another – and major - facet of the ‘Economics of Changing Course’.

2 This affect has been studied using both theoretical and empirical methods, for example Pindyck, R. (1979). "Interfuel Substitution and the Industrial Demand for Energy: An International Comparison." The Review of Economics and Statistics 61(2): 169-179.3 A survey of the literature associated with this channel can be found in Ang, B. and F. Zhang (2000). "A survey of index decomposition analysis in energy and environmental studies." Energy 25: 1149-1176.4 For an investigation into this effect see Newell, R., A. Jaffe, et al. (1999). "The Induced Innovation Hypothesis and Energy-Saving Technological Change." The Quarterly Journal of Economics 114(3): 941-975.5 Atkeson, A. and P. Kehoe (1999). "Models of Energy Use: Putty-Putty versus Putty-Clay." The American Economic Review 89(4): 1028-1043.Document last changed: 7/6/2010 10:47:00 PM

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7.2 Pricing for energy security: gasoline taxes

The oil price shocks of the 1970s were a wake-up call to many governments. They had lost control of the world’s oil markets; they were hurt, and vulnerable.

The economists’ remedy was seemingly perverse: to tax the stuff. This, they argued, was the only way of weaning the rich economies off a dangerous level of oil dependence. It would also start to seize back the “economic rents” – the difference between the cost of getting it out of the ground, and its final price – for western consuming governments. The bitter pill was swallowed to varying degrees by different countries, but most now have excise duties on energy products, combined sometimes with royalties from domestic production or income taxes on profits of energy companies. The role of energy taxation has slowly expanded6.

The rates of energy taxation vary dramatically between countries, helping to explain the varying end-user energy prices in Figure 7.1. As shown in the next Figure (7.2), western Europe has systematically higher rates, Japan also quite high levels, and North America lower rates. Many developing countries, as we shall see, still subsidise energy.

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The European experience still shows how difficult the process is. In the late 1980s, the UK had relatively low levels of gasoline taxation. The Conservative government introduced a ‘price escalator’ – a predictable increase in gasoline tax at 3%/yr, on grounds of both security and environment. The incoming Labour government in 1997 6 Maten, L. (1999). "Energy taxation - a historical overview." International Journal of Global Energy Issues 12(7/8): 304-314.Document last changed: 7/6/2010 10:47:00 PM

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got greedy, and increased the escalator to 5%/yr. A few years later, drivers – commercial and private – rebelled, blockading refineries, and the escalator was frozen. Nevertheless, the UK had moved towards the top levels of tax rates in Europe, which helped both to fund a massive upgrade of transport infrastructure, and helped the UK weather the storms of oil prices and public debt that followed in the second half of the decade.

Given the political sensitivities, governments still fiercely guard their right to tax (or not). In the EU, efforts to harmonise rates of energy taxation across member states finally culminated in 2003 with a directive on Energy Taxation. This aimed to remove distortions due to differences in rates between member states, between fuels and to encourage greater energy efficiency. After more than a decade of struggle, it was in fact the rump left from Europe’s first efforts to price carbon.

7.3 Pricing for pollution: the carbon dimension

The fact that energy prices can help to cut long-term energy dependence signals their possible role in tackling wider challenges. But by how much? Is it fair and compatible with free market economies? And how can we do in ways that support and reward the move to a low carbon economy, without excessive adverse consequences?

Answers to the first couple of questions are now deeply rooted in economic thought. Arthur Pigou was one of the first to develop the idea of “externalities” – impacts from economic activity which do not naturally appear in prices, such as environmental damage (the risks from energy insecurity are in fact another form of externality).7 Externalities are now recognised as a major form of market failure – where the market system doesn’t deliver the welfare benefits it should. Worse than that; if activities impose such external costs but they are not paid for, then the market risks amplifying those activities, and amplifying the damage. William Baumol was one of those to develop proposals for ‘Pigouvian taxes’, to ensure that the cost of damage is factored into the decisions of individuals and firms.

Controlling externalities, such as pollution, through a pricing mechanism has advantages over traditional ‘command-and-control’ regulations, in which governments impose a standard or otherwise dictate the response. It gives all those in the market the freedom to choose the most appropriate response, and flexibility to hunt out the cheapest options. Imposing a price rather than a regulatory standard allows firms to choose how to cut emissions; at a given price, those with low-cost opportunities can reduce emissions by more, whilst those for which it is far more difficult may prefer to pay the imposed price. The same signal transmits through the economy.

Carbon pricing potentially allows three types of flexibility: - ‘what’, ‘where’ and ‘when’:

7 Pigou, A. (1950). The Economics of Welfare. London, MacMillan.Document last changed: 7/6/2010 10:47:00 PM

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‘What flexibility’ allows reductions to take place by whatever technical measures are available and effective at least cost. This contrasts with governments mandating the choice, often with imperfect information about the options. This ‘what flexibility’ also makes it easier to utilise the shifting, developing nature of technology – it ensures that policy is not locked into supporting one specific technology while other alternatives become cheaper and more desirable.

‘Where flexibility’ allows those with the lowest costs of abatement to cut emissions while those facing higher costs may choose to pay the price associated with their carbon emissions. In contrast regulatory standards have to either impose standard reductions on all firms, no matter the cost, or set individual firm targets – which would get incredibly complex and contentious. ‘Where flexibility’ allows the decisions to be taken at firm level where costs are known, whilst ensuring that polluters are paying the cost.

‘When flexibility’ allows the effort to be scheduled over time. As we have seen in Pillar I the costs of abatement are likely to change, as capital stock turns over and different technologies develop in different and unpredictable ways. The ‘when flexibility’ of carbon pricing allows some balance, of when to cut vs when to pay for continuing to emit.

Of course, flexibilities can be dangerous if abused, and it took the environmental community a long time to warm to the idea. For some kinds of problems, indeed, straightforward standards may be better, for example providing greater certainty in preventing local toxic pollutants. But for a problem like carbon – emissions from activities throughout the economy, whose impacts are even more spread over time and place - it makes no sense to try and micro-manage responses in this way. Broad-ranging sources and far-reaching impacts point to the need for a incentive that can work right across the economy – namely price.

An additional advantage lies with the long-term signals that carbon pricing can send. It signals to firms, investors and innovators that they will be rewarded in the future from investing in low-carbon technologies today.

Indeed, one of the complications in policy debates has been the sheer number of objectives that instruments to cap and price carbon can have:

to internalise the external costs imposed by greenhouse gas emissions – ie. as a matter of economic principle to ensure efficient markets;

to deliver a specific emission target; to cut emissions in the most-cost effective and economically efficient manner; to ensure that CO2 concentrations are kept to a pre-determined level; to incentivise investment in low carbon technologies.

Different ways of placing a price on carbon can meet these objectives more or less effectively. A clear understanding of these multiple objectives is central to debate over how to design carbon pricing. However, there is one other thing to consider first: the contours of existing prices.



7.4 First steps first: reforming energy subsidies

It’s all very well to talk about pricing carbon – the fact is that many countries in the world do the opposite. Subsidies to fossil-fuel production, fossil-fuel power-generation and energy-use exist in many places around the world. Economists are convinced that most of these are, ultimately, damaging to the countries concerned. That does not make it any easier to tackle them.

Subsidies can take a wide variety of forms, and can be direct and transparent, but are much more often indirect, and hidden. This makes defining a subsidy, and identifying all that currently exist, extremely difficult. They range from explicit subsidisation of gasoline to consumers in oil-producing countries like Iran and Venezuela, to state aid for the coal industry in Germany and tax breaks for US oil production8 – as well as renewable energy supports. Although such subsidies vary in scope, size and impact, fossil fuel subsidies contradict efforts to strengthen climate policy and price carbon effectively. Prices of fossil-fuels should take into account all costs: economic, social and environmental. Anything less than this impedes the shift to a sustainable low-carbon economy.

The problem of fossil fuel subsidies has become a mantra. To move beyond the mantra however, means understanding the underlying structures and causes. One notable feature is that most subsidies in developing countries are to consumers, helping to shield poor people or industries from the true costs of their energy consumption. Most subsidies in industrialised countries, in contrast, are to producers – sustaining production in the face of cheaper options, like imports.

The former – consumer energy subsidies – are estimated at US $200-300 billion a year across the transition and developing countries, if this is measured in terms of the difference between domestic and international prices.9 In practice, fossil fuel producing countries such as Iran, Saudi-Arabia and Russia tend to give their populations access to cheap energy, well below world prices; these three countries account for more than half the total global subsidies as measured in this way (Figure 7.3). China and India also feature prominently.

8 The political difficulties of repealing subsidies can be seen in the US where a recent effort to repeal tax breaks to the oil and gas industry of $35 billion failed in the Senate. Smith, D. (2010). Effort to repeal oil tax breaks fails in Senate. Reuters.9 IEA (2008). World Energy Outlook. Paris, OECD. The 2006 report estimated $220bn in 2005; this rose to an estimated $310bn in the 2008 report, as the producer nations held domestic prices constant in the face of rising international energy prices. These estimates are based on the most common methodology for estimating consumption subsides, the Price Gap approach, which measures the net effect of all the varying support mechanisms by comparing end-use consumer prices with the price in international markets, net of transport costs.Document last changed: 7/6/2010 10:47:00 PM

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Figure 7.3 Energy Subsidies by fuel in non-OECD countries, 2007 Source: IEA[Any chance of also including producer subsidy chart?]

Production subsidies in the energy sector are estimated at around $100 billion a year10. In contrast to consumption subsidies, most of these are in the rich countries. A sizeable proportion is directed to low-carbon energy sources – estimated at about a quarter of the total, with $10 billion for deployment of renewable energy and $16 billion on existing nuclear power11.

The good and bad of energy subsidies Subsidies that lower final energy prices make life easier for consumers – except that they pay in other ways, such as general taxation or poor services. The adverse impact on efficiency is now abundantly clear. Under communism, both the Soviet Union and its Eastern European satellites heavily subsidised both residential and industrial energy prices, in line with Marxist theory and the desire to meet the basic needs of the population; cheap Russian energy to Eastern Europe also offered an instrument of political control. All this led the Eastern Bloc to have among the worst energy profligacy of any economies in the world – off the scale of Figure 7.1. As part of the post-Soviet economic transition, most Eastern European states have managed to phase out energy subsidies, particularly under the pressure of joining the EU. In Russia, large energy subsidies – and associated inefficiencies - remain.12

Subsidies to incumbent producers can undermine incentives to invest in new, more efficient equipment or to innovate in alternative more expensive technologies. However they may also – as explained in Chapters 5 – play a role in fostering the

10 GSI (2009). Biofuels - At What Cost? Government support for ethanol and biodiesel in Canada, IISD.11 Stern, N. (2007). The Economics of Climate Change: The Stern Review, Cambridge University Press.12 For a more detailed discussion see Urge-Vorsatz, D., G. Miladinova, et al. (2006). "Energy in transition: From the iron curtain to the European Union." Energy Policy 34: 2279-2297.Document last changed: 7/6/2010 10:47:00 PM

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growth of new technologies and industries. It depends on how they are applied – and whether there is a plausible exit strategy in favour of more broad-based market incentives.

Subsidies need to be placed in a wider political and social context. They are most prevalent in developing countries where they help to give even the poorest access to basic needs such as heating, lighting and cooking. In countries such as India they are used in lieu of social security nets, and provide a method for governments to provide support to vulnerable members of society who they would otherwise be unable to reach. Such rationale explains why for example many states in India, until recently, provided free electricity to rural small farmers.

There may be more overt political reasons for such subsidies. Producers can be a powerful political force, and indeed a major source of employment in often underdeveloped rural regions. Subsidies may be politically attractive in order to capture the votes of such regions. The fossil fuel industry is one of the richest industries on earth; it will try to stay that way, as witnessed by the long-standing struggles over both energy subsidies and efforts to price carbon, as outlined later.

Removing subsidies is neither easy, nor a panacea – but it remains important. Continuing subsides to fossil fuel production and use undermines energy efficiency and makes it harder for new sources to develop. Removing consumption subsidies alone could reduce global greenhouse gas emissions by as much as 2% in 2020, rising to 10% by 205013; whilst subsidising fossil fuel production inevitably undermines any attempts to price carbon. Reform has to be gradual process and operate in a clear and planned fashion; as the east European experience shows, the transition hurts, but is possible. Ensuring that subsidies are in the first instance clearly targeted, soundly-based, practical and transparent at least removes some of their most damaging features, and allows mapping out a clear path to their removal14. Then at least, economic instruments to price carbon can operate in a rational way.

7.5 Tax versus trade: which is more efficient?

There are two basic ways to price carbon: impose a tax, or set a cap by issuing emission allowances that participants can trade. Carbon taxes levy a price directly on either the carbon content of a fuel, the emissions from a production process or the carbon embodied in a final good; the government sets the price, and collects the revenue. A cap-and-trade scheme involves the government issuing allowances for a target level of emissions, either through free allocation or through auctions. Firms then need to make sure they get enough allowances to cover their emissions in a defined period. If a firm requires more in order to cover their emissions, they can purchase them through the market from firms who can cut back by more; through this trading, a market price of carbon emerges.

13 Burniaux, J. P., J. Chateau, et al. (2009). The Economics of Climate Change Mitigation: How to build the necessary global action in a cost-effective manner. Paris, OECD.14 UNEP (2008). Reforming Energy Subsidies: Opportunities to Contribute to the Climate Change Agenda, United Nations Environmental Programme.Document last changed: 7/6/2010 10:47:00 PM

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If there were perfect markets and complete information the two approaches would be very similar, and it would be easy to make them directly equivalent. The real world of course is more complex.

Some of the difference comes down to how to set the level. In economic theory, the price should reflect the damages imposed – or more precisely, the marginal damage associated with emitting more. The price, or the cap, drive down emissions and this change forms the “benefits” of the policy – the declining slope in Figure 7.4.Of course, the costs of control rise with the degree of cutback – the rising slope. Economic textbooks show neat straight lines, and where they cross – where the marginal benefits intersect with the marginal costs – defines the nirvana of optimal control, whether through taxes (vertical axis) or quantity (horizontal axis). Which instrument is chosen is then almost irrelevant.

In practice of course the world does not have perfect markets, certainty or complete information. Even imperfect, uncertain, and incomplete are modest descriptions of the reality of energy markets and environmental damages. This applies to the scale of damages, “in spades” - as we sketched in Chapter 2, and attempt to illustrate with the broad swathe of possible damage estimates in Figure 7.4. Uncertainties also exist over the real cost of emission cutbacks, due to a mix of market and technological uncertainties (think back to Chapter 4). There are asymmetric damages – who will be hurt and how to value them – and asymmetric information, including between firms and governments, over what it will actually cost to cut emissions. The clear history from other environmental regulations is one of over-estimating the costs of pollution control.15

Figure 7.4: Representation of the Marginal Benefits and Marginal Costs of Abatement of Greenhouse Gases15 See Harrington, W., R. Morgenstern, et al. (2000). "On the Accuracy of Regulatory Cost Estimates." Journal of Policy Analysis and Management 19(2): 297-322.Document last changed: 7/6/2010 10:47:00 PM

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This means we face a very different challenge from the one with nice known straight lines that economists might like. Its more like the sketch in Figure 7.4 – which itself would change over time. The lines are uncertain and non-linear. In particular, it’s likely that modest cutbacks are quite cheap - a relatively low slope at low levels of abatement with low-hanging fruits in areas such as energy efficiency – whilst costs may rise a lot for bigger cutbacks, particularly if these are imposed quickly. It is very difficult, if not nigh impossible, to calculate the perfect levels at which taxes or caps should be set.

In these conditions, the two instruments are not the same. A tax can generate highly uncertain levels of emission reductions. A cap gives environmental certainty but generates an uncertain price. Which is more efficient and effective will then depend on many factors, including how we rank the various multiple objectives of carbon pricing set out above. Economists have been wrestling between the choice of these two instruments in conditions of uncertainty and asymmetric information since a seminal paper by Harvard Economist Martin Weitzman in 197416. The only firm conclusions that haved emerged are that depending what types of uncertainty or information is included elements either price or quantity instruments may be preferred, with a general tendency toward price instruments.

Amendments to ‘pure’ tax or cap-and-trade schemes are possible. The sequential rounds of allocation in the European trading scheme discussed in chapter 8, for example, have enabled the cap to be adjusted over time in response to revelations about the (low) cost of achieving the early targets. A tax could similarly be ramped up if it turned out that emissions were not cut back as much as hoped, or if the problem became recognised as more serious, though this might be more politically difficult. There are more direct measures, such as price floors and ceilings on trading schemes discussed in the next chapter, that give it more direct price-like characteristics. And tax thresholds, where firms only pay the level of carbon tax above a pre-defined allowance, have been proposed as an amendment that may make taxes more palatable17. In short, there are “hybrid instruments”, and they may have potential to offer the best mix of the various objectives indicated earlier.

To foster long-term change, an important element is the long-term investment signals that the two instruments may offer. As we have seen, decarbonising the energy system requires large investments over significant timescales. Providing clear signals that low-carbon investments will be rewarded is important. But again, the implication for choice of instrument is ambiguous. Taxes can provide clear long-term signals if the government lays out a long-term price path and there is sufficient trust in successive governments seeing this through. Taxes, however, may be much harder to adjust to

16 Weitzman, M. (1974). "Prices vs. Quantities." The Review of Economic Studies 41(4): 477-491. Additional work has extended Weitzman’s analysis for example Stavins, R. (1996). "Correlated Uncertainty and Policy Instrument Choice." Journal of Environmental Economics and Management 30: 218-232. Hoel, M. and L. Karp (2001). "Taxes and quotas for a stock pollutant with multiplicative uncertainty." Journal of Public Economics 82: 91-114. Newell, R. and W. Pizer (2003). "Regulating stock externalities under uncertainty." Journal of Environmental Economics and Management 45: 416-432.17 Pezzey, J. (2003). "Emission Taxes and Tradeable Permits: A Comparison of Views on Long-Run Efficiency." Environmental and Resource Economics 26: 329-342.Document last changed: 7/6/2010 10:47:00 PM

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unexpected changes in economic and emission trends or technological developments. Caps provide a mechanism for the price to adjust to such changes - for good and bad. They also do offer some assurance to technology developers that key technologies – like CCS – will find a market, and that the carbon price will rise to levels required to make them economic. However, overall, how these different advantages play off with each other is still a matter of discussion – and probably eclipsed by the underlying political issues considered later.

Another dimension is how consumers may perceive the different instruments – if they do so at all. As a cap-and-trade scheme effectively sets a limit on emissions, this can create the perception that individual behaviour in saving emissions is irrelevant – its taken care of by the cap. Actions by individuals will cut their costs – and in a very indirect way, the carbon price – but not emissions, since it gives someone somewhere else in the system scope to emit more. With taxes, all efforts to reduce emissions deliver just that. Whether this is crucial to the choice between instruments in a world where individuals are disconnected from the problem is a question of debate, but in some countries this has become a fierce point of discussion, notably in the development of the Australian Carbon Pollution Reduction Scheme. Mechanisms that can be built into cap-and-trade schemes to help get around this feature are [discussed in Chapter 12]. At the end of the day, however, two decades of experience now suggest that the biggest questions concern not the finer points of design – but the sheer political difficulty of doing anything to price carbon.

7.6 Pricing pollution in practice

Although Pigouvian taxes have been discussed for a number of decades their use has been limited at least in their strictest form, although some types of environmental taxation have started to creep into budgets around the world. Cap-and-trade schemes have been used most notably in the US for Acid Rain prevention, and in the EU for carbon mitigation.

In the mid 1990s the US introduced the unique policy instrument of emissions trading in order to undertake mitigation of Sulphur Dioxide emissions in the most efficient manner. Sulphur Dioxide from the combustion of coal, mainly for electricity generation, is a major cause of acid rain pollution, combining with water vapour to form sulphuric acid. Acid rain caused major environmental problems across much of the United States and neighbouring Canada in the 1980s and 1990s (as well as across Europe). The amendments to the US Clean Air Act in 1990 aimed to reduce annual Sulphur Dioxide emissions by 10 million tonnes below 1980 levels. This level wasn’t the result of a controversial Cost-Benefit Analysis, but was instead chosen for its scientific merit (and the roundness of the number in all probability18).

In order to achieve this reduction in emissions a trading scheme was introduced, covering almost 500 installations in its first phase, beginning in 1995, rising to over 2,000 in its second phase which began in 2000. The introduction of the instrument followed lobbying from various sides, notably from the Environmental Defense Fund,

18 MacKenzie, D. (2007). "The Political Economy of Carbon Trading." London Review of Books 29(7): 29-31.Document last changed: 7/6/2010 10:47:00 PM

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an American environmental advocacy group, one of whose members was highly influential in the drafting of Title IV of the Clean Air Act Amendments of 1990 that put Sulphur Dioxide emissions trading into law.

Utilities were allocated freely tradable allowances based on historic fuel consumption and a specific emissions rate. Further annual auctions were available where additional allowances could be purchased. The programme has been a clear success. There has been 100% compliance, and indeed in the first phase emission reductions were 22% below mandated levels as firms found emissions reductions cheaper than expected, and banked allowances forward for future purchases. Crucially the emission reductions have been achieved at much lower costs than those anticipated. Market prices have been in the range of $100-200 per ton in contrast to expected prices in the range of $650-850 per ton at the outset of the programme (Figure 7.5). Industry lobbyists claimed that the programme would cost approximately $10 billion a year to implement. In fact the reductions have been achieved at around a tenth of that estimate!19

Several explanations have been proposed for these much lower-than-expected costs. The competition across abatement options that emissions trading allows encouraged rapid cost reductions, for example by as early as 1997 costs of flue gas desulphurisation, a major Sulphur Dioxide abatement technology, had fallen by 40% compared to 1990 levels20. Costs of transportation of low-sulphur coal have also fallen, allowing fuel substitution to take place. Innovation took place in both technologies for abatement, and also in the allowance market, with the development of allowance bundling, options and swaps. Crucially however the market allowed the true cost of compliance to be shown. Evidence has emerged that ex-ante per-unit costs of meeting environmental regulations have been consistently overestimated21. Incentives for industry to over-estimate the initial costs of action may combine with the ability of the market to search out hidden cheap options, in explaining this phenomenon.

19 For a full analysis of the experience of the US Sulphur Trading Programme see Ellerman, D., P. Joskow, et al. (2000). Markets for Clean Air: The U.S. Acid Rain Program. Cambridge, Cambridge University Press.20 McLean, B. (1997). The evolution of marketable permits: the US experience with sulphur dioxide allowance trading. Controlling Carbon and Sulphur: Joint Implementation and Trading Initiatives. D. Anderson and M. Grubb, Royal Institute of International Affairs.21 Harrington, W., R. Morgenstern, et al. (2000). "On the Accuracy of Regulatory Cost Estimates." Journal of Policy Analysis and Management 19(2): 297-322.Document last changed: 7/6/2010 10:47:00 PM

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Figure 7.5: Average Monthly SO2 Allowance Price, August 1994 – May 2009 Source EPA22

The success of the US Sulphur Dioxide emissions trading scheme led to interest in the instrument of cap-and-trade for pollution control and calls for the introduction of the concept into the Kyoto Protocol. The introduction of the instrument into the Protocol was at the behest of the United States. The EU preferred a policy mix of harmonised carbon taxes and coordinated government measures to promote low carbon technologies. However after years of failure in the adoption of a carbon tax the EU moved toward an emissions trading system.

The European Community, as it then was, first committed to stabilisation of greenhouse gases in 1990 just before the Second World Climate Conference in Geneva. A series of directives followed in 1992, including a directive on a community-wide combined carbon and energy tax. This was proposed to start in 1993 at a relatively low level, but ramp up towards 2000. The proposal met considerable opposition from industry and also from individual member states. To deal with this, substantial exemptions for energy-intensive industries were proposed, along with a move to tax electricity as per output rather than as per input fuels. The tax was also made conditional on the introduction of similar measures in the other countries of the OECD. Despite these concessions, which watered down the emission reduction potential of the tax considerably, it still failed to gain the Council support that was necessary for its enactment.

A further attempt was made in 1994 with even greater concessions, including maintaining a low level of taxation for three years until a review could be conducted, greater exemptions for both energy-intensive industries and also for countries with relatively low levels of emissions. These further concessions weakened the emission reduction impact of the tax even further, but were still not sufficient to gain the level of support required, and at the end of 1994 attempts at an EU-wide carbon tax were abandoned in favour of attempts to harmonise energy taxes across the community.

22 Accessed from: http://www.epa.gov/airmarkets/progress/ARP_1.html


http://www.epa.gov/airmarkets/progress/ARP_1.html


This failure to enact carbon taxation heralded a move toward the introduction of the EU Emissions Trading Scheme, which we shall discuss in more detail in Chapter 8. A major advantage that became apparent with the move to an emissions trading scheme over a tax came from the political structure of the EU decision making process. To implement an EU-wide tax requires unanimity between all Member States, effectively giving each state a veto. Given the political difficulties the tax encountered a unanimous decision was extremely unlikely. An emissions trading scheme, on the other hand, fell within the realm of environmental policy rather than taxation and as such only required qualified majority voting, implying that only a block of relatively populous countries could stop its enactment, smoothing the political process.

Despite the political failures to enact an EU-wide carbon tax there are individual countries which have enacted such instruments. Beginning with Finland in 1990 who introduced a carbon tax levied on all energy products except transport fuels, the four Scandinavian countries along with the Netherlands have introduced carbon taxation. Even here where there are significant environmental constituencies the taxes, although adopted, have run into significant difficulties. In all four countries the taxes are beset by exemptions and differentiated rates that mean that they are very different on paper from the uniform economy wide tax that theory dictates. The levels of carbon tax vary between and within the countries, with the level of taxes varying by up to a factor of five in both cases (see Table 7.1). Energy-intensive industries and electricity producers have managed to negotiate significant exemptions in most of these tax regimes, playing on competitiveness concerns. Norway, for example, levies the highest rate of tax on offshore oil and gas, with exemptions for the majority of industry, meaning that the tax only covers about 60% of Norway’s CO2 emissions23. Sweden initially levied the same rate upon industry and households, but after outcries over competitiveness concerns the industry rate was reduced to 25% of the household rate in 1993, although it was subsequently raised to 50% of the level, before being reduced again to 21% of the rate in 2004. Denmark has a three tier approach to levying its tax on industry, comprising one standard rate and 3 bands of refunds for energy-intensive processes, with refunds applying to the CO2 resulting from industrial processes if CO2 tax burden as a percentage of the difference between sales and purchases is sufficiently high. These exemptions have significantly weakened the emission reducing impacts of the taxes, even where they have been set at high levels, such as in Sweden.

23 Andersen, M. (2004). "Vikings and virtues: a decade of CO2 taxation." Climate Policy 4: 13-24.Document last changed: 7/6/2010 10:47:00 PM

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Country Year begun Level ExemptionsFinland 1990 $30 per ton CO2 Commercial shipping

and aviation, fuels for electricity

Norway 1991 $15.93 to $61.76 per ton CO2

Majority of industry pay reduced rates, fishing and external shipping and aviation exempt

Sweden 1991 Standard rate $104.83 per ton CO2

Industry rate Approx $23.04 per ton CO2

Industry taxed at quarter of household rate

Denmark 1992 $16.41 per ton CO2 Reduced rates for energy-intensive industry in combination with energy saving agreements

Table 7.1 European Carbon Taxes Source: Sumner, Bird and Smith (2009)24

The failures to enact sufficient and robust carbon taxation regimes are not limited to Europe. Along with its general failures to enact climate policy regulation the US also has its own history of failures of carbon and energy taxes. Most notably amongst these is the failure of the Clinton proposed British Thermal Unit (BTU) tax of the mid-1990s. In the backdrop of fiscal stimulus packages and deficit reduction measures President Clinton in his 1993 State of the Union address proposed a:

“broad-based energy tax as the best way to provide [us with] revenue to cover the deficit , because [the tax] also combats pollution, promotes energy efficiency, and promotes the independence economically of the country, as well as helping to reduce the debt.”25

Many of these messages are surprisingly similar to the objectives of President Obama and his plans for cap-and-trade a decade and a half on. The proposal for a broad-based energy tax led to discussions on what form it should take. Earlier fallers in the race included a pure carbon tax, through objections from Senators from coal-rich states, notably from the late Senator Robert Byrd of West Virginia. A gasoline tax had already been denounced by the President during his campaign as too “back-breaking”26. This left two options, one a BTU tax based upon the heat content of fuels, the second an ad-valorem tax, based upon the sales price of fuels. Resistance to the second from leading environmental campaigners led to the proposal of a BTU tax. As the tax passed from committee to committee the lobbying pressure on it grew and grew. Industry and State pressure led to a wide range of exemptions for both industries, and specific fuels. The lobbying-induced exemptions led to a bill that had been significantly watered down and had removed its own raison d’être, deficit 24 Sumner, J., L. Bird, et al. (2009). Carbon Taxes: A Review of Experience and Policy Design Considerations, National Renewable Energy Laboratory 25 Clintion, W., J. (1993). State of the Union Address.26 Quoted in Erlandson, D. (1994). "The BTU Tax Experience: What Happened and Why it Happened." Pace Environmental Law Review 173: 175-176.Document last changed: 7/6/2010 10:47:00 PM

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reduction and environmental protection. This lost it the support of even its own initial proponents and the proposal died under its own weight. No significant attempts at a broad-based energy tax have emerged for the next 15 years. Indeed in the Bush presidency many taxes on energy were cut, though this also included support for renewable and low-carbon technology.27

7.7 The politics of pricing

The political problems of enacting either a tax or cap-and-trade scheme are likely to be, and indeed history teaches us that they are, huge. There may be contexts, however, where one or the other is more politically palatable, beyond any pure economic advantages that either instrument yields. In many (and some would argue, all) circumstances political economy factors may dominate over pure economic rationale. In these cases it is important to understand not just what instrument may be best on paper, but in fact what instruments it is possible to enact, and what instrument is less likely to be rendered ineffective and indeed obsolete by the political process.

One key example of the crucial role of political economy factors surround the fact that the political connotation of the word ‘tax’ is very different in the US and Europe. The perception of tax as a dirty word in the United States may be enough of a justification to attempt to control greenhouse gases through an alternative instrument. Indeed a leading US economist Robert Stavins, actively uses the fact that cap-and-trade scheme is not a tax as a key argument for the introduction of emissions trading28. In the EU the view of taxation is different, with more countries categorised by high tax economies. The different perceptions of government taxation has been widely discussed with explanations ranging from the nature of the American Revolution, America’s history of slavery and the evolution of American democratic institutions, to the ideological conflicts with socialism in the twentieth century. Whatever the reasons behind this aversion what is clear is that it makes the imposition of any taxes, whether real or perceived, in the US especially difficult.

The differences between the US and EU regarding tax can help to explain their differing positions up to and around the Kyoto Protocol. The US was one of the first proposers of cap-and trade mechanisms in the debates leading up to the Protocol. Indeed the flexibility included in the Protocol through its adoption of international emissions trading was a key part of the reaching of an agreement in Kyoto. At the time the EU was focused on enacting a taxation based system and was a somewhat reluctant adopter of the trading mechanism. In the intervening years, however, when the US retreated from the international climate scene under the Bush Presidency, the concept of emissions trading found favour in the EU and led to the creation of the EU Emissions Trading Scheme.

The political connotations of the word tax can be seen with the adoption of the phrase ‘cap-and-tax’ by leading opposition figures in the US debates about the introduction of climate change legislation. Despite the attempts of the Administration to move the

27 For a more detailed discussion of US energy tax policy see Lazzari, S. (2007). Energy Tax Policy: History and Current Issues. CRS Report for Congress, Congressional Research Service.28 Stavins, R. (2008). Cap-and-Trade or a Carbon Tax? The Environmental Forum.Document last changed: 7/6/2010 10:47:00 PM

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debate away from carbon taxation, the lobbying campaigns have (largely successfully) managed to associate the schemes with taxes and the negative connotations that are associated with the word in the US. Opponents of cap-and-trade have jumped on the phrase cap-and-tax, from journalists such as Robert J. Samuelson in the Washington Post29, politicians such as former Vice-Presidential candidate Sarah Palin30, to right-wing think-tanks such as Americans for Prosperity. . A major argument amongst those that propose cap-and-trade schemes above taxation regimes, at least, initially, focuses on the ability to scale up such instruments to global level. As we have seen climate change is a global public good problem and any effective solution requires full international cooperation. A world of unequal and/or missing carbon prices raises further challenges (as we shall see in Chapter 9). This raises the question as to whether taxes or trading mechanisms are more suitable to be scaled up to international levels.

As we have seen the EU struggled to implement a community wide carbon tax, partly due to the veto powers of all member states. The international community lacks even the partial supra-national authority of the EU, and thus there is no body that can impose, or enforce a global carbon tax level. Indeed even agreeing caps may be beyond the scope of current international frameworks, as we witnessed at Copenhagen.

Creating an implementable instrument that can be scaled up as interest in it spreads is a crucial element of any international framework. Cap-and-trade schemes may be more attractive from this point of view.

Much has been said about the double-dividend benefit of carbon taxation, it not only creates a price for the environmental externality, it also raises revenue for the government, which can either be used for government spending, deficit reduction or for reducing other distortionary taxes, such as those on labour or spending. Economically this is seen as a very desirable property. Cap-and-trade schemes can achieve the identical result if the allowances are fully auctioned. Although such results are much sought after by economists, there are many political difficulties in trying to achieve both a large-scale amendment to relative prices and also a large redistribution of income from one group of society to another. This may make cap-and-trade an attractive option as it can achieve the former without necessitating the latter. It can raise relative prices and reallocate the income back to the parties involved, thus obtaining industry support. Indeed as we shall discuss more in Chapter 8, it was this mechanism that gained it the support it required to pass in the EU.

Any discussion between cap-and-trade schemes and taxes needs to be placed into the information that is available to those that are enacting the mechanisms. The effectiveness of either instrument is dependent on setting either the carbon price or the overall cap at something like the suitable level, within the provisos made above regarding uncertainty.

29 Samuelson, R. J. (2008). Just Call it 'Cap-and-Tax'. Washington Post. Washington.30 Palin, S. (2009). The 'Cap And Tax' Dead End. The Washington Post. Washington.Document last changed: 7/6/2010 10:47:00 PM

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From theory we know that a carbon tax should be placed at the level of the social cost of carbon. But as we have seen in Chapter 2, there is a wide band within which this value could fall. So at what level should we adequately set the tax?

It is likely that given the scale of uncertainty the tax level could not be set at the theoretically efficient level, and given the political considerations lobbying may lead it to be set at the lower end of the range, reducing the effectiveness of the instrument. For the cap classical economic theory tells us it should be set at the level which equalises the marginal costs and the marginal benefits of the abatement. This level as we have already discussed is highly uncertain given the uncertainty over future emission levels, the costs of abatement and the damages from climate change. However what science can tell us is what sort of scale of emission reductions might be required for stabilisation of greenhouse gas concentrations and the limiting of the chances of significant environmental and economic damage. This can help inform us somewhat over what level of emissions reductions might be needed in the short, medium and long terms and thus what sort of scale of cap we should set. This also helps place the instrument in the overall goal of climate policy which is to limit the chances of catastrophic damages from climate change.

Cap and trade schemes may be able to operate as an intermediate measure toward carbon taxation. Cap-and-trade schemes can establish the principle of setting a price on carbon and can even help to establish the sort of levels of tax that may be suitable and palatable. Through initially allocating the allowances for free cap-and-trade schemes can help to secure the support of important industry groups who, although they will face a shift in relative prices, will be compensated (and indeed over-compensated in some cases) through the income from the freely allocated allowances. A gradual move to auctioning once the instrument has been established can help governments’ secure vital revenue, and can create double dividends. Once the practice of auctioning emission allowances and paying a clear price for carbon in all forms is established a move to taxation regimes may then become more politically palatable.

The crucial factor in choosing between a tax and a cap is what instrument is it possible to implement, and then amend to solve any initial problems, and therefore which instrument can survive the political process most effectively. In all probability there is very little difference between the best designed carbon tax and the best designed cap and trade scheme, but due to the many vagaries of the real world we are unlikely to end up with either of these. A well-designed tax is likely to be better than any cap and trade scheme we can actually implement, and vice versa. The question, therefore, is really between a cap-and-trade scheme with all the exemptions and design features that are necessary to make it politically acceptable, and a carbon tax set at a politically acceptable level, with exemptions and differentiated rates. It is within the context of this question that the value of being able to allocate allowances to important constituents or being able to scale up the mechanism and incorporate new elements and sources of emissions over time becomes valuable.



7.8 Conclusions

So what lessons can we draw over the choice of instruments for climate policy? We can see a clear rationale for creating a price of carbon. There is clear evidence in the long-run for the effectiveness of pricing energy in reducing energy use, without dramatic effects on long-term growth. This leaves us with two clear methods for creating a price of carbon, taxes and cap-and-trade schemes. With strong assumptions over perfect markets, information and certainty these two methods are identical. In practice however, especially in the context of the climate change problem, none of these conditions hold. Theoretical work here has offered different conclusions, although with perhaps more favouring carbon taxes over cap-and-trade schemes. The history of climate policy, however, is littered with the failures of carbon taxes (with the partial exception of Scandinavia). This follows from a number of political economy advantages from cap-and-trade schemes, including the ability to directly compensate affected parties with free allowances, the ability to scale up the mechanism over time toward international-level mechanisms, and the ability to control the most important element, the level of emissions produced.

Although there may be advantages to cap-and-trade schemes from a political economy perspective, they are still not easy to initiate as the experience of the United States and Australia attests to. Australia first looked towards carbon trading in 2007, the year of its ratification of the Kyoto Protocol, with both the Labour government and the Liberal-led opposition promising to introduce carbon pricing. Draft legislation was put forward in 2008 but its progress has been dogged by massive opposition and the legislation has been revised and weakened, with looser targets and greater handouts to industry. Despite these concessions the bill was defeated in the Australian Senate in late 2009, although a revised version was put forward again in February 2010. The political climate in Australia has changed since 2007 however, with the new Liberal leader Tony Abbott describing the theory of climate change as ‘absolute crap’31. The scheme has now been put on hold until at least 2013. The process in Australia shows clearly that emission trading schemes are likely to come under severe pressure during the legislative and design phase and even if concessions are made may still be difficult to pass.

New Zealand also gives a case of how politically difficult enacting an emissions trading scheme can be. The country first proposed an ETS in 2008, however within two months the proposing Labour party had lost a national election. The incoming National-led coalition commissioned a review of the scheme, after at least some of its constituent parties had campaigned on amending the scheme. The review led to significant weakening of the scheme and the cap-and-trade scheme lost its ‘cap’. The scheme moved toward an intensity-based scheme with no overall cap on emissions. Indeed in the transitional period now scheduled from its beginning in July 2010 until the end of 2012 unlimited allowances will be available at a fixed price of NZ$25 a unit (and indeed in this period one unit will be worth two tons of CO2 equivalent, effectively halving the price). This experience shows how many of the design features of an emissions trading scheme have been influenced more by political concerns rather than economic rationale.31 Rintoul, S. (2009). Town of Beaufort changed Tony Abbott's view on climate change. The Australian.Document last changed: 7/6/2010 10:47:00 PM

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The question thus becomes how we best design an emissions trading scheme to take into account the concerns of industries and households and also to produce effective environmental results. This is the question we address in the next chapter.

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