Most of the attention in discussion of climate change policies has been on a carbon market. But what about a carbon tax? Some well-qualified economists have expressed a preference for it.

In PD#104 I talked about a market for carbon emissions, which is the approach taken in the Kyoto Protocol. Kees van Kooten (from the University of Victoria in Canada) emailed to ask, what about a carbon tax?

In a sense the two options are mirror images:

(a) A market for carbon emissions is based on direct restrictions on the quantity of emissions. The price of emissions adjusts according the supply of emission permits – more restrictive supply, higher price.

(b) A carbon tax is based on setting the price of emissions, and allowing the quantity of emissions to adjust – higher tax, fewer emissions.

William Nordhaus is probably the leading economic researcher working on climate change. He has a new paper out that argues the case for a carbon tax, instead of a carbon market. Advantages of a tax approach (mostly taken from the Nordhaus paper) include the following:

• One of the difficult issues in negotiating the Kyoto protocol was reaching agreement about the target emission levels for each country. In a carbon tax system, there would be no need to haggle about the targets of individual countries. Emitters in each country would face the same tax. “Countries would not be advantaged or disadvantaged by their past policies or the choice of arbitrary dates” (Nordhaus, 2007, p. 36).
• We would like to strike the “right” balance between economic activity and emissions abatement, but because of the great uncertainty about almost everything in the climate change problem, we don’t know which quantity of permits or which tax level would strike that balance. Given that we are likely to get the permit level or the tax level wrong, which mistake is likely to be worse? This is a question first posed by Martin Weitzman in a famous paper back in 1974. Nordhaus argues that, in the case of climate change, the scope for costly mistakes is greater for a market system. For example, Pizer (1997) estimated that, for this reason, the expected net benefits of a carbon tax would be five times greater than for a market system.
• In a carbon market in the short term, the supply of permits is fairly fixed, while the demand for them is not very responsive to price. This means that prices can be very volatile, as they have been in the European CO2 market. Such volatility can be very costly as people constantly attempt to adjust. The price of a carbon tax is set administratively, and so is not volatile at all.
• The receipts from a carbon tax can be used to reduce taxes on income or other goods or services.
• Quantity-based systems probably have a greater potential to generate corruption. In a market system, emission permits have a value, and so who gets them at what price can be manipulated by corrupt regimes and officials.
• The administrative apparatus already exists for a tax system

On the other hand, there are some disadvantages of a tax approach, including the following.

• Even once the tax was in place, it would be difficult to tell what effect it was having on emissions.
• There would still be a need for haggling on a country-by-country basis, although on different issues. For example, some countries already have higher taxes on transport fuels. How should these be considered when setting a new carbon tax?
• People just don’t like taxes. Their unpopularity may affect the acceptability of the policy in some countries.
• When the market approach is introduced, the permits can be given to current emitters, increasing the political acceptability of the system.
• There may be equity concerns about applying the same tax rate in developing and developed countries.

Overall, Nordhaus concludes that a carbon tax would probably be better than a carbon market. Given the above disadvantages, it’s possibly not a clear-cut thing, but he may be right on balance. It’s at least worth considering in the debate.

An interesting side issue in Nordhaus’s paper was that he put the carbon price in the context of current fuel prices. According to Nordhaus, a CO2 price of $30 per tonne (which sometimes is discussed as the sort of thing we should expect) would result in a rise in petrol price of 6 cents per litre (22 cents per gallon). I was really surprised at how low that was. It’s roughly the magnitude of weekly fluctuations in retail petrol price where I live, and less than the range among petrol stations at any point in time. It seems to me that this would have a tiny impact on carbon emissions, at least from transport fuels, and probably from other sources as well. Given the very large emission reductions that scientists claim are necessary, it suggests to me that the carbon price required to achieve the desired emission reductions will be much higher than the prices we’ve heard about so far. (Either that, or we’ll be needing some radical new technologies, and hence a strong focus on technology development.)

David Pannell, The University of Western Australia

Further Reading

Nordhaus, W.D. (2007). To tax or not to tax: Alternative approaches to slowing global warming, Review of Environmental Economics and Policy 1: 26-44. http://reep.oxfordjournals.org/content/1/1/26.full.pdf

Pizer, W.A. (1997). Prices vs. quantities revisited: The case of climate change, Discussion Paper 98-02, Resources For the Future, Washington D.C. http://www.rff.org/documents/RFF-DP-98-02.pdf

Weitzman, M. (1974). Prices vs. quantities, Review of Economic Studies 41: 477-491.