Ethos Perspectives
Policy Approaches to Carbon Pricing
In September, Ethos Perspectives examined the challenges and opportunities of climate change. One key issue identified was the need to price carbon to create the right incentives for more efficient resource use, so as to reduce carbon dioxide emissions. Ideally, this would be undertaken in tandem with the establishment of a global emissions reduction regime.
This issue of Ethos Perspectives lays out the broad parameters that a carbon pricing policy would have to address, and postulates what such a policy could look like in Singapore’s context.
POLICY FRAMEWORKS
To evaluate a global emissions reduction policy framework, economist Nicholas Stern has proposed three key criteria. A good policy framework should be:
- Effective at managing the risks from climate change affordably;
- Efficient at guiding mitigation efforts toward the most cost-effective options; and
- Equitable in recognising that developed countries have an obligation due to past emissions, and also that all countries have to contribute to varying degrees to address a shared problem.
Policy approaches for pricing carbon generally fall into three categories: (1) command and control regulation, (2) cap-and-trade systems, and (3) carbon taxes.
Traditional command and control regulations implicitly place a price on carbon by mandating emissions levels across all polluters. Polluters then pursue emissions reducing measures to comply with the regulations. However, unnecessarily costly measures may be pursued, and aome industries may pay a higher price than others to mitigate the same quantity of emissions. On the other hand, cap-and-trade systems and carbon taxes establish explicit prices for carbon, incentivising producers and consumers in the economy to prioritise the most cost-effective emissions reduction measures.
A cap-and-trade programme does this by setting quantitative targets for emission reductions and timetables to achieve them, and allowing polluters to buy and sell "rights" to produce the targeted emissions. Permits representing any difference between targeted and actual emissions can be traded or transferred.
Carbon taxes reduce emissions by raising the cost and price of products and activities that result in CO2 emissions by taxing the fossil fuels that produce them, either nationally or through international agreement on a harmonised tax on carbon-based fuels.
EFFICACY
By directly controlling the quantity of emissions, cap-and-trade systems provide greater certainty in meeting short and long term climate control objectives. However, the inability of rigid caps to adapt to the business cycle means that prices of energy and goods will experience substantial volatility. Permit prices under the US Acid Rain Program and the EU Emissions Trading Scheme resulted in prices fluctuating more than 40% annually.
Long-term R&D in energy, especially with high upfront costs, may be adversely affected by a cap-and-trade system. Such R&D may be dependent on stability in mainstream fuel prices. The prospect of volatility in permit prices could make it harder to justify investment. Carbon saving innovations could push down the price of permits, thereby reducing returns on innovation. Some cap-and-trade advocates propose incorporating "safety valves" in the form of price floors and ceilings for permits to address this.
In comparison, carbon taxes give one control over the price of carbon. However, it offers less certainty in level of emissions reduction. Nevertheless, some argue that because the consequences of climate change depend more on the stock of greenhouse gases, rather than on annual emissions (flow), this shortcoming is ultimately correctable in the long-term through gradual tax adjustments.
Internationally, commentators worry that a harmonised carbon tax can be easily undermined by countries providing countervailing subsidies to negate the agreed tax. Nonetheless, simulations show that a harmonised carbon tax will be more environmentally effective, and less dependent on compliance by all countries. In contrast, within a cap-and-trade regime, non-compliance by a few countries might render the entire system ineffective. If fraudulent "over-selling" occurs, or if polluters "under-buy" permits, the price of permits would converge to zero.
EFFICIENCY
Domestically, any form of carbon pricing leads to deadweight losses. Under a carbon tax, the increase in efficiency loss from carbon pricing can be compensated by an equivalent reduction in other taxes. The transparency of a carbon tax allows one to easily determine the quantum of this tax reduction. In contrast, a cap-and-trade system makes it hard to discern the impact of the caps on consumer prices. For this reason, no major study of the effect of the EU Emissions Trading Scheme on prices for energy and consumer goods has yet been completed. While opaque prices can be politically advantageous for cap-and-trade advocates and rent-seeking businesses, a critical question is how much of a cost burden are consumers willing to bear to have the true costs of a policy hidden from them.
I I |
