Access Economics and CEDA on carbon taxes

I’ve seen a number of reports of statements by CEDA supporting a carbon tax as an alternative to emissions trading. This seemed surprising, since the two are basically equivalent. Given that the ETS is almost in place, suggesting such a variation seemed rather pointless.

But I’ve now received an email from CEDA which appears to explain everything. The real distinction is not between a tax and a trading scheme but between a tax levied at the point where carbon is used and one where final products are consumed. Since Australia exports a lot of embodied carbon, the tax on final consumption would raise a lot less revenue, and cause a much smaller economic shock.

In fact, modelling by Access Economics (PDF) suggests that the loss of income under a consumption-based carbon tax would be about half that from a production-based tax or ETS

So what’s the catch ?

Actually, there are two. The first is obvious. The consumption tax costs about half as much, but also achieves about half as much in terms of emissions. You could get the same outcome by proposing a tax levied at half the rate implied by an ETS.

The other problem is more technical, but more fundamental. In general, it makes no difference whether a tax is imposed on consumers or producers. If the tax is imposed on producers, they raise their prices as much as market demand permits, and consumers are affected just the same as if they paid directly. The same point is applicable here, but it’s missed in the analysis because there is (it appears) no modelling of the determination of world prices. But pretty clearly, if consumers of Australian exports had to pay tax on the embodied carbon, they would be willing to pay less than if the tax had already been paid in Australia.

35 thoughts on “Access Economics and CEDA on carbon taxes

  1. The problem with both ETS and most carbon tax proposals is that they “exclude by exception” and depend on “putting a price on carbon” to drive change. As a consequence, any practical version of ETS or carbon taxes requires a complex system of exclusions and compensation to minimize the unproductive price increases that occur when polluters decide that it makes more sense to pay the price instead of acting to reduce emissions.
    It makes more sense start with a much simpler system that “includes by exception” and feels free to think outside the put a price on carbon mindset. For example, we might start with a system that focuses on cars (oil shock) and electricity generation (50% of emissions) and adds other opportunities to reduce net emissions at a later date.
    In the case of cars the most price effective approach would be to leave the price of fuel unchanged and use a combination of regulation and offset credit trading to drive down the average emissions of new cars.

    In the case of electricity generation it would make sense to leave the price of dirty electricity unchanged and while only paying a higher price for clean electricity. As a result, the average price of electricity would only ramp up slowly as the proportion of clean electricity increases. One way of doing this would be for the government to set up a series of contracts for the supply of clean electricity. Price and sales guarantees would be negotiated as part of the process of setting up each contract.
    It will be a lot easier to sell an approach that is simple enough for mere mortals to understand, particularly if there are no price shocks.

  2. @John Davidson

    In the case of electricity generation it would make sense to leave the price of dirty electricity unchanged and while only paying a higher price for clean electricity.

    I’ve read this from you a number of times but it makes no more sense to me than it did the first time. Wouldn’t that give an advantage to dirty electricity? If you force people to buy increasing amounts of clean electricity wouldn’t that simply mean that the government would be seen as forcing people to buy more expensive power?

    This seems like a recipe for buisiness as usual to me, but if it isn’t it makes much less sense than carbon trading, at least in terms of the notional objective of reducing resort to dirty power. Surely we have to be saying

    look, there is a cost to filth, but it’s invisible, an externality and so we are going to insert that into the cost so that when producing filth is the least of all evils, we will do it but those responsioble will make adequate restitution.

    That gets us away from “oh it’s about the government raising taxes” and moves it onto “it’s the community preventing people from embezzling the value of the commons and killing us”.

  3. @Ilya
    No-one cares. Not only do we burn a lot of coal at home, we are the world’s largest coal exporter. We peddle the enemy-of-the-human-race and are richly rewarded for it.

  4. They are not really equivalent for the same reasons an auctioned quota is not equivalent to a tariff at equilibrium price in trade theory – there is a vast trade literature on this. They respond differently to market changes, the cap-and-trade generates a huge securities market which some see as intrinsically undesirable, asymmetric information etc. Under cap-and-trade the carbon price might vary by 20% per month which makes longer-term planning by affected firms difficult. But I agree, overall, the issue of choice is second order.

    More importantly however taxing consumption rather than production is vastly different if you account for foreign trade. Taxing exports puts Australian exporters at a disadvantage compared to other countries if they do not charge for carbon emissions and encourages carbon leakages – shifts of local polluters to offshore pollution havens. In this event a local carbon charge becomes of zero effectiveness since the reimported outputs are not subject to a charge if charging is based on production.

    It is pointless to destroy local industries and people’s livelihoods if there are no pollution gains at all. Indeed if the rest of the world employs dirtier technologies than we do there could be a net global environmental disadvantage.

    I strongly support consumption based charging with exemptions for exporters and border tax adjustments on untaxed imports. The difficulty is to structure the exemptions – ad valorem exemptions create incentives to divert output to foreign markets which again means carbon is leaked while fixed exemptions run into problems as the world changes.

    I think Waxman-Markey gets it right. Provide fixed exemptions for exports but let them fade away through time.

  5. ” I strongly support consumption based charging with exemptions for exporters and border tax adjustments on untaxed imports. ”

    This is an important point. It is promising to see that the WTO appears to be happy with border taxes to protect domestic industries in the case of carbon taxes.

    “”Rules permit, under certain conditions, the use of border tax adjustments on imported and exported products,” said the WTO. “The objective of a border tax adjustment is to level the playing field between taxed domestic industries and untaxed foreign competition by ensuring that internal taxes on products are trade neutral.””

  6. “The other problem is more technical, but more fundamental. In general [emphasis added], it makes no difference whether a tax is imposed on consumers or producers. If the tax is imposed on producers, they raise their prices as much as market demand permits, and consumers are affected just the same as if they paid directly.”

    JQ, could you please comment on any circumstances which can produce particular cases where things don’t work out like that? It would help in identifying other stuff to look out for, to see if the insights from the general pattern might need to be adjusted.

  7. Surprising that Access have come up with such basic mistakes. As Prof JQ suggests, in a static general equilibrium world model the impact of a tax on consumers and a tax on producers would be the same. One question is, how would you calculate the tax on consumers? You would have to account for the components of everything going into every product that may or may not have used a greenhouse gas producing technology. I imagine this would be difficult to do and also extremely costly. The other important difference would be where the revenue from the two schemes would be collected. The revenue in both cases ought to be about the same but instead of the countries with the problem producers collecting more revenue, it would be the high consumption countries that would get it. This suggests that the economic impact on Australia would be considerably greater under the consumption tax approach compared with the producer tax approach because in the former approach there would be a substantial loss of tax revenue that, instead, would be collected by other, consuming, jurisdictions.

  8. I venture to say that the proposition of the equivalence of a carbon tax and cap and trade price is a special case. It holds if C02 emission is the only negative externality in an otherwise Arrow-Debreu model representing the ‘global economy’ (ie, the introduction of ‘a carbon price’ would complete a purely commodity market). But this is not the world we live in.

    I agree with hc that cap and trade introduces another set of financial contracts. This ‘market’ can grow bubbles through debt financed price speculation. Then there will be derivatives, written on the pollution right certificates (or whatever the contracts are called) because people seem to still suffer from the illusion that this helps to ‘manage price risk’.

    Further, in my own theoretical model of a partially segmented world economy with multinational firms (an extension of the Arrow-Debreu model, which excludes further complications arising from financial markets as well as incomplete markets and sequential markets), certain beliefs as to gains from international trade do not hold. For example, as a consequence of introducing a market structure which is a little bit more realistic, the Fisher Separation Theorem does not hold – sub-sets of consumers (shareholders) are ‘exploited’ by other sub-sets (generic). That is, one cannot find a ‘price mechanism’ which removes this potentially systematic redistribution of (real) wealth, even though markets are locally coplete in each sub-economy.

    Then there is this habit of thinking with the category ‘country’. There are many geopolitically defined countries, each of which would be better represented by a partially segmented economy than by a model of ‘an economy’ each. Specifically, all those which are relatively ‘large’ and have non-trivial income or wealth inequalities, relative to say Denmark. India and China come to mind. I am suggestig that such countries should have higher prices for C02 for those segments of their population which are at least as wealthy as those in say Denmark (ie pay the same price as in, say, Denmark). – Just a thought.

  9. @Ernestine
    But taxes on the rich with transfers to the poor and one C02 price for all might be a pareto improvement on your suggestion? And if, under your suggestion, the prices are too generous for the poor it might not be possible to achieve the reduction goal. After all, if the poor face lower prices as CO2 producers they will substitute into CO2 production.

  10. Freelander, @ 12, I don’t understand your question. Are you referring to relatively poor individuals in various countries or relatively poor countries?

  11. Freelander @ 12 and 14,

    As I understand it (I might be wrong), the Kyoto framework uses the category ‘country’ and there is no requirement on individual governments to link internal income redistribution (via taxes and subsidies) to differences in emission targets (and hence implicit prices).

    In your last sentence @12 you talk about the ‘poor’ being producers. Are you still talking about individuals?

  12. Administrative simplicity requires carbon penalties to be imposed high in the supply chain. Consider the case of nitrogen fertiliser made from natural gas. The process creates CO2 at the factory but further N2O (nitrous oxide) emissions will occur when each bag of fertiliser is used by farmers. That N20 has as CO2 equivalence factor of 340. I doubt it would be practical for each farmer to submit a carbon tax return listing how many bags of fertiliser were used.

    Another issue to consider is that of global rather than local benefit if aluminium smelters powered by coal fired electricity were to go offshore. Rather than carbon penalty free China aluminium smelting could go Russia, Congo, Quebec or Iceland with low carbon generation. This might be an eventual outcome of high carbon penalties but politicians can’t countenance the loss of jobs. This is why carbon penalties need to exist in the first place but secondly they need to be consistent across all countries.

  13. @Fran Barlow
    Fran: And I have consistently said that the use of clean electricity must take preference over dirty electricity under normal situations provided that the clean electricity is offered at the negotiated price. This is why I keep rabbiting on about the use of sales and price guarantees fro clean alternatives being a more price effective way of encouraging investment on clean alternatives than boosting the price of the dirty alternative. I find it hard to understand why you think this gives an advantage to dirty electricity.

  14. @Fran Barlow
    Fran: My solution is to force everyone to buy their share of clean electricity with essentially all clean electricty produced going on to the grid and the shortfall being made up by dirty electricity.
    To clarify where I am coming from consider a hypothetical case where clean electricity has to be sold for 10 cents extra per kWh to justify investment in clean electricity, all current power is dirty and we are aiming to replace 25% of dirty electricity by 2020:
    1. Under ETS or carbon taxes the price of dirty electricty has to be increased by 10 cents to bring the price of all electricty up to the point where investment in clean electricty is judtified. The average price of electricty will be 10 cents above the current price of dirty electricity well before 2020 if we ignore inflation.
    2. Under schemes where the price of dirty electricity is left unchanged and the higher price only paid for clean electricity the average price of electricity will only rise to 2.5 cents above the current price of dirty electricty by 2020 if we ignore inflation. Seems like a winner to me.

  15. HC, I agree on the difference between ETS and taxes and support ETS on that basis.

    As regards the international trade questions, this depends critically on what you assume about other countries. If no other countries are acting, then it makes sense for us to exclude our entire traded goods sector, not just exports as with a consumption tax. But the idea that we should design a scheme on that basis is planning for failure.

    On the other hand, as a proposal for a global agreement, a consumption-based tax will inevitably be seen as self-serving (though, if it were accepted, the Oz government would get more tax revenue).

  16. @jquiggin

    “(though, if it were accepted, the Oz government would get more tax revenue).”

    John, we consume more than we produce? Is this mainly due to imported oil?

  17. @John Davidson

    What makes you think you can contract substantially cleaner electricity (apart, perhaps, from nuclear) for a price only 2.5 cents more than dirty electricity?

  18. JQ @21, if I understand correctly, you are saying we need as set of contingent plans for negotiation purposes.

  19. John, Other countries – including major trading partners such as India and China – are not acting. Moreover, they have so far suggested that they will not act – in China’s case up until 2030 or 2050. Despite some noises India, which has vastly lower energy consumption/head than China, will probably respond equivalently.

    Of course if all countries act equivalently then production-based taxes make sense. There are then no carbon leakage issues either directly from trade or from footloose polluters. In an unconstrained world what you suggest is correct.

    An advantage of a consumption-based charge can be transitional. If it is levied then countries like China will face the price of their exports increasing by the amount of the border tax. But this tax will accrue to countries like Australia who import the goods. China gets advantage by leving the tax itself.

    The incentives are for China to tax production itself and to urge Australia to do the same. Then we get to your (and indeed my) preferred scenario.

    I don’t understand your remark about excluding the trade sector entirely if other countries do not charge carbon. Under a consumption basis we would tax carbon-intensive imports via border taxes and for practical reasons only carbon intensive exports would be exempted.

    In my view we should urge all countries to shift to production based taxes eventually by leving consumption based charges now. Countries such as China should be urged to levy charges on their own consumptions by providing compensations and finance to them (in income, technology transfer etc) from developed countries. In fact the offerings of techniocal assistance made under the Waxman-Markey bill and by the Europeans can be seen as a first step in this direction.

  20. John, On the choice between ETS and taxes, like you, I have been rather indifferent. It is obviously more important to get one of these operating than none. On balance I have gone for ETS for the standard reasons – you should get a definite carbon outcome.

    But I think concerns about carbon price instability are of concern. You have mentioned in earlier posts that variable carbon prices can act as an automatic stabiliser and that is true. But they are also a signal for investment decisions for firms. Lots of noise in these prices might lead firms to delay investments in carbon friendly technologies for quasi-option reasons. That might be privately optimal but socially disadvantageous.

    I worry too about the huge new created financial markets in carbon. Won’t these be subject to asymmetric information and insider trading issues from energy and power suppliers.

    Finally in practical terms I am becoming pessimistic about the prospects for agreements at Copenhagen or soon thereafter. Maybe a decentralised set of national taxes has greater chance of getting agreement among very different countries. This might be so even if the optimum is a global cap-and-trade with transfers.

  21. It’s a shame the Federal Opposition is inept at pointing out Rudd’s inconsistencies. Recall that Rudd’s two big election promises were Work Choices and Kyoto and that the thorough Garnaut review wanted the ETS to start in July 2009, two months ago. Since then the Rudd government has approved every extension to the coal industry and evidently now wishes to continue a high migration program. It’s extraordinary that he has only received the mildest of criticism. That makes me wonder if he will be emboldened to come back from Copenhagen with some new blather that will never be implemented because he can get away with it.

    There are however risks of political inaction. Confrontations such as Hazelwood could get nastier. Perhaps consumers will be ask to boycott certain carbon intensive products. An extreme weather event will galvanise the public out of complacency for a while. I believe a return to $150 oil will slow emissions, not only transport based but general production and consumption. Whatever transpires I think in the long run there will be diminished respect for politics.

  22. @Hermit

    It’s a shame the Federal Opposition is inept at pointing out Rudd’s inconsistencies. Recall that Rudd’s two big election promises were Work Choices and Kyoto and that the thorough Garnaut review wanted the ETS to start in July 2009, two months ago. Since then the Rudd government has approved every extension to the coal industry […]

    It’s not so much a shame as a consequence of the Opposition’s attachment to the coal industry and the big polluters in general.

  23. @Fran Barlow
    Fran: I said that my figures were based on

    a hypothetical case where clean electricity has to be sold for 10 cents extra per kWh.

    I used this figure to SIMPLIFY THE ARITHMETIC. For this assumption the 2.5 cents/kWh is the increase in the AVERAGE price after 25% of the dirty electricity had been replaced by clean electricity. There was no suggestion that contracting would give a clean power premium as low as 2.5 CENTS/kWh.
    The advantages of using a series of contracts (for the supply of clean electricity) going through the normal tendering process include:
    1. The negotiated prices that prices will be competitive.
    2. The option is there to put boundaries on location, technology etc. if appropriate.
    3. Lower prices may be obtained for later contracts as technology improves without adding tech progress as a risk that early investors need to factor into their pricing.

  24. HC, I am more optimistic and see no sense in maintaining the status quo. Copenhagen is more about setting an appropriate target of betweeen 25-40%. How countries go about reducing their greenhouse gas emissions is their problem.

  25. @Fran Barlow

    The best thing I heard all week was Rudd’s latest outburst “I dont care what you f*****s think” re him cutting the excessive printing expense allocations! I laughed so hard!. Good on him. If the opposition wasnt such a bunch of f*****s in bed with big Coal he might get more legislation through that is useful as well.

  26. @Alice

    You’re overlooking the reality that Kevin Rudd is part of a threesome … a ménage à trois, in which both Rudd and the Opposition love “Big Coal” and compete for its love.

    It’s all very well to get all bothered about stamps, but when it comes to all this lovely filth … they go weak at the knees …

  27. @Fran Barlow
    Maybe your are right Fran…and we are doomed. Coal – its just a big oilemof filthy dust and if thats the best of production they can manage from this economy…they have swallowed the global empire and obstructed the bowels of Australia (call it proectionism if anyone wants but Im over the global economy when all that matters is a filthy black dust that is wrecking the planet). My son found love on a night I will refer to as hell visits Sydney (choking red dust) – -never have I ever seen it before in my entire life (heard about it in places like Coonamble – never seen it before). Its truly scary. If that much red dust was whipped up to travel this far to Sydney, it must be as dry as a bone in the red heart.

    Im actually scared for my kid and the future, and the love affair with big Coal needs to die a million political deaths in this country, before we do. Turnaround needed.

  28. I have heard of another approach to Carbon Trading/Carbon Tazes that is being promoted, I believe, in the US. It is called Cap & Dividend. It is promoted as a simpler and possibly fairer alternative to Cap & Trade

    This is a link to a site promoting it.

    Any opinions?

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