Climate change is one of the world’s biggest economic problems. To sufficiently reduce its impact, governments across the world must take significant action. This includes implementing policies to abate carbon emissions: a known cause of climate change. These policies—regardless of their form—are almost always politically controversial. In spite of this, there is a solution that is demonstrably economically superior.

Anyone who has taken an introductory economics course would recognise that carbon emissions create a negative externality. Even the father of free market economics himself, Adam Smith, advocates for government intervention to correct externalities; it increases economic efficiency.

The two primary methods of (market-based) control are policies directly targeting the quantity of emissions (cap-and-trade schemes) or policies directly putting a price on emissions (taxes). For the uninitiated, cap-and-trade scheme or emissions trading scheme is (generally) where the government sets a cap on carbon emissions and issues permits to firms to allow a certain amount of carbon emissions (e.g. one tonne). Firms must hold such a permit for each tonne of carbon they emit. Firms are able to trade their permits, meaning that those who are in less need of permits can sell them to those who require more permits. In contrast, price mechanisms do not cap the quantity of emissions, but rather charge a tax for each unit of emissions. 

Australia has a particularly patchy policy history in this area. Politicians of various parties are seemingly deeply divided from each other on the method of best tackling the issue. This wasn’t always the case. Leading up to the 2007 election, both the Prime Minister (John Howard) and the Opposition Leader (Kevin Rudd) promised to implement an emissions trading scheme (ETS) after the election. After winning government, the Rudd government designed an ETS and sought to pass it through Parliament in 2009. It was initially supported by the Malcolm Turnbull-led opposition. Shortly before the scheme was to be voted on in the Senate, Tony Abbott became the opposition leader and withdrew support from the bill. The Greens also refused to support the scheme.

In 2011 the Gillard government introduced (and passed) the Clean Energy Act 2011 with the support of the Greens. The Act established a fixed-fee for carbon emissions for three years (a carbon tax) before a legislated transition to a cap-and-trade scheme in July 2015. In an effort to offset the increases in living costs due to carbon pricing and make the scheme revenue-neutral, the government reduced income taxes from the 2011-12 financial year onward. There was significant political and public backlash to this scheme, and it was repealed in 2014 (before the transition to the ETS) by the newly elected Abbott government. It was replaced by the current policy: the Emissions Reduction Fund (ERF). This involves the government directly paying polluters to reduce emissions (which seems to be somehow more palatable to climate skeptics than the revenue-neutral scheme it replaced). Everyone’s favourite ECON2030 lecturer Dr Ian MacKenzie, an environmental economist, has discussed the merits of that policy multiple times.

Leaving aside political difficulties, the primary technical issue facing regulators is that the efficient level of carbon abatement is unknown. While it is great to set Marginal Social Benefit equal to the Marginal Private Cost on a neat graph in a classroom, difficulties arise when we don’t know these curves. The MSB curve is relatively easy to estimate; it is the benefits to society from reduced emissions. However, the MC curve is tricker. It consists of the aggregate cost of carbon abatement for firms.

Luckily for us, there is a solution. If the marginal benefit curve is relatively flat compared with the marginal cost curve, a price mechanism results in less deadweight loss than a quantity mechanism. If the MB curve is relatively steeper, then a quantity mechanism causes less deadweight loss. This is seen in the figure below, where the difference in relative size of deadweight loss (from miscalculating the efficient point) is stark.

(Figure from William Pizer, “Prices vs. Quantities Revisited: The Case of Climate Change”,
Discussion Paper 98-02, Resources for the Future, October 1997, page 5. Available here ).

So which case applies to carbon emissions?

Climate change is a ‘stock externality’. This means that the majority of the negative effects come from the build-up of carbon emissions (and other greenhouse gases) over time: not so much on the marginal emissions in a particular year. There is not a great difference in incremental benefit between each unit abated. What this means is that the marginal benefit of abatement curve is relatively flat. Thus, the graph on the left is the most accurate depiction, and a price mechanism is economically superior.

This is borne out in the literature. While it is difficult to objectively measure net social benefits from these policies (for the same reasons it’s difficult to predict the MC curve) several studies have shown that the marginal benefit curve is relatively flatter than the MC curve in the context of carbon emissions. Further studies (Newell and Pizer, 2001, for example) have shown that price regulations as opposed to quantity regulations cause at least twice as much economic surplus for controlling carbon emissions. That is, there is at least twice as much economic benefit from using carbon taxes over cap-and-trade schemes. Can someone please tell Canberra?

Normatively, even oil and gas executives prefer a carbon tax over an ETS. In his former life as ExxonMobil CEO, Rex Tillerson said that a cap-and-trade scheme “inevitably introduces unnecessary cost and complexity” while a carbon tax is a “a more direct, more transparent and more effective approach”.

In spite of this, cap-and-trade schemes seem to be more popular than carbon taxes. These are in place in the European Union, Switzerland, California, South Korea, New Zealand, and various regions in China and Japan. China is planning a full national implementation in 2020.

Sweden, the United Kingdom and Ireland each have a carbon tax that supplements the EU ETS (due to the persistently low price of carbon permits). Canada has also implemented a national carbon price for provinces that do not have their own ETS or carbon tax in place.

There is a clear economic solution to the current climate policy fiasco. Externalities should be corrected, and the most efficient way to correct this externality is through a price on carbon. If only Canberra could put aside the three-word slogans for long enough to read an economics paper, the state of our national climate policy would be significantly better.

-Isaac Nankavill

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