Are carbon taxes a solution to the climate emergency?

With the growing recognition of the global climate emergency (see also), attention is being increasingly focused on policies to tackle global warming.

In the October version of its journal, Fiscal Monitor, the IMF argues that carbon taxes can play a major part in meeting the goal of achieving net zero carbon emissions by 2050 or earlier.

As the blog accompanying the journal states:

Global warming has become a clear and present threat. Actions and commitments to date have fallen short. The longer we wait, the greater the loss of life and damage to the world economy. Finance ministers must play a central role to champion and implement fiscal policies to curb climate change. To do so, they should reshape the tax system and fiscal policies to discourage carbon emissions from coal and other polluting fossil fuels.

The effect of a carbon tax on production

The argument is that carbon emissions represent a massive negative externality, where the costs are borne largely by people other than the emitters. Taxes can internalise these externalities. The effect would be to raise the price of carbon-emitting activities and reduce the quantity consumed and hence produced.

The diagram illustrates the argument. It takes the case of carbon emissions from coal-fired electricity generation in a large country. To keep the analysis simple, it is assumed that all electricity in the country is generated from coal-fired power stations and that there are many such power stations, making the market perfectly competitive.

It is assumed that all the benefits from electricity production accrue solely to the consumers of electricity (i.e. there are no external benefits from consumption). Marginal private and marginal social benefits of the production of electricity are thus the same (MPB = MSB). The curve slopes downwards because, with a downward-sloping demand for electricity, higher output results in a lower marginal benefit (diminishing marginal utility).

Competitive market forces, with producers and consumers responding only to private costs and benefits, will result in a market equilibrium at point a in the diagram: i.e. where demand equals supply. The market equilibrium price is P₀ while the market equilibrium quantity is Q₀. However the presence of external costs in production means that MSC > MPC. In other words, MEC = b – a.

The socially optimal output would be Q* where P = MSB = MSC, achieved at the socially optimal price of P*. This is illustrated at point d and clearly shows how external costs of production in a perfectly competitive market result in overproduction: i.e. Q₀ > Q*. From society’s point of view, too much electricity is being produced and consumed.

If a carbon tax of d – c is imposed on the electricity producers, it will now be in producers’ interests to produce at Q*, where their new private marginal costs (including tax) equals their marginal private benefit.

Assessing the benefits of carbon taxes

The diagram shows the direct effect on production of electricity. With widespread carbon taxes, there would be similar direct effects on other industries that emit carbon, and also on consumers, faced with higher fuel prices. In the UK, for example, there are currently higher taxes on high-emissions vehicles than on low-emissions ones.

However, there are other effects of carbon taxes which contribute to the reduction in carbon emissions over the longer term. First, firms will have an incentive to invest in green energy production, such as wind, solar and hydro. Second, it will encourage R&D in green energy technology. Third, consumers will have an incentive to use less electricity by investing in more efficient appliances and home insulation and making an effort to turn off lights, the TV, computers and so on.

People may object to paying more for electricity, gas and motor fuel, but the tax revenues could be invested in cheaper clean public transport, home insulation and public services generally, such as health and education. This could be part of a policy of redistribution, with the tax revenues being spent on alleviating poverty. Alternatively, other taxes could be cut.

The IMF estimates that to restrict global warming to 2°C (a target seen as too modest by many environmentalists), large emitting countries ‘should introduce a carbon tax set to rise quickly to $75 a ton in 2030’.

This would mean household electric bills would go up by 43 per cent cumulatively over the next decade on average – more in countries that still rely heavily on coal in electricity generation, less elsewhere. Gasoline would cost 14 percent more on average.

It gives the example of Sweden, which has a carbon tax of $127 per ton. This has resulted in a 25% reduction in emissions since 1995, while the economy has expanded 75% since then.

Limits of carbon taxes

Although carbon taxes can make a significant contribution to combatting global warming, there are problems with their use.

First, it may be politically popular for governments not to impose them, or raise them, with politicians arguing that they are keen to help ‘struggling motorists’ or poor people ‘struggling to keep their homes warm’. In the UK, successive governments year after year have chosen not to raise road fuel taxes, despite a Fuel Price Escalator (replaced in 2011 by a Fuel Duty Stabiliser) designed to raise fuel taxes each year by more than inflation. Also, governments fear that higher energy prices would raise costs for their country’s industries, thereby damaging exports.

Second, it is difficult to measure the marginal external costs of CO₂ emissions, which gives ammunition to those arguing to keep taxes low. In such cases it may be prudent, if politically possible, to set carbon taxes quite high.

Third, they should not be seen as a sufficient policy on their own, but as just part of the solution to global warming. Legislation to prevent high emissions can be another powerful tool to prevent activities that have high carbon emissions. Examples include banning high-emission vehicles; a requirement for coal-fired power stations and carbon emitting factories to install CO₂ scrubbers (filters); and tougher planning regulations for factories that emit carbon. Education to encourage people to cut their own personal use of fossil fuels is another powerful means of influencing behaviour.

A cap-and-trade system, such as the European Emissions Trading Scheme would be an alternative means of cutting carbon efficiently. It involves setting quotas for emissions and allowing firms which manage to cut emissions to sell their surplus permits to less efficient firms. This puts a price pressure on firms to be more efficient. But the quotas (the ‘cap’) must be sufficiently tight if emissions are going to be cut to desired levels.

But, despite being just one possible policy, carbon taxes can make a significant contribution to combatting global warming.

Articles

• Fiscal Policies to Curb Climate Change

IMF blog, Vitor Gaspar, Paolo Mauro, Ian Parry and Catherine Pattillo (10/10/19)

• Energy bills will have to rise sharply to avoid climate crisis, says IMF

The Guardian, Larry Elliott (10/10/19)

• Huge global carbon tax hike needed in next 10 years to head off climate disaster, says IMF

Independent, Chris Mooney and Andrew Freedman (11/10/19)

• World urgently needs to quicken steps to reduce global warming – IMF

Reuters, Lindsay Dunsmuir (10/10/19)

• The Case for a Goldilocks Carbon Tax

Forbes, Roger Pielke (13/9/19)

• The world needs a massive carbon tax in just 10 years to limit climate change, IMF says

Washington Post, Chris Mooney and Andrew Freedman (10/10/19)

• People like the idea of a carbon tax – if the money is put to good use

New Scientist, Michael Le Page (18/9/19)

• The IMF thinks carbon taxes will stop the climate crisis. That’s a terrible idea.

The Guardian, Kate Aronoff (12/10/19)

• Firms ignoring climate crisis will go bankrupt, says Mark Carney

The Guardian, Damian Carrington (13/10/19)

• How central banks can tackle climate change

Financial Times, The editorial board (31/10/19)

• World Economic Forum: Climate change action needed to avoid societal ‘collapse’ says minister

The National, UAE, Anna Zacharias (3/11/19)

• Riots and trade wars: Why carbon taxes will not solve climate crisis

Recharge, Leigh Collins (31/10/19) (Part 1)

• The plethora of effective alternatives to carbon pricing

Recharge, Leigh Collins (31/10/19) (Part 2)

• Are these the real reasons why Big Oil wants a carbon tax?

Recharge, Leigh Collins (31/10/19) (Part 3)

• Do we need carbon taxes in an era of cheap renewables?

Recharge, Leigh Collins (31/10/19) (Part 4)

Report

• How to Mitigate Climate Change

IMF Fiscal Monitor, Ian Parry (team leader), Thomas Baunsgaard, William Gbohoui, Raphael Lam, Victor Mylonas, Mehdi Raissi, Alpa Shah and Baoping Shang (October 2019)

Questions