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Carbon policy: reducing emissions while preserving economic vitality 1

Carbonpolicy:reducingemissionswhilepreservingeconomicvitality

AndrewJ.Mackay

CaadaCollege

Carbon policy: reducing emissions while preserving economic vitality 2
Abstract

The challenges posed by greenhouse gas emissions is both pressing and unique. While previous
environmental issues were solved using traditional statute regulation, and more recently a capandtrade
scheme, carbon dioxide has a huge number of sources and longterm costs that are difficult to estimate.
Capandtrade systems were able to reduce emissions that were leading to acid rain. But the largest
effort against carbon the Kyoto Protocol and the European Unions Emissions Trading Scheme, have
been deeply flawed and wracked by political infighting. A revenueneutral carbon tax, which would set
a universal price for carbon emissions, and then use the revenue to lower business and personal income
taxes, is a way to efficiently reduce carbon emissions over time. And in light of the failure of the Kyoto
Protocol and issues with nationstates cooperating emissions, it provides an option that is economically
competitiveevenifotherstatesdonotenactsimilarpolicy.

Carbon policy: reducing emissions while preserving economic vitality 3
Global climate change is an increasing threat to both present and future economic wellbeing. To
address the social costs of continued carbon dioxide (CO
2
, henceforth called carbon) emissions, a
comprehensive, but also efficient mechanism must be used to regulate and reduce emissions over time.
Of potential economic policies aimed at longterm reductions of carbon emissions, a revenueneutral
carbon tax has clear advantages over both a capandtrade system and traditional government
regulation. This analysis will look over short and longterm environmental goals, how the nature of
carbon emissions fits a tax best, and what the economic impact of such a policy is compared to
alternatives.
Pollution of all types is classified as an externality. Externalities are interactions that affect
unaffiliated third parties these come in both positive and negative varieties. An example of a positive
externality is when a neighbor spruces up their house and yard before selling it though surrounding
homeowners do not spend money on this project, they benefit because nicer houses raise surrounding
property values. A negative is when the neighbor doesnt maintain the property and it becomes an
eyesore, thus reducing surrounding property values. Pollution as a negative externality affects larger
society due to the economic decisions of a few industries. The damage of the externality is the difference
betweenprivatecostsandsocialcosts.

Carbon policy: reducing emissions while preserving economic vitality 4

The above graph demonstrates the economic market created by a negative externality. There
are different marginal costs, one for the producers of pollution (MPC) and the marginal cost for society
as a whole (MSC). They are separate because private costs are a subset of the larger societal costs
thus MSC is greater. Producers increase quantity to the detriment of marginal social benefit (MSB).
The ultimate goal is to minimize social costs while avoiding a large shock to the economy in essence the
goalistomoveallocationfromQtoQ1.Thequestionofpolicythencomesintoplay.
Carbon control policy must be suited for the unique aspects of the carbon market. Each type of
pollution has a unique market. In the case of carbon, sources are disparate. Livestock and the human
population emit large amounts of greenhouse gases, as does transit and industrial processes. Unlike
chemicals linked to acid rain, carbon pollution is not concentrated in defined geographic areas.
Emissions do not dissipate quickly, so Global climate change is a stock externality. The consequences
depend not on emissions in a single year, but on the accumulated stock of emissions over time (Newell
&Pizer,2003).Thenatureofcarbonemissionsisdistinctitseffectsareuncertain..
Carbon policy: reducing emissions while preserving economic vitality 5
Uncertainty is a key aspect of carbon pollution, and which effective policy must address. While
there is a consensus that carboninduced climate change will be economically damaging, the range of
estimates are huge. Suggestions range between 5% and 20% of global GDP (Hilsenrath), a difference in
the trillions of USD per year. Thus policy must be able to respond to new data, as it may drastically
changethecostestimate.
There exist three major options when faced with serious social costs brought on by pollution
you can create a capandtrade market, institute a carbon tax, or implement commandandcontrol
(CAC) regulation. The first two are market options. Capandtrade focuses on setting a quantity of
allowable pollution, while a carbon tax assigns a direct price on a given unit of carbon emissions.
Commandandcontrol is the creation of regulatory statutes that reduce emissions over time. Market
options emerged in the past few decades as a response to issues with commandandcontrol
(Harrington&Morgenstern,2004).
The traditional policy of regulation, commandandcontrol, has wellestablished flaws. Under
CAC, specific statutes are crafted to deal with sources of pollution certain technologies and processes
are allowed or forbidden. A major problem is that rigid statutes force firms into narrow paths towards
reducing emissions indeed, the Congressional Budget Office (CBO) says that capandtrade has a
benefit over CAC because The trading aspect of the program would lead to substantial cost savings
relative to commandandcontrol approaches because it would provide more flexibility about where and
how emission reductions were achieved (Orszag, 2008). Secondly, past efforts found that The nearly
limitless variety of American industries and industrial processes required the EPA to write very detailed
and complex regulations, but despite these efforts, the Agency faced a raft of legal challenges.
(Harrington & Morgenstern, 2004) Finally, CAC may create unintended consequences that hurt the
Carbon policy: reducing emissions while preserving economic vitality 6
ultimate goal creating higher standards for new power plant construction, for instance, may lead to
firms keeping older and less efficient plants open. The switch to capandtrade programs led to some
marveloussuccessesinthenoncarbonpollutionmarket.
Capandtrade is a policy solution based on limiting the quantity of available pollution allowed.
As Robert Stavins states in 2001 discussion paper, Under a capandtrade system, an allowable
overall level of pollution is established and allocated among firms in the form of permits, which can be
freely exchanged among sources and that these permits are distributed through free distribution or
through sale (for example, auction) by the government. Permits would be required to pollute, and thus
would gain value. Firms that could reduce emissions quickly would have extra permits left over they
could then sell them to higherpolluting firms, providing an incentive to innovate and streamline industrial
processes. The price of these permits depends on the level of the cap and the economy permit prices
rise in economic booms and fall in recessions. There have been scenarios when the policy has yielded
greatsocialbenefit.
The big day for capandtrade came from its incredible results against emissions of sulfur
dioxide (SO
2
) and nitrogen oxides (NO
x
), the two compounds that lead to acid rain. After a
capandtrademarketforemissionswasestablishedthroughthe1990CleanAirActamendments,

The Acid Rain Program has produced remarkable and demonstrable results. It has
reduced SO2 emissions faster and at far lower costs than anticipated, yielding
wideranging health and environmental improvements... the Acid Rain Program
accounted for the largest quantified human health benefits over $70 billion annually
ofanymajorfederalregulatoryprogramimplementedinthelast10years.(EPA2003)
Carbon policy: reducing emissions while preserving economic vitality 7
Harrington & Morgenstern (2004) back up the low costs (1/2 of expected costs when implemented)
and point out that capandtrade worked better than CAC programs in Europe. These results are
amazing and unambiguous. But the question is does the carbon market act the same as the acid rain
market?
In a word, no. Carbon as a stock externality makes its danger difficult to quantify. Acid rain had
clear, quick consequences forest damage, riparian destruction it was easy to figure out what the
socially optimal levels SO
2
and NO
x
were. Setting a useful cap requires a great amount of information.


Thomas Crocker, an economist who codeveloped capandtrade theory in the 1960s, is skeptical of
his idea in the carbon market because "Once a cap is in place...it is very difficult to adjust" (Hilsenrath,
2009). The largest capandtrade market, the European Union Emissions Trading Scheme (EU ETS) is
in a serious crisis an overallocation of permits, followed by a deep recession, have made the permits
are nearly worthless and the cap meaningless (Plumer, 2013). While recessions under a cap do not
increaseemissions,cheappermitsdonotencourageaswitchtogreenertechnology.
The third option is a carbon tax, which puts a single price on each unit of carbon emissions.
There are several attractive attributes of a carbon tax. One is certainty and consistency in pricing
because capandtrade permit prices depend on the business cycle, it is difficult to predict the price of
carbon years down the road. Secondly, it is better suited to uncertainty an inaccurate cap is much more
difficult to adjust then an inaccurate price important given the longterm nature of a stock externality.
And though taxes are politically unpopular, a carbon tax has a simplicity that commandandcontrol can
neverhave.Oneofthemostimportantpartsofacarbontaxisitcaneasilybemaderevenueneutral.
A revenueneutral carbon tax uses what the state collects from polluters to create offsets in the
tax code. British Columbia, which has the largest example of a revenueneutral tax, has used carbon tax
Carbon policy: reducing emissions while preserving economic vitality 8
receipts to lower both personal and corporate income taxes to the lowest levels in Canada (British
Columbias carbon tax shift, 2012). The tax naturally affects carbonintensive industries the most.
Kevin Perese, in a 2010 CBO paper, estimated with a hypothetical $20/ton carbon tax that
commodity price changes would be largest for carbonintensive commodities such as natural gas
distribution (12.0%), coal mining (11.6%), electricity (9.3%), and petroleum and coal products
(7.6%). Since lowerincome households spend a higher proportion of income on heating and gasoline,
the income tax cuts are aimed at the bottom two brackets, and there is also a substantial lowincome tax
credit(BritishColumbiascarbontaxshift).
The available evidence indicates that a revenueneutral carbon tax does not negatively affect the
larger economy. A University of Ottawa study released in 2012 concludes that While it would be a
stretch to claim that the tax shift has had a positive impact on the economy...the data appear to indicate
it has not had a negative effect (British Columbias carbon tax shift, 2012). B.C GDP growth has
been largely consistent with other Canadian provinces, and it recovered just as well from the
20082009recessionthatcoincidedwiththebeginningofthetax.

A carbon tax is not immune to political manipulation that can undermine its effectiveness.
Exemptions for certain industries would cripple the tax both by leaving large sources of emissions
unregulated, and not providing needed revenue. Harvard economics professor Robert N. Stavins states
that a carbon tax would be sensitive to the same political pressures [as capandtrade], and should be
expected to succumb in ways that are ultimately more harmful: reducing environmental achievement and
driving up costs (2012). Exemptions in collecting the tax are not the only issue, the politics of revenue
dispersalcanjeopardizeeffectiveness.
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Using tax revenue in unbalanced ways can also cause economic problems. In the current debate
prior to the British Columbia provincial election, the New Democratic Party (NDP) would expand the
carbon tax to included vented emissions from the oil and gas industry, worth an estimated $35 million
when it takes effect next year and $100 million by 201617...the New Democrats would not balance
the carbon tax with tax reductions. In fact, an NDP government would increase the corporate income
tax at the same time (Moore, 2013). Not balancing taxes on firms with tax cuts and credits for firms is
dangerous and may make B.C. business less competitive. What has worked well so far record low
taxes for many people and certain industries could be reversed due to political considerations. This is
dangerous, because a true revenueneutral carbon tax has something that the international climate
dialoguehaslackedapolicythatfunctionswellindependentofinternationalaction.
United Nations climate talks before and after the Kyoto Protocol have been plagued by the
prisoners dilemma, a central issue in game theory. The idea, explained as two separate prisoners who
can either cooperate or betray the other, is a game...in which it is difficult to get rational, selfish agents
to cooperate for their common good (Kuhn 2007). The reality as it stands is that the international
response to climate change will go the way of the prisoner's dilemma. Rational leaders will always
neglect the problem, on the grounds that others will either solve it, allowing their country to become a
freerider, or let it fester, making it a doomed cause anyway (Economist, 2007). The present
stalemate in the Kyoto Protocol age includes the Peoples Republic of China and the United States, the
two biggest carbon emitters, who will only cut emissions if the other does as well. If carbon policy is a
statistically significant impediment to economic growth, largescale action requires an improbable
agreement.However,ifacarbonpolicywasnotanimpediment,thisissuebeginstodissolve.
What a revenueneutral carbon tax does is reduce social costs while keeping the economy
Carbon policy: reducing emissions while preserving economic vitality 10
constant on the whole. Since B.C has shown that GDP growth need not be impaired by the tax, it could
be said that the game theory is now different. Since a party can reduce carbon without losing
competitiveness with nontax parties, the decision no longer weighs on the decision of others. Since it
does not require external resources, the tax does not worsen the deficit problems that some countries
suffer assuming parties do not use the revenue as a funding source for social programs that would
create a distortion in the economy. States, provinces, and countries can correct the negative externality
and through the stimulus of lower corporate and income taxes not pay for having done so. This feasible
path to lower emissions across a wide range of state and substate actors is due to the relative
advantageofarevenueneutralcarbontaxoverotherformsofregulation.
The present world of environmental policy is a world of chaos. As the symptoms of climate
change become harder to ignore (e.g. record heat, crop failure, unusual storms), the political sphere has
erupted in conflict regarding what to do. While selfinterested political concerns can ruin any carbon
policy be it CAC, capandtrade, or a tax the evidence seems to favor a tax that offsets rising energy
and electricity costs with lower taxes for lowincome families and corporations. In regards to
international concerns, the fear of economic disaster by unilaterally cutting emissions can be dissuaded
through a revenueneutral tax, which does not seem to negatively affect GDP growth. In that regard, the
policymaybecomemorepoliticallypopular.


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