Cap ‘n Tax Carbon Policy – a new perspective..

Following my post on carbon policy in South Africa, here is an article that proposes a hybrid solution to carbon policy in America, the only region that does not intend to ratify the Kyoto Protocol. It is based on original research by the author, David Apple, who is a dual citizen of France and the U.S. and is currently residing in London. He has a BS in Mechanical Engineering from The Johns Hopkins University, and an Executive MBA at Imperial College in London. His professional experiences have made him aware of the limitations of current carbon-related policies. This article is based on his MBA thesis about the future of carbon policy.

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As more countries continue to commit to ambitious carbon reduction targets, there has been growing interest in determining which policies governments should adopt in order to achieve the carbon emission levels to which they have committed. Generally, the debate exists between two policies: carbon tax or carbon trading. The victor has not been determined due to the fact that both of these policies contain inherent benefits and drawbacks. Based on substantive analysis, I have coined an innovative policy which is effectively a hybrid of carbon tax and carbon trading. It aims to capture the benefits of both schemes while avoiding some of their drawbacks. This hybrid policy is entitled ‘Cap-and-Tax’.

The key points of the cap-and-tax policy are that each carbon-emitting entity will be granted a carbon emission allowance (equivalent to the “cap” in a carbon trading scheme). The allowance will be set such that if it is not surpassed, the government will achieve its carbon emission reduction targets. The allowance will be reduced each year at a pre-determined rate based on the government’s carbon emission target. If an entity exceeds its allowance, it will be taxed for each additional kilogram of carbon it emits. If an organisation’s annual emissions are lower than its allowance, it will receive a tax credit for the reduction in carbon emission at the same rate as the carbon tax. Each organisation’s carbon emissions will be publicly reported every year.

The tax rate of the cap-and-tax policy will be based on the government’s cost of offsetting carbon emissions and will increase at a pre-determined rate every year. A portion of the tax revenue will be re-distributed to organisations which emitted less than their allowance while the rest of the tax revenue will be invested in low-carbon projects in order to offset the emissions which were taxed. An independent organisation will be put in charge of investing the tax revenue in order to guarantee that the scheme is revenue-neutral for the government.

Pros and Cons of Existing Policies

Carbon emissions have historically been handled in an inefficient way. In economic terms, carbon emissions are considered to be an “externality” because their cost is not directly taken into account in investment decisions. As a result, because it is currently far more cost-effective to generate energy by emitting carbon dioxide than without, society has been emitting far more than the optimal amount of carbon dioxide.

Different countries have approached the issue of reducing their carbon emissions in different ways. In some cases governments have aimed to incentivise private investment in low-carbon systems through various forms of subsidies, in other cases governments have forced low-carbon systems into the economy through regulations. The four principal categories of carbon-related policies are:

  • Command and control policies (e.g. building regulations)
  • Government funding (feed-in tariffs and capital grants)
  • Ecological tax policies
  • Carbon trading policies

Each of these policies have inherent benefits and drawbacks:

Command and control policies are essential due to the fact that they ensure that minimum standards are achieved. On the other hand, a command and control policy does not provide any incentive for developers to go beyond the minimum standard. As such, command and control policies are effective at dictating minimum standards; however another type of policy must be utilised in order to provide motivation for entities to go beyond the minimum standards.

Feed-in tariffs have proven to be effective at incentivising investment in technologies which generate energy by improving the return on investment of environmentally friendly technologies. The drawback with feed-in tariffs is that the government determines both the appropriate tariff and the type of technology that is worthy of a feed-in tariff as opposed to letting the market select the best system. This could lead to the government subsidising a technology which is not worthy of investment or offering a disproportionately high subsidy to one technology over another.

An alternative to a feed-in tariff is a capital grant. Capital grants will reduce the initial capital cost of a technology. They tend to be most appropriate for technologies where a feed-in tariff could not be applied (for example a system which does not generate energy – such as the insulation of a loft) due to the fact that they do not provide a financial incentive for the system to be installed efficiently nor to be maintained regularly.

Ecological taxes aim to make people’s consumption and behaviour more environmentally friendly by increasing the cost of products and services with a negative environmental impact. Based on the economic theory of supply and demand, increasing the price of carbon due to taxes will directly reduce the demand for carbon. Taxes also have the advantage of providing revenue for the government, allowing them to reinvest the taxes collected in order to mitigate the negative impact which was being taxed in the first place.

The principal drawback of a carbon tax system is that it is a burden which is imposed evenly on everyone in the market. As a result, it serves as an artificial method of increasing the cost of energy. This has the negative consequence of imposing the same tax level on the entire population, thus increasing the levels of fuel poverty.

Another drawback to an eco-tax system is that politicians often gain or lose popularity based on whether they increase or decrease taxes. A tax on carbon emissions could be perceived as yet another scheme to increase government revenue, and whoever implements this policy could lose precious public support (also known as committing “political suicide”). As a consequence of this, it may be difficult for a traditional carbon tax to be implemented for strategic political reasons as opposed to practical reasons.

In a carbon trading scheme, such as the one proposed in the American Clean Energy and Security Act (see sidebar), the economy’s total carbon emissions are theoretically “capped”, which should ensure that the target for emissions reductions will be achieved. The market determines the cost of offsetting carbon emissions (as opposed to the government) based on the most cost-effective systems and geographical locations to offset carbon emissions. The reason why carbon trading has been popular with businesses is that it will theoretically ensure that the total cost to the economy of offsetting carbon emissions will be kept at a minimum.

One of the drawbacks of carbon trading lies in the necessity of hiring specialised staff. This requirement limits the scale of a carbon trading scheme to large organizations who can afford to participate. Another significant drawback to carbon trading is that the price of carbon will fluctuate due to speculation.

The EU ETS European-wide carbon trading market saw a 200% increase in the price of carbon in one year, followed by a 50% decrease shortly thereafter. The uncertainty surrounding the price of carbon will be counter-productive as it will make it difficult for companies to make long-term investment decisions in energy efficient systems to reduce their carbon emissions. In general, a trading scheme is best applied to a market where there are few players (e.g. the NOx and SOx trading scheme used by industrials in the USA), but is less effective when the market is very large (e.g. in the case of trading carbon emissions).

Benefits of the Hybrid Cap-and-Tax Policy

There are several important benefits with a hybrid policy, which are listed below.

Carbon emission allowance. The principal perceived drawback of a carbon tax policy is that it will increase fuel poverty because it is a burden which is imposed equally on the entire population. In an effort to avoid this drawback to a traditional eco-tax system, each entity will be granted an annual allowance for their carbon emissions (in the same way as in a carbon trading policy). If this allowance is not surpassed, it will enable the government to achieve their carbon emission reduction targets. The UK government’s target is currently to achieve an 80 percent reduction in carbon emissions from 1990 levels by 2050. The carbon emissions allowance in the cap-and-tax scheme will follow a planned and incremental reduction every year culminating in a 20 percent allowance (i.e. an 80 percent reduction) in 2050 from 1990 levels.

Tax rates and tax benefits. For entities which surpass their annual allowance, each kilogram of carbon emitted thereafter will be taxed based on the government’s cost of reducing the equivalent carbon emissions. Entities which consume less than their allowance will be granted the difference as tax credit. As a result, the polluter pays for their emissions, and the environmentally friendly entities receive a benefit.

Long-term investment incentives. In order to increase the financial incentive for companies to achieve their emissions reductions on their own by making long-term investments, it will be announced that the tax-rate will be increased every year at a steady rate, independent of market forces. The objective is to provide an incentive to make long-term investment decisions immediately, while avoiding the negative repercussions of a sudden price-hike.

Collected taxes are used to offset the equivalent emissions. If an organisation surpasses its annual allowance, each kilogram of carbon emitted thereafter will be taxed based on the government’s cost of offsetting carbon emissions (i.e. the cost of wind, tidal, nuclear, planting trees, etc). The consequence will be that for each extra kilogram of carbon which is emitted, the polluter pays enough money for the government to offset it. Based on the current cost of offsetting carbon and on historical carbon trading prices, the tax on carbon emissions would likely start around £20 per ton of carbon dioxide (which represents an increase in the order of 10% on energy costs).

In order to ensure revenue neutrality for the government, the tax will be run by an organisation which is independent of the government (eg. Ofgen). This independent organisation will be expected to produce a long-term budget showing how they intend to reduce carbon emissions if the market doesn’t, and how much each technology will cost per kilogram to offset. The organisation will begin by investing in the low-cost technologies (e.g. planting trees) and will progressively invest in the more expensive technologies. This will both justify the progressive increase in the tax rate and will ensure that the collected taxes are used as efficiently as possible.

The more you emit, the more you pay. Currently, large energy consumers are able to negotiate preferential rates with energy suppliers. The net result of this is that the more energy an entity consumes, the lower their cost per kilowatt hour. By imposing a tax on over-consumption, a cap-and-tax scheme will reverse this trend by making organisations pay an incrementally higher average price per kilowatt hour as their consumption increases beyond their allowance.

Avoids “political suicide.” A cap-and-tax policy will be easier for the government to promote when compared to a traditional carbon tax because it is a tax which can be avoided. Indeed, if an organisation achieves the targeted reduction in carbon emissions, the cap-and-tax policy will not adversely affect it. If an organisation consumes less than their allowance it will actually benefit them. The concept that the polluters pay is popular which makes it easier for a politician to “sell” to the population.

Awareness of emissions and corporate social responsibility. Commercial entities will have to report their carbon emissions annually. This will force companies to measure their emissions, which is the first step in starting to manage their carbon emissions. High emission rates will have a negative impact on the image of a company and will provide an additional incentive for them to reduce their carbon emission level below that of their competitors.

Simplicity and scale. A cap-and-tax scheme is simple to understand and to execute. The concept can therefore be applied to the carbon emissions of all residential and commercial entities, and in the future the structure of the system could also be used for other forms of regulations relating to externalities (e.g. levels of water consumption).

Cap-and-tax is fail-proof. The cap-and-tax policy is designed to be fail-proof as the taxes will fully fund the government’s efforts to offset emissions. Consequently, regardless of the effort which organisations put into reducing their carbon emissions, the government will achieve the targeted level of carbon emission reductions by using the taxes to subsidize offsetting the carbon emissions.

Cap-and-tax is cost-effective. The cap-and-tax policy is cost-effective. Organisations will reduce their carbon emissions so long as they can do so more cost-effectively than the government’s tax. When the organisation reaches the point where a further reduction in carbon emissions would be more expensive than the tax, it will choose to pay the tax. In this case, their emissions will be offset by the government in a more cost-effective way than the organisation could achieve on its own. As a result, both the government and organisations will manage their carbon emissions more cost-effectively.

Conclusion

Because it is both fail-proof and cost-effective, the new cap-and-tax policy will be the best compromise between carbon trading and a carbon taxes because it will cater to the market while ensuring compliance to the targeted reduction in carbon emissions.

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2 Responses to Cap ‘n Tax Carbon Policy – a new perspective..

  1. kimbo October 11, 2010 at 9:49 am #

    This article really clarifies the options and I like the idea of a hybrid solution to ensure that the cons of either pure tax or cap schemes are mitigated. The key is to ensure that whatever scheme is selected allows business to make long term investment decisions with clear signals, after all a power station will have a lifetime of 30 years +.

  2. South Africa Travel Online April 3, 2011 at 8:39 am #

    I agree that the carbon tax can easily be used as a method for collecting more revenue. This is easily dealt with though, by equivalent reductions in other taxes (e.g. income tax).

    See details of my thoughts in the official response to the carbon tax, submitted to National Treasury.

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