Carbon Taxes versus Carbon Credits: Assessing the options

The scene for environmental actions seems unclear as far as the choice between policy options are concerned. When the world today is facing the risk of global warning on a scale too high than ever and that nations across the globe are already witnessing the effects of such warning the sense of changed climatic conditions and nature making too vigorous counterstrike more often than not, it seems that while the intent to take action on such cause does exist but then the attempt to translate this intent into hard realities has not found considerable strength as it should have.

While the environmentalists the world over are calling for stringent and immediate action, the governments are still divided over the policy options available with them to address the issues at hand. Nonetheless, the choices it seems, have boiled down to two main ones being; carbon taxes and carbon credits, both having been discussed and addressed in detail by both fronts; the policy makers and the academia. In our attempt to amplify the law to its whys and hows, we bring to post to to explain the underlying idea (with the options available and the manner in which the choice is exercised) as to how law in this field has been enacted, thus offering insights into the law making process.

Why the choice?

So what do we have? Hotter climate, more cyclones in the world, melting ice at the glaciers, ... and what not. How does it care to us? Or in fact even if we care, how is it linked to either taxes or carbon credits? Since when did environment start talking of economic terms? A lots of question, no doubt, but all essential linked. Linked for the entire thing started when like-minded nations were convinced to do something at the international level; an attempt which culminated into the vociferously discussed Kyoto Protocol. The object of this Protocol, as a part of the international (United Nations sponsored) Framework Convention on Climate Change (UNFCCC or simply FCCC), was to reduce emission of green house gases. This Protocol, signed in 1997 (but coming into effect as late as 2005) marked the first step towards an international addressing of the issue of climate change and discussion of ways to deal with the issue, which can in sum and substance be described as 'tackling global warming'. However, the measure conceived in the Protocol are controversial enough to incite governments to hold positions at variance. [click here for a wiki description]

Besides Kyoto, what we have is the Stern Review, the most comprehensive and almost exhaustive research report from Lord Nicholas Stern (who currently heads the India Observatory at LSE), a 700 page document which unravels the relationship between climate change and world economy and nicely dealienates the issues at hand. [click here for more of Stern Review, and here for full text of Stern Review]

Thus (though only morally I would say) the governments across the world came to realize the need for a consorted effort in this area and

What are the choices?

The scheme under the Protocol envisages limits being imposed upon nations and industries situated therein as to how much they can emit. With these limits come sanctions (though not in the formal sense of the term) and thus arise the need to come to terms with these sanctions. So what we have is allowance to trade. This would mean that the industries which emit less than their sanctioned limit could sell of the excess of emission (called as 'carbon credits' as CO2 or carbon dioxide is the major emission and credits because these are the points they earn for not polluting). [Explained in greater detail in the later half of this post]

Besides this option of trading, governments always have the choice to rely back upon their tax systems to impose a levy on non-green practices and simultaneously confer incentives for greener practices, thereby promoting a culture of climate conservation and thus environmental taxes. In fact this area has also received considerable academic attention for the ease of administration and the notions of a compulsory levy (i.e. tax) to preserve the environment sounds too great an opportunity to be missed. Since these taxes would be imposed on emission of green house gases, they are also known as 'carbon taxes'.

So we end up with carbon taxes and emissions trading as the two strategically most viable and significant options available with nations governments (in both of which an international accord is also conceivable) for placing a control on global warming. Let us analyze the two to assess these options.

Explaining carbon taxes?

A carbon tax system presupposes (i) increased taxes on 'bad' activity (i.e. carbon and other polluting activity) and (ii) reduced taxes or even incentives in form of tax concessions on 'good' activity (i.e. employing eco-friendly way), on businesses. This acts not only an inducement for business to go green but also brings to the government revenues which can be spent on building infrastructure and generally working towards reduction of emissions and global warming. To speak in international terms, this would achieve a 'Global Clean Technology Fund', which could be channelized for preserving environment under the aegis of a dedicated international institution.

Inspired by wiki, I decided to make a graph to explain how these taxes would come to terms to establish a eco-sensitive transaction mechanism in the markets and here I seek to demystify how. [click on the photo to enlarge]

In the above graph, the two key elements are the MSC (Marginal Social Cost) and MPC (Marginal Private Cost). To illustrate, for a cigarette manufacturer (let us say) finds that cost of producing one cigarette comes out to be $0.20. In a perfect competition scenario, the manufacturer would sell the cigarette at cost or with an amount of profit that is generally attributable to such product in the industry. Let us say that this comes out to be $0.25. Therefore the purchaser has to bear $0.25 for each cigarette and this price represents the MPC of the parties to the transaction.

However, this is not the end of story for upon the consumption of cigarette the buyer emits smoke and pollutes the environment. It has negative impact upon the health of others as well and let us say the overall cost to society (which would come if these negative impacts were to be valued) comes to $0.75. This would incorporate the cost of cleaning or rather reinstating the society to the original level had that cigarette not been consumed. Thus the cost to the society comes to be higher than that decided between the parties for the transaction. These costs to the society are denoted by MSC curve on the graph.

Given a global scenario and each man for himself philosophy, it is but fair for the parties to the transaction to also bear the social costs they bring in the system. Thus it would be but fair for the government to impose a levy on the cigarette (in our example) to bring the transaction price at the right terms, incorporating the social costs incurred thereon. Therefore the government imposes a tax upon the transaction meant to bring the MPC curve at equivalence with MSC, thus forcing the parties to take into account the social costs of the transactions they undertake.

As seen from the diagram, t (measured as distance between OE) is the amount of tax imposed and because of this tax, the cost of the good increases (therefore the revised MPC curve as MPC+t) and consequently (given the perfect competition assumption), the quantity supplied also falls from Qo to Qs. Also, the government earns revenue (in this case the area covered in OEAB). But what is more important is that the market interacts at a level at which MSC = MPC+t and therefore all social costs are accounted for, thereby making the parties pay for the harm they carry to the environment. Though economists may argue that determination of this 't' at which the social costs are accounted for is something not pragmatic, nonetheless the concept is worthy enough to be emulated.

Once this tax is collected, it is the prerogative of the national government to spend it on climate control on its own or to subscribe to a global climate fund for the matter to be handled globally. Nonetheless, in either case, the major role remains with the government which also can bring in regulation to ensure that these aims are sought after both in text and spirit.

Unraveling emissions trading?

The arena of emissions trading looks similar to the idea of a global stock exchange and really is an offshoot of the Kyoto model of dealing with climate change and global warming. The economics of global warming has been instrumental in ensuring that trading takes place with a optimal price of carbon determined by markets to ensure that environment is in fact benefited by the trading.

The idea behind this essentially starts by allocation of emission limits to industries, the limit being applied across the board depending upon the nature of industry. The idea is to set a bench-mark limit to emulate and reduce the emissions level below this limit. Thus the industries which attain a higher efficiency to reduce the emissions lower than that prescribed are free to trade these credits and to ensure that these are sold at the right price, as have a trading mechanism, which looks essentially as a stock exchange. It is worthwhile here to note that the Multi-Commodity Exchange of India (MCX) has already become Asia's first exchange to allow trading of carbon credit contracts. [click here for full report] With these emission norms aimed to be applied globally, the optimal price determination would require an international trading regime wherein participations offering and bidding for these credits could interact, something which we are yet to witness but we would soon witness one.

Thus the idea is that emissions would be controlled within a predetermined level (based upon which emission limits are determined for industries) as industries would be able to pollute only till the extent of entire quotas being allocated to the industries. To illustrate, let us suppose the amount of Carbon dioxide added to atmosphere per year is 150 tonnes and the global consensus is to reduce it to 100 tonnes. Now 100 tonnes would be the benchmark for allocating emission limits (or 'quotas') to the industry and in a situation wherein there are 10 homogeneous industries, the quota for each would be 10 ton. Now let us say that five industries total emit 35 tonnes. Therefore the remaining five industries can only emit 50 tonnes of their quota plus 15 tonnes of the quota bought from others and nothing beyond. In this scenario the low emitters might gain windfall profits by selling the excess of their quotas but then on a global scenario, the total emission is indeed reduced to 100 tonnes. The global trading platform just ensure that there do not remain unused quotas and that the credits sold are sold at the right price, determined by the market forces of demand and supply, nothing beyond.

The system works with the level of permitted emissions progressively being reduced. Thus say next year instead of 100 tonnes only 90 tonnes are available. Thus the carbon trading regime does come out as an equally worthwhile option for reducing emissions but only subject to the fact that there remains a global consensus on the limits of emissions and the manner in which they are allocated to the industries, something which is yet eluding the policy makers to come to a consensus to. Nonetheless the European Union seems to have stuck with this model of emissions trading and has unveiled Phase - III of the European Trading System (ETS) (scheduled to commence from 2013) wherein the aim is to reduce the emissions level by 21 percent compared to the Phase - II currently in operation.

What next?

One of the major emitters, the United States is yet to take a concrete decision on this regard of dealing with the situation, though the idea of emission trading has indeed found a lot of support internally. Nonetheless the world will have to wait till a new President is elected who decided to commit the country to one approach or the other. The United Kingdom's Green Fiscal Commission and other activities there has seem to come up with the idea of a Climate Change Bill to be introduced, as a part of the regulation based approach to be adopted therein to manage the issue.

The two options have been so deeply discussed that there even have been suggestion of a Hybrid Model which seek to incorporate the best of both these features, thereby ensuing a regulatory-cum-trading regime for climate control. However the future lies essentially in the hands of the developing countries, especially China which is one of the highest green house emitter, which have to come to terms with the developed world to ensure that the ecological balance on this planet does not become a victim of the north-south tussle. The 2009 Conference in Copenhagen as a prelude to the post Kyoto framework is expected to come out with some solid groundwork on the issue but then as of now the future of either options is uncertain.

Further readings;

1. A nice discussion on Europe's adoption of trading regime
2. A series of publication on global warming and the two options
3. Wikipedia on Pigovian Taxes, EcoTax, Social Costs, Emissions Trading
4. Excerpts from Nicholas Stern's Review
5. An LSE professor on Emissions Trading