EU Economics: Hopes for a low carbon future in Europe

With EU carbon emissions market has closed since the middle of January after hackers stole €30m of permits the economics of a EU wide carbon tax has been given fresh prominence in recent weeks. Charles Hart evaluates the arguments for and against a tax on emissions in this super applied micro essay. After the essay there are some links to recent blog posts and other resources on carbon trading and carbon taxation.

Question: A European-wide Carbon Tax across the Single Market represents the best Hope for a Significant Movement towards a Low Carbon Economy for the EU. Discuss.

A carbon tax is a tax that is levied on the carbon content of fuels, an example of a Pigouvian tax which is a tax on market activities with negative externalities, and is implemented by taxing the burning of fossil fuels in proportion to their carbon content. Carbon dioxide rises in the atmosphere and remains resident there, trapping heat re-radiated from the Earth’s surface and causing global warming and other climate change. The main intended effect of installing a carbon tax is that the overall production of carbon will be reduced, as well as increasing the competitiveness of non-carbon technologies thus protecting the environment while maintaining revenues. However, it is not the only idea that has been proposed as a means of reducing the EU’s carbon footprint; other methods include the implementation of a carbon trading scheme within the EU, an increase in the levels of investment in carbon capture and storage as well as stricter regulation of both consumers and producers.

The strength of a carbon tax is that it internalizes the externalities associated with the consumption of goods which cause carbon dioxide emissions. A tax would raise the marginal cost of all carbon dioxide emitting activities which in turn would provide not only firms with an incentive to cut their emissions but also an impetus for consumer behaviour to change. Taxing fuels according to their carbon content will have varied and numerous effects on the choices of both firms and consumers that will cause a rapid decline in the world’s output of carbon dioxide; for consumers a carbon tax will affect what cars, appliances and housing they buy and for firms it will alter their investment objectives towards greener technology, change their existing methods of production as well as their product design. Furthermore, the tax revenue that the government would earn through a carbon tax could be spent on funding projects with green ambitions, or could be used to fund tax breaks for firms working in the green sector or with larger research and development departments.

However, the implementation of a carbon tax has been opposed by some within the EU who resent the loss of national autonomy which a mandatory pan-European tax would represent. Another problem with introducing a carbon tax is that it would require the agreement of all 27 member nations and while most, if not all, would agree that the notion of a carbon tax is a good idea it would be still be unlikely that a tax was created that pleased every nation. Furthermore, if the EU failed to make a carbon tax law it is unlikely that individual countries would install their own due to the competitive advantage that doing so would give the other EU nations. Another source of opposition to the idea of a cross-Europe carbon tax is that it would harm the competitiveness of industries within the EU, especially farmers and car manufacturers, and this could be especially damaging in the current recovery. Perhaps the most fundamental weakness of a European-wide carbon tax is that the 27 nations which comprise the EU are all different, whether in their fiscal state or their current carbon dioxide emission levels, and so trying to set one carbon tax for the entire region is not practical. If one tax was set, it would result in the industries in some countries suffering greatly while industries in other countries would fare much better as a result of each individual country’s level of emissions prior to the implementation of the tax.

Another policy approach to lower emissions of carbon dioxide within the European Union is emissions trading, a form of pollution control that uses the market mechanism to change relative prices and the incentives of producers and consumers. Emissions trading is an example of a cap and trade policy and works thusly: a fixed number of emissions permits is allocated each year to factories within a particular industry and these permits can be traded so firms that produce less emissions than their limit can sell their permits to firms which pollute more than their limit, over time the total number of permits is reduced and so the total emission within the industry decreases. As the total number of permits begins to lower their price begins to increase, and this increases the cost of emitting carbon dioxide. Therefore, lowering the total number of permits should act as a catalyst for innovation and investment in reducing emissions.

A carbon trading scheme has already been introduced in the EU, called the European Union Emissions Trading Scheme (EU ETS), but in a form that has been much criticised. Some have argued that it adds to the cost of EU producers and so causes a loss of competitiveness, and others have pointed out that it does not cover enough industries within the EU, for example airlines are not included in the scheme and are among the biggest producers of carbon emissions. Another fault of the scheme is that it has been poorly policed and is subject to high levels of fraud as well as thievery; in fact in January 2011 the carbon market in the EU was suspended due to criminal activity. Also many have argued that when the scheme was first launched, too many permits were issued and so the impetus to invest in greener technologies and alter behaviour was not created; furthermore the EU’s generosity with the permits in conjunction with the global recession has lead to a sharp fall in prices, to around €13-15, which is too low to have an effect on decisions.

The introduction of much tougher regulations on carbon emission by the European Union could result in lower emissions in the area, and has in particular been applied to vehicle emissions. The European emission standards define the acceptable limits for exhaust emission of new cars sold within the region. For each vehicle type different standards apply, and those which fail to pass the standards cannot be sold within the EU. However the standards do not apply to those cars which are already on the roads so the effect of the scheme is limited, however its effects will be more pronounced in the long term. One criticism of this scheme is that although it will result in lower carbon emissions, it does not directly incentivise the production of vehicles that run on other fuels, such as electricity or hydrogen, and so is not a catalyst for a complete product innovation but simply a catalyst for improving existing vehicle models.

Subsidising non-pollutants and firms in the green sector would increase incentives for innovation and could result in lower carbon emissions across the European Union. By either offering subsidies to those companies which are lowering their emission or by providing tax breaks to firms setting up in the green sector the EU would decrease the costs faced by businesses who are trying to cut their emissions, by cutting their marginal abatement cost. The EU could also promote initiatives in the private sector, such as TheGreenXchange whose aim is to bring about sustainable change, which attempt to bring companies together to try and find solutions to high levels of emissions collectively.

The key to bringing about the required change to move the EU towards a low carbon economy, in my opinion, is to acknowledge that no one single panacea exists for the problem. Therefore the most effective way in which the EU can tackle emissions is to embrace all the tools at its disposal, and importantly use them effectively and correctly, especially in the case of carbon trading which in theory is very powerful but in practice has been weakened by the manner of its implementation.