Why a carbon tax should be Australia’s answer to climate change

The recent release of the draft Garnaut Report has focused attention on how an emissions trading scheme (ETS) should be implemented in Australia in order to curb our carbon emissions. In serving this purpose, the draft Report glosses over a number of considerations and makes several assumptions that appear designed to make an ETS a fait accompli as far as the best response to climate change goes. This is unfortunate, since an ETS suffers from a number of problems that do not arise under a carbon tax.

As with many official pronouncements regarding climate change, the draft Report starts from a position that carbon emissions must be reduced. While this may be the case, it mischaracterises the problem of carbon pollution by setting up the issue as one of quantity control. The correct approach, which would lead to a more appropriate regulatory response, is to recognise that the problem is really one of undercharging (or, as here, not charging at all) for the use of a particular resource, specifically, emitting carbon into the atmosphere.

It is entirely appropriate that some form of charge be levied on carbon emitters, since carbon emissions do impose a cost on non-emitters (what economists call a negative externality). Even if one is not convinced that carbon emissions cause climate change, it is difficult to argue that they do not impose some cost on the community at large in the form of air pollution generally, respiratory illness and the like. Debate about what sort of damage carbon emissions cause is really one about what the cost of carbon emissions really is, not whether there is a cost at all.

In substance, an ETS is the same as a carbon tax. Each represents one side of the same issue. An ETS is a mechanism that indirectly imposes a price by directly controlling quantity (in this case, emissions). A tax indirectly controls quantity by directly imposing a price. By controlling one and not the other, both options represent market mechanisms.

Most issues that arise with the one also tend to feature with the other, albeit sometimes in a different form. For example, concerns regarding measurement (so emitters don’t exceed their permits under an ETS or pay the appropriate amount under a carbon tax) arise under both alternatives. Concerns that the government must set the carbon tax rate such as to achieve an appropriate level of emissions is the flip side to setting the cap on emissions under an ETS so that activity is affected appropriately. This latter point is illustrated by the EU’s ETS; too many permits were issued (the cap was set too high), resulting in the collapse of the secondary market (the “price” outcome being too low). As such, most of the criticisms of one option can be equally applied to the other.

A carbon tax, though, has two practical advantages over an ETS. There is no bureaucratic structure in place to administer an ETS (establishing the permit auction market and then maintaining the secondary market, at least). Such a structure does already exist that could administer a carbon tax based upon current capabilities (it’s called the Australian Taxation Office).

Arguably more important is the political opposition that traditionally accompanies these measures. As already seen in Australia, the most vocal opposition often comes from emissions-intensive industries. However, experience elsewhere has shown that such opposition dissipates if international competitiveness concerns can be resolved (the proposed BTU tax in 1993 in the U.S. springs to mind).

Such concerns are resolved through an effective border tax adjustment (BTA) mechanism, in which imports are subjected to an equivalent charge and exports are exempted (or, more correctly, have the charge rebated upon export). This is how imports and exports are currently treated under Australia’s (and most other countries’) goods and services tax. Concerns arise, though, regarding Australia’s obligations under the WTO (e.g. whether a rebate represents an illegal export subsidy). It is arguable that a BTA under a carbon tax is consistent with the WTO; this is not the case with an ETS.

Assuming legality, Australia can afford to act unilaterally in imposing a carbon tax incorporating a BTA, thereby addressing concerns over climate change without losing international competitiveness. This removes the first mover problem that has received so much publicity. Those seeking a global solution to this issue should prefer this option. Experience has proven that achieving multilateral consensus on environmental issues is unlikely any time soon. Eventual general agreement is more probable where one or a few actors take the initiative and implement a suitable system. This is highly unlikely if the price of such action is to sacrifice international competitiveness. A carbon tax is capable of addressing these concerns whereas an ETS is not.

An edited version of this post originally appeared in The Age on 13 August 2008.

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