Tax the way to save the planet

Euston Quah, For The Straits Times 27 Nov 10;

THE United Nations climate summit in Cancun, which begins on Monday, has taken on fresh urgency. New information shows that, alarmingly, the reduction in carbon dioxide emissions last year was less than expected and emissions are set to rise this year and the next.

There is a clear need to move to low-carbon economies. Yet there is little consensus as to how this can be achieved, as the disappointing Copenhagen climate talks demonstrated.

But there is a ray of hope. Climate change is not a completely alien phenomenon to economists. It is simply another case of negative 'externalities', albeit on a global scale.

Economists speak of negative externalities when they refer to a cost item that has not been captured in the price of something in everyday legal transactions. The noise from constructing infrastructure, the stench from landfills, and air pollution from industrial activity are some examples of externalities.

So when fossil fuels such as coal and oil are used, the externality is the carbon emissions they produce, which lead to global warming and climate change. The prices we pay for these fuels do not capture the external costs of their use.

The solution is to put a value on all such externalities. For example, putting a price tag on noise and the destruction of scenic views, cultural heritage and environmental features such as mangroves, would be key to using resources more wisely. Pricing emissions would have a similar effect.

Where public projects involving society's well-being are concerned, it is incumbent on the authorities to gather information from the public as to what kinds of externalities could arise and follow up with monetary valuations of costs and benefits. The government must take the initiative to act as a coordinator and solicitor of economic values. This will allow all externalities to be appropriately priced.

But it is not enough for any government to take the price of carbon into account in public projects. Producers and consumers must price carbon in their production and consumption decisions as well. The role of consumers is often obscured by that of industries in emission reduction discussions. But consumption activities also contribute to emissions, vehicular transport being a good example.

How then can the price of carbon be introduced into production and consumption decisions? The two most touted methods are to tax carbon or introduce a cap-and-trade system.

Carbon taxes fix the price of emissions but leave the amount of emissions variable. Cap-and-trade fixes the amount of emissions but allows the price to vary. Theoretically, assuming the authorities compute the optimal price and amount of emissions accurately, the two methods will yield the same outcome.

Unfortunately, reality seldom mirrors theory. The complexity of the cap-and-trade system means that the administrative cost incurred may be significant - a fact often overlooked in theory. The price variability of emission permits may also discourage investment in green technology as businesses cannot determine if the payoff from selling the permits freed up by adopting emissions-reducing technologies is worth it. This is a serious problem as any long-run solution to global warming must involve greater use of green technology.

Carbon taxes, in contrast, give businesses clear incentives to cut emissions. The taxes will encourage a switch in the fuel mix of the industrial and electricity sector as well as the household sector and lead to overall energy conservation. The taxes will also provide revenue that governments may use to fund green research.

Much of the criticism levelled at carbon taxes revolves around the issue of how much to charge. But this has to do with a lack of accurate information - a problem that can be fixed.

The idea of making both producers and consumers pay for activities that generate carbon emissions by levying a straightforward tax remains an appealing one. Starting with a small tax on carbon and gradually moving it up over time would be the best way forward. The fact that Finland, Norway and a number of other countries have successfully implemented carbon taxes shows that they may not be that unpalatable after all.

Given that a low-carbon world must involve pricing carbon, is the UN's attempt to impose carbon quotas too simplistic, and is Cancun doomed to failure? Yes, for the main reason that countries are at different stages of economic development and have different priorities.

Yet, however essential carbon pricing may be, it alone is not enough. There must also be investment in green technology, the widespread use of cost-benefit analysis and externality pricing. The Cancun talks, with its focus on secondary issues such as climate financial aid and deforestation, may help to move these other areas forward.

The writer is a professor of environmental economics at Nanyang Technological University.