Politics aside, a simple carbon tax makes more sense than a convoluted emissions trading scheme

Writing recently on The Conversation, Clive Hamilton correctly pointed out that an emissions trading scheme (ETS) can in no sense be called a tax – the two are fundamentally different. Under an ETS, the amount of emissions is fixed by the government and the market then sets the price; under a carbon tax, the price of emissions is fixed and polluters decide how much to emit.

In this sense, Hamilton is right to opine that “emissions trading is the opposite of a carbon tax”. But during Australia’s fractious debate about climate policy in recent years, the two have often been conflated together, and we have generally been starved of sober analysis of the contrasting merits of different policy instruments.

To put it more succinctly, what are the actual merits of a carbon tax, specifically as opposed to an ETS?

Start small

A carbon tax could begin at a relatively low level, to avoid economic disruption, and then could increase steadily and predictably over time. This would encourage affected companies to cut their emissions and to use energy more efficiently, in turn encouraging a move to lower-emission technology. As a result, companies that made better progress in cutting their emissions would have fewer costs to pass on to their consumers, leading to more competitive prices.

A carbon tax would provide government revenue which could then be used to reduce or offset other taxes, such as corporate and personal income tax. A carbon tax could be “revenue-neutral”, either through offsetting other taxes or by using the proceeds to subsidise alternative fuel industries and projects.

Taxes are relatively easy to understand, having been around for centuries in one form or another. For Yale University economist William Nordhaus, the advantages are even clearer when compared to the operation of an international ETS. He recently proposed redesigning climate treaties to adopt a “club model” in which participating states enact carbon taxes in concert with one another, which Nordhaus describes as “the easiest way” to deliver costly emissions reductions.

Price-based taxes capture revenue more cheaply and easily than quantitative instruments such as an ETS, not least because tax-collection infrastructure is already in place. Taxation has lower administrative and compliance costs than carbon trading.

Taxation is arguably more direct and transparent than emissions trading, and affords less opportunity for gaming, speculation or corruption; money moves from polluters directly to the government.

A carbon tax provides price certainty and stability (as opposed to the volatility of prices for tradable carbon permits) and a fixed price for carbon emissions across all economic sectors and markets. This price certainty allows corporations more easily to determine the viability of new, clean technology investments.

Finally, the argument for carbon taxation is concisely made by Harvard economist Richard Cooper:

Decisions to consume goods and services made with fossil fuels are made by over a billion households and firms in the world. The best and indeed only way to reach all these decision makers is through the prices they must pay. If we are to reduce CO2-emitting activities, we must raise the prices of those activities. Levying a [tax] … does that directly.

Was carbon taxation ever given a fair go?

Despite all this, Australia has always focused firmly on emissions trading, while arguably giving much less consideration to carbon taxation. A 2006 report from all of the Australian states on action to address climate change proposed an ETS without examining other options in any real detail.

The following year a task force, convened by then Prime Minister John Howard specifically to look at the possible design of an ETS, proposed a cap-and-trade scheme to begin in 2011 or 2012. Howard accepted the plan but lost the 2007 election, and when the incoming Labor government tried to implement a similar scheme – the Carbon Pollution Reduction Scheme – it was twice rejected by the federal parliament.

The Clean Energy Act 2011, which (with other legislation) set up “a mechanism to deal with climate change by encouraging the use of clean energy”, ushered in the infamous “carbon tax”, despite not being a tax but an ETS with a fixed-price period at the outset. It was repealed last year.

Currently in place is the A$2.55 billion Emissions Reduction Fund, a core aspect of the Abbott government’s Direct Action climate plan, while opposition leader Bill Shorten has reaffirmed Labor’s commitment to emissions trading.

Pricing carbon: the simpler, the better

Tackling climate change requires urgent cuts to greenhouse emissions. The main problem, economically speaking, is that many emitters don’t pay the current and future costs of their emissions – hence the famous description of climate change, by UK climate economist Nicholas Stern, as “the greatest and widest-ranging market failure ever seen”.

Nordhaus, writing in 2009, suggested a remedy:

…we need to correct this market failure by ensuring that all people, everywhere, and for the indefinite future face a market price for the use of carbon that reflects the social costs of their activities. Economic participants [governments, firms, people] … need to face realistic prices for the use of carbon if their decisions about consumption, investment, and innovation are to be appropriate.

If we are to reduce carbon-emitting activities, the prices of those activities must be increased. Appropriate prices are the key here, and one way to make people happier about paying them is to make them as simple and transparent as possible. That’s what a carbon tax does.

The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.