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An Economic Analysis of the Carbon Tax

By Ishita Gupta

Introduction

Last year, the United Nations released a shocking report, highlighting how if nothing changes by 2030 it will be nearly impossible to contain the adverse effects of climate change. As the negative externalities of our poor consumption and production habits snowball into climate catastrophe, it is interesting to consider how the carbon tax, introduced nearly 30 years ago, holds up against today's modern technologies.

In this essay, an idea will be considered a viable solution if it can cut carbon pollution down by 45% (in line with the IPPC goals) to ensure we are on track for our 1.5-degree target. This in no way is a healthy temperature rise, however, it is a safe level, at which the impact of climate change can be managed.


Part 1: THE CARBON TAX

The Carbon tax is the simplest way to internalise the negative externalities of production of greenhouse gases. Levied on the amount of carbon dioxide emitted, the basic idea is simple, tax cheaper, more polluting fuels highers, and cleaner ones lower, in order to make the price of carbon-based energy comparable to the alternative: renewable energy.

And there is significant evidence to show that carbon pricing does work. Among other examples, the introduction of the carbon tax in Sweden at US$139/tCO2 saw a 25% decrease in carbon emissions. However, our current system of carbon taxing is not on track to achieve the necessary carbon reduction goals. It is estimated that carbon prices should be $40-$80/tCO2 by 2020 however, today 80% of all emissions are not covered by a carbon price and the ones that are well below the $40-80/tCO2 target.

From the economic, and even the policy perspective, carbon taxes are quite unpopular. They distort raw material costs, reduce the competitiveness of domestic products, and are generally regressive (The burden is 1.4-4 times higher on lower-income families. ). Unpopular in public opinion, opposed by corporate lobbies, and protested by low-income groups, they have the potential to brew up significant dissatisfaction.

The inelastic nature of the demand for fossil fuels arises due to significant investment involved in switching to a new infrastructure that supports sustainable energies, (like electrical engines over oil engines) arises. Most economies will be hesitant to majorly upgrade all their capital if the percentage change in the price of carbon is not high enough. If all cars today were replaced by electric cars, the efficiency of the power consumption will go up significantly, and emissions down (not considering emissions involved in the manufacture of the new cars,) but still, this isn't happening because the average savings from the electrical vehicle do not make up for the cost of replacing the old vehicle.

Clearly, many things can go wrong and implementing a carbon tax is a delicate situation. The success of a carbon pricing strategy depends mainly on how it is introduced. Sweden was a success story for a number of reasons, one of which was the extensive public dialogue before, which transparently conveyed to citizens the importance of the fiscal reform.

Before enforcing the tax, it's important to ensure that the tax

Is clubbed with a scheme designed to redistribute the revenue, back to the poor

Revenue contributes visibly to a program that mitigates the externalities caused by climate change

Reinforces transparency and public trust in the government; the public understands why these taxes are needed

Is Introduced gradually and provide enough of an incentive switch seamlessly to renewable forms of energy

Is introduced alongside methods that provide firms and households with alternative energy

An alternative to carbon taxes could be an Emission Trading System (Also known as cap and trade systems). Unlike the carbon tax that alters the price of carbon, by shifting the Marginal Private Cost curve inwards to meet the marginal Social costs, the cap and trade system this creates a maximum upper limit on the amount of carbon that can be used by an economy. A fixed number of allowances are set and issued to firms act as the currency of the carbon market. Firms can use them, save them, or sell them on the market, effectively capturing the external costs of pollution using the forces of supply and demand, creating a financial incentive for the biggest emitters to cut back. By focusing on meeting targets the impact of a policy on can be more accurately predicted than a simple tax.

However, the system could create significant uncertainty in the price of carbon-based commodities and an unfavourable atmosphere for investors by distorting real costs of production.


Part 2: THE TECHNOLOGIES

While carbon pricing is necessary for decarbonisation, it alone will not be sufficient. Even in the case of Sweden, one of the best implementations of the tax, emissions were reduced by only 25%, not sufficient for IPCC target. But unlike the carbon tax, there really isn't a one size fits all technological solution but rather a tech designed to individually tackle different aspects of the problem. While many creative and interesting technologies exist, the following few are the ones that are most realistic and capable of achieving the IPPC goals due to extensive research and development.

Nuclear power is often regarded as the solution to the climate crisis, and probably is the only one capable of satisfying our insatiable demand for energy. Thorium reactors that are still in the testing stages could hold the key to safe, reliable nuclear power. The main reason thorium was overlooked by governments in favour of uranium is because, due to its safe nature, it does not result in the capacity to create nuclear weapons. Although countries like India and China are pouring significant investment into thorium-based reactors, it is unlikely the technology will be ready in the next decade.

Another viable solution could be wind energy, and it has surpassed coal to become the cheapest source of energy in the UK. Wind plants, however, have some very real problems that need solutions before they can replace all carbon-based fuels. Wind is unpredictable, limited by geography, climate and lengths of connecting cables, Wind plants are also expensive to construct, to produce enough power to utilise economies of scale, a wind farm can cost up to $32 million.

Even promising negative emissions technology is not ready to take on the daunting task of altering our atmosphere, due to high costs and lack of scalability. Companies like General fusion-based in Canada, have created machines that are capable of removing one million tons of carbon dioxide each year and converting them back to fuels. However, it is simply not scalable, and in order to reverse one year of human emissions, we would require 38,000 massive units working 24 hours every day.

Efforts could also be directed towards the food industry. Current farming practices, especially for meat are highly unsustainable and responsible for one-quarter of all global emissions. The solution here lies in synthetic plant-based meat like those being created by companies like beyond meat. Will this be ready to replace all sources of meat in the next ten years? Probably not. But as our population approaches the 8 billion mark, it is important to reform every source of carbon in our atmosphere.


Conclusion

Carbon taxes are a very real solution to the climate crisis, only if done right. Capitalist lobbies and conservative climate deniers stand in the way of their ultimate success and therefore an effective carbon tax needs to be backed by able politicians, transparent awareness systems, and knowledge into behavioural insights. They need to be supported by other economic reforms like the removal of government subsidies to fossil fuels and Cap and Trade Carbon credit trading systems.

And it's not enough just for developed economies to adopt this approach. Although the economics are extremely skewed against developing economies, it's integral that carbon pricing strategies are enforced globally, through a universal agreement backed by trade sanctions and tariffs if necessary.

Many promising solutions lie in technology however as of now, none of them are equipped to reduce our emissions to meet the 45% target. In the next 20 years, technology may hold all the answers but we need to give it time. That being said, should we still continue to invest? Absolutely.

Economic reform and tax revenue and investment in technology are two sides of the same coin. We need to create a system, where the consumption of carbon-based consumption is discouraged through taxation and revenue is used to fund the search for more solutions like the development of vital negative emission technologies and sustainable energies.

Yes, the Carbon tax and other systems including the cap and trade system come at a price, and risks of inflation and threats to growing economies. But the cost of the climate catastrophe that would be higher by tenfold. Millions dead, billions of dollars of capital destroyed, years of planning and infrastructure and development lost to unpredictable weather and rising sea levels. Is it really worth ignoring?


Image source: Foundation for Economic Education