Carbon tax emerges as a genuine alternative

Media release issuedSaturday, 29 August 2009

A carbon tax on national emissions consumption would be more economically and environmentally sound than a cap-and trade system applied to emissions production, such as the CPRS (carbon pollution reduction scheme), according to new modelling released today by CEDA (the Committee for Economic Development of Australia). 
The modelling, based on the same Treasury framework as earlier models, was commissioned by CEDA from Access Economics.¹ 
The modelling follows the release earlier this month of a CEDA report on the best economic response to climate policy, A Taxing Debate: Climate policy beyond Copenhagen (August 2009). The report examined whether cap-and-trade should really be the policy of choice to reduce greenhouse gas emissions.
The modelling evaluates the merits of a consumption-based carbon tax compared with a CPRS cap-and trade model, as set out in Geoff Carmody's paper in the CEDA report, "Consumption-based emissions policy: A vaccine for the CPRS 'trade flu'?".
The Senate Select Committee on Climate Policy had, in June, requested modelling of a consumption-based carbon tax as one of five alternative policy responses to climate change; however, it wasn't pursued by the government or the opposition. 
This modelling is 'proof of concept', and the first step in filling that gap; more detailed modelling is needed. 
A lower-cost alternative to cap-and-trade models
CEDA's Chief Executive David Byers said the modelling confirmed the case for carbon tax on consumption as a genuine alternative to cap-and-trade. 
"The modelling shows that the CPRS would involve losses of real GDP per million tonnes of abatement about 50% higher than a consumption-based carbon tax," he said. 
"While more detailed modelling work is needed, CEDA aims to contribute to ongoing policy debate on this critical issue by facilitating evidence-based policy making; that is, making sure different policy options are put on the table and explored comprehensively before binding decisions are made."
"This approach gives us the greatest chance of coming up with the best economic approach to the global goal of reduced greenhouse gas emissions."
"It may not be the current policy of choice but the careful reasoning of most independent economic experts in current and earlier CEDA reports on climate change, including US economist Dr Robert Shapiro in a paper for CEDA in 2007, suggest a carbon tax - an explicit carbon pricing approach - is preferred to a complex and compromised cap-and-trade system," he said. 
Less impact on consumption and investment
CEDA's Research and Policy Director Dr Michael Porter said the Access Economics modelling, consistent with economic arguments, indicated that a carbon tax applied to consumption is a preferred alternative to cap-and-trade. 
"A tax enables more flexible economic adjustment by imposing a carbon price penalty on production that may be passed on via the GST," he said.
"Overall the consumption tax system is less distorting to production and investment." 
The table below from the full Access Economics report shows real GDP falling by 1.0% under a consumption-based carbon tax, compared with 3.0% under a CPRS.
Table 4.1 Macroeconomic impacts, per cent change, relative to the reference case (2020)

	CPRS	CPRS plus EITE	Consumption-based
Real GDP	-3.0	-2.6	- 1.0
Investment	-6.6	-5.4	-1.8
Export volumes	-3.4	-3.0	-1.2
Emissions	-25.5	-23.1	-12.9
Carbon Tax, $A	49	49	49

Source: Access Economics AER-GEM model results 
The modelling also indicates the CPRS would involve losses of real GDP about 50% higher than a carbon tax through the GST. The table below indicates the impacts per million tonnes of abatement.
Table 4.2: Impacts per MT of abatement, million $A, 2008 prices

Scenario		Impact in 2020
CPRS	Real GDP $ million (2008 prices)	-331
	Export volumes $ million (2008 prices)	-82
	RoW emissions MT	0.04
CPRS plus EITE	Real GDP $ million (2008 prices)	-312
	Export volumes $ million (2008 prices)	-81
	RoW emissions MT	0.01
Consumption-based	Real GDP $ million (2008 prices)	-218
	Export volumes $ million (2008 prices)	-56
	RoW emissions MT	-0.12

Source: AE-RGEM modelling 
Note: RoW indicates Rest of the World. Whereas RoW emissions rise by 0.04% under the CPRS, they fall by 0.12% under the   consumption-based carbon tax.
The modelling shows industry sectoral impacts as well. Petroleum products, alumina, aluminium products and other nonferrous metal products fare better under a consumption-based approach. LNG exports would also fare better as they would be exempt from a consumption tax, yet would be taxed or seek EITE assistance under a cap-and-trade system such as the CPRS.
Cap-and-trade not a genuine market response
Dr Porter said a trading scheme for carbon credits or permits may appear, superficially, to be more of a market solution than a tax on carbon emissions, but the facts go the other way.
"Cap-and-trade is not a genuine market response to reducing emissions, but a process that lacks transparency and can be readily corrupted, not least in jurisdictions with less advanced standards of economic and financial governance," he said.
"The permits, credits and carve outs under a CPRS or ETS are issued by a political, bureaucratic process that runs the risk of being readily corrupted by the lobbying process."
"In contrast, a X$ per tonne tax on emissions translates into a shift in relative prices that has far less scope for manipulation and is transparent."
"The tax is readily capable of being applied internationally, with some countries in early stages of development being allowed to ramp up the tax more slowly." 
"The emissions tax can also finance both reductions in distorting taxes and the financing of new technologies, R&D and assistance to countries for which the burden of adjustment is most substantial."
"The community needs to appreciate that the CPRS is not trading of carbon emissions, but of carbon credits, and derivatives of financial obligations relating to greenhouse gases. And this trade has to occur across some of the most problematic financial jurisdictions worldwide."
"Many polluting countries that issue credits will not have high standards of financial governance for some time, and so the carbon securities issued will be problematic. It will be a real carbon bubble!" he said.
Maintaining competitive advantage
Dr Porter said a key difference in the consumption tax model used is that it avoids the problem of first mover disadvantage of cap-and-trade (which hits export and import-competing industries). 
"A consumption-based carbon tax via the pass-through mechanism of the GST is not paid upon export and avoids the pressures for carve-out, compensation and a revival of protectionism. Australia has done well to foster an efficient market economy over the last 30 years," Dr Porter said. "We don't want to go backwards."
"The counterparties under the cap-and-trade schemes will become more problematic as the trading in credits and derivatives expands. To deny this trading would mean cap-and-trade won't deliver minimum emissions. But to implement cap-and-trade across much of the emitting world will undermine national balance sheets in a major way." 
"This is why CEDA is interested in exploring sound economic policy alternatives such as the consumption-based carbon tax," he said.
A viable 'Plan B'
CEDA's Chief Executive David Byers said a carbon tax may not be the policy of choice now, but there was growing national and international debate about the need for alternative policy responses to mitigating climate change.
"The ETS bubble may burst, and the world may - in the not too distant future - be looking for a viable Plan B to replace problematic cap-and-trade systems."
Notwithstanding the EU emissions trading scheme, there are signs that individual European countries (such as France and Sweden) are increasingly looking to carbon taxes as a preferred pathway to overcome the political, financial, transparency and efficiency risks inherent in cap-and trade. 
And in the US, according to experts such as Shapiro in a speech to CEDA on Wednesday, 26 August, the passage of the cap-and-trade legislation through the US senate looks less and less certain. According to Shapiro, the emerging debate in the US is whether it will pursue a carbon tax or direct regulation. 
Professor Ross Garnaut's final report for the Climate Change Review had earlier favoured a carbon tax over a heavily-compromised emissions trading system: "A well-designed emissions trading scheme has important advantages over other forms of policy intervention. However, a carbon tax would be better than a heavily compromised emissions trading scheme." (Emphasis added; Garnaut Climate Change Review Final Report 2008, p. xxiv.)
Summary of modelling results
The Access Economics modelling can be viewed here. While the modelling is a 'proof of concept' paper and additional detail is required before supporting implementation of a carbon consumption tax via the GST, it is a major contribution consistent with the judgements of most independent economic experts in favour of a carbon tax.
The modelling result is based on the application of a $10/ton tax on carbon emissions from 2012, rising to $49 in 2020, applied through the GST. 
Production processes that involve no extra carbon emissions would only face the present GST of 10%.
The modelling shows for the same assumed carbon price:

• The projected decline in welfare, as measured by GNP, per tonne of CO2-e abated within Australia, is smaller for the consumption-based approach than a production-based CPRS approach.
• Falls in exports per tonne of emissions abated are much smaller under the consumption based approach than either variant of the production-based CPRS approach.
• However, a consumption-based approach results in a lower absolute level of emissions abatement in Australia than a production-based scheme. This is largely driven by a lower reduction in output under a consumption-based approach compared to the CPRS model, while the avoidance of 'carbon leakage' under the consumption-based approach is also a factor.
• The concept of 'carbon leakage' reflects the shifting of Australian emissions offshore under the CPRS, in order to avoid the costs of emissions reduction in Australia. Globally, this effect may result in a net increase, no change, or a reduction, in global CO2-e emissions. Therefore there is a need to consider the net global emissions result in determining which option is most efficient at emissions abatement.
• Generally, on a per-industry basis the consumption-based approach results in smaller declines in production when compared with a CPRS-style production-based approach without trade assistance.
• However the results are more mixed when the consumption-based approach is compared with a CPRS production-based approach with assistance for emissions-intensive trade-exposed (EITE) industries. For example, petroleum products, alumina, aluminium products and other nonferrous metal products fare better under a consumption-based approach. In contrast, non-metallic minerals products (cement) fare better under the EITE-adjusted CPRS.
• This finding reflects the imprecision of the 'trade exposed' sector adjustments under the CPRS compared with the more precise adjustments possible under the consumption-based approach.

¹ "Preliminary economic modelling of a national consumption-based approach to greenhouse gas emissions", Report by Access Economics for the Committee for Economic Development of Australia, 24 August 2009, p18. Access Economics used a large scale, dynamic, multi-region, multi-commodity computable general equilibrium model of the world economy. It was developed specifically with climate change response policy in mind.

More information

To download a copy of the modelling click here.