Carbon Pricing – Markets, Taxes or Regulation?

By John Kemp
 
The cost of European Union emissions allowances has doubled over the last two years, which is likely to renew debate over the relative merits of market-based and tax-based approaches to pricing carbon dioxide emissions, according to a media partner Medi Telegraph report.
 
Prices for allowances expiring in December 2023 in April to more than €51 per metric tonne of carbon dioxide, up from less than €26 in the same month two years ago.
 
Energy-intensive manufacturers have already begun to warn about pressure on costs and push for accelerated introduction of a border tax adjustment to protect them from foreign competitors that do not have to buy allowances. Pushing back, the EU’s top climate official on May 7 warned policymakers worried about rising costs against intervening to curb price increases, warning this would undermine the credibility of the emissions allowance trading scheme.
 
 
Critical Policy Choices
 
If policymakers want to reduce emissions significantly in the coming decades, they will have to price them, and the price will have to be substantially higher than it is at present. Substantially higher prices will spur faster investment in alternatives to fossil fuels, more energy storage, improvements in energy efficiency, and investments in carbon capture and storage.
 
But how emissions are priced matters as much as the level of those prices. The form in which CO2 prices are imposed matters: it has profound distributional consequences and is not just an arcane technical issue. The EU is likely to stick with its market-based system because it is already mature and has won broad political acceptance as well as creating a lot of intermediaries with a stake in its success.
 
But the system has been amended in the past  and will almost certainly be altered again in future to keep prices within a politically acceptable trajectory. Outside the EU, market-based systems have proved popular in several other jurisdictions, but most schemes are still small-scale in geographical scope and limited to a small number of industries. If CO2 prices are to become more widespread and higher in the future, policymakers will need to conduct a serious discussion about the best way to impose them – whether through regulation-based shadow prices, trading systems or taxes.
 
 
Markets vs Taxes
 
Putting a direct price on emissions, rather than creating a complex web of quantitative regulations and standards, is likely to be the most efficient way to reduce the net amount of CO2 discharged into the atmosphere. As in other markets for raw materials, manufactured items and services, price signals harness private information only available to businesses and individuals about the lowest-cost ways to deliver the intended benefit.
 
Regulations, standards, mandates and other forms of planned controls simply create a system of shadow prices or implicit costs, which tends to be less efficient because it fails to utilize private information. In principle, market-based and tax-based systems can deliver similar increases in CO2 prices and the same outcomes in terms of emissions reduction.
 
In practice, the two systems have different implications for the trajectory of CO2 prices and the distribution of costs and benefits across businesses and households:
 
• Market-based systems generate short-term price volatility, which is costly for businesses and consumers to manage, while tax-based systems generate certainty and predictability, which makes long-term planning easier.
 
• Markets generate private cash flows to fund investments; taxes generate public sector revenue streams to compensate businesses and households that would otherwise lose out from higher CO2prices.
 
• Markets guarantee a particular reduction in emissions is achieved, but at an uncertain cost; taxes guarantee cost, but with uncertainty about the eventual reduction in emissions.
 
• Markets create the appearance of distance between prices and policymakers, which may make higher prices more tolerable politically; taxes emphasize governments’ direct responsibility for prices which may make higher prices less acceptable.
 
• Markets create a class of traders, brokers, exchanges, investment funds, portfolio managers and other intermediaries who earn direct financial benefits from the system and are likely to offer political support; taxes have no direct beneficiaries, other than lawyers, accountants and auditors, but they do create revenues that can be distributed to build political support.
 
• Markets will generate different prices in different countries unless linked together, which is technically complex; tax-based systems can generate different prices but may be easier to harmonize.
 
 
Hybrid Price Systems
 
In the real world, differences between market-based and tax-based pricing systems are less than they appear, and most systems in operation or likely to be introduced in future are hybrids. Even in a market-based system, policymakers can still intervene to change the magnitude and timescale for emissions reductions, altering the supply and demand for allowances, to influence prices.
 
The EU has created the world’s most mature emissions trading system, but the rules have been changed multiple times over the years to boost prices and accelerate emissions reductions. In a tax-based system, policymakers can still adjust tax rates to accelerate or retard the rate of emissions reductions in response to incoming information and changing circumstances.
 
EU environment chief Frans Timmermans came close to admitting some of this inherent hybridity even as he called for policymakers to avoid intervening in the trading system to curb the rapidly rising cost of allowances: “It’s a market and we should be very, very careful not to intervene because that would create a non-market-based price, and that would absolutely undermine the credibility of the emissions trading system,” he said on May 7. “It’s a market, so who am I to say what’s too high or too low? It’s a market mechanism, but if we want to achieve our goals, I think the price should be much higher than it is even at €50. But that’s up to the market."
 
The EU does not set the price in the market, but its policies influence the supply and demand of permits, which guides the price. “You influence the behavior of markets, but you don’t control the markets," Timmermans said.
 
This may be a distinction without a difference. For the time being, however, the EU is happy to see the price of emissions increase, and the market-based mechanism allows policymakers to distance themselves from the cost to businesses and households. If prices escalate too quickly, there is likely to be a threshold at which policymakers intervene by changing the rules to increase the supply of allowances, or cut demand, thereby restraining the cost.

John Kemp is senior market analyst, commodities and energy for Reuters News.