CARBON TAX VERSUS CAP AND TRADE

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CARBON TAX AND CAP AND TRADE VERSUS CARBON TAX OR CAP AND TRADE IN EUROPE

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CARBON TAX VERSUS CAP AND TRADE

  1. 1. JORNADA DE CO2 Y FISCALIDAD: Cuestiones Actuales CEU Instituto de Disciplinas y Estudios Ambientales UNIVERSIDAD CARDENAL HERRERA IMPUESTO SOBRE EL CARBONO Y LIMITACION DE EMISIONES VS. IMPUESTO SOBRE EL CARBONO O LIMITACION DE EMISIONES Guillermo G. Ruiz Zapatero Valencia December 15, 2009 All opinions expressed here are those of their autors
  2. 2. SCIENCE CULTURE ON C02 SOURCES AND SINKS
  3. 3. GLOBAL WARMING A TALE OF TWO CULTURES A tale of two cultures (Nordhaus) The natural sciences are doing an admirable job of describing the geophysical aspects of climate change. The science behind global warming is well established. Designing an effective political and economic strategy to control climate change will require the second culture the social sciences to analyze how to harness our systems to achieve our climate goals effectively and at low cost. The design of policy instruments: quantity-based or price-based constraints The quantity approach embodied in the Kyoto Protocol (it will be useful to call it the Kyoto model (European Trading Scheme in Europe)) will not accomplish the goals of those who would like to slow climate change. As currently designed, it is both inefficient and ineffective and should be supplemented or replaced (Nordhaus).
  4. 4. INCONVENIENT ECONOMIC TRUTHS Emissions of carbon dioxide are externalities, i.e., social consequences that are not accounted for in the market place. They are market failures because people do not pay for the current and future costs of their emissions. If economics provides a single bottom line for policy, it is that 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. Raising the market price of carbon provides strong incentives to reduce carbon emissions through four mechanisms . First, it provides signals to consumers about what goods and services produce high carbon emissions and should therefore be used more sparingly. Second, it provides signals to producers about which inputs (such as electricity from coal) use more carbon, and which inputs (such as electricity from wind) use less or none. It thereby induces producers to move to low-carbon technologies. Third, high carbon prices provide market signals and financial incentives to inventors and innovators to develop and introduce low-carbon products and processes which can eventually replace the current generation of carbon-intensive technologies . Finally, and most subtle of all, the use of carbon pricing economizes on the information requirements that market participants need to undertake each of these three tasks. Of course, without a strong price signal, there is simply no hope for making the vast number of decisions in a remotely efficient manner.
  5. 5. WARMING AS GLOBAL PUBLIC GOOD Economics leads to a second important truth about climate-change policies. The analytical basis for an efficient global-warming policy is extremely simple. Because global warming is a global public good, everyone, everywhere must face the same price. The European Trading Scheme (ETS) covers only about half of EU emissions. The most controversial policy question : the decision whether to rely primarily on quantity-based or price-based constraints Relative advantage of a cap-and-trade system (such as is embodied in the Kyoto model and the ETS), or a carbon tax system (such as is used for limiting gasoline or cigarette consumption). System of harmonized domestic taxes on carbon emissions. Conceptually, the carbon tax is a dynamically efficient Pigouvian tax that balances the marginal social costs (ANNEX I: Nordhaus) and marginal social benefits of additional emissions.
  6. 6. CAP AND TRADE (ETS) SHORTCOMINGS There is no experience zero with international cap-and-trade systems. Quantitative limits have proven to produce severe volatility in the market price of carbon under an emissions-targeting approach. The volatility arises because of the inelasticity of both supply and demand of permits. The volatility of CO2 allowances in the EU ETS was large: in the period from October 2008 to February 2009 alone, ETS carbon prices varied between 9 and 24 per ton of CO2 (also see ANNEX II : Metcalf). It should be emphasized that the volatility of allowances is not due to policy errors. It is inherent in this kind of instrument. International counterproducti ve effect: A higher domestic price of carbon leads to an increase in the social cost of production beyond the point at which the domestic cap or ceiling is reached (Gros: Why a cap-and-trade system can be bad for your health ).Differences in carbon intensities. Whatever initial target we set is almost sure to prove incorrect for either taxes or quantities The cap-and-trade approach is a poor choice of mechanism. It is untested in the international context; it has been unable to attain anything close to universal participation; and it has the inherent flaws just described
  7. 7. IT IS TIME TO DECIDE ON TAX VS CAP&TRADE Despite its clear advantages carbon tax has not been the preferred policy option.Only a few countries, mainly in north europe, apply the tax. Path dependence could make that option harder at a later stage To design durable and effective international economic systems is difficult. They are complex ecosystems, full of hidden prey and predators, with many unforeseen results. History is littered with failed institutions. You need only look today at the wreckage of the current financial system. So, if the Kyoto model (European Trading Scheme) turns out to be another failed model, it has lots of company. But it would be better to recognize and change it now, rather than in one or two more decades of ineffective and inefficient efforts to slow emissions (Nordhaus). That is the alternative the EU, its member states and citizens are alltogether facing now and such decision should not be neither avoided nor postponed
  8. 8. THE EUROPEAN COMPROMISE BETWEEN CARBON TAX AND THE ETS (CAP&TRADE) MAIN FEATURES OF THE PROPOSAL A MENDING DIRECTIVE 2003/96: Distinction between CO2 related taxation (EUR/kgCO2) and general energy consumption taxation (EUR/GJ) Exemption of CO2 related taxation for activities subject to and not excluded from the Community scheme within the meaning of Directive 2003/87/EC (ETS) (art. 14.1.d)) Exemption of energy products and electricity issued to produce electricity (only from general energy consumption taxation) (art.14.1.3) Exemption of fuel for the purposes of navigation within Community waters (art. 14.1.c)) As regards CO2 related taxation, the tax shall not apply to energy products that are biomass Only differentiated rates depending on consumption levels could be applied to CO2 related taxation, provided that they respect the minimum levels (art. 5) Minimum levels of taxation applicable from 1 January 2013 to motor fuels (articles 7.1 and 7.2 (0,03 /kg CO2) and article 8.2 (0,01 /kg CO2)) and to heatings fuels (0,01 /kg CO2) Minimum levels of taxation applicable from 1 January 2013 to electricity (nil)
  9. 9. THE EUROPEAN COMPROMISE BETWEEN CARBON TAX AND THE ETS (CAP&TRADE) MAIN FEATURES OF THE PROPOSAL A MENDING DIRECTIVE 2003/96 (II): TOTAL O PARTIAL EXEMPTI ONS OR REDUCTIONS IN THE LEVEL OF TAXATION TO Electricity from the origins specified in article 15.1.b) (solar, wind, wave, tidal or geothermal;hydraulic origin; biomass, methane from abandoned coalmines;fuel cells) Energy products and electricity used for Combined Heat and Power generation (articles 15.1 c) and d)) Energy products and electricity used for the carriage of goods and passangers by rail, metro, tram and trolley bus Fuel used for navigation on inland waterways Natural gas in members states in which the share of its in finally consumption was less than 15% in 2000 Energy products and electricity used for non business activities of households and charitable organizations
  10. 10. THE EUROPEAN COMPROMISE BETWEEN CARBON TAX AND THE ETS (CAP&TRADE) MAIN FEATURES OF THE PROPOSAL A MENDING DIRECTIVE 2003/96 (III): Tax reductions (provided minimum levels are respected on average) on products ussed for heating purposes or for the purposes of article 8 (2)(b) (stationary motors) and (c) (plant and machinery used in construction) in the following cases: Energy intensive business (article 17.1.a) Agreements or tradable permit schemes to achieve environmental protection or improvements in energy efficiency (article 17.2, 3, 4 and 5). Tradable permit schemes shall mean other permits than those traded in the ETS. Until 31 december 2020, Member States shall exempt from CO2 related taxation the use of energy products for purposes other than those referred in article 7, in a unit subject to qualifiying expenditure (article 17.a): The amount of the exemption shall not exceed 70% of the qualifiying expenditure Qualifiying expenditured shall be capital expenditure leading to a reduction of at least 20% of CO2 emissions Proof of the reductions achieved through the capital expenditure
  11. 11. ISSUES RAISED BY BUSINESS EUROPE: NO TAXATION OF INSTALATIONS COVERED BY THE ETS 1. No taxation of installations covered b y the ETS (Article 14.1.d) ) No carbon tax on installations covered by the ETS whether or not allowances are allocated free of charge Background Under the EU ETS, full auctioning of emission allowances will be phased in from 2013. Installations from sectors deemed to be exposed to a significant risk of carbon leakage will receive relatively more free al lowances than other sectors. Free allowances will in principle be allocated based on product-specific benchmarks for each relevant product. The starting point for the benchmarks is the average of the 10% most efficient installations in a sector. The benchmarks will be multiplied by historical production to calculate the amount of free allowances to be allocated and in order to ensure a declining cap, a correction factor will be applied. For carbon leakage sectors, the free allocation will be multiplied by a factor 1 (100%) while for other sectors the allocation will be multiplied by a lower figure (0,80 in 2013,and reduced every year to reach 0.30 in 2020). Nevertheless, exposed sectors are not 100% exempt from the auction costs. Because of the over-all EU CO2 cap, a nd the fact that the benchmarks will be stringent, the ETS is not for free also for the most efficient installations.
  12. 12. ISSUES RAISED BY BUSINESS EUROPE: NO TAXATION OF INSTALATIONS COVERED BY THE ETS BUSINESSEUROPE position There must be no CO2 tax on installations/final energy consumption (electricity) covered by the ETS (including free allowances): CO2 taxation on EU ETS installations would raise production costs without generating additional emission reductions. Therefore, installations and final energy consumption (electricity) already covered by the ETS must be exempted from the CO2 tax to avoid economic inefficiencies. A CO2 tax on EU ETS installations that receive free allowances to compensate for carbon leakage will create the negative effect on competitiveness that free allocation aims to avoid. Even when receiving (partly) free allocation of allowances, the installations will face a price on carbon emissions: the cap on emission allowances will decrease by 21% until 2020 and companies outside a narrow efficiency benchmark will have to partly buy their allowances already in 2013. Exemptions from a carbon tax for ETS installations as foreseen for the revision of the Energy Tax Directive should not be challenged by the State Aid guidelines.
  13. 13. ISSUES RAISED BY BUSINESS EUROPE: NO TAXATION OF OTHER COVERED BY EM 2. No taxation of installations covered by equivalent measures (article 17.1.a) and b)) Mix of equivalent measures to the carbon tax at the national level to (a) allow small installations to opt out from ETS and (b) cover emissions from non-ETS sectors Background The term equivalent measure is normally used with reference to the ETS Directive (2009/29/EC, art. 27) which stipulates that small installations can be excluded from the ETS if they are subject to equivalent measures or measures that will achieve equivalent contribution to emission reductions . According to point 11 of the pre-amble Such measures could include taxation, agreements with industry and regulation. Under the current Energy Tax Directive, Member States may apply tax reductions in favour of energy intensive businesses and where agreements are concluded with undertakings or associations of undertakings, or where tradable permit schemes or equivalent arrangements are implemented, as far as they lead to the achievement of environmental protection objectives or to improvements in energy efficiency.
  14. 14. ISSUES RAISED BY BUSINESS EUROPE: NO TAXATION OF OTHER COVERED BY EM BUSINESSEUROPE position Voluntary agreements between industry and government at national level are the preferred equivalent measure for European business. To mirror the ETS Directive, such voluntary agreements should lead to commitments for concerned industries in terms of CO2 reduction (which implies a monitoring and penalties system). Where national schemes have been proved to meet challenging energy and emission targets, e.g. Climate Change Agreements, they should be approved as equivalent measures. Companies exempt from the ETS, and subject to other equivalent measures than taxes, should be exempted from a CO2 tax. Small installations not covered by the ETS Directive, as they do not reach the thresholds in Annex I should also be eligible for equivalent measures and exempted from the carbon tax. Where national schemes for reducing emissions in the non-ETS sectors are in place, countries should be allowed to opt out of from the EU CO2 tax framework. Existing national CO2 tax regimes should be recognised as equivalent for emissions covered by the Energy Tax Directive framework as long as they respect the ETD provisions. Some Member States have high energy taxes on environmental grounds. If national energy tax rates are above the combined EU minimum of energy and carbon taxation, this should trigger exemption from the carbon tax.
  15. 15. ISSUES RAISED BY BUSINESS EUROPE: MIRROR FREE ALLOCATION IN TAX SYSTEM 3. Mirror free allocation in tax s ystem How can the free allocation of emission allowances for ETS installations be replicated in the European framework for carbon taxation? BUSINESSEUROPE position To mirror the EU ETS free allocation, they propose the following options: For small installations from ETS sectors: Exempt sectors on the ETS carbon leakage list from carbon taxation. Ideally, tax reductions for individual installations would be in line with the % of free allocation from sectoral or sub-sectoral benchmarks or other fall back options. Given that allocation of emission allowances to installations in carbon leakage sectors is not completely free, the reduced CO2 tax might be computed based on the estimated ETS cost (e.g. % of allowances the ETS companies will have to buy). For installations from non-ETS sectors: develop quantitative criteria that allow to identify which non-ETS sectors are exposed to the risk of relocation under a carbon tax and exempt them based on the efficiency of the processes. Implement a transitory period for installations covered by the carbon tax and not exposed to carbon leakage in line with ETS auctioning rules: a linear increase with 20% of CO2 tax in 2013, 70% in 2020 and 100% in 2027. Further exemptions might be needed to prevent distortions of competition in specific situations. BUSINESSEUROPE believes there is no case for abandoning certain exemptions such as the existing Energy Tax Directive exemption for mineralogical transformation to ensure that these sectors remain competitive compared to sectors receiving free allowances under the ETS.
  16. 16. ISSUES RAISED BY BUSINESS EUROPE: MIRROR FREE ALLOCATION IN TAX SYSTEM Additional observation: the ETS covers installations, but the Energy Tax Directive (ETD) makes reference to processes. This could limit the efficient combination of the ETS and the ETD. They urge the Commission to consider alternatives to avoid creating excessive compliance requirements for companies and governments. This issue has been considered in the draft of the French finance bill: installations of energy intensive industries or industries using biomass as fuel are exempted from the French carbon tax provided that they will be subjected to ETS in 2013.
  17. 17. ISSUES RAISED BY BUSINESS EUROPE :USE OF OFFSET MECHANISMS 4. Use of offset mechanisms How can the use of offset mechanisms for ETS installations be replicated? Background Companies can convert international carbon credits from Joint Implementation projects or through the Clean Development Mechanism into allowances that can be used for compliance under the EU ETS. Moreover, 50% of EU ETS auctioning revenues should be earmarked to environmental improvements through incentives for eco-innovation, carbon capture and storage projects, renewables or reforestation (Art. 10.3 ETS). BUSINESSEUROPE position A similar offset mechanism should be envisaged for a carbon tax to ensure cost efficiency and a level playing field. Therefore, we strongly support to keep Art 17a of the draft proposal for revision of the ETD which foresees an exemption from CO2- related taxation for CO2-reducing investments (up to 70% of investment). International offset could be implemented through widening the scope of this article also to international emission reduction projects. With regard to respecting the Treaty s freedom of establishment, article 17a should also allow for offsetting the carbon tax by reducing emissions in installations in another Member State.
  18. 18. ISSUES RAISED BY BUSINESS EUROPE: EXPECTED ADMINISTRATIVE COSTS 5. Expected administrative costs On the basis of the current draft for revision of the Energy Tax Directive: what are the expected administrative costs BUSINESSEUROPE position A high level assessment indicates an additional administrative cost of at least 50 M (one- off to reset the systems) and additional cost of product analyses of some 1,5 M / year if the reporting fundamentals change from volume and weight to CO2 factors and GJ . Mitigation of some of these costs is possible if the Commission would provide Standard conversation factors and reporting system fundamentals would not need to be changed to cope with "CO2 factors" and "GJ" rather than with volume and weight. These costs do not include the potential additional compliance and pre-financing burden that occurs from the fact that the carbon tax is introduced next to the EU ETS. According to the Commission, the carbon tax will be handled like an excise duty, e.g. collected by the supplier for the tax authority. It is unclear how the supplier should make the difference between different sizes of installations, one inside ETS and one outside when providing the company with energy. Moreover, in case where the tax would be recovered by energy suppliers, important changes in current reporting and invoicing systems might be required since the scope of consumers subject to the taxation might evolve and exemptions / derogation processes must be entered into existing IT systems.
  19. 19. ISSUES RAISED BY BUSINESS EUROPE: EXPECTED ADMINISTRATIVE COSTS It is therefore not possible for the Commission to conclude so quickly on the non- issue of administrative costs and detailed impact assessments should therefore be run to analyze the question in depth. Moreover, on the basis of such assessments, appropriate measures should be designed in order to provide for cost recovery mechanisms or upfront exemptions for fuel and energy supplies to sectors covered by the EU ETS. A refund mechanism would require such sectors to pre-finance the carbon tax. This is a cost that most installations are either already bearing through the EU ETS or should not have to bear to avoid carbon leakage. Such inefficiencies should be avoided, especially in the current financial climate. Finally, a transition period would be needed in order to allow companies sufficient time to implement the new modalities.
  20. 20. PROVISIONAL CONCLUSIONS (I) PRICES ( CARBON TA XES) OR QUANTITIES (CAPS) BUT NOT BOTH CARBON TAX SEEMS A BETTER POLICY TO REDUCE CARBON EMISSIONS THROUGH SIGNALS TO CONSUMERS, PRODUCERS AND INNOVATORS AND TO ECONOMIZE ON THE INFORMATION REQUIREMENTS THAT MARKET PARTICIPAN TS NEED (Nordhaus) COORDINATION OF CARBON TAX AND ETS IS A COMPLEX, DIFFICULT AND COSTLY TASK COORDINATION OF CARBON TAX AND ETS SENSIBLY PROPOSED BY BUSINESSEUROPE WOULD LEAVE A RESIDUAL CO2 TAXATION -COMPARED WITH THE INITIAL TAXABLE BASE- AND HIGH AD MINISTRATIVE COS TS UNILATERAL CAP & TRADE (ETS) WITH HIGHER DOMESTIC CARBON PRICE LEADS TO AN INCREASE IN THE SOCIAL COST OF PRODUCTION BEYOND THE POINT AT WHICH THE DOMES TIC CAP IS REACHE D (Gros) A CARBON PRICE WOULD NEED BORDER TAX ADJUSTMENTS. THE BTA GIVES THE OTHER C OUNTRIES INCENTIVE TO ADOPT A CARBON POLIC Y
  21. 21. PROVISIONAL CONCLUSIONS (II) A CARBON TA X COULD BE BETTER ADJUSTE D THROUGH TIME (Nordhaus) A CARBON TAX WOULD ALSO NEED TO ADDRESS THE PHASING OUT OF FOSSIL-FUEL SUBSIDIES: SUBSIDISED PRICES ARE ALSO PART OF THE PROBLEM A CARBON TA X SHOULD BE USED TO FINANCE TAX REDUCTIONS IN INCOME TAX (A GREEN E MPLOYMENT TAX SWAP?; Metcalf))
  22. 22. ANNEX I Figure 1. Central case and uncertainty bands for social cost of carbon The figure shows the central case and the current uncertainty bands for the social cost of carbon (SCC) at different dates in the future. The square and circle in the center of the bars are respectively the certainty equivalent for the SCC and the mean SCC for the 100 runs in a Monte Carlo uncertainty analysis. This is for the base no-controls case for the DICE-2007 model. (Source: William Nordhaus, DICE model.)
  23. 23. ANNEX II Figure 2. Volatility of Prices under a Cap-and-Trade Regime This figure shows the history of two contracts under the EU Emissions Trading Scheme. The volatility is representative of trading prices for allowances under cap-and-trade systems. (Source: Gilbert Metcalf, A Proposal for a U.S. Carbon Tax Swap, Hamilton Project.)
  24. 24. ANNEX III: Policies to Cut Emissions I. Traditional regulations II. Direct subsidies for certain technologies III. Economic incentives (price per ton CO2 ) A. Cap-and-trade permit system B. Carbon tax
  25. 25. ANNEX IV: Comparing a Tax vs. Cap-and-Trade Source: Prof. Don Fullerton: Choice of Climate Policy in the EU OR: a vertical supply curve (a fixed number of permits) Price (in per ton) A tax, per unit of pollution, imposes a price, like a flat supply curve Demand ( willing to pay for the right to pollute) Quantity (millions of tons)
  26. 26. ANNEX V: Comparing a Tax vs. Cap- &-Trade A carbon tax can be equivalent to a cap and trade permit system, IF: If government sells the permits at auction (so that the revenue is the same) And if policymakers know exactly where is the demand curve ( certainty )
  27. 27. ANNEX VI: Comparing: What if demand is not known for sure? Source: Prof. Don Fullerton: Choice of Climate Policy in the EU A fixed quantity of permits, leads to uncertain price, and costs for firms Price A tax, leads to uncertain amount of pollution Quantity of pollution
  28. 28. ANNEX VII: Comparing a Tax vs. Cap-and-Trade Source: Prof. Don Fullerton: Choice of Climate Policy in the EU Normally firms are prohibited from colluding to restrict output and raise price. With permits, Price they are required to restrict output (and raise price) Fixed pollution per unit output (tons carbon per Kwh). The demand for electricity is a demand for pollution MC + carbon tax Marginal Cost Restricted number of permits Demand Quantity of coal-fired electricity
  29. 29. ANNEX VIII: Relative Carbon Intensities. Source: Gros Countries carbon intensities CO2 intensity of CO2 intensity of exports GDP 2005 EU27 0.47 0.43 USA 0.72 0.53 China 2.46 2.43 India 2.67 1.78 Brazil 1.05 0.5 Russia 3.85 4.4
  30. 30. ANNEX IX: Effect of ETS with higher carbon intensity abroad. Source:Gros
  31. 31. ANNEX X: Bibliography Businesseurope: Contribution to the revision of the Energy Tax Directive . Position Paper. November 5, 2009 Fullerton, D.: Choice of Climate Policy in the EU . November 30, 2009 Gros, D.: Why a cap-and-trade system can be bad for your health . VoxEU, December 5, 2009 Gros, D.: Why the EU needs a border tax on carbon .VoxEU, December 9, 2009 Hansen, J.: Cap and Fade .New York Times, December 6,2009. http://www.nyti mes.com/2009/12/07/opi nion/07hansen.html?_r=1 Komanoff & Rosenblum: Carbon Taxes First . www.carbontax.org Nordhaus, W.: Economic Issues in Designing a Global Agreement on Global Warming . Copenhagen March 10-12,2009 Melillo,J.M.: Terrestrial Ecosystem Model http://ecosystems.mbl.edu/staff/melillo.html; http://ecosystems.mbl.edu/TEM/index.html Ruiz Zapatero, G.¨: Los biocarburantes y el Impuesto sobre Hidrocarburos a la luz de las últimas propuestas de la Comisión Europea .Cuadernos de Energía nº 20, Abril 2008,páginas 93-106. http://www.deloitte.com/view/es_ES/es/industrias/energia/cuadernos-de- energia/index.htm

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