Whether we choose carbon taxes or carbon trading to cut emissions, it’s action now that matters

It’s a debate that refuses to go away and it’s back in the news: should we use carbon taxes or carbon trading to bring greenhouse gas emissions down? For anyone around before the start of the EU emissions trading system (ETS) 15 years ago, or who has followed the endless post-referendum discussions on how to replace it, this feels like a particularly geeky sort of Groundhog Day.

At its most theoretical level, the choice is whether to use a tax where the carbon price is set upfront without any guarantee about the emissions cuts it will achieve. Or whether to use an ETS, where the price of an allowance to emit a tonne of carbon dioxide might vary, but collective annual emissions are capped and must fall progressively over time.

Of course, the debate is more complicated than that. The EU ETS, which covers the energy and aviation sectors and other large industrial emitters, was successful from the start at keeping emissions below a cap. However, a generous cap, the 2008 recession and an option to import cheap overseas offsets into the scheme resulted in a huge oversupply of free allowances that crashed the price. This weakened the drive to cut carbon. The scheme has been progressively tweaked over the years, making it increasingly complicated, to try and overcome this and other issues.

A UK trading scheme, aligned with the EU’s, now looks hard to achieve
Until recently, the intention was to create a trading scheme for the UK that, over time, would be integrated with the EU ETS, retaining the market driven approach, with as large a market as possible, and ensuring a continued level playing field with EU competitors. However, this now looks hard to achieve and some want a fresh approach using a carbon tax. Much of the appeal of this is that a tax looks simple by comparison. Its behaviour and revenues would also be more predictable than a standalone UK-only ETS with a much smaller market than the EU’s scheme.

Both options could be expanded to other sectors, but this might be easier for a tax, and it might also be easier to integrate a tax with some kind of future carbon border adjustment mechanism that levies carbon charges on imports to ensure UK producers are not disadvantaged by the UK’s carbon price.

The Treasury’s tax proposal is far from simple
However, the carbon tax the Treasury has drawn up as an alternative to emissions trading is already far from simple. Industrial emitters deemed to be at risk of competitive disadvantage internationally, as a result of the scheme, will only be taxed on the emissions they produce over a certain benchmark level. For now, the benchmark proposed is the same level used to decide free allocation for at risk industries in the EU ETS. The carbon price would initially track the EU ETS price to maintain a level playing field, with adjustments possible if the EU’s price fluctuates unexpectedly. A new reward measure has also been proposed to address the fact that industrial emitters no longer receiving free allowances will not have anything to sell if they reduce their emissions below the level at which the tax ceases.

The complexity of the EU ETS and its long term targets have helped to insulate it from daily politics. A carbon tax, by comparison, is much more open to lobbying and political pressure, with the parallels to the fuel duty escalator hard to ignore. This is a different situation to the fuel duty in that a carbon tax is more explicit and targeted at sectors used to this kind of measure. Nevertheless, carbon prices are passed through to households in their electricity bills and it’s hard to imagine that struggling industries won’t ask for some kind of relief in future. All of this will make it harder for businesses to invest in emissions reductions with any certainty about their financial rewards.

Good design and no political interference are what matters
It might be tempting, and makes good headlines, to see this as a tussle between the Treasury, which would administer a carbon tax, and BEIS, which is responsible for action on climate change, over which measure should be applied, but the reality is that either option could be effective if designed well, and if political interference is avoided.

An independent mechanism for overseeing prices, both in terms of future links to the EU ETS and long term direction, is needed to make sure carbon pricing is kept away from politics. And UK officials should keep working on a carbon border adjustment, as the EU is doing, so that all sectors can eventually be subject to the full carbon price.

A cool headed look at expansion to other sectors is needed to ensure more consistent carbon pricing across the economy. This could also increase the size of a UK ETS market. At the very least, aviation must be included, removing the uncertainty in its future status created by the Treasury’s new tax proposals.

Incentives to invest will still be needed
It’s important too to be realistic about what can be achieved by carbon pricing. However strong and predictable it is, companies could still struggle to invest if it takes longer than a couple of years to generate savings. To address this, revenues from either a tax or allowance sales should be recycled to provide investment incentives in potential game changing solutions, like carbon capture and storage. And there also needs to be a strong market for lower carbon products and services, driven by regulatory standards on sectors such as construction.

Finally, and most importantly, the government should get on with making a decision. It’s astonishing that we’re still debating this four years since the referendum and only months before something needs to be in place. Whatever the outcome, I’d like to think we won’t be back here again in years to come. But I wouldn’t put money on it.

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