Introduction
Despite speculation surrounding the speed and scale of global warming, it cannot be denied that the threat of anthropogenic induced climate change beckons. Greenhouse gases (GHG’s) continue to be produced at a high rate and are being trapped in the Earth’s atmosphere, causing the perpetuation of dramatic global warming. Although the science is settled that a sharp decrease in global GHG emissions would substantially reduce the risk of catastrophic climate change in the foreseeable future, as long as our climate remains a public good, thus non-rival and non-excludable, it will continually be over-utilised and thus GHG emissions will only increase in years to come.
For this reason, many countries across the globe are attempting to internalise the global warming externality by mitigating their GHG emissions through carbon pricing, a market-based scheme that shifts the cost of damages caused by carbon back to the emitters. As the utilisation of carbon pricing schemes grows globally, in several forms, we are now able to analyse the effectiveness of differing policies to ascertain which strategies, if any, can significantly mitigate GHG emissions as intended. This will be the key focus of the paper. First, carbon pricing will be broadly defined before the two most common carbon pricing strategies – emissions trading schemes (ETS) and carbon tax policies – are explained in depth. The paper will then draw upon two case study countries which have utilised carbon pricing strategies, these being the EU and Japan, to analyse the true efficiency of such schemes for reducing GHG emissions.
Background
Carbon pricing strategies in their basic form seek to capture the external social costs of carbon emissions. These are the projected costs from the damages caused by climate change, for example, the damage to crops caused by heat waves and droughts, increase in health care costs due to extreme weather events, or property damage and displacement caused by flooding and sea level rise (Neilson, 2008). These costs are then tied to their source – those who emit GHG’s – through a price on carbon. By shifting this cost burden back to the emitters, carbon pricing strategies create an incentive for these polluters to reduce their GHG emissions by investing in low-emissions technologies (Bailey, 2010). In this way, GHG mitigation is achieved in the most flexible and least-cost way to society, whilst also stimulating clean technology and market innovation, fuelling new, low-carbon drivers of economic growth.
Mechanisms for implementing carbon pricing schemes
The two most commonly cited forms of carbon pricing strategies are emissions trading systems (ETS) and carbon taxes.
Emissions Trading Schemes (ETS)
An ETS caps the total level of greenhouse gas emissions that polluters in aggregate are legally allowed to produce. Within this cap, emissions permits are distributed to firms, with the number of permits dictating how much CO2 (or equivalent) they can produce within a given period (Neilson, 2008). For every tonne of CO2 produced over and above this given amount, additional permits must be purchased on the market from a lower emitter who has surplus permits (Bailey, 2010). Thus, an ETS establishes a market price for GHG emissions, which ensures that the required emission reductions will take place to keep the emitters (in aggregate) within their carbon budget (Neilson, 2008). This trade both incentivises firms who keep their emissions low (as they can boost profits by selling surplus permits) and disincentivises polluters, who must spend money (thus decreasing profits) to continue to emit high levels of CO2.
However, many have demonstrated concerns over the volatility of carbon prices under the scheme. Indeed, because the price is determined by the market, a myriad of external forces could cause dramatic fluctuations in the price of carbon, thwarting activity in affected markets (Bell, 2008). Additionally, as with any form of government intervention in the market, an ETS carries deadweight loss to the economy. This is primarily due to the high regulatory and administrative cost of operating the system (Barnes & Hoerber, 2017). Indeed, managing the issuance of permits, participation in the scheme, platforms for trading, and the consequences of non-compliance, are all very costly processes for the government (Barnes & Hoerber, 2017).
Carbon Taxes
In contrast to the “cap-and-trade” policy under an ETS, carbon taxes define an explicit tax on the burning of carbon-based fuels (coal, oil, gas) which must be paid to the government by all major emitters (World Bank, 2018). It is different from an ETS in that the overall amount of CO2 mitigated under the carbon tax is not pre-defined. If set high enough, it motivates high emitters to switch to invest in low-emissions technology, simply by making it more economically rewarding to move to non-carbon fuels and energy efficiency (World Bank, 2018). In addition to the positive environmental effects of a carbon tax, such a policy also generates significant tax revenues, which can be re-invested into the development of sustainable technologies, or to subsidise firms who are investing in renewables (Parliament of Australia, 2018).
Still, similarly to ETS, carbon tax schemes face several major challenges. The effectiveness of a carbon tax depends on the price elasticity of demand for carbon (PEDC), thus there are no guarantees that emissions will decline if consumption of the goods and services that produce carbon emissions remains unresponsive to price increases (Parliament of Australia, 2018). Additionally, we cannot know in advance which level to set the tax at to produce the best outcomes. Thus the tax may have to go through several changes before having the desired effect, making it politically vulnerable (Parliament of Australia, 2018).
Case Studies
In differing forms, many countries have started to adopt these carbon pricing strategies to mitigate their own carbon emissions. Through analysis of each case study discussed below, this paper will attempt to ascertain the true value of carbon pricing schemes for mitigating GHG’s. These case study countries are the European Union, with its ETS, and Japan with its carbon tax.
EU ETS: The Basics
Under the provisions of the Kyoto Protocol (KP), which legislated legally binding emissions reduction commitments for the 38 member countries (Vlachou & Pantelias, 2017a), the European Union emissions trading scheme (EU ETS) began in 2005. The system works by limiting overall emissions, and distributing an equivalent number of European Emissions Allowances (EUA’s) to emitters which can then be traded between firms as desired. Each emissions allowance gives the holder the right to emit one tonne of co2, or the equivalent amount of nitrous oxide or perfluorocarbons. Heavy fines are imposed if companies do not submit enough allowances to match their emissions (Elias et al., 2017). The EU ETS covers approximately 11,000 power stations and manufacturing plants, with around 45% of total EU emissions regulated by the scheme (Elias et al., 2017). The ETS was designed to run for two phases, phase 1 (2005–2007) and phase 2 (2008–2012), which coincided with the first commitment period of the KP (Vlachou & Pantelias, 2017a). According to the European Commission (EC)(2018), the scheme has resulted in a reduction of GHG emissions by approximately 8% after phase 1 and 2. After a review process of the first and second phases, the EC presented an ETS amendment proposal in 2008 for phase 3 (2012-2020)(Vlachou & Pantelias, 2017b). In phase 3, the cap on emissions from power stations and other fixed installations is reduced by 1.74% every year. This means that in 2020, greenhouse gas emissions from these sectors will be 21% lower than in 2005 (European Commission, 2016).
Criticisms
Despite the drop in GHG emissions caused by the scheme, its has been openly criticised for several structural flaws that have prevented it from reaching its full potential. Firstly, polluters are not limited to covering their emissions with only EUA’s, due to the ETS’s linkages with the KP. Under the KP, reduction targets could be achieved by various domestic efforts at the national level and by the use of international flexible mechanisms: international emissions trading (IET), clean development mechanism (CDM) and joint implementation (JI) (Vlachou & Pantelias, 2017b). CDM and JI create project-based credits, that is, certified emissions reductions (CERs) and emissions reduction units (ERUs), respectively, which can be used for KP targets (Vlachou & Pantelias, 2017a). By extension, under the EU ETS, emitters can also obtain and use, albeit to a limited extent, CERs and ERUs from CDM and JI projects, respectively, for compliance with the EU ETS (Vlachou & Pantelias, 2017a). Importantly, the majority of CDM projects were undertaken in countries which also attract high levels of foreign direct investment (FDI). As multinational companies move globally by shifting their productive operations from core countries to large developing ones such as China, taking benefit of lower costs (especially wages) and of limited environmental regulation, they also relocate the origination of GHG emissions from advanced countries to developing ones (Vlachou & Pantelias, 2017a). EU transnational firms might then not only export GHG emissions by relocating emitting activities abroad, but also compromise domestic reduction obligations by using credits from dubious carbon-reducing CDM projects. Overall, the CERs and ERUs used for compliance in EU-27 accounted for 10.4 percent of the total amount of allocated allowances (Vlachou & Pantelias, 2017a). Since CERs and ERUs were cheaper than EUAs, EU ETS installations obviously used the offsets and retained and banked EUAs for future use. Thus, in aggregate, member states are still exceeding their allowances.
The 2012 World Bank report on the state and trends of the carbon market (Kossoy & Guigon, 2012) confirmed that these and several other malfunctions and frauds occurred in the first two phases of the EU ETS. Notably, the report took issue with the market-based pricing mechanism that is implicit in the scheme, arguing for more regulation to protect smaller players. Research discovered several instances in which big players in the market pressured smaller (and often cash-strapped) players to sell their portfolios for a miniscule share of their true value, thus allowing these firms to accelerate the process of concentration in carbon markets and exercise market power (Kossoy & Guigon, 2012). Additionally, the 2008 economic crisis led to emissions reductions that were greater than expected, resulting in a large surplus of allowances and credits. This weighed heavily on the carbon price throughout phase 2 and into phase 3, limiting the incentive for investment in renewables (Kossoy & Guigon, 2012). This demonstrates that the EUA market can be easily swirled in the turmoil of financial markets, thus increasing the volatility of the scheme and undermining its overarching goal of emissions reduction.
This informed the report’s recommendation that enhanced registry infrastructure, regulation and surveillance were necessary to improve the functioning of the ETS scheme (Kossoy & Guigon, 2012). As a result, a single EU registry, the Union Registry, has replaced member states’ national registries since 2012, which holds accounts for all ETS installation and keeps record of transactions (European Commission, 2016). It is operated by the Commission and thus surveillance is centralized. Such requirements could only be met, however, by increasing administrative costs, thus increasing deadweight loss associated with the scheme and further limiting its optimality.
Opportunity for Reform
The European Commission (EC) recognised these criticisms in the structural reform of Phase 3, introducing more harmonised rules and regulations (European Commission, 2016). However, the problem caused by a significant surplus of allowances remains, in the short term undermining the orderly functioning of the carbon market. The EC first addressed this issue through the introduction of a market-stability reserve in 2015. This reserve, which will start operating in January 2019, aims to neutralise the negative impacts of the existing allowance surplus and improve the system’s resilience to future shocks. 900 million withheld surplus allowances will be transferred to the reserve to decrease the supply of EUA’s in the market, thus shifting prices back towards equilibrium (European Commission, 2016).
Further revisions for phase 4 also look promising for the improvement of the EU ETS. The key aspects of the proposal include: updated benchmarks to reflect technological progress; an overall decline in the number of allowances by 2.2% annually, rather than 1.74% currently (reflects increased emissions reduction targets), and; improved support mechanisms to help the industry and power sectors meet the innovation and investment challenges of the transition to a low-carbon economy. If these targets are achieved, the EU ETS may live up to its goals for significantly reducing GHG emissions (Lehmann & Gawel, 2013). However, based on past precedent, it is impossible to conclude that the current system has significantly reduced GHG emissions due to structural defects within the scheme. That is not to say that ETS’s are not a key policy tool for mitigating climate change, as the policy has led to an overall reduction of emissions in the EU as explained in “The Basics” above, rather that several structural reforms must occur for the policy to reap more significant long-term benefits.
Japan’s Carbon Tax: The Basics
An alternative carbon pricing mechanism to the EU’s ETS is Japan’s Carbon Tax Scheme, which became operational in 2012. The Japanese Global Warming Tax is imposed on the consumption of fossil fuels such as petroleum, natural gas and coal, with the tax burden equalling 289 Japanese Yen per ton of CO2 emissions (Arimura & Iwata, 2015). This tax rate is added on top of the pre-existing Petroleum and Coal Tax, with the initial rate of 38 Japanese Yen raised gradually over three and a half years before its full implementation in April 2016 (Kawakatsu, 2017). The tax rate has since been frozen and there is no plan for further increases. Exemptions and refunds are provided for certain fuels such as imported and domestic volatile oil for petro- chemical production (Kreiser et al., 2015). The revenues collected from the tax were estimated to be 39.1 billion JPY for the first year and 261.3 billion JPY annually starting from the year 2016 (Kreiser et al., 2015).
The emissions impact of the tax is expected to be around 6–24 Mt/yr by 2020 (0.5–2.2 percent of CO2 emissions in 1990), of which 1.8 Mt/yr results from a “price effect” (reduction in energy use through taxation) and 3.9–22 Mt/yr results from a “budget effect” (reduction through the use of tax revenue for emissions reduction projects) (Kawakatsu, 2017). This is far lower than Japan’s formerly stated 2020 target, which was to reduce emissions by 25% below 1990 levels.
Praise for Japan’s Carbon Tax
Because the carbon tax is not a completely new tax, rather a small additional levy on the pre-existing Petroleum and Coal Tax, it is far easier for Japanese emitters to adapt to it. Thus, detrimental effects of the tax to low-income households are minimized, as producers don’t pass on huge price increases with the introduction of the carbon levy (Kawakatsu, 2017). The effects of the tax on average households is relatively small, and this does not even consider that low-income households, especially in sparsely populated and cold areas, are protected by supportive measures (Kawakatsu, 2017). Additionally, the Japanese carbon tax is not revenue neutral, thus the entirety of the revenue collected will be used to promote energy conservation, renewable energy, distributed generation, and innovative technologies through various measures, including facility installation subsidies and R&D support (Kreiser et al., 2015). Some of the specific measures outlined by the Japanese government include ‘promotion of domestic business location for innovative low-carbon technology-intensive industries, installation of energy-saving equipment by small and medium-sized enterprises, introduction of financial assistance for local governments to promote energy-saving and renewable energy sources’ (Kreiser et al., 2015). These initiatives represent a flow on reduction of GHG’s. Finally, the administration of the tax is simple. The carbon tax is essentially applied and collected in the same way as the Petroleum and Coal Tax, therefore limiting deadweight loss and making the system relatively efficient, effective, and fair overall (Kawakatsu, 2017).
Criticisms
A key criticism of Japan’s Global Warming Tax is that the emissions reduction resulting from the scheme is too low, and therefore the policy is not aggressive enough to significantly mitigate GHG’s (Jiji Press, 2010). Although the tax rate is designed to moderate detrimental economic and social effects by starting low and increasing gradually, giving consumers and businesses time to adjust their consumption patterns, the tax rate remains frozen at 2016 levels, which are still extremely low. Indeed, it remains considerably lower than carbon prices emerging from most cap-and-trade schemes (US$3/tCO2 average) or other carbon taxes (CAN$30/tCO2) (International Energy Agency, 2012). Hence, the Japanese Global Warming Tax appears to be too low for significantly shifting technology investments or behaviour towards cleaner and more efficient energy choices.
The scheme has also been criticised for the inflexibility of the revenue allocation. Although Japan has been praised for the direct investment of carbon tax revenues into low-emissions technology, therefore increasing GHG mitigation, some argue that the Japanese government should be able to draw upon these revenues to support the state should socio-economic conditions change, which the current policy does not allow (Kawakatsu, 2017).
Opportunity for reform
The key issue faced by Japan in terms of reaching its 25% GHG mitigation target is its low price elasticity of demand for energy, with consumers not very sensitive to energy price changes (Lee et al., 2012). If Japan wished to maximise the price effects of its carbon tax, and dramatically reduce GHG’s, it would need to increase the tax rate dramatically, therefore leading to a significant rise in energy costs. Thus the adverse economic impacts associated with increasing the tax rate outweigh the perceived benefits of increased mitigation in the short term.
This has informed the suggestion that to reach the 25% GHG mitigation target, Japan should proceed with a dramatic increase in the tax rate, but instead of directing revenues into low-emissions technology projects, these should be used to supplement income tax cuts (known as revenue recycling), thus decreasing the burden of increased energy costs (Lee et al., 2012). For example, Lee et al. (2012) model three scenarios for Japanese carbon tax pricing: a baseline, where they maintain current tax levels; an increase in tax rates that will achieve 25% emissions reduction, with no revenue recycling, and; an increase in tax rates achieving 25% reduction, with revenue recycling. They found that where revenue recycling was implemented efficiently, there were positive effects to GDP compared to the baseline, thus such a strategy would offset the potentially high economic cost of mitigation (Lee et al., 2012). With these reforms, the Japanese Carbon Tax could live up to its environmental goals, and thus become a key tool for mitigating GHG’s.
Conclusion
As this paper has demonstrated, the benefits of carbon pricing schemes in theory, have failed to come to fruition in practise, with structural flaws limiting the mitigation of GHG’s. The EU ETS is flawed by its allowance of the use of international credits and CDM’s for compliance, as this allows firms to undercut EUA prices and limits the ability of the market price to incentivise emissions mitigation. Increased regulation could help with this, as could a re-evaluation of the rules surrounding the use of CDM and JI credits. Indeed, this would increase the long-term benefits of the policy in terms of GHG mitigation, however this would also increase costs and thus deadweight loss. In Japan, the Carbon Tax, while efficient by definition, is too low to generate significant changes in climate change. More aggressive policies need to be put in place, such as that suggested by Lee et al. (2012), to maintain the administrative ease and low cost of the policy whist promoting more dramatic long term change. Overall, the policies themselves certainly have value, in that they are key policy tools for mitigating greenhouse gases and thus limiting climate change, significant adjustments are needed to ensure the long-term success of these climate pricing schemes.