The Carbon Conundrum

Last week, Canada announced that it had taken its first steps towards joining a small and exclusive group of nations with a national carbon tax. Prime Minister Justin Trudeau called upon the country’s provinces to individually adopt either a carbon tax or a cap-and-trade framework by 2022, or have Ottawa impose a tax by that date. But why should government interfere with the free market in order to reduce carbon consumption? Does the market not always result in an efficient amount of carbon being bought and sold?

Indeed, economics has often been the seat of contention, not in the least because of its impact on politics (and often, the impact of ideology on fiscal research). Between reforming the tax code, tackling our healthcare epidemic or determining how to best trade with foreign nations, today’s pre-eminent thinkers have much to debate over. However, a surprisingly large consensus exists on the need for government intervention in curbing carbon consumption.

Simply put, carbon emissions are a negative externality – that is, they impose a social cost upon third parties not directly involved in the market for fossil fuels. Additionally, markets generally fail to properly consider these costs. As a result, the quantity of carbon-emitting fuels at market equilibrium is too high.

To address these issues, governments can either fix a consumption ceiling through company quotas or incorporate the social cost of carbon consumption in the market through a tax (which will lower quantity demanded to the efficient amount). This latter option is by far the most prevalent, as command-and-control approaches are not politically viable and most governments jump to raise revenue from an ecologically-friendly tax.

However, for all its apparent merits, taxes seeking to bring about consumption efficiency (called Pigovian taxes) have often failed because demand is often too inelastic (unresponsive) for them to function without their being extremely high. A good example might be smoking in France. In an attempt to buck the trend of increasing consumption rates among minors and women, the government enacted considerable taxes on tobacco, leading to exorbitant prices around $9.50 per pack. The result? Though the trend diminished slightly, consumption rates of tobacco have remained relatively stable as demand for cigarettes has proven to be incredibly inelastic to price changes. What can governments  do if traditional taxes do not work?

Cap-and-trade systems of tradable allowances for emissions have had remarkable success in promoting socially efficient levels of pollution. Here, firms are allowed to trade their carbon allowances among each other in a market, for instance the Chicago Mercantile Exchange. Thus, companies which have a harder time reducing pollution can buy allowances, while those with an easier time would sell theirs. In a sense, the “invisible hand” of the market enables the burden of emission reduction to be more intelligently distributed. This reasoning is what caused the American government to set up cap-and-trade for sulfur in 1990, hoping to put an end to acid rain the United States. Initially, analysts estimated that the compliance cost would be around $7.4 billion. However, the system was so wildly successful that by its end in 2013, only $870 million had been spent in achieving the emission goals.

Do these examples point towards the superiority of a cap-and-trade system? Not necessarily, for they are indeed extremely difficult to set up. Finding the economically efficient scale of consumption is not simple. Moreover, maneuvering the political scene to impose direct restrictions on firms has proven ever more difficult in a time of increased scrutiny of government coercion. Indeed, President Bush’s sulfur plan was eventually dismantled because of lobbying and deadlock in Congress in the past decade.

If these examples are of any worth, it is that they show how tackling externalities cannot be one-dimensional. Different goods demand different approaches, which is why Trudeau has been able to push for a tax when his European counterparts increasingly speak of an EU-wide emission allowance system. Indeed, oftentimes in policy concerns, it is experience rather than theory that prevails (just ask any formerly socialist nation).

Perhaps it is precisely this last concern that brought Trudeau to retroactively offer cap-and-trade as a valid alternative to provincial taxes. This Canadian saga, as well as past examples, show the need for variety and testing when tackling externalities, rather than sycophant consensus on a single method. Indeed, when push comes to shove and America will too have to implement such a program, it is essential that we do not get bogged down in the pursuit of conformity, and much like Canada, promote variety in our methods.

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