Opinion Pieces: Is it a carbon price or a carbon tax?

Opinion Pieces: since 2007, Prof. David Hensher has written an opinion column in the Australasian Bus and Coach magazine, where he monthly discusses a lot of different transport-related hot topics. In this section we are revisiting these columns.
April 2011
There is so much confusion out in the real world about whether we will get a carbon tax or a price on carbon. It is time for a lesson in language and clarity.
Prime Minister Julia Gillard is reportedly determined to fight on with her carbon tax proposal despite a new poll showing Labor’s primary vote has hit rock-bottom. Labor’s primary vote plunged to 30 per cent in the early March poll, with the Coalition leading 54 to 46 per cent in two-party terms, although Labor rebounded a week later.
There are clear sensitivities out there in the real world, which in many ways may be attributable to a lack of clarity in simple language as to what is planned, not helped by the repetitive reference to ‘another big tax’ by the Federal opposition.
In clarifying the language, let me begin with a distinction between a ‘tax’ and a ‘charge’ and then move onto a ‘price’. A ‘charge’ is a sum that is calculated to reflect the cost of resources consumed that need paying for by the beneficiaries of this consumption. It is often related to the idea of paying for a negative externality such as the creation of carbon dioxide (CO2) as a direct or by-product of the act of an individual, household or business. By imposing a charge, Government is, on behalf of society, recognizing this negative externality and ensuring that those who create it pay for it. Once we have identified the appropriate level of the charge (which is a challenge in itself), then imposing it is equivalent to internalizing the negative externality so that it is no longer an externality, since it is now being paid for by those who created it.
There are a number of ways in which we can establish the right level for this charge, and this is where the confusion abounds. As a prelude, however, we must now be clear what a tax is. We all know it is a sum of money the government takes from us; however it often includes two components – a sum to represent the cost of resources consumed (for petrol this is the opportunity cost of the oil resource), plus a sum that is on top of this amount which government chooses and which is nothing more than a means to raise revenue to be used as the government wishes. (Heavy vehicles (including buses) are charged an amount that represents road damage costs, mainly recovered through the excise but also partly through registration. They get a rebate of the rest of the excise). Government typically imposes the revenue raising component on activities where the market is far less price sensitive (e.g., cigarettes and alcohol and fuel), since we typically are addicted to the consumption of these items, and have in many situations little choice (which includes using the car).
So now we should understand that there exists a price that government adds onto the cost of consumption (and production) that can be a mixture of a charge and a tax, which in the current context of a carbon tax is associated directly with the externality element. The biggest challenge is how to determine this price in terms of some reasonable objectives such as economic efficiency and fairness, given in the case of CO2 the desire to clean up the environment. If it all works out well, we would expect the price to be an incentive to look at alternative measures to achieve the desired outcomes of households and businesses, while at the same time reducing CO2.
The discussion thus far is designed to help in understanding some of the language used by economists and policy commentators (including some politicians); however from the real politics of pricing carbon, there are two ways to identify a price. Through a carbon tax/charge or through establishing a carbon price. A Government, where it supports a price determination, will establish a carbon price through some market mechanism, which is often referred to as an emission trading scheme (ETS). Alternatively a carbon tax (or charge) can be explained (justified) as the charge for the externality. The tax sets a price on carbon and consumption leads then to a level of emissions. An ETS operates in reverse: it sets the level of emissions and a price (tax or charge) for carbon results, consistent with this level of emissions.
Under ETS, trading takes place in a market for carbon (credit and debits), with an announced cap on the amount of emission reduction to target (hence cap and trade), which should, if markets are efficient (or close to efficient), deliver a market price for a unit of carbon. This is then the carbon price, which pundits can then claim is the efficient level of a carbon tax. Imposing a carbon tax without ETS does not ensure the equivalent price on carbon.
The challenge with the ETS is that we need efficient markets, or dare I say a market of any level of efficiency, to get started. They do exist in parts of the world (notably Europe and California); however it is unclear how Australia might enter that market. At the end of the day, it is the rate of emissions reduction that will be critical and that is an argument in favour of an ETS, where targetting is clear (but able to be captured by the rent seekers – who will probably capture the tax too). If the tax is set too low, emissions will not fall quickly enough and the tax will need to be increased. Research undertaken for ‘Climate Works’ at Monash University by McKinsey suggests a 25 percent cut in Greenhouse Gas Emissions by 2020 would require a marginal price of about $50/t CO2, which is what we might reasonably expect to see by 2020. A starting price might be about half this estimate.
The ‘debate’ and ‘noise’ in Federal Parliament is very much connected to what this ‘right’ price might be. Although politicians and their advisers are unlikely to know the price, they do have a right to announce such a price – that is what they get elected to do – operationalise social value judgments on tough calls. As a consequence (or for other reasons that elude me), politicians have moved away from an ETS (The Rudd preference), and started promoting a carbon tax (often mixing the language with a carbon price), with plans to announce the level of tax ($/kg of carbon). Curiously, a carbon tax is highly correlated with the cost of fuel in car and heavy vehicle uses (being the product of fuel price, fuel efficiency (litres per 100km) and kilometres travelled). Research I have undertaken using the TRESIS software developed at my Institute, suggests we might be just as effective in reducing CO2 (if the only route is a carbon tax) to ‘quietly’ hike up fuel excise, which is expected to have almost the same effect on transport users, avoiding the emotion attached to a carbon tax, although the downside is that it may not send the right message to the market to develop alternative products with less carbon. I doubt governments have fallen over a higher fuel excise, but they may just fall over a carbon tax, possibly for all the wrong reasons.
So what we appear to have now is a carbon tax at a level not yet announced (as of March 24 when this thought piece was written), which we are told is a transition to a carbon price under an ETS. Exactly how we can transition is a bit of a mystery, since the carbon tax will not create a market for carbon, although it should signal responses from the market to make changes in services and technology to reduce CO2, and hence the impost of the carbon tax.
I am however reminded that a switch to clean fuels (those with no carbon content), which is what government wants to encourage through a tax or a price on carbon, could in the long run erode the revenue base of government, who I predict will introduce another tax on these alternative fuels as a way of establishing revenue. Time will tell, but for now readers might benefit by the clarification of language
Food for thought
I acknowledge the substantial comments of my colleagues Professors Corinne Mulley and John Stanley who have helped to ensure the language is clear.
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