Carbon Tax

One of the most contentious political issues facing a number of countries either now or in future years involves placing a price (or tax) on carbon.   It has been said that arguably the two most important issues the world currently faces are:
 
1) The prevention of  nuclear weapons falling in to the hands of rogue states or terrorist organisations; and
2) Human induced climate change.
 
In that context the importance of the climate change issue cannot be understated and so there is little wonder that the carbon tax issue has generated such passionate debate. 
 
Let’s consider some of the key issues in turn:
 
Is There Sufficient Evidence to Support Action on Climate Change?
 
What is clear about the science behind global warming is that it is incredibly complex.  The only true experts in the field are climatologists.  Arguably, the world’s leading climatologist, Dr Jim Hansen, is employed by NASA and has devoted his life to this field.  He has been fortunate enough to draw upon the skills of leading atmospheric chemists, physicists and paleoclimatologists to prove beyond any reasonable doubt that human induced climate change is real.  Furthermore, his scientific rigour has debunked the main theory espoused by many sceptics.  The sceptics key argument is that 1) climate change is a natural cyclical event not impacted by humans and 2) the build up of carbon dioxide is a natural reaction to warming. 
 
There are two key limbs to this argument, the first being:“that climate change is a natural cyclical event.”  This argument is not disputed.  Historical records confirm this to be the case.  Climate change has been occurring ever since the earth came into being some 4.6 billion years ago.    The issue is whether human interference is increasing the rate of change. 
 
Let’s look at the second limb of the argument:  “the buildup of carbon dioxide is a natural reaction to warming.”  Bear with us on this as this is critical.  What the sceptics are suggesting is that carbon dioxide is aresult of warming (the build up in carbon dioxide lags warming).   This differs from the human induced climate change argument that carbon dioxide is causing the warming - a subtle but very important difference.   
 
The science shows that the sceptics argument is partially correct when viewed in terms of pre-industrial emissions.   Carbon dioxide emissions didn’t initiate warming from past ice ages.  Where the sceptics are wrong however is that the studies show that carbon dioxide did amplify the warming.  Further, the argument that carbon dioxide in the post industrial age is not causing the warming and so human activity isn’t having any impact has been proven to be patently false.  This does not mean the sceptics should be lambasted for their efforts because they have, perhaps inadvertently, helped push the science to new levels - levels where climatologists are now comfortable to say that the science is beyond any reasonable doubt.   
 
We do not want to get bogged down on this area but it is important for sceptics to be sceptical because that promotes more scientific rigour and improves our understanding.  But it is also important for individuals to recognise that the science is incredibly complex and so best left to the experts. 
 
Why Should Countries Act If Some Key Polluters Including the United States, Japan and Russia Have Not Priced Carbon?
 
There is no definitive answer to this question but we will make some observations.  Firstly the economies of Japan and the United States are suffering from enormous public debt burdens that are placing extreme stresses on their finances.  Russia is still recovering from the sovereign debt bailout in 1998.   The inference here is that the above countries have not enacted good public policy in recent times and so should not be held out as good examples to follow. 
 
Will A Price On Carbon Make A Difference?
 
Most countries per capita emissions are dwarfed by China and the United States.  The efforts of smaller countries alone are unlikely to make a material difference.  This cannot be denied.  We can understand why some sections of the business community hold onto this view as being critical.
 
If we act first then there is a logical basis to the argument that some businesses will be at a competitive disadvantage as against overseas counterparts who have not imposed a price on carbon.  We do not disagree with this line of thinking.  It is not incorrect.  What it is though, is incredibly short sighted.  If we do nothing then we cannot persuade others to take action.  If we do nothing we cannot expect the problem to go away. 
 
But sitting back and doing nothing is akin to being on a leaky boat and refusing to bail out water while others around you are trying desperately.   It is not the right thing to do.  We need to ask ourselves are we willing to make small sacrifices for the potential of long term gain.  Science suggests we have little choice.  According to NASA, about one-third of the carbon dioxide emitted today will still be in the air 100 years from now.  This means even if we stopped global emissions today completely, the planet would continue to warm for more than a century.  If we do nothing the potential damage to our economy in 20-50 years time (let alone the planet) is likely to be far worse.   
 
Is A Carbon Tax The Best Option?
 
Let’s consider the recent Australian experience where two options were available:
 
Carbon Tax– The incumbent Gillard Government proposed a starting price of $23/tonne on carbon that would shift to an Emissions Trading Scheme by 2015.  The tax on polluters will theoretically impose an incentive upon business to reduce emissions to reduce the tax burden.  The goal is to reduce emissions by 5% by 2020. 
 
Direct Action– The Opposition proposed no price on carbon.  Instead, it was proposed that taxpayer funds would be directed to support clean energy initiatives with a view of reducing emissions by 5% by 2020. 
 
Both policies profess to work towards the same outcome, albeit via vastly different methods.  Let’s consider each policy in turn:
 
A. Carbon Tax
 
From an economic perspective, the tax on polluters is technically appealing as pollution is really only another cost of production which has not been priced in by the market before.  Just as there is a cost for labour, there is also a cost to the environment from pollution.  A tax on carbon goes some way to capturing this cost. 
 
When any cost is imposed on business they have one of two choices;
-           pass on the cost to consumers in part or in full; or
-           absorb the cost
 
Typically business will try and pass on the cost where they think consumers will pay.  This is referred to as the elasticity of demand.  Demand is said to be inelastic when prices rise but demand falls away by a smaller percentage.  Essential goods tend to have a stable or inelastic demand profile.  Businesses that sell such goods where competition is limited tend to be able to pass on costs to consumers more readily.  Electricity is one such example.
 
In contrast, demand is said to be elastic when prices rise and demand falls away by the same or a greater percentage.  Import competing products typically display elastic demand curves and are less able to pass on costs.  It follows that businesses that can pass on costs to consumers should not receive any compensation and those that can’t should receive due consideration. 
 
Businesses most exposed to a decline in profitability will be those that 1) have high emissions, and 2) are not in a position to pass on the extra costs to consumers and 3) receive little or no compensation.  Based on a $23 per tonne starting price, modeling indicates that the overall impact is not expected to be significant but industry compensation details have yet to be finalised.  Fears of mass job losses appear to be ill-founded but some restructuring is inevitable in high pollution industries.  The policy would not work if this was not the case. 
 
In terms of living costs, it is true that a carbon tax will put upward pressure on some products more than others.  Treasury modeling suggests that the price rises will, on average, be minor and offset by compensation to low to middle income earners.  There is no free ride.  A carbon tax will impose a cost but in turn there will be a clear incentive to reduce emissions.  It is hoped that clear incentives will also promote research and development into clean energy alternatives that have otherwise been too expensive to consider. 
 
B.  Direct Action
 
What about Direct Action?  If direct action can achieve the same emission reductions then it could also be said to be sound public policy.  The difference in achieving the overall outcome however could not be more stark.  Direct Action does not capture the true cost of production and so does not reduce the incentive for polluters to reduce emissions.  Instead of relying on polluters to pay the price, it relies on taxpayer funds.  Economists estimate that this will end up being a significantly more expensive measure to implement.   Again, there is no free ride.  The Coalition would have to maintain the program by either reducing funding to areas such as health or education or increasing taxes.  This may be possible when the emissions target is only 5% but when it is necessarily increased in future years (it is generally accepted that emissions need to be reduced drastically, certainly much more than the 5% so far targeted), the Coalition scheme over the long term would become a significant drain on public finances. 
 
It should be made clear that there is no perfect solution to the problem.  All solutions involve a cost/benefit trade-off.  But it is also true that the longer that action is delayed, the more difficult the task becomes.  An imperfect solution is better than delaying or doing nothing at all. 
 

Martin Fowler is a director of Moore Stephens Sydney Wealth Management where he provides financial advice to high net wealth individuals and conducts research into the social impact of economic policy. He is also a director of Whitefield Limited, an investment company listed on the Australian Stock Exchange.
 
Martin can be contacted via email at mjfowler@moorestephens.com.au or alternatively by phoning +61 2 8236 77000.