Carbon Taxation - Topic 3 PDF

Topic 3 - Carbon Taxation Carbon Pricing 110 Instruments implemented in 53 national and 40 subnational jurisdictions. Carbon pricing is a market-based strategy to reduce GHG emissions by assigning a monetary cost to emitting CO₂ since the emissions impose...

Topic 3 - Carbon Taxation Carbon Pricing 110 Instruments implemented in 53 national and 40 subnational jurisdictions. Carbon pricing is a market-based strategy to reduce GHG emissions by assigning a monetary cost to emitting CO₂ since the emissions impose environmental, social and economic costs. Carbon pricing includes: Government interventions → carbon taxation, allowances, trading and credits. Voluntary carbon markets → entities choose to engage in carbon offsetting and price involves funding carbon avoidance, reduction/removal project. Long term pricing Reduce Emissions → main goal is to facilitate gradual shift to reduction in carbon emissions Renewable Energy → Increase investments in renewable energy sources + cost of carbon emitting increases companies → transition to cleaner sources E.g. IMF → Intl. Carbon Price Floor (ICPF) different price points to incentivize participation in carbon pricing schemes. High income countries → $75/tonne, Middle → $50 and Low→$25. Short term pricing Focused on immediate cost impacts to reduce carbon-intensive activities. Adjustments based on current emission levels and mitigation needs. May involve transitional measures to prevent sudden economic disruptions. Profit Maximization Profit = Total Revenue - Total Cost TR → Price and Quantity sold TC → Fixed costs + Variable costs Fixed Costs → plant, machinery Variable costs → raw materials, labour, energy etc. Long run costs→ all of the above costs are variable and firm can build a new energy efficient factory. Output is the only component that a firm can control. Marginal Revenue = addition to TR from selling an additional unit of output Marginal Cost = addition to TC from producing an additional unit of output Profit maximization by producing outputs at MR=MC MR > MC → produce and sell more MR < MC → produce and sell less Marginal Cost in Carbon Pricing Marginal Abatement Cost (MAC): Represents the cost of reducing an additional unit of carbon emissions. Without Carbon Pricing: Firms emit carbon freely without accounting for the environmental costs (negative externality). This leads to excessive emissions as firms minimize only their private costs. With Carbon Pricing: A carbon price imposes a cost on emissions, effectively internalizing the externality. Firms compare the carbon price to their MAC: If the carbon price is lower than their MAC, they choose to pay for emissions. If the carbon price is higher than their MAC, they abate emissions to save costs. Carbon price affects variable production costs and output decisions Firm produces at MR = MC + carbon price but then MC+ carbon price > MR so firm reduced output → reducing emissions Marginal Revenue in Carbon Pricing In a competitive market, firms aim to maximize profits by equating marginal cost with marginal revenue. Impact of Carbon Pricing on MR: Carbon pricing does not directly affect a firm’s marginal revenue from producing goods. Topic 3 - Carbon Taxation 1  However, it indirectly shifts the supply curve upward by adding a cost to emissions-intensive production. This can reduce output or incentivize price increases, depending on demand elasticity. Social Optimum Social optimum, the price of carbon equals the marginal damage caused by an additional ton of CO₂. Firms reduce emissions until the marginal cost of abatement equals the carbon price, ensuring economically efficient reductions. Carbon Pricing Graphs Marginal Private Cost (MPC) cost for producing a unit of output Without carbon pricing, firms base their decisions on this curve, leading to excessive production. Marginal Social Cost (MSC) reflects the total cost to society for producing a unit of output MSC is higher than MPC because it accounts for these negative externalities. Marginal Private Cost + Carbon Tax with carbon tax or permit system → MPC curve shifts upward to include the external cost of emissions. Firms now face higher costs for emitting carbon, incentivizing them to reduce emissions. Demand (D = Marginal Benefit) Marginal benefit (value) to consumers from consuming a unit of the good. downward slope = diminishing marginal benefits as consumption ↑ Private Optimum Absence of carbon pricing → firms maximize profit (D intersects MPC) → overproduction. external costs are not accounted → higher emissions and social inefficiency Social Optimum With carbon pricing equilibrium shifts → D intersects MSC At this point, production and consumption align with societal costs, achieving a socially optimal outcome. Tax per Unit vertical distance between MPC and MSC → external cost per unit of output (or the carbon tax rate) By imposing this tax, producers internalize the cost of their emissions Market Price with Carbon Tax/Permit price consumers pay increases due to the carbon tax or permit cost higher price reflects the true social cost of the good Carbon Tax Revenue Rectangular area represents the revenue generated from the carbon tax Revenue can be used for redistribution, green investments, or other purposes Short-Run This graph captures the short-run effects of carbon pricing, focusing on immediate cost increases, output reduction, and modest behaviour changes. Topic 3 - Carbon Taxation 2  1. Limited Flexibility for Firms: In the short run, firms have limited options to change their production technology or invest in cleaner alternatives. They respond to the carbon tax mainly by reducing output or marginally adjusting inputs. 2. Immediate Impact on Prices and Output: The graph shows how the carbon tax immediately increases the cost of production (shifting the Marginal Private Cost curve upward). This leads to higher market prices and lower output in the short term. 3. Fixed Capital and Technology: The production capacity and technology are largely fixed in the short run, so firms cannot easily innovate or switch to low-carbon technology. Firms can only make marginal adjustments, like using energy more efficiently or cutting back on production. 4. Behavioural Response: Consumers and producers adjust their behaviour primarily through price signals rather than long-term investment or innovation. Higher prices reduce demand, leading to a new equilibrium closer to the social optimum. Long -Run This graph represents the long-run effects of carbon pricing on the market, focusing on how firms and consumers adapt over time to achieve a more sustainable balance between production and environmental costs. All factors of production are variable: Firms can adjust labour, capital, energy use, and production methods. Full adjustment to carbon pricing: Firms can fully respond to current and expected carbon pricing policies by changing operations and investments. New Marginal Social Cost (New MSC) Long run, firms invest in cleaner technologies and more efficient production processes, reducing the external costs of emissions. This shifts the MSC curve downward, reflecting lower societal costs for each unit of output. Demand Curve → It remains unchanged because consumer preferences typically adjust slowly in the long run. Social Optimum Price Original Social Optimum Price: Before long-term adjustments, the social cost of production was higher. New Social Optimum Price: After long-term changes, the price that reflects the true social cost of production is lower, due to reduced emissions and cleaner technology. Equilibrium Point In the long run, the Private Optimum equals the Social Optimum. Firms naturally produce at a socially efficient level because the external costs have been internalized and reduced. Key Insights from the Graph 1. Efficiency Gains Long-term innovation is driven by sustained carbon pricing. Firms invest in clean technologies and improve production processes. This leads to a reduction in the Marginal Abatement Cost (MAC). Private costs align with social costs, achieving efficient production levels. 2. Lower Social Costs The Marginal Social Cost (MSC) curve shifts downward due to lower emissions. Reflects a reduction in external environmental damage. Society benefits from improved air quality, reduced health risks, and mitigated climate impacts Topic 3 - Carbon Taxation 3  3. Price Stabilization The new social optimum price is lower than before. Long-term investments in sustainable technologies reduce production costs. Clean and eco-friendly products become more affordable for consumers. Reduces economic pressure while maintaining environmental responsibility. 4. Market Correction Carbon pricing helps the market internalize externalities. Firms naturally adjust production to reflect true social costs. Less reliance on strict regulations or government intervention. The market moves towards a self-regulating and sustainable equilibrium. 5. Market Exit Firms that cannot adapt to higher costs from carbon pricing may exit the market. Particularly affects carbon-intensive industries. 6. Location Decisions Firms might relocate to regions with lower or no carbon pricing. This can lead to carbon leakage, where emissions shift geographically rather than decreasing overall. 7. Production Techniques: Factor Substitution: Shift from carbon-intensive inputs to greener alternatives (e.g., renewables). Factor substitutability is guided by the Marginal Rate of Technical Substitution (MRTS), meaning firms balance inputs based on their productivity and cost. Firms aim for the least-cost factor combination, shown by: M PP L ​ P rice L ​ ​ = M PP K ​ P rice K ​ ​ = M PPE P rice E  ​ ​ ​ MPP L , MPP K , MPPE are marginal products of labour, capital, and energy. ​ ​ ​ Price L, Price K, Price E are their respective input prices. Adoption of New Technology: Investing in cleaner technologies to lower carbon emissions. Innovations improve efficiency and reduce dependence on fossil fuels. Energy Efficiency: Implementing processes that consume less energy, reducing costs and emissions. 8. Scale of Production Adjusting the size of operations in response to carbon pricing. Decisions on plant size and the number of production facilities are re-evaluated to minimize costs. Overall Impact The combined effect of these strategic decisions leads to a reduction in external costs (e.g., pollution, carbon emissions). Long-term adjustments encourage a shift towards a sustainable production model and help firms remain competitive in a low-carbon economy. Carbon Leakage Carbon leakage occurs when firms shift their carbon-intensive production to countries or regions with weaker or non-existent carbon pricing policies. This relocation undermines the effectiveness of carbon pricing in reducing global emissions. Causes Asymmetric Carbon Policies: Some countries impose strict carbon taxes or emission regulations, while others have little to no carbon controls. Higher Production Costs: Carbon pricing increases production costs in regulated regions, incentivizing firms to move operations to cheaper, unregulated markets. Global Competition: To remain competitive, firms may relocate to countries with lax environmental policies. Topic 3 - Carbon Taxation 4  Consequences No Net Reduction in Global Emissions: Emissions are simply shifted, not reduced. Economic Impact: Loss of industries and jobs in regions with strict carbon policies and distortion to trade-flows → trade-embodied carbon emissions due to increased transportation emissions increase. Negative Spill over effect: Local residents and environment may suffer increased pollution. Difficult to identify: Due to differences in climate policy amongst countries. Long run adjustments to Carbon pricing Carbon Border Tax → Places tariffs on imports from countries with less stringent climate policies aiming to reduce emissions. Helps in levelling the playing field for domestic companies which are subject to carbon pricing or other climate regulations → preventing foreign companies from gaining competitive advantage through lower costs. Carbon Border Adjustment Mechanism (CBAM) - EU introduced 2023 → transition phase → report emissions but no payment 2026 → full implementation → required to purchase CBAM certificates based on carbon content for EU ETS to price it. Incentivise importers and foreign countries to invest in greener production. Carbon Taxation Imposes a tax on the carbon content → price on each tonne of carbon emissions → polluter pays principle Market Efficiency: Designed to change behaviour of consumers & firms using market mechanism → relative price changes to incentivise. Internalizes Externalities: Firms account for the true social cost of production. Based on Pigouvian Taxes (Economist Pigou) A tax imposed on market activities that generate negative externalities (uncompensated social costs). It aims to correct market failure by aligning private costs with social costs. Increases the marginal private cost for polluters to match external costs they are imposing on society. Impacts: Short Run: Firms may face higher production costs but have limited flexibility to adjust. Long Run: Firms adapt by adopting greener technologies, improving energy efficiency, and potentially reducing output. Regressive Nature: Carbon taxes can disproportionately affect low-income households, as they spend a larger share of income on energy. Equity (fairness) principle: net impact on firm and household budgets is 0 Double dividend: reduction in emissions + positive macroeconomic effect Mitigation Strategies: Revenue Recycling: Redistribute tax revenue through rebates or lower income taxes → can be used for financing other projects Subsidies for Clean Energy: Support for affordable green alternatives. Targeted Assistance: Direct support for vulnerable groups. Carbon Tax (CT) Design considerations Scope % or level of emissions covered avoid double charging Tax Rate (amount per tonne) too low → ineffective too high → negative macroeconomic consequences Recycling carbon tax revenue → prescriptive Sweden → highest globally , Japan → relatively low, UK → power generation Findings of Koppl & Schratzenstaller (2022) Difficult to compare since differences in CT designs across countries. Reduce emissions only: Taxes are high enough generous exemptions from the tax → ineffective how the revenue is distributed also effects emissions → finance improvements in energy efficient technologies Topic 3 - Carbon Taxation 5  tax has to be credible and accepted by society No aggregate impact on employment → promotes shift b/w sectors No effect on competition Limited impact on innovation Regressive nature Price Elasticity of Demand (PED) Measures how much the quantity demanded of a good or service responds to a change in its price. %ChangeinQ Sensitivity of Consumers to price changes PE D ​ = %ChangeinP  ​ Market Demand Curve → Adding each individual’s demand curve Determinants of PED: 1. Availability of Substitutes: More substitutes → more elastic demand. 2. Necessity vs. Luxury: Necessities → inelastic; luxuries → elastic. 3. Proportion of Income: Higher cost relative to income → more elastic. 4. Time Horizon: Demand is more elastic over the long run as consumers adjust. 5. Addictiveness: Addictive goods (e.g., cigarettes) have inelastic demand. Types of Elasticity 1. Elastic Demand (PED > 1): Flatter demand curve Small price change → large quantity change. Total consumer expenditure falls as price rises P↑ → TR ↓ 2. Inelastic Demand (PED < 1): Steeper demand curve. Large price change → small quantity change. Total consumer expenditure rises as price rises P ↑ → TR ↑ 3. Unitary Elastic Demand (PED = 1): Demand curve with a constant proportion change. Total revenue remains unchanged. 4. Perfectly Inelastic Demand (PED = 0): Vertical demand curve. Price changes do not affect quantity. 5. Perfectly Elastic Demand (PED = ∞): Horizontal demand curve. Any price increase drops demand to zero. Carbon Tax: Distributional Impacts Regressive Nature of Carbon Taxes → impacts disproportionate on poor in many countries. Incidence of taxation → firms can pass on some tax burden to consumers Due to relatively low price elasticity of demand (like energy among households). Low PED relative to PES → increases the ability of firms to pass on carbon tax Equity Issues → if lower income consumers are adversely effected by CT. Deadweight Loss → fall in output and increase in market price is not recouped by tax revenue → current generations are sacrificing their welfare. E.g. France planned to increase carbon tax on energy by 25% → Poor 1.5 times impacted than average population → Poor 2.6 times greater impact than top 10% rich Incidence of Carbon Pricing Topic 3 - Carbon Taxation 6  The incidence of carbon pricing refers to how the economic burden of a carbon tax or carbon pricing mechanism is shared between producers and consumers. Depends on the price elasticity of demand and supply for carbon-intensive goods. Carbon tax reduces supply at each quantity level. Statutory Incidence → The party that is legally responsible for paying the carbon tax to the government. A carbon tax is imposed on coal power plants (they must pay the tax) Economic Incidence → The party that actually bears the economic burden of the carbon tax, regardless of who pays it legally. If electricity demand is inelastic, the power company raises electricity prices, and consumers bear the burden. Post tax price firms receive is lower while post tax price paid by consumers is higher → both lose out! Tax has been capitalised into prices Final Notes Carbon pricing in isolation → not effective → need complementary policies such as R&D subsidies, public investment (transport, EV infrastructure - least cost approach to reducing emissions) How much to charge is the most controversial debate Nature journal → a price of 120 euros per tonne needed by 2030 to decarbonise economies by 2050 in line with EU goals. Fairly high price of a tonne of carbon → encourage firms and households to switch to using low carbon energy → decarbonising the economy. Topic 3 - Carbon Taxation 7