The economic thinking behind a carbon tax   Leave a comment

An externality is a cost or a benefit arising from an economic transaction that falls on a third party and that is not taken into account by those who undertake the transaction1. Economics studies two forms of externalities.  A positive externality is something that benefits society, but in such a way that the producer does not fully profit from the gains made.  A negative externality is something that costs the producer nothing, but is costly to society in general.

For example, when a home owner fills her garden with beautiful spring flowers, she generates an externality – in this case an external benefit – for all the joggers and walkers who pass by, inhaling the fragrances and admiring the scene behind her fences. But, in deciding how much to spend on her display, the gardener takes into account only the benefits accruing to herself. On the other hand, when a paper mill dumps its waste products into a river, killing the fish, it imposes an externality – in this case, an external cost – on the people who live downstream and depend on the fish for their livelihood. Since the mill does not bear these costs, it doesn’t take them into account in deciding whether to dump waste into the river.  

Unfortunately, negative externalities are a much more common scenario. A particularly dramatic negative externality is now receiving a lot of attention. Human-induced climate change – its causes, consequences and responses – is a current subject of major debate in Australia and overseas. It’s a subject on which there is a wealth of information produced by experts from a range of different perspectives – scientific, economic, legal, social policy and foreign affairs.

When utilities, businesses or homeowners consume fossil fuels, they create pollution that has a societal cost which affects everyone – greenhouse gases that are believed to be causing human-induced climate change. 

The Intergovernmental Panel on Climate Change (IPCC) is the leading body for the assessment of climate change, established by the United Nations Environment Programme (UNEP) and the World Meteorological Organisation (WMO) to provide the world with a clear scientific view on the current state of climate change and its potential environmental and socio-economic consequences. In its Fourth Assessment Report (AR4) on Climate Change, the IPCC concluded that global warming is unequivocal, and that almost certainly (a probability of 90%) this warming is caused by human activities – chiefly the burning of carbon-containing fuels.

The IPCC report warns climate change would precipitate more droughts, floods and storms, higher hurricane intensity, rising sea levels, declining crop yields, degraded fisheries, damaged reefs and widespread extinctions. Such environmental impacts would inevitably have major social and economic consequences, damaging infrastructure, destabilising financial and energy markets, boosting the cost of insurance and impacting on the flows of migration.

For further discussion of the costs (and potential benefits) of climate change, google “Stern Review: the economics of climate change”, or see Australia’s analysis by Professor Ross Garnaut (Garnaut Climate Change Review: update 2011).

The problem with greenhouse gas emissions is that businesses and households do not fully measure and account for the true economic costs of their actions.  They do not have to subtract these outside costs from their revenues or income, which means that profits inaccurately portray the company’s or household’s actions as positive.  This can lead to inefficiency in the allocation of resources. Because neither the market nor private individuals can be counted on to prevent this inefficiency in the economy, the government will intervene to try and correct the market failure.

The government’s basic goal is to force companies to internalise the negative externality (ie. to take into consideration the outside costs imposed on society).  To achieve this goal, the government can use one of several types of regulation: it can tax companies for polluting, it can create pollution limits and/or hand out tradable pollution permits (ie. a “cap and trade” system).

The current Australian Federal government has opted to start with the carbon tax in 2012, and then transitioning to a cap and trade system in 2015. Imposing a carbon tax on the biggest polluters, in addition to creating incentives for energy conservation and cleaner technologies, will put renewable energy sources such as wind, solar and geothermal on a more competitive footing, stimulating their growth.

1 McTaggart, Findlay and Parkin (1992), ‘Economics’, Addison Wesley Publishers, p467

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Posted August 23, 2011 by equilibrium in Climate Change & Sustainability

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