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Market-based instruments for reducing CO2 emissions
Market-based instruments for reducing COz emissions The case of UK manufacturing Alan Ingham and Alistair Ulph
In this paper we present the case for using a carbon tax to control C02 emissions, and illustrate the implications for the UK manufacturing sector using a vintage model of energy demand. We show that tax rates are very sensitive to assumptions about economic growth and the target to be achieved for emissions reduction. We also compute the economic cost of reducing C02 emissions and show that, for a target date of 2010, these are rather modest, and do not display any critical level of reductions at which costs escalate sharply. However, costs do rise dramatically if we try to achieve the same cumulative reduction in emissions but delay taking any action till 1995 or 2000. The use of a vintage model is important for deriving these conclusions. Keywords: Carbon tax; Manufacturingsector; Vintage model
Designing policy to deal with the political dangers of global warming poses fundamental challenges to economists. Unlike conventional pollution problems, we are confronted with a problem where there are complex dynamic effects, the potential damages are global, and there are considerable uncertainties attached to the scale of potential damages. Some of the conceptual issues this raises have still to be worked out, 1'2 and there are formidable difficulties in trying to provide empirical evidence to guide policymakers. Yet policymakers are being urged to commit themselves to targets such as reducing COz emissions to their 1990 level or below by 2005, without any economic analysis (that we are aware Alan Ingham and Alistair Ulph are in the Department of Economics, University of Southampton, Southampton SO9 5NH, UK. 1 38
of) which could justify such targets. So there is a desperate need to provide policymakers with some empirical guidelines, however rudimentary, and that is what this paper aims to do. We shall elaborate on some of the conceptual issues surrounding the design of policy, and in particular, the rationale for a carbon tax. To provide some empirical guidance for policymakers we shall then study the use of carbon taxes to reduce CO2 emissions in the UK manufacturing sector. After a brief description of the model used to study the impact of carbon taxes, we shall assess the carbon tax rates required within the manufacturing sector to reach some of the more commonly discussed targets by 2005, and go on to assess the impact of varying the target date. We shall then attempt to address one of the fundamental difficulties confronting policymakers already mentioned - uncertainty about damages. We shall consider this first, in two ways: by computing a total abatement cost curve corresponding to different levels of emissions reduction to see whether there are critical points at which costs rise sharply; and second, by computing the costs of delaying taking action in the hope that some of the uncertainties could be substantially reduced. Finally we present our results. THE DESIGN OF POLICY FOR GLOBAL WARMING It is usual, and useful, to divide the design of pollution policy into two phases - deciding what is the desired level of pollution (or equivalently, pollution abatement) to aim for, and then deciding what policy instruments can be used to achieve that aim. On the first point, in the conventional textbook model, the cost of damages caused by emissions of a pollutant is traded against the cost of abating or 0301-4215/91/020138-11 © 1991 Butterworth-Heinemann Ltd
C a r b o n tax use to c o n t r o l C O 2 emissions - U K m a n u f a c t u r i n g
reducing such emissions. The aim, therefore, is to cut pollution to the point where the cost of reducing one more unit of pollution (marginal abatement cost) equals the cost of the damage caused by that extra unit of pollution (marginal damage cost). Because of the three complicating factors mentioned earlier - dynamics, global damages and uncertainty, this needs to be modified to saying that the global pollution level should be set such that the marginal abatement cost each period equals the present value of the expected marginal damage cost in each future period, allowing for the fact that the impact of a unit of pollution emitted today will have different effects in future periods. The usual textbook rule is difficult enough to implement empirically, and clearly the more sophisticated rule is even more formidable. The only attempts which come near to taking account of both damage and abatement costs in the case of global warming are the studies by Nordhaus3"4; the first, which corresponds to the textbook model, suggests that by 2050 it would be appropriate to reduce CO2 emissions by between 9% and 28% from their uncontrolled levels; the latter, which takes account of dynamic features, suggests that developed countries should aim to reduce their emissions from uncontrolled levels by about 10% now, rising to about 12% by 2030. These studies are very preliminary, but it is interesting that the suggested reductions in emissions are well short of the kinds of targets currently under discussion in some European countries. Given the enormous difficulties in quantifying damage costs, the more usual approach has been to analyse the costs of reaching particular, arbitrarily defined, targets expressed either in terms of atmospheric concentrations of CO2, for which doubling over the pre-industrial levels is widely used, 5'6 or in terms of emissions. 7's'9,m Of course there is a danger in looking at only one class of costs (abatement costs) that this could inject an inherent conservative bias against taking actions which would incur such costs, and authors are driven to making judgements about whether costs are large or small. But this judgement is fraught with difficulties. For example, the Manne and Richels study considers the costs to the USA of reducing CO2 emissions to their 1990 level by 2000, and to 80% of that level by 2020 and thereafter; they calculate the present value cost of this policy at $3.6 trillion. As Barker 11 shows this can be expressed as a reduction in 1990 GNP of 1.48%, a reduction in 1990 consumption of 2.47%, or a reduction in the rate of growth of consumption (over the period 1990-2100) of 0.074 percentage points from
ENERGY POLICY March 1991
2.52% to 2.46%. What is the conclusion? We would argue that as well as being concerned with the level of costs for any given target for abatement, it is also important to study the sensitivity of costs to different target levels. We know from economic analysis that abatement costs should be convex, so that, for example, small reductions in emissions should have negligible costs. 12 But the important question is to identify whether there are levels of reductions beyond which marginal abatement costs rise sharply. THE CASE FOR A CARBON
TAX
This brings us to the second part of policy design, and the major part of the case for a carbon tax. For in considering the costs of achieving a particular target for emissions or concentrations, what the studies cited above calculate is the m i n i m u m cost of reaching such targets; in other words there is an efficient pattern of emission reductions. This requires that policies can be designed to bring about such an efficient pattern of reductions. The standard argument is that if there is more than one source of pollution, then to minimize the total costs of achieving some total level of reduction in emissions it must be ensured that, at the margin, no source of pollution has a higher cost of reducing pollution than another. If pollution authorities are poorly informed about pollution abatement costs of different polluters then they should use marketbased policies, either emission taxes or tradeable pollution licences, which ensure an efficient outcome. Since COe emissions are directly linked to combustion of fossil fuels (at least under current technologies), a tax on fossil fuels in proportion to their carbon content (a carbon tax) is equivalent to a tax on CO2 emissions; similarly tradeable permits to burn fossil fuels (carbon permits) are equivalent to tradeable permits to emit CO2. The argument favouring efficiency-inducing policies are more powerful the greater is the diversity of sources of pollution and the larger are the costs of abatement; the first of these conditions is certainly satisfied for C O 2.
As we have argued elsewhere, 13 there are three considerations which distinguish carbon taxes and carbon permits, and we need only summarize them here briefly. First, administration costs are likely to be significantly higher for carbon permits than for carbon taxes. Second, in addition to the real costs of reducing CO2 emissions, carbon taxes will have distributional impacts, which will also depend on
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Carbon tax use to control C 0 2 emissions - U K manufacturing
how the revenues from the tax are used (the same distributional impacts would arise if carbon permits were auctioned rather than being distributed free). Pearson and Smith TM provide some preliminary evidence on these distributional effects, noting that the direct effect of higher fuel prices for heating, lighting etc (ie ignoring the effect of such increases on prices of goods) will be regressive, while the effect of higher prices for petrol would be slightly progressive looking at all households, though slightly regressive if one considers only car-owning families. Obviously these distributional effects may be offset by cuts in other taxes or increases in social security payments (eg pensions). A further offsetting consideration is that using revenue from a carbon tax to replace the revenue from other taxes will reduce the deadweight burden of taxation. The extent of these distributional considerations will depend on the size of the tax that needs to be imposed, which in turn depends on the elasticity of demand for fossil fuels. Third, there is the familiar argument that it may be difficult for the government to know the size of the tax required to achieve a given level of reduction in emissions, while with permits the quantity is assured and it is left to the market to find the equilibrium price. We have two comments on this. First, with conventional taxes on emissions what the authorities need to know to calculate the tax is the aggregate marginal abatement cost curve, and it is not surprising that this may be difficult to estimate. But carbon taxes are levied on fossil fuels, not emissions, so what needs to be known is the demand curves for fossil fuels, and there have been numerous studies of these demand curves. However, as Homer-Dixon notes, ~5 this is not much comfort when one considers the disparity in estimates of elasticities of demand for energy in different sectors (see also Watkins 16 for a useful recent survey of the developments in energy demand forecasting and the methodological pitfalls that remain). Second, it is only important to ensure that one achieves a precise target for emissions reduction if one is dealing with a pollutant where damages are related to the flow of emissions and where damages display a threshold effect. However, CO2 is a stock pollutant, ie damages are related to the atmospheric concentrations, or stock, of CO2, not to the flow of emissions. Therefore, if a carbon tax does not achieve the expected reduction in emissions in one period, there will be time to adjust the tax in subsequent periods. This last point raises a related issue, namely, if one is dealing with a stock pollutant what should be the path of taxes over time? The rule for determining the optimal level of emissions in any period of
140
time implies that a carbon tax should rise over time, at a rate which will reflect the real risk-free rate of interest and the rate at which the concentration of atmospheric CO2 would decay. The latter is rather small, of the order of 0.5%/year. 17 An offsetting argument is that since fossil fuels are exhaustible, taxes should decline over time to induce holders of resources stocks to delay depletion.~S The net effect of these two considerations is ambiguous, and so is an empirical matter. Models which have reflected these considerations (eg Nordhaus ~9) suggest that the first effect dominates over the next century, so it is reasonable to suppose that taxes will be rising over the foreseeable future. The conclusion we draw from this brief discussion of policy design is that there are strong arguments in favour of using a carbon tax as a major policy instrument for achieving CO2 reductions. An argument sometimes raised against a carbon tax is that there are important market failures in the energy market which mean that consumers do not respond to price signals in the way economists assume in their analysis; in particular, there are imperfections of information and capital markets which mean that there is underinvestment in energy conservation. We discuss these issues elsewhere and present some evidence for the manufacturing sector which does not support this argument; 2° however, we acknowledge that the evidence is tentative, and do not want to rule out the possibility of such market failures. This does not mean that carbon taxes are ineffective, merely that they are not the only policy instrument that is relevant - there must be other policies addressed to these market failures. After this brief overview of some of the issues concerning design of policy, we turn to the empirical evidence from the manufacturing sector which could help policymakers attach some numbers to the factors we have been discussing.
A MODEL TAXES
FOR STUDYING
CARBON
In seeking to present yet another set of estimates of possible rates of carbon taxes, it is necessary to recognise that there already exist a plethora of such estimates. 2~ There are three broad factors which could explain this diversity: (1) the models used to study COa emissions, or equivalently, demand for fossil fuels; (2) the assumptions about future economic growth or energy prices; (3) the targets to be achieved and their dates. We use only one model,
ENERGY POLICY March 1991
C a r b o n tax use to c o n t r o l C 0 2 e m i s s i o n s - U K m a n u f a c t u r i n g
but shall show how sensitive calculated tax rates are to differences in the other factors.
1. The models: A major difficulty with energy demand models is capturing the dynamic aspects of energy demand, and in our model of fuel demand for the UK manufacturing sector we employ a sophisticated vintage model of the production structure. The model is more sophisticated than conventional vintage models because we allow for the possibility that firms will be able to change the energy-output ratio on existing machines in response to changes in current factor prices. Moreover, how much flexibility firms have to vary energy-use at this stage is determined by firms themselves when they come to design their new machines; not only can they vary the design of machines in terms of the input-output ratios of different factors in response to the relative prices of factors they expect to prevail over their planning horizons, they can choose how flexible they want their production process to be in response to how volatile they expect relative prices to be over the planning period. The model is estimated over the period 1955Q1 to 1987Q4. 22 There is a slight extension of the vintage model of factor demands which we need to make to handle CO2 emissions, namely to deal with the problem of CO2 emissions associated with the electricity used by the manufacturing sector (indirect CO2 emissions). We handle this in a very crude way, by assuming that the shares of fuels in electricity generation stay constant. 2. Assumptions on future economic growth or energy prices. The background assumptions about future growth of output and future factor prices are those used by the Department of Energy for the Intergovernmental Panel on Climate Change (IPCC) Response Strategies Working Group. 23 There are two growth rates for output, 1.25%/year and 3.25%/ year (in the previous study we used 1% and 2%). For (real) energy prices we modified the IPCC 24 assumptions slightly; they used forecasts of world prices for oil and coal for 1990, 2005 and 2020 from a base in 1985. We extrapolated the data series for energy prices from 1987Q4 to 1990Q3 using data in Energy Trends; we then used the growth rates in prices over the period 1990-2005 contained in the IPCC scenarios and applied these to the 1990 data. For the low price scenario, oil prices are virtually stationary, growing at 0.6%/year, while coal prices grow at 0.8%/year; for the high price scenario, oil prices grow at 3.5%/year while coal prices grow at l%/year; gas prices are assumed to rise at the same rate as oil prices. Finally, real wages are assumed to
ENERGY POLICY March 1991
rise at the rate of growth of output per head, while the real price of capital (including interest rates) are assumed to stay constant. These assumptions are displayed in Figure 1. It will be clear that the high growth rate assumption for output is very optimistic given the past performance of manufacturing, and the assumed real energy prices are all rather low by historical standards.
3. Targets. Finally, for targets we have selected two targets for emission levels in 2005 - stabilization at 1990 levels and a 25% reduction on 1990 levels (our previous study used the Toronto target of an 80% reduction on 1988 levels). We later consider varying the date for target emissions to 2000 and 2010. In setting emissions targets for a specific date, there is an implicit ambiguity about policies towards emissions in the intervening period. Reflecting our previous discussion we shall assume that the tax on CO2 emissions (ie the carbon content of fuels) rises over time, and we have chosen rates of 3% and 5% (our previous study used 7.5% and 15%).
CARBON TAXES FOR DIFFERENT SCENARIOS The implications of the scenarios outlined in the previous section for CO2 emissions in the absence of any policy intervention, as estimated by our model, are shown in Table 1. This emphasizes the rather unreal assumptions about output growth and prices; in the case of the target of a 25% cut from 1990 emissions, in the high growth, low price scenario we are being required to cut emissions to one third of their unconstrained value; recall that the high level of emissions is being driven not just by high growth of output but by the fact that real wages are rising significantly faster than real energy prices. Tables 2 and 3 show the tax rates (as % of the net of tax prices) that would be required to achieve the targets of stabilization and 25% cut respectively given rates of growth of taxes over time of 3% and 5%/year. What emerges very strikingly from these Tables are the two crucial influences on tax rates the rate of growth of output and the level of emissions reductions to be achieved. With low growth, and seeking only to stabilize emissions at their 1990 level, requires fairly modest tax rates, even for coal and oil; by the year 2005 no tax rates above 45% are required; although low energy prices would lead to higher unconstrained growth of emissions, tax rates do not have to be significantly higher to offset this. Seeking a target of 25% reduction from 1990 emis-
141
Carbon
t a x u s e to control C 0 2 emissions - U K m a n u f a c t u r i n g
6
O u t p u t index
0.3
Gas price ( r e a l ) index
0.25
0.2
0.15
0.1
0.05
0 1955 O. 16
I 1967
I 1980
Year
I 1991
I 2005
Coal p r i c e ( real ) index
0 1955 0.55,
0.14
I 1967
I
1980
Yea r
I
I
1991
2005
Oil p r i c e ( r e a l ) index
0.5
0.12
/
0.25 0.10 0.2 0.08 0.15 0.06 0.1 0.04
0.05
0.02 ~-
1955
I 1967
I
I
I
1980
1991
2005
Year
Figure 1. Assumptions about exogenous variable. sions requires a sharp increase in the level of tax rates. For example for coal, the increase is from the range 20-50% to the range 120-320%. This brings out an interesting feature, namely that what matters is not just the overall size of the required reduction in emissions, but also whether 142
0
I
1955
1967
I
1980
Year
I
1991
(Figure I,
'2005
c o n t i n u e d on
p 143).
the cut involves cutting future growth in emissions or cutting associated with already existing plant. To illustrate this point, we can see from Table 1 that achieving the 1990 emissions with low growth and low prices requires emissions to fall by about 44% from their unconstrained level; if we aim for a ENERGY POLICY March 1991
Carbon tax use to control C02 emissions - UK manufacturing 6
Real wage index
Table 1. Unconstrained CO2 emissions. CO2 emissions (2005) Output growth
Energy price growth
CO2 emissions (1990)
Low Low High High
High Low High Low
1.275 1.442 2.010 2.250
5-
2
I
0 1955
I
I
I
1967
1980
1991
2005
Yeor Figure 1.
(Continued f r o m p 142).
r e d u c t i o n o f 2 5 % f r o m 1990 e m i s s i o n s , with low g r o w t h a n d high e n e r g y p r i c e s , t h e n we a r e r e q u i r i n g e m i s s i o n s to fall by a b o u t 5 3 % f r o m t h e i r u n c o n s t r a i n e d v a l u e . So t h e s e two cases i n v o l v e v e r y s i m i l a r o r d e r s o f m a g n i t u d e r e d u c t i o n s in e m i s s i o n s f r o m t h e i r u n c o n s t r a i n e d values. Y e t t h e t a x e s in the two cases a r e v e r y d i f f e r e n t (initial t a x e s o n coal o f 2 4 % a n d 122% with 5 % g r o w t h in t a x e s ) . A s an
a l t e r n a t i v e c o m p a r i s o n , if we h a v e a t a r g e t o f stabilization at 1990 levels a n d low g r o w t h , a n d c o n s i d e r just the d i f f e r e n c e b e t w e e n high a n d low e n e r g y p r i c e s , t h e n we see f r o m T a b l e 1 that t h e r e q u i r e d r e d u c t i o n s in e m i s s i o n s f r o m t h e i r u n c o n s t r a i n e d v a l u e s a r e , r e s p e c t i v e l y 28% a n d 4 4 % . Y e t this d i f f e r e n c e , which is slightly l a r g e r t h a n o u r p r e v i o u s c o m p a r i s o n , o n l y has t h e initial tax r a t e o n coal rising f r o m 19% to 2 4 % . O f c o u r s e w e w o u l d e x p e c t t h e r e to be a n o n - l i n e a r effect o f r e d u c t i o n s on tax r a t e s , so t h a t going f r o m a 28% r e d u c t i o n in emissions f r o m t h e i r u n c o n s t r a i n e d level to 4 4 % c o u l d well h a v e a s m a l l e r effect on t a x e s than g o i n g f r o m 44% to 5 3 % . B u t t h e o r d e r o f m a g n i t u d e in t h e d i f f e r e n c e in tax r a t e s s u g g e s t s t h a t t h e r e is a n o t h e r f a c t o r at w o r k , n a m e l y that t h e m o v e f r o m 2 8 % to 4 4 % is a s s o c i a t e d with a t a r g e t o f s t a b i l i z a t i o n , which can be a c h i e v e d b y p r e v e n t i n g f u t u r e g r o w t h in e m i s s i o n s , while t h e m o v e f r o m 44% to 53% is a s s o c i a t e d with a r e d u c t i o n in t h e initial level of e m i s s i o n s , which r e q u i r e s c u t t i n g e m i s s i o n s on a l r e a d y i n s t a l l e d p l a n t . A n d it is m u c h m o r e e x p e n sive to u n d o t h e effects o f e m i s s i o n s - g e n e r a t i n g p l a n t a l r e a d y i n s t a l l e d , t h a n it is to offset t h e effects o f e m i s s i o n s - g e n e r a t i n g p l a n t yet to be i n s t a l l e d .
Table 2. Tax rates % for different scenarios (2005 target: 1990 level). Fuel
Coal Coal Coal Coal Coal Oil Oil Oil Oil Oil Gas Gas Gas Gas Gas Electricity Electricity Electricity Electricity Electricity
Growth price tax growth
Low High 5%
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010
19 24 29 35 43 19 20 22 24 25 11 12 14 17 20 9 9 9 10 11
ENERGY POLICY March 1991
High High
3%
Low 5%
3%
5%
3%
5%
3%
22 25 28 31 34 21 21 21 21 20 12 13 14 15 16 10 10 9 8 8
24 29 36 45 56 23 29 36 45 57 13 16 20 26 32 11 12 13 14 17
27 30 34 39 44 26 30 34 39 44 15 17 19 22 25 12 12 12 l2 12
249 3114 3711 452 551 244 262 282 303 326 135 158 185 216 253 118 129 142 156 172
379 420 466 516 573 371 363 355 347 339 205 219 233 247 263 180 186 192 198 205
2711 335 417 519 645 264 330 413 517 647 146 185 233 294 371 128 143 160 179 200
407 460 520 588 665 398 453 515 586 667 221 253 290 333 382 194 204 214 225 237
Low
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Carbon tax use to control C 0 2 emissions - U K manufacturing
Table 3. Tax rates % for different scenarios (2005 target: 75% of 1990 level). Fuel
Coal Coal
Coal Coal
Coal Oil Oil Oil Oil Oil Gas Gas Gas Gas Gas Electricity Electricity Electricity Electricity Electricity
Growth price tax growth
Low High 5%
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010
122 149 181 221 269 119 128 138 148 160 66 77 90 106 124 58 63 70 78 86
3%
Low 5%
196 217 241 267 296 192 187 183 179 175 106 113 120 128 136 93 96 99 102 106
143 178 221 275 342 140 175 220 275 344 78 98 124 156 197 68 76 86 97 110
Raising the rate of growth to 3.25%/year takes tax rates on coal into ranges of 250-600% with the target of stabilization, and 500-1 000% for the 25% reduction. These reflect the fact that emissions are having to be reduced to 50% and 33% of their unconstrained values respectively, which are much larger cuts than might be sensibly contemplated. In Tables 4 and 5 we show the pattern of energyuse corresponding to the scenarios indicated in Tables 2 and 3. These show a considerable degree of fuel switching. With the 1990 target, and low growth, oil is cut back significantly along the high
3%
High High 5%
3%
Low 5%
3%
224 253 286 323 366 219 249 283 322 367 121 139 160 183 210 106 112 118 124 131
518 632 770 939 l 145 507 545 587 631 678 281 329 385 450 526 247 268 292 319 347
700 777 861 951 1 059 686 671 656 642 628 380 404 430 458 487 335 345 356 367 379
530 659 820 1 020 1 268 519 650 813 1 017 1 272 288 363 458 578 729 252 280 310 340 382
704 796 901 1 018 1 152 690 785 893 1 016 1 156 382 438 503 577 662 336 353 370 389 408
price path, oil and coal on the low price path, with gas and especially electricity expanding. With the same target, but high growth, coal is cut back heavily, oil falls sharply initially, but recovers by 2005, while gas is kept fairly stable. With the more stringent target of cutting 25% from 1990 emissions, the use of all fuels is cut; coal again bears the brunt of the reduction, falling to about 60% of its 1990 level by 2005, while oil and gas fall to between 75% and 80% of .'their 1990 levels, gas again doing rather better under the low growth scenario; electricity consumption does not fall much from its 1990 level.
Table 4. Fuel-use for different scenarios (1990 = 100) (2005 target: 1990 level). Fuel
Coal Coal Coal Coal Coal Oil Oil Oil Oil Oil Gas Gas Gas Gas Gas Electricity Electricity Electricity Electricity Electricity
144
Growth price tax growth
Low High 5%
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010
100.0 120.8 136.9 107.2 88.5 100.0 69.6 102.5 81.4 66.5 100.0 121.9 148.2 115.0 93.4 100.0 128.6 151.0 122.9 106.7
3%
Low 5%
100.0 120.3 133.9 105.9 89.0 100.0 69.3 100.2 80.4 65.8 100.0 121.1 144.3 112.8 92.1 100.0 127.8 147.6 121.1 105.5
100.0 118.7 129.3 97.5 76.0 100.0 69.3 104.7 87.2 74.8 100.0 122.4 148.3 116.4 94.5 100.0 127.1 147.3 118.9 100.5
3%
High High 5%
3%
5%
3%
100.0 118.1 126.5 96.5 76.6 100.0 68.9 102.1 86.1 73.9 100.0 121.4 144.3 114.2 93.5 100.0 126.1 143.8 116.9 99.1
100.0 86.4 78.6 76.0 71.0 100.0 55.8 88.3 107.9 100.2 100.0 91.0 97.7 103.7 101.1 100.0 96.1 113.2 133.2 142.1
100.0 77.8 72.9 74.9 71.7 100.0 52.0 83.2 106.2 110.1 100.0 82.2 89.2 99.2 98.8 100.0 86.9 104.1 126.6 135.9
100.0 84.3 77.5 76.4 72.1 100.0 55.0 88.1 109.0 112.1 100.0 89.7 96.8 103.4 100.6 100.0 94.3 111.6 131.6 139.8
100.0 75.9 71.7 75.1 72.8 100.0 51.3 82.5 106.9 111.8 100.0 80.9 87.9 98.7 98.5 100.0 85.1 102.2 124.9 133.7
Low
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Carbon tax use to control C 0 2 emissions - U K manufacturing
Table 5. Fuel-use for different scenarios (1990 = 100) (2005 target: 75% of 1990 level). Fuel
Coal Coal Coal Coal Coal Oil Oil Oil Oil Oil
Gas Gas Gas Gas Gas Electricity Electricity
Electricity Electricity Electricity
Growth price tax growth
Low High 5%
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000
100.0 95.8 75.0 61.1 50.5 100.0 57.8 72.7 76.1 65.8 100.0 100.4 91.2 82.2 69.2 100.0 106.1 101.7
2005
99.7
2010
90.9
VARIATIONS DATES
3%
Low 5%
100.0 88.4 69.9 57.7 47.5 100.0 55.8 71.4 76.8 66.7 100.0 92.3 84.9 78.0 65.8 100.0 97.3 96.4 96.3 87.3
100.0 93.1 72.8 58.7 46.5 100.0 57.8 73.7 78.9 70.4 100.0 98.6 90.4 81.3 67.7 100.0 103.2 100.3 98.1 88.6
IN EMISSION TARGET
We now consider the sensitivity of tax rates to variations in the date by which the target is to be achieved. For this comparison we have selected the scenario where there is low growth, high prices, taxes rise at 5%/year and the target is a reduction of 25% from 1990 emissions. In Table 6 we show the tax rates and energy-use corresponding to achieving the target in 2000, 2005, and 2010 respectively. Two
3%
High High 5%
3%
Low 5%
3%
100.0 85.5 68.1 57.6 46.5 100.0 54.9 71.4 77.9 69.5 100.0 90.2 83.8 77.5 65.2 100.0 94.5 94.6 94.7 85.3
100.0 70.1 61.2 58.7 50.9 100.0 48.5 69.3 81.8 76.6 100.0 74.8 74.0 75.7 67.8 100.0 79.7 88.2 100.9 100.1
100.0 63.9 56.3 57.9 53.0 100.0 45.5 63.4 80.5 79.3 100.0 68.3 67.1 73.4 69.4 100.0 72.7 79.0 95.4 97.9
100.0 69.4 60.9 59.3 51.8 100.0 48.3 69.4 82.8 78.0 100.0 74.6 73.9 76.3 68.3 100.0 79.1 87.7 100.7 99.9
100.0 63.8 56.5 58.9 54.7 100.0 45.5 63.9 82.3 81.9 100.0 68.5 67.6 74.7 71.0 100.0 72.6 79.2 96.3 99.1
points are worth noting. First, tax rates fall the later the date at which the target has to be achieved, and this is most strikingly so when the target is pushed back from 2005 to 2010. Note that there is nothing inevitable about this - it is a consequence of the relative growth rates of energy prices, tax rates and output; in particular, with faster growth, tax rates could rise the later the target date, because there would be more years of growth to offset. Second, the difference in dates affects the pattern of fuel-use. In general, associated with a later target date there is a greater use of each fuel at each date
Table 6. Tax rates and fuel-use for different target dates. Target
Date
Tax rates (%) 2000 2005
Coal Coal Coal Coal Coal Oil Oil Oil Oil Oil
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010
180 211 246 288 336 177 190 204 220 236 98 105 113 122 131 85 91 98 105 113
Gas Gas Gas Gas Gas Electricity Electricity Electricity Electricity Electricity
ENERGY POLICY March 1991
122 149 181 221 269 119 128 138 148 160 66 77 90 106 124 58 63 70 78 86
2010 32 38 44 52 60 32 34 37 39 42 18 19 20 22 24 15 15 16 17 18
Fuel-use (index) 2000 2005
2010
100.0 90.1 69.0 55.3 44.3 100.0 56.2 69.7 71.0 57.7 100.0 93.2 83.3 73.4 59.0 100.0 98.9 95.9 92.8 81.3
100.0 118.1 118.4 98.4 87.9 100.0 57.9 85.3 73.5 60.5 100.0 117.5 124.4 101.5 85.5 100.0 125.0 131.5 114.3 104.0
100 95.8 75.0 61.1 50.5 100.0 57.8 72.7 76.1 65.8 100.0 100.4 91.2 82.2 69.2 100.0 106.1 101.7 99.7 90.9
145
Carbon tax use to control COe emissions - U K manufacturing
Table 7. Costs of reducing emissions. 2 PV tax revenues
3 Net cost emissions
4 Cumulative
Case
1 PV costs of production
No Tax Tax 1 Tax 2 Tax 3 Tax 4 Tax 5 Tax 6
100.0 101.73 103.19 105.63 108.19 113.80 119.38
0.0 1.37 2.69 4.75 6.74 11.41 16.86
0.0 0.36 0.50 0.88 1.45 2.39 2.52
100.0 84.21 75.27 66.79 62.27 56.95 53.07
1995, 2000, 2005, 2010. The exception is that when the target date moves from 2005 to 2010, oil-use actually falls in 2005 and 2010; indeed, with a 2010 target, oil has the major cutback in use, with coal and gas having rather similar patterns. The difference is due to the rather different assumptions about growth rates for oil and coal prices over the period, which will dominate the rather low tax rates. COSTS OF POLICIES EMISSIONS
FOR
REDUCING
While consideration of tax rates is important, it is also important to consider the economic costs associated with policies to reduce emissions. In this respect tax rates can be slightly misleading, for two reasons. First, taxes do not themselves represent a cost to the economy - they are simply the instrument for bringing about emissions reductions, and are a transfer between producers and the government. Second, energy costs are a relatively small component of total cost, so quite large increases in energy prices need not imply very large increases in costs. We shall now consider the costs of policies to reduce emissions. An important question is how abatement costs vary with the level of emissions reduced, and in particular whether there is any threshold at which costs start rising very sharply. We have considered just the scenario we used for Table 6, ie low output growth, high price growth and taxes rising at 5%/year. To construct a total abatement cost curve for cutting emissions we started from the base case of unconstrained emissions and calculated the present value of operating plus capital costs for each year over the period 1990-2010, with the flow of costs being discounted back to 1990 at the constant real interest rate of 3.5%. We also calculated the cumulative emissions that would occur in that base period. We then took different levels of initial carbon tax, and let that grow at 5%/year over the period 1990-2010. For each initial tax rate we computed the present value of costs, the present
146
value of tax revenues and the cumulative emissions over the period 1990-2010. The calculations are shown in Table 7 for the base case of no tax and for six positive levels of tax, where we have normalized present value costs and tax revenues on the base present value costs, and have normalized cumulative emissions on base cumulative emissions. For cross reference to earlier Tables tax 2 corresponds to the tax rates shown in Table 2 for this scenario; ie if we aim to reduce emissions in 2005 to 25% below their 1990 level, that represents about a 25% reduction in cumulative emissions over the period 1990-2010. The net cost to the economy of reducing emissions is the difference between the increase in costs faced by producers and the extra tax revenue earned by the government, and this is shown in the net cost column of Table 7. Figure 2 graphs the net cost (as a percentage of base total cost) against reduction in cumulative emissions (also in percentage terms), and 3
2,~
"~ 2 "~ "6 > I. 5 ~ E
.~ g o5
o 0
Figure 2.
IO
20 30 % reduction in total emissions
40
50
Total abatement cost curve.
ENERGY POLICY March 1991
C a r b o n tax use to control C O e e m i s s i o n s - U K m a n u f a c t u r i n g
thus represents a total abatement cost curve. The shape of the curve is as expected, and the interesting feature is the rather low costs involved; cutting cumulative emissions by 25% would represent a cost to the economy of about 0.5% of total cost. In terms of the question of critical threshold effects, while the total cost curve has the expected convex shape, there do not appear to be any critical levels of reductions in emissions at which costs escalate sharply, Two caveats are in order. First, the costs have been rather arbitrarily truncated at 2010; second the costs we are calculating exclude costs of raw materials.
THE COSTS OF D E L A Y The final question we wish to address is the cost of delaying policy action, perhaps in order to learn more about the potential damage costs before having to incur abatement costs. The way we tackle that is to ask: supposing we delay taking action till 1995 or 2000, and only started to impose a tax at that date? Again letting the tax rise at 5%/year, what would be the resulting reduction in cumulative emissions over the period 1990-2010, and what would be the resulting increase in present value costs (evaluated over the period 1990-2010)? We can then compare those costs with the costs of achieving the same reduction in cumulative emissions if immediate action was taken. We have examined the option of a 10% reduction in cumulative emissions. From Figure 2 we can see that if we took action starting in 1990, the net cost would be about 0.3% of present value total costs over the period 1990-2010. If we delay taking action until 1995, the costs of a 10.5% reduction in emissions would become 22.4% of base costs, while if we delayed taking action till 2000 the cost of a 10.2% reduction would be 45.2% of base costs. These figures are very striking and suggest very substantial costs of delay. However, we need to be a little cautious in interpreting these figures. First there are the caveats already mentioned about the calculation of costs. Second, we have imposed an arbitrary time horizon of 2010 for comparing cumulative emissions, which is rather close given the nature of the greenhouse effect. What this is really telling us is that we take action over a 20-year period, the costs of reducing emissions need not be very dramatic, because we can meet that by redesigning new capital equipment (the average life of equipment is 16-18 years). If we compress the time horizon to only 10 years, we have three effects: 1.
We just have less time to cut the emissions, so
ENERGY POLICY March 1991
2.
3.
the reductions per year are greater; this is magnified by the fact that we have to offset the unconstrained emissions that have taken place in the first 10 years; so we have to make much more drastic cuts in the emissions per year; and we have accumulated a stock of inappropriate capital over the first 10 years, so much more of the reductions in emissions are having to come about from ex-post substitution on existing vintages rather than redesigning new vintages, and this is very much more expensive.
Obviously if we had taken as our target cumulative emissions over the period, say 1990-2030, then the effect of delay of 10 years would have been less dramatic. Nevertheless, the results are very strong and suggest that this is an area where more work is urgently needed to guide policymakers.
CONCLUSIONS In this paper we have argued from first principles that there are strong grounds for preferring the use of a carbon tax to control CO2 emissions. We have explored the empirical implications of such a policy by using a vintage model of factor demands (including fossil fuels) for the U K manufacturing sector. By considering a range of possible scenarios, we showed that the crucial features affecting the size of taxes required are the rate of growth of output, and whether the target requires cutting existing emissions or preventing growth of future emissions. We also examined the sensitivity of taxes to target date, and showed that there is a significant reduction in taxes in going from a target date of 2005 to 2010, essentially because in the latter case more of the adjustment comes through altering design of new machines, rather than fuel switching on existing plant. Looking at costs of abating CO2 emissions, we found that if we start policy now with a target date of 2010, costs are rather modest, and do not display any dramatic threshold effect. However, delaying taking action till 1995 or 2000, and seeking to achieve the same cumulative reduction in emissions by 2010, there is a dramatic increase in the cost of abatement. The intuition is the same - the later policy starts the more adjustment has to be done by expensive factor substitution on existing plant r a t h e r than redesigning new plant. These results show the importance of using a model with a vintage structure to capture the dynamics of adjusting fuel-use. 147
Carbon tax use to control C02 emissions - UK manufacturing
aS. Barrett, 'Economic instruments for global climate change policy', Report for OECD Economic Directorate, London Business School, UK, 1990. 2A. Ingham and A. Ulph, 'The economics of global warming', in J. Bennett, ed, Economics and the Environment: A Reconciliation, Australian Institute for Public Policy (forthcoming). 3W.D. Nordhaus, 'The economics of the greenhouse effect', mimeo, Yale University, MA, USA, 1989. 4W.D. Nordhaus, 'An intertemporal general-equilibrium model of economic growth and climate change', paper presented to Workshop on Economic/Energy/Environmental modelling for Climate Policy Analysis, Washington, DC, USA, 1990. 5W.D. Nordhaus, 'Economic growth and climate - the carbon dioxide problem', American Economic Review, Vol 67, No 1, 1977, pp 341-346; and W.D. Nordhaus, The Allocation of Energy Resources, Yale University Press, New Haven, MA, USA, 1979. 6.1. Edmonds and J. Reilly, 'Global energy and CO2 to the year 2050', The Energy Journal, Vol 4, No 3, 1983, pp 21-47; and J. Edmonds and J. Reilly, Global Energy: Assessing the Future, Oxford University Press, New York, USA, 1985. 7W.R. Cline, 'Political economy of the greenhouse effect', mimeo, Institute for International Economics, Washington, DC, USA, 1989. 8j. Whalley and R. Wigle, 'Cutting CO2 emissions: the effects of alternative policy approaches', mimeo, University of Western Ontario, London, Ontario, Canada, 1989. 9A.S. Manne and R.G. Richels, 'CO2 emission limits: an economic cost analysis for the USA', The Energy Journal, No 11, Vol 2, 1990, pp 51-74. I°T. Barker and R. Lewney, 'Macroeconomic modelling of environmental policies: the carbon tax and regulation of water quality', paper presented to conference The UK Economy and the Green 1990s, Cambridge, UK, 11-12 July 1990. I1T. Barker, 'Measuring economic costs of CO2 emission limits', Working Paper, Department of Applied Economics, Cambridge, UK, 1990.
148
12Nordhaus, op cit, Ref 3. 13Ingham and Ulph, op cit, Ref2; and A. Ingham, J. Maw and A. Ulph, 'Empirical measures of carbon taxes', Oxford Review of Economic Policy, (forthcoming). 14M. Pearson and S. Smith, 'Taxation and environmental policy: some initial evidence', 1FS Commentary No 18, Institute for Fiscal Studies, London, UK, 1990. ~ST.F. Homer-Dixon, 'Taxes, fuel consumption and carbon dioxide emissions', Paper for Greenhouse Policy Project, World Resources Institute, Washington, DC, 1989. 16G.C. Watkins, 'The economic analysis of energy demand', in D. Hawdon, ed, Energy Demand: Evidence and Expectations, University of Surrey, Guildford, Surrey, UK, (forthcoming). 17Nordhaus, op cit, Ref 4. ~sp. Sinclair, 'High does nothing and rising is worse: carbon taxes should keep declining to cut harmful emissions', Applied Economics Discussion Paper 99, Institute of Economics and Statistics, Oxford, UK, 1990. 19Nordhaus (1979), op cit, Ref 5. 2°A. Ingham, J. Maw and A. Ulph, 'Energy conservation in the UK manufacturing sector - a vintage approach', in Hawdon, ed, op cit, Ref 16. 21See surveys in A. Ingham and A. Ulph, 'Carbon taxes and the UK manufacturing sector', Discussion Paper 9004, Department of Economics, Southampton, UK, 1990; Cline, op cit, Ref 7; and S. Barrett, Memorandum for the House of Commons Energy Select Committee, HMSO, London, UK, 1990. 22In an earlier study of carbon taxes, Ingham and Ulph, lbid, we used an earlier version of the model estimated over the period to 1985Q1; this study differs from that previous work in other respects, which we mention in the text. 23Department of Energy, An Evaluation of Energy Related Greenhouse Gas Emissions and Measures to Ameliorate Them, Energy Paper 58, HMSO, London, UK, 1989. 24IPCC, Scientific Assessment of Climate Change, Third draft, World Meteorological Office/UNEP, Geneva, 1990.
ENERGY POLICY March 1991
In this paper we present the case for using a carbon tax to control C02 emissions, and illustrate the implications for the UK manufacturing sector using a vintage model of energy demand. We show that tax rates are very sensitive to assumptions about economic growth and the target to be achieved for emissions reduction. We also compute the economic cost of reducing C02 emissions and show that, for a target date of 2010, these are rather modest, and do not display any critical level of reductions at which costs escalate sharply. However, costs do rise dramatically if we try to achieve the same cumulative reduction in emissions but delay taking any action till 1995 or 2000. The use of a vintage model is important for deriving these conclusions. Keywords: Carbon tax; Manufacturingsector; Vintage model
Designing policy to deal with the political dangers of global warming poses fundamental challenges to economists. Unlike conventional pollution problems, we are confronted with a problem where there are complex dynamic effects, the potential damages are global, and there are considerable uncertainties attached to the scale of potential damages. Some of the conceptual issues this raises have still to be worked out, 1'2 and there are formidable difficulties in trying to provide empirical evidence to guide policymakers. Yet policymakers are being urged to commit themselves to targets such as reducing COz emissions to their 1990 level or below by 2005, without any economic analysis (that we are aware Alan Ingham and Alistair Ulph are in the Department of Economics, University of Southampton, Southampton SO9 5NH, UK. 1 38
of) which could justify such targets. So there is a desperate need to provide policymakers with some empirical guidelines, however rudimentary, and that is what this paper aims to do. We shall elaborate on some of the conceptual issues surrounding the design of policy, and in particular, the rationale for a carbon tax. To provide some empirical guidance for policymakers we shall then study the use of carbon taxes to reduce CO2 emissions in the UK manufacturing sector. After a brief description of the model used to study the impact of carbon taxes, we shall assess the carbon tax rates required within the manufacturing sector to reach some of the more commonly discussed targets by 2005, and go on to assess the impact of varying the target date. We shall then attempt to address one of the fundamental difficulties confronting policymakers already mentioned - uncertainty about damages. We shall consider this first, in two ways: by computing a total abatement cost curve corresponding to different levels of emissions reduction to see whether there are critical points at which costs rise sharply; and second, by computing the costs of delaying taking action in the hope that some of the uncertainties could be substantially reduced. Finally we present our results. THE DESIGN OF POLICY FOR GLOBAL WARMING It is usual, and useful, to divide the design of pollution policy into two phases - deciding what is the desired level of pollution (or equivalently, pollution abatement) to aim for, and then deciding what policy instruments can be used to achieve that aim. On the first point, in the conventional textbook model, the cost of damages caused by emissions of a pollutant is traded against the cost of abating or 0301-4215/91/020138-11 © 1991 Butterworth-Heinemann Ltd
C a r b o n tax use to c o n t r o l C O 2 emissions - U K m a n u f a c t u r i n g
reducing such emissions. The aim, therefore, is to cut pollution to the point where the cost of reducing one more unit of pollution (marginal abatement cost) equals the cost of the damage caused by that extra unit of pollution (marginal damage cost). Because of the three complicating factors mentioned earlier - dynamics, global damages and uncertainty, this needs to be modified to saying that the global pollution level should be set such that the marginal abatement cost each period equals the present value of the expected marginal damage cost in each future period, allowing for the fact that the impact of a unit of pollution emitted today will have different effects in future periods. The usual textbook rule is difficult enough to implement empirically, and clearly the more sophisticated rule is even more formidable. The only attempts which come near to taking account of both damage and abatement costs in the case of global warming are the studies by Nordhaus3"4; the first, which corresponds to the textbook model, suggests that by 2050 it would be appropriate to reduce CO2 emissions by between 9% and 28% from their uncontrolled levels; the latter, which takes account of dynamic features, suggests that developed countries should aim to reduce their emissions from uncontrolled levels by about 10% now, rising to about 12% by 2030. These studies are very preliminary, but it is interesting that the suggested reductions in emissions are well short of the kinds of targets currently under discussion in some European countries. Given the enormous difficulties in quantifying damage costs, the more usual approach has been to analyse the costs of reaching particular, arbitrarily defined, targets expressed either in terms of atmospheric concentrations of CO2, for which doubling over the pre-industrial levels is widely used, 5'6 or in terms of emissions. 7's'9,m Of course there is a danger in looking at only one class of costs (abatement costs) that this could inject an inherent conservative bias against taking actions which would incur such costs, and authors are driven to making judgements about whether costs are large or small. But this judgement is fraught with difficulties. For example, the Manne and Richels study considers the costs to the USA of reducing CO2 emissions to their 1990 level by 2000, and to 80% of that level by 2020 and thereafter; they calculate the present value cost of this policy at $3.6 trillion. As Barker 11 shows this can be expressed as a reduction in 1990 GNP of 1.48%, a reduction in 1990 consumption of 2.47%, or a reduction in the rate of growth of consumption (over the period 1990-2100) of 0.074 percentage points from
ENERGY POLICY March 1991
2.52% to 2.46%. What is the conclusion? We would argue that as well as being concerned with the level of costs for any given target for abatement, it is also important to study the sensitivity of costs to different target levels. We know from economic analysis that abatement costs should be convex, so that, for example, small reductions in emissions should have negligible costs. 12 But the important question is to identify whether there are levels of reductions beyond which marginal abatement costs rise sharply. THE CASE FOR A CARBON
TAX
This brings us to the second part of policy design, and the major part of the case for a carbon tax. For in considering the costs of achieving a particular target for emissions or concentrations, what the studies cited above calculate is the m i n i m u m cost of reaching such targets; in other words there is an efficient pattern of emission reductions. This requires that policies can be designed to bring about such an efficient pattern of reductions. The standard argument is that if there is more than one source of pollution, then to minimize the total costs of achieving some total level of reduction in emissions it must be ensured that, at the margin, no source of pollution has a higher cost of reducing pollution than another. If pollution authorities are poorly informed about pollution abatement costs of different polluters then they should use marketbased policies, either emission taxes or tradeable pollution licences, which ensure an efficient outcome. Since COe emissions are directly linked to combustion of fossil fuels (at least under current technologies), a tax on fossil fuels in proportion to their carbon content (a carbon tax) is equivalent to a tax on CO2 emissions; similarly tradeable permits to burn fossil fuels (carbon permits) are equivalent to tradeable permits to emit CO2. The argument favouring efficiency-inducing policies are more powerful the greater is the diversity of sources of pollution and the larger are the costs of abatement; the first of these conditions is certainly satisfied for C O 2.
As we have argued elsewhere, 13 there are three considerations which distinguish carbon taxes and carbon permits, and we need only summarize them here briefly. First, administration costs are likely to be significantly higher for carbon permits than for carbon taxes. Second, in addition to the real costs of reducing CO2 emissions, carbon taxes will have distributional impacts, which will also depend on
139
Carbon tax use to control C 0 2 emissions - U K manufacturing
how the revenues from the tax are used (the same distributional impacts would arise if carbon permits were auctioned rather than being distributed free). Pearson and Smith TM provide some preliminary evidence on these distributional effects, noting that the direct effect of higher fuel prices for heating, lighting etc (ie ignoring the effect of such increases on prices of goods) will be regressive, while the effect of higher prices for petrol would be slightly progressive looking at all households, though slightly regressive if one considers only car-owning families. Obviously these distributional effects may be offset by cuts in other taxes or increases in social security payments (eg pensions). A further offsetting consideration is that using revenue from a carbon tax to replace the revenue from other taxes will reduce the deadweight burden of taxation. The extent of these distributional considerations will depend on the size of the tax that needs to be imposed, which in turn depends on the elasticity of demand for fossil fuels. Third, there is the familiar argument that it may be difficult for the government to know the size of the tax required to achieve a given level of reduction in emissions, while with permits the quantity is assured and it is left to the market to find the equilibrium price. We have two comments on this. First, with conventional taxes on emissions what the authorities need to know to calculate the tax is the aggregate marginal abatement cost curve, and it is not surprising that this may be difficult to estimate. But carbon taxes are levied on fossil fuels, not emissions, so what needs to be known is the demand curves for fossil fuels, and there have been numerous studies of these demand curves. However, as Homer-Dixon notes, ~5 this is not much comfort when one considers the disparity in estimates of elasticities of demand for energy in different sectors (see also Watkins 16 for a useful recent survey of the developments in energy demand forecasting and the methodological pitfalls that remain). Second, it is only important to ensure that one achieves a precise target for emissions reduction if one is dealing with a pollutant where damages are related to the flow of emissions and where damages display a threshold effect. However, CO2 is a stock pollutant, ie damages are related to the atmospheric concentrations, or stock, of CO2, not to the flow of emissions. Therefore, if a carbon tax does not achieve the expected reduction in emissions in one period, there will be time to adjust the tax in subsequent periods. This last point raises a related issue, namely, if one is dealing with a stock pollutant what should be the path of taxes over time? The rule for determining the optimal level of emissions in any period of
140
time implies that a carbon tax should rise over time, at a rate which will reflect the real risk-free rate of interest and the rate at which the concentration of atmospheric CO2 would decay. The latter is rather small, of the order of 0.5%/year. 17 An offsetting argument is that since fossil fuels are exhaustible, taxes should decline over time to induce holders of resources stocks to delay depletion.~S The net effect of these two considerations is ambiguous, and so is an empirical matter. Models which have reflected these considerations (eg Nordhaus ~9) suggest that the first effect dominates over the next century, so it is reasonable to suppose that taxes will be rising over the foreseeable future. The conclusion we draw from this brief discussion of policy design is that there are strong arguments in favour of using a carbon tax as a major policy instrument for achieving CO2 reductions. An argument sometimes raised against a carbon tax is that there are important market failures in the energy market which mean that consumers do not respond to price signals in the way economists assume in their analysis; in particular, there are imperfections of information and capital markets which mean that there is underinvestment in energy conservation. We discuss these issues elsewhere and present some evidence for the manufacturing sector which does not support this argument; 2° however, we acknowledge that the evidence is tentative, and do not want to rule out the possibility of such market failures. This does not mean that carbon taxes are ineffective, merely that they are not the only policy instrument that is relevant - there must be other policies addressed to these market failures. After this brief overview of some of the issues concerning design of policy, we turn to the empirical evidence from the manufacturing sector which could help policymakers attach some numbers to the factors we have been discussing.
A MODEL TAXES
FOR STUDYING
CARBON
In seeking to present yet another set of estimates of possible rates of carbon taxes, it is necessary to recognise that there already exist a plethora of such estimates. 2~ There are three broad factors which could explain this diversity: (1) the models used to study COa emissions, or equivalently, demand for fossil fuels; (2) the assumptions about future economic growth or energy prices; (3) the targets to be achieved and their dates. We use only one model,
ENERGY POLICY March 1991
C a r b o n tax use to c o n t r o l C 0 2 e m i s s i o n s - U K m a n u f a c t u r i n g
but shall show how sensitive calculated tax rates are to differences in the other factors.
1. The models: A major difficulty with energy demand models is capturing the dynamic aspects of energy demand, and in our model of fuel demand for the UK manufacturing sector we employ a sophisticated vintage model of the production structure. The model is more sophisticated than conventional vintage models because we allow for the possibility that firms will be able to change the energy-output ratio on existing machines in response to changes in current factor prices. Moreover, how much flexibility firms have to vary energy-use at this stage is determined by firms themselves when they come to design their new machines; not only can they vary the design of machines in terms of the input-output ratios of different factors in response to the relative prices of factors they expect to prevail over their planning horizons, they can choose how flexible they want their production process to be in response to how volatile they expect relative prices to be over the planning period. The model is estimated over the period 1955Q1 to 1987Q4. 22 There is a slight extension of the vintage model of factor demands which we need to make to handle CO2 emissions, namely to deal with the problem of CO2 emissions associated with the electricity used by the manufacturing sector (indirect CO2 emissions). We handle this in a very crude way, by assuming that the shares of fuels in electricity generation stay constant. 2. Assumptions on future economic growth or energy prices. The background assumptions about future growth of output and future factor prices are those used by the Department of Energy for the Intergovernmental Panel on Climate Change (IPCC) Response Strategies Working Group. 23 There are two growth rates for output, 1.25%/year and 3.25%/ year (in the previous study we used 1% and 2%). For (real) energy prices we modified the IPCC 24 assumptions slightly; they used forecasts of world prices for oil and coal for 1990, 2005 and 2020 from a base in 1985. We extrapolated the data series for energy prices from 1987Q4 to 1990Q3 using data in Energy Trends; we then used the growth rates in prices over the period 1990-2005 contained in the IPCC scenarios and applied these to the 1990 data. For the low price scenario, oil prices are virtually stationary, growing at 0.6%/year, while coal prices grow at 0.8%/year; for the high price scenario, oil prices grow at 3.5%/year while coal prices grow at l%/year; gas prices are assumed to rise at the same rate as oil prices. Finally, real wages are assumed to
ENERGY POLICY March 1991
rise at the rate of growth of output per head, while the real price of capital (including interest rates) are assumed to stay constant. These assumptions are displayed in Figure 1. It will be clear that the high growth rate assumption for output is very optimistic given the past performance of manufacturing, and the assumed real energy prices are all rather low by historical standards.
3. Targets. Finally, for targets we have selected two targets for emission levels in 2005 - stabilization at 1990 levels and a 25% reduction on 1990 levels (our previous study used the Toronto target of an 80% reduction on 1988 levels). We later consider varying the date for target emissions to 2000 and 2010. In setting emissions targets for a specific date, there is an implicit ambiguity about policies towards emissions in the intervening period. Reflecting our previous discussion we shall assume that the tax on CO2 emissions (ie the carbon content of fuels) rises over time, and we have chosen rates of 3% and 5% (our previous study used 7.5% and 15%).
CARBON TAXES FOR DIFFERENT SCENARIOS The implications of the scenarios outlined in the previous section for CO2 emissions in the absence of any policy intervention, as estimated by our model, are shown in Table 1. This emphasizes the rather unreal assumptions about output growth and prices; in the case of the target of a 25% cut from 1990 emissions, in the high growth, low price scenario we are being required to cut emissions to one third of their unconstrained value; recall that the high level of emissions is being driven not just by high growth of output but by the fact that real wages are rising significantly faster than real energy prices. Tables 2 and 3 show the tax rates (as % of the net of tax prices) that would be required to achieve the targets of stabilization and 25% cut respectively given rates of growth of taxes over time of 3% and 5%/year. What emerges very strikingly from these Tables are the two crucial influences on tax rates the rate of growth of output and the level of emissions reductions to be achieved. With low growth, and seeking only to stabilize emissions at their 1990 level, requires fairly modest tax rates, even for coal and oil; by the year 2005 no tax rates above 45% are required; although low energy prices would lead to higher unconstrained growth of emissions, tax rates do not have to be significantly higher to offset this. Seeking a target of 25% reduction from 1990 emis-
141
Carbon
t a x u s e to control C 0 2 emissions - U K m a n u f a c t u r i n g
6
O u t p u t index
0.3
Gas price ( r e a l ) index
0.25
0.2
0.15
0.1
0.05
0 1955 O. 16
I 1967
I 1980
Year
I 1991
I 2005
Coal p r i c e ( real ) index
0 1955 0.55,
0.14
I 1967
I
1980
Yea r
I
I
1991
2005
Oil p r i c e ( r e a l ) index
0.5
0.12
/
0.25 0.10 0.2 0.08 0.15 0.06 0.1 0.04
0.05
0.02 ~-
1955
I 1967
I
I
I
1980
1991
2005
Year
Figure 1. Assumptions about exogenous variable. sions requires a sharp increase in the level of tax rates. For example for coal, the increase is from the range 20-50% to the range 120-320%. This brings out an interesting feature, namely that what matters is not just the overall size of the required reduction in emissions, but also whether 142
0
I
1955
1967
I
1980
Year
I
1991
(Figure I,
'2005
c o n t i n u e d on
p 143).
the cut involves cutting future growth in emissions or cutting associated with already existing plant. To illustrate this point, we can see from Table 1 that achieving the 1990 emissions with low growth and low prices requires emissions to fall by about 44% from their unconstrained level; if we aim for a ENERGY POLICY March 1991
Carbon tax use to control C02 emissions - UK manufacturing 6
Real wage index
Table 1. Unconstrained CO2 emissions. CO2 emissions (2005) Output growth
Energy price growth
CO2 emissions (1990)
Low Low High High
High Low High Low
1.275 1.442 2.010 2.250
5-
2
I
0 1955
I
I
I
1967
1980
1991
2005
Yeor Figure 1.
(Continued f r o m p 142).
r e d u c t i o n o f 2 5 % f r o m 1990 e m i s s i o n s , with low g r o w t h a n d high e n e r g y p r i c e s , t h e n we a r e r e q u i r i n g e m i s s i o n s to fall by a b o u t 5 3 % f r o m t h e i r u n c o n s t r a i n e d v a l u e . So t h e s e two cases i n v o l v e v e r y s i m i l a r o r d e r s o f m a g n i t u d e r e d u c t i o n s in e m i s s i o n s f r o m t h e i r u n c o n s t r a i n e d values. Y e t t h e t a x e s in the two cases a r e v e r y d i f f e r e n t (initial t a x e s o n coal o f 2 4 % a n d 122% with 5 % g r o w t h in t a x e s ) . A s an
a l t e r n a t i v e c o m p a r i s o n , if we h a v e a t a r g e t o f stabilization at 1990 levels a n d low g r o w t h , a n d c o n s i d e r just the d i f f e r e n c e b e t w e e n high a n d low e n e r g y p r i c e s , t h e n we see f r o m T a b l e 1 that t h e r e q u i r e d r e d u c t i o n s in e m i s s i o n s f r o m t h e i r u n c o n s t r a i n e d v a l u e s a r e , r e s p e c t i v e l y 28% a n d 4 4 % . Y e t this d i f f e r e n c e , which is slightly l a r g e r t h a n o u r p r e v i o u s c o m p a r i s o n , o n l y has t h e initial tax r a t e o n coal rising f r o m 19% to 2 4 % . O f c o u r s e w e w o u l d e x p e c t t h e r e to be a n o n - l i n e a r effect o f r e d u c t i o n s on tax r a t e s , so t h a t going f r o m a 28% r e d u c t i o n in emissions f r o m t h e i r u n c o n s t r a i n e d level to 4 4 % c o u l d well h a v e a s m a l l e r effect on t a x e s than g o i n g f r o m 44% to 5 3 % . B u t t h e o r d e r o f m a g n i t u d e in t h e d i f f e r e n c e in tax r a t e s s u g g e s t s t h a t t h e r e is a n o t h e r f a c t o r at w o r k , n a m e l y that t h e m o v e f r o m 2 8 % to 4 4 % is a s s o c i a t e d with a t a r g e t o f s t a b i l i z a t i o n , which can be a c h i e v e d b y p r e v e n t i n g f u t u r e g r o w t h in e m i s s i o n s , while t h e m o v e f r o m 44% to 53% is a s s o c i a t e d with a r e d u c t i o n in t h e initial level of e m i s s i o n s , which r e q u i r e s c u t t i n g e m i s s i o n s on a l r e a d y i n s t a l l e d p l a n t . A n d it is m u c h m o r e e x p e n sive to u n d o t h e effects o f e m i s s i o n s - g e n e r a t i n g p l a n t a l r e a d y i n s t a l l e d , t h a n it is to offset t h e effects o f e m i s s i o n s - g e n e r a t i n g p l a n t yet to be i n s t a l l e d .
Table 2. Tax rates % for different scenarios (2005 target: 1990 level). Fuel
Coal Coal Coal Coal Coal Oil Oil Oil Oil Oil Gas Gas Gas Gas Gas Electricity Electricity Electricity Electricity Electricity
Growth price tax growth
Low High 5%
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010
19 24 29 35 43 19 20 22 24 25 11 12 14 17 20 9 9 9 10 11
ENERGY POLICY March 1991
High High
3%
Low 5%
3%
5%
3%
5%
3%
22 25 28 31 34 21 21 21 21 20 12 13 14 15 16 10 10 9 8 8
24 29 36 45 56 23 29 36 45 57 13 16 20 26 32 11 12 13 14 17
27 30 34 39 44 26 30 34 39 44 15 17 19 22 25 12 12 12 l2 12
249 3114 3711 452 551 244 262 282 303 326 135 158 185 216 253 118 129 142 156 172
379 420 466 516 573 371 363 355 347 339 205 219 233 247 263 180 186 192 198 205
2711 335 417 519 645 264 330 413 517 647 146 185 233 294 371 128 143 160 179 200
407 460 520 588 665 398 453 515 586 667 221 253 290 333 382 194 204 214 225 237
Low
143
Carbon tax use to control C 0 2 emissions - U K manufacturing
Table 3. Tax rates % for different scenarios (2005 target: 75% of 1990 level). Fuel
Coal Coal
Coal Coal
Coal Oil Oil Oil Oil Oil Gas Gas Gas Gas Gas Electricity Electricity Electricity Electricity Electricity
Growth price tax growth
Low High 5%
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010
122 149 181 221 269 119 128 138 148 160 66 77 90 106 124 58 63 70 78 86
3%
Low 5%
196 217 241 267 296 192 187 183 179 175 106 113 120 128 136 93 96 99 102 106
143 178 221 275 342 140 175 220 275 344 78 98 124 156 197 68 76 86 97 110
Raising the rate of growth to 3.25%/year takes tax rates on coal into ranges of 250-600% with the target of stabilization, and 500-1 000% for the 25% reduction. These reflect the fact that emissions are having to be reduced to 50% and 33% of their unconstrained values respectively, which are much larger cuts than might be sensibly contemplated. In Tables 4 and 5 we show the pattern of energyuse corresponding to the scenarios indicated in Tables 2 and 3. These show a considerable degree of fuel switching. With the 1990 target, and low growth, oil is cut back significantly along the high
3%
High High 5%
3%
Low 5%
3%
224 253 286 323 366 219 249 283 322 367 121 139 160 183 210 106 112 118 124 131
518 632 770 939 l 145 507 545 587 631 678 281 329 385 450 526 247 268 292 319 347
700 777 861 951 1 059 686 671 656 642 628 380 404 430 458 487 335 345 356 367 379
530 659 820 1 020 1 268 519 650 813 1 017 1 272 288 363 458 578 729 252 280 310 340 382
704 796 901 1 018 1 152 690 785 893 1 016 1 156 382 438 503 577 662 336 353 370 389 408
price path, oil and coal on the low price path, with gas and especially electricity expanding. With the same target, but high growth, coal is cut back heavily, oil falls sharply initially, but recovers by 2005, while gas is kept fairly stable. With the more stringent target of cutting 25% from 1990 emissions, the use of all fuels is cut; coal again bears the brunt of the reduction, falling to about 60% of its 1990 level by 2005, while oil and gas fall to between 75% and 80% of .'their 1990 levels, gas again doing rather better under the low growth scenario; electricity consumption does not fall much from its 1990 level.
Table 4. Fuel-use for different scenarios (1990 = 100) (2005 target: 1990 level). Fuel
Coal Coal Coal Coal Coal Oil Oil Oil Oil Oil Gas Gas Gas Gas Gas Electricity Electricity Electricity Electricity Electricity
144
Growth price tax growth
Low High 5%
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010
100.0 120.8 136.9 107.2 88.5 100.0 69.6 102.5 81.4 66.5 100.0 121.9 148.2 115.0 93.4 100.0 128.6 151.0 122.9 106.7
3%
Low 5%
100.0 120.3 133.9 105.9 89.0 100.0 69.3 100.2 80.4 65.8 100.0 121.1 144.3 112.8 92.1 100.0 127.8 147.6 121.1 105.5
100.0 118.7 129.3 97.5 76.0 100.0 69.3 104.7 87.2 74.8 100.0 122.4 148.3 116.4 94.5 100.0 127.1 147.3 118.9 100.5
3%
High High 5%
3%
5%
3%
100.0 118.1 126.5 96.5 76.6 100.0 68.9 102.1 86.1 73.9 100.0 121.4 144.3 114.2 93.5 100.0 126.1 143.8 116.9 99.1
100.0 86.4 78.6 76.0 71.0 100.0 55.8 88.3 107.9 100.2 100.0 91.0 97.7 103.7 101.1 100.0 96.1 113.2 133.2 142.1
100.0 77.8 72.9 74.9 71.7 100.0 52.0 83.2 106.2 110.1 100.0 82.2 89.2 99.2 98.8 100.0 86.9 104.1 126.6 135.9
100.0 84.3 77.5 76.4 72.1 100.0 55.0 88.1 109.0 112.1 100.0 89.7 96.8 103.4 100.6 100.0 94.3 111.6 131.6 139.8
100.0 75.9 71.7 75.1 72.8 100.0 51.3 82.5 106.9 111.8 100.0 80.9 87.9 98.7 98.5 100.0 85.1 102.2 124.9 133.7
Low
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Carbon tax use to control C 0 2 emissions - U K manufacturing
Table 5. Fuel-use for different scenarios (1990 = 100) (2005 target: 75% of 1990 level). Fuel
Coal Coal Coal Coal Coal Oil Oil Oil Oil Oil
Gas Gas Gas Gas Gas Electricity Electricity
Electricity Electricity Electricity
Growth price tax growth
Low High 5%
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000
100.0 95.8 75.0 61.1 50.5 100.0 57.8 72.7 76.1 65.8 100.0 100.4 91.2 82.2 69.2 100.0 106.1 101.7
2005
99.7
2010
90.9
VARIATIONS DATES
3%
Low 5%
100.0 88.4 69.9 57.7 47.5 100.0 55.8 71.4 76.8 66.7 100.0 92.3 84.9 78.0 65.8 100.0 97.3 96.4 96.3 87.3
100.0 93.1 72.8 58.7 46.5 100.0 57.8 73.7 78.9 70.4 100.0 98.6 90.4 81.3 67.7 100.0 103.2 100.3 98.1 88.6
IN EMISSION TARGET
We now consider the sensitivity of tax rates to variations in the date by which the target is to be achieved. For this comparison we have selected the scenario where there is low growth, high prices, taxes rise at 5%/year and the target is a reduction of 25% from 1990 emissions. In Table 6 we show the tax rates and energy-use corresponding to achieving the target in 2000, 2005, and 2010 respectively. Two
3%
High High 5%
3%
Low 5%
3%
100.0 85.5 68.1 57.6 46.5 100.0 54.9 71.4 77.9 69.5 100.0 90.2 83.8 77.5 65.2 100.0 94.5 94.6 94.7 85.3
100.0 70.1 61.2 58.7 50.9 100.0 48.5 69.3 81.8 76.6 100.0 74.8 74.0 75.7 67.8 100.0 79.7 88.2 100.9 100.1
100.0 63.9 56.3 57.9 53.0 100.0 45.5 63.4 80.5 79.3 100.0 68.3 67.1 73.4 69.4 100.0 72.7 79.0 95.4 97.9
100.0 69.4 60.9 59.3 51.8 100.0 48.3 69.4 82.8 78.0 100.0 74.6 73.9 76.3 68.3 100.0 79.1 87.7 100.7 99.9
100.0 63.8 56.5 58.9 54.7 100.0 45.5 63.9 82.3 81.9 100.0 68.5 67.6 74.7 71.0 100.0 72.6 79.2 96.3 99.1
points are worth noting. First, tax rates fall the later the date at which the target has to be achieved, and this is most strikingly so when the target is pushed back from 2005 to 2010. Note that there is nothing inevitable about this - it is a consequence of the relative growth rates of energy prices, tax rates and output; in particular, with faster growth, tax rates could rise the later the target date, because there would be more years of growth to offset. Second, the difference in dates affects the pattern of fuel-use. In general, associated with a later target date there is a greater use of each fuel at each date
Table 6. Tax rates and fuel-use for different target dates. Target
Date
Tax rates (%) 2000 2005
Coal Coal Coal Coal Coal Oil Oil Oil Oil Oil
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010
180 211 246 288 336 177 190 204 220 236 98 105 113 122 131 85 91 98 105 113
Gas Gas Gas Gas Gas Electricity Electricity Electricity Electricity Electricity
ENERGY POLICY March 1991
122 149 181 221 269 119 128 138 148 160 66 77 90 106 124 58 63 70 78 86
2010 32 38 44 52 60 32 34 37 39 42 18 19 20 22 24 15 15 16 17 18
Fuel-use (index) 2000 2005
2010
100.0 90.1 69.0 55.3 44.3 100.0 56.2 69.7 71.0 57.7 100.0 93.2 83.3 73.4 59.0 100.0 98.9 95.9 92.8 81.3
100.0 118.1 118.4 98.4 87.9 100.0 57.9 85.3 73.5 60.5 100.0 117.5 124.4 101.5 85.5 100.0 125.0 131.5 114.3 104.0
100 95.8 75.0 61.1 50.5 100.0 57.8 72.7 76.1 65.8 100.0 100.4 91.2 82.2 69.2 100.0 106.1 101.7 99.7 90.9
145
Carbon tax use to control COe emissions - U K manufacturing
Table 7. Costs of reducing emissions. 2 PV tax revenues
3 Net cost emissions
4 Cumulative
Case
1 PV costs of production
No Tax Tax 1 Tax 2 Tax 3 Tax 4 Tax 5 Tax 6
100.0 101.73 103.19 105.63 108.19 113.80 119.38
0.0 1.37 2.69 4.75 6.74 11.41 16.86
0.0 0.36 0.50 0.88 1.45 2.39 2.52
100.0 84.21 75.27 66.79 62.27 56.95 53.07
1995, 2000, 2005, 2010. The exception is that when the target date moves from 2005 to 2010, oil-use actually falls in 2005 and 2010; indeed, with a 2010 target, oil has the major cutback in use, with coal and gas having rather similar patterns. The difference is due to the rather different assumptions about growth rates for oil and coal prices over the period, which will dominate the rather low tax rates. COSTS OF POLICIES EMISSIONS
FOR
REDUCING
While consideration of tax rates is important, it is also important to consider the economic costs associated with policies to reduce emissions. In this respect tax rates can be slightly misleading, for two reasons. First, taxes do not themselves represent a cost to the economy - they are simply the instrument for bringing about emissions reductions, and are a transfer between producers and the government. Second, energy costs are a relatively small component of total cost, so quite large increases in energy prices need not imply very large increases in costs. We shall now consider the costs of policies to reduce emissions. An important question is how abatement costs vary with the level of emissions reduced, and in particular whether there is any threshold at which costs start rising very sharply. We have considered just the scenario we used for Table 6, ie low output growth, high price growth and taxes rising at 5%/year. To construct a total abatement cost curve for cutting emissions we started from the base case of unconstrained emissions and calculated the present value of operating plus capital costs for each year over the period 1990-2010, with the flow of costs being discounted back to 1990 at the constant real interest rate of 3.5%. We also calculated the cumulative emissions that would occur in that base period. We then took different levels of initial carbon tax, and let that grow at 5%/year over the period 1990-2010. For each initial tax rate we computed the present value of costs, the present
146
value of tax revenues and the cumulative emissions over the period 1990-2010. The calculations are shown in Table 7 for the base case of no tax and for six positive levels of tax, where we have normalized present value costs and tax revenues on the base present value costs, and have normalized cumulative emissions on base cumulative emissions. For cross reference to earlier Tables tax 2 corresponds to the tax rates shown in Table 2 for this scenario; ie if we aim to reduce emissions in 2005 to 25% below their 1990 level, that represents about a 25% reduction in cumulative emissions over the period 1990-2010. The net cost to the economy of reducing emissions is the difference between the increase in costs faced by producers and the extra tax revenue earned by the government, and this is shown in the net cost column of Table 7. Figure 2 graphs the net cost (as a percentage of base total cost) against reduction in cumulative emissions (also in percentage terms), and 3
2,~
"~ 2 "~ "6 > I. 5 ~ E
.~ g o5
o 0
Figure 2.
IO
20 30 % reduction in total emissions
40
50
Total abatement cost curve.
ENERGY POLICY March 1991
C a r b o n tax use to control C O e e m i s s i o n s - U K m a n u f a c t u r i n g
thus represents a total abatement cost curve. The shape of the curve is as expected, and the interesting feature is the rather low costs involved; cutting cumulative emissions by 25% would represent a cost to the economy of about 0.5% of total cost. In terms of the question of critical threshold effects, while the total cost curve has the expected convex shape, there do not appear to be any critical levels of reductions in emissions at which costs escalate sharply, Two caveats are in order. First, the costs have been rather arbitrarily truncated at 2010; second the costs we are calculating exclude costs of raw materials.
THE COSTS OF D E L A Y The final question we wish to address is the cost of delaying policy action, perhaps in order to learn more about the potential damage costs before having to incur abatement costs. The way we tackle that is to ask: supposing we delay taking action till 1995 or 2000, and only started to impose a tax at that date? Again letting the tax rise at 5%/year, what would be the resulting reduction in cumulative emissions over the period 1990-2010, and what would be the resulting increase in present value costs (evaluated over the period 1990-2010)? We can then compare those costs with the costs of achieving the same reduction in cumulative emissions if immediate action was taken. We have examined the option of a 10% reduction in cumulative emissions. From Figure 2 we can see that if we took action starting in 1990, the net cost would be about 0.3% of present value total costs over the period 1990-2010. If we delay taking action until 1995, the costs of a 10.5% reduction in emissions would become 22.4% of base costs, while if we delayed taking action till 2000 the cost of a 10.2% reduction would be 45.2% of base costs. These figures are very striking and suggest very substantial costs of delay. However, we need to be a little cautious in interpreting these figures. First there are the caveats already mentioned about the calculation of costs. Second, we have imposed an arbitrary time horizon of 2010 for comparing cumulative emissions, which is rather close given the nature of the greenhouse effect. What this is really telling us is that we take action over a 20-year period, the costs of reducing emissions need not be very dramatic, because we can meet that by redesigning new capital equipment (the average life of equipment is 16-18 years). If we compress the time horizon to only 10 years, we have three effects: 1.
We just have less time to cut the emissions, so
ENERGY POLICY March 1991
2.
3.
the reductions per year are greater; this is magnified by the fact that we have to offset the unconstrained emissions that have taken place in the first 10 years; so we have to make much more drastic cuts in the emissions per year; and we have accumulated a stock of inappropriate capital over the first 10 years, so much more of the reductions in emissions are having to come about from ex-post substitution on existing vintages rather than redesigning new vintages, and this is very much more expensive.
Obviously if we had taken as our target cumulative emissions over the period, say 1990-2030, then the effect of delay of 10 years would have been less dramatic. Nevertheless, the results are very strong and suggest that this is an area where more work is urgently needed to guide policymakers.
CONCLUSIONS In this paper we have argued from first principles that there are strong grounds for preferring the use of a carbon tax to control CO2 emissions. We have explored the empirical implications of such a policy by using a vintage model of factor demands (including fossil fuels) for the U K manufacturing sector. By considering a range of possible scenarios, we showed that the crucial features affecting the size of taxes required are the rate of growth of output, and whether the target requires cutting existing emissions or preventing growth of future emissions. We also examined the sensitivity of taxes to target date, and showed that there is a significant reduction in taxes in going from a target date of 2005 to 2010, essentially because in the latter case more of the adjustment comes through altering design of new machines, rather than fuel switching on existing plant. Looking at costs of abating CO2 emissions, we found that if we start policy now with a target date of 2010, costs are rather modest, and do not display any dramatic threshold effect. However, delaying taking action till 1995 or 2000, and seeking to achieve the same cumulative reduction in emissions by 2010, there is a dramatic increase in the cost of abatement. The intuition is the same - the later policy starts the more adjustment has to be done by expensive factor substitution on existing plant r a t h e r than redesigning new plant. These results show the importance of using a model with a vintage structure to capture the dynamics of adjusting fuel-use. 147
Carbon tax use to control C02 emissions - UK manufacturing
aS. Barrett, 'Economic instruments for global climate change policy', Report for OECD Economic Directorate, London Business School, UK, 1990. 2A. Ingham and A. Ulph, 'The economics of global warming', in J. Bennett, ed, Economics and the Environment: A Reconciliation, Australian Institute for Public Policy (forthcoming). 3W.D. Nordhaus, 'The economics of the greenhouse effect', mimeo, Yale University, MA, USA, 1989. 4W.D. Nordhaus, 'An intertemporal general-equilibrium model of economic growth and climate change', paper presented to Workshop on Economic/Energy/Environmental modelling for Climate Policy Analysis, Washington, DC, USA, 1990. 5W.D. Nordhaus, 'Economic growth and climate - the carbon dioxide problem', American Economic Review, Vol 67, No 1, 1977, pp 341-346; and W.D. Nordhaus, The Allocation of Energy Resources, Yale University Press, New Haven, MA, USA, 1979. 6.1. Edmonds and J. Reilly, 'Global energy and CO2 to the year 2050', The Energy Journal, Vol 4, No 3, 1983, pp 21-47; and J. Edmonds and J. Reilly, Global Energy: Assessing the Future, Oxford University Press, New York, USA, 1985. 7W.R. Cline, 'Political economy of the greenhouse effect', mimeo, Institute for International Economics, Washington, DC, USA, 1989. 8j. Whalley and R. Wigle, 'Cutting CO2 emissions: the effects of alternative policy approaches', mimeo, University of Western Ontario, London, Ontario, Canada, 1989. 9A.S. Manne and R.G. Richels, 'CO2 emission limits: an economic cost analysis for the USA', The Energy Journal, No 11, Vol 2, 1990, pp 51-74. I°T. Barker and R. Lewney, 'Macroeconomic modelling of environmental policies: the carbon tax and regulation of water quality', paper presented to conference The UK Economy and the Green 1990s, Cambridge, UK, 11-12 July 1990. I1T. Barker, 'Measuring economic costs of CO2 emission limits', Working Paper, Department of Applied Economics, Cambridge, UK, 1990.
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12Nordhaus, op cit, Ref 3. 13Ingham and Ulph, op cit, Ref2; and A. Ingham, J. Maw and A. Ulph, 'Empirical measures of carbon taxes', Oxford Review of Economic Policy, (forthcoming). 14M. Pearson and S. Smith, 'Taxation and environmental policy: some initial evidence', 1FS Commentary No 18, Institute for Fiscal Studies, London, UK, 1990. ~ST.F. Homer-Dixon, 'Taxes, fuel consumption and carbon dioxide emissions', Paper for Greenhouse Policy Project, World Resources Institute, Washington, DC, 1989. 16G.C. Watkins, 'The economic analysis of energy demand', in D. Hawdon, ed, Energy Demand: Evidence and Expectations, University of Surrey, Guildford, Surrey, UK, (forthcoming). 17Nordhaus, op cit, Ref 4. ~sp. Sinclair, 'High does nothing and rising is worse: carbon taxes should keep declining to cut harmful emissions', Applied Economics Discussion Paper 99, Institute of Economics and Statistics, Oxford, UK, 1990. 19Nordhaus (1979), op cit, Ref 5. 2°A. Ingham, J. Maw and A. Ulph, 'Energy conservation in the UK manufacturing sector - a vintage approach', in Hawdon, ed, op cit, Ref 16. 21See surveys in A. Ingham and A. Ulph, 'Carbon taxes and the UK manufacturing sector', Discussion Paper 9004, Department of Economics, Southampton, UK, 1990; Cline, op cit, Ref 7; and S. Barrett, Memorandum for the House of Commons Energy Select Committee, HMSO, London, UK, 1990. 22In an earlier study of carbon taxes, Ingham and Ulph, lbid, we used an earlier version of the model estimated over the period to 1985Q1; this study differs from that previous work in other respects, which we mention in the text. 23Department of Energy, An Evaluation of Energy Related Greenhouse Gas Emissions and Measures to Ameliorate Them, Energy Paper 58, HMSO, London, UK, 1989. 24IPCC, Scientific Assessment of Climate Change, Third draft, World Meteorological Office/UNEP, Geneva, 1990.
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