Carbon Taxes in Developed Economies

How do they work, and how can we implement them?

It is predicted that over the next decade, the equivalent fall in carbon emissions during the Covid-19 pandemic must be realised every other year. Climate change is a global issue that we cannot socially distance from. Hence, the UK and the EU have implemented a carbon tax to reduce carbon emissions. While it may incentivise firms to reduce their GHG production, they can manipulate the rules.

Impact on the environment and the economy

One reason carbon taxes could positively impact the environment and the economy is that they reduce carbon emissions. By raising the cost of production of heavy-emitting firms, the market mechanism will reduce the firm’s supply. It will reduce emissions in the affected sectors by 14% compared with a ‘business as usual scenario. The environment benefits from fewer GHG that speed up global warming, which benefits the future economy by mitigating severe natural disasters that disproportionally hit underdeveloped countries. However, firms could instead transfer the tax burden onto consumers by raising the price of their products. The demand for a good is price inelastic, consumers may not reduce their spending but accept higher prices, and there will be no net reduction in carbon emissions.

One reason carbon taxes could negatively impact the environment and the economy is that they may lead to carbon leakage. Since their competitiveness is reduced due to a carbon tax, firms move their dirty assets offshore to locations that do not tax. It could lead to a net increase in emissions when foreign firms outcompete European ones. Hence, higher missions would accelerate global warming, and extreme weather events can destroy capital assets, causing economic havoc. To avoid this situation, unilateral carbon taxes could be levied, reducing the race to the bottom. Firms would not relocate their emissions, and lax environmental standards elsewhere would not advantage foreign firms.

Broader implications

Implementing carbon taxes in rich developed economies may slow down the transition to net-zero. Facing higher prices, firms’ profits will diminish. Those with the highest emissions will struggle the most, causing financial struggle and reducing the capital available for investment. A result would be stunted investment whereby firms do not invest in renewable projects or suspend current projects to free up capital. In the long run, this will prolong the transition to net-zero and result in an overall increase in emissions. Instead of taxing emissions, governments should subsidise investment projects, allowing firms to restructure their business models in preparation for the transition.

Carbon taxes may have discriminatory effects on countries reliant on carbon exports. Developing economies, such as Venezuela, whose economy depends on its oil exports, will see a significant reduction in their incomes, which could induce another period of hyperinflation following a correction in oil prices in the early 2010s in Venezuela. Hence, developing economies may suffer, and global inequalities could rise. However, it may instead cause these economies to revolutionise in response to a changing economic environment. By specialising in other areas, they could diversify, meaning that they are not affected by less demand for their goods.

Carbon taxes may also result in ‘resource shuffling’. Facing a lack of demand for their dirty output, foreign companies may redirect their greenness exports to the EU and their dirtiest exports elsewhere. Instead of reducing carbon emissions, this would only relocate them. As a result, they would not fall. However, similarly to carbon leakage, all emissions would be taxed by implementing a global carbon tax, leaving no scope for manipulating supply chains or export destinations.

To conclude, while the EU CBAM attempts to tackle the troubles of reducing the effectiveness of European firms, it does not go far enough to reduce total carbon emissions. Firms can import their emissions without paying a penny. Hence, to significantly reduce emissions, a global carbon tax would be required to prevent such rent-seeking from occurring. It would not only reduce emissions but accelerate the transition to net-zero on a global scale.

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Ted Jeffery