Tax or Trade: Sunak’s Choice

By Benjamin Gregg

The Chancellor has an opportunity to cut the U.K.’s carbon emissions while raising government revenue, will he take it?

The Conservative government is keen to appear ‘green’. Boris Johnson spoke excitedly of a “Green Industrial Revolution” ^[i] and pronounced the UK’s future as the “Saudi Arabia of wind [energy]”^[ii] in October. But Britain’s most substantial step towards such a ‘transformation’ may come tomorrow, the twelfth of December, when the Chancellor, Rishi Sunak, is expected to announce the future of carbon-reduction in the UK^[iii]. For now, the UK relies on the EU-run Emissions Trading Scheme. But, with the UK exiting the EU-run scheme in January, the Chancellor is under-pressure to introduce a bold, new policy: a carbon tax.

The 2015 Paris Climate Agreement aimed to limit damage to “health, livelihoods, food security, water supply, human security, and economic growth”^[iv] by keeping global warming to 1.5℃ by 2100^[v]. Achieving it requires carbon emissions to fall to net-zero by 2050, according to the Intergovernmental Panel on Climate Change (IPCC)^[vi]. But the world is off track. In 2019, the UK became the first major economy to commit to the IPCC’s target^[vii]. Yet, confused regulations and weak carbon-reduction mean the UK is nowhere near^[viii].

For economists, the most appealing way to cut carbon emissions is carbon pricing. The principle has broad support, most notably from William Nordhaus who received the Nobel Memorial Prize in 2018 for modelling ways to calculate the best price^[ix].

Simply, firms and customers do not consider the costs of climate change when buying or selling goods. Carbon emissions are a by-product that cost firms nothing. So, with carbon pricing, the government sets a price on each tonne of carbon firms emit. To cut costs, Firms limit their emissions and invest in green alternatives, while higher prices put consumers off carbon-intensive goods. With a high enough price, consumers and firms are forced to consider climate change, and emissions fall.

In practice, there are two ways to price carbon. One is a carbon tax. The other is a trading scheme, like the EU Emissions Trading Scheme (ETS) that the UK is currently part of.

Under the ETS, the EU gives companies a carbon allowance. Firms can emit as much carbon as they are permitted. If they emit less, they sell the surplus to another firm. If they emit more, they must buy more allowance. Theoretically, firms have a double incentive to lower emissions: avoiding the costs of buying more allowance and profiting from selling the leftover.

Yet, the carbon price depends on the allowances set by the EU, and the willingness of firms to trade. Prices fluctuate, causing uncertainty, and are often too low to encourage cuts. Many observers remain critical of the ETS, believing it is largely ineffective^[x].

Between 2017 to 2018, there was a 4% drop in greenhouse gas emissions from 11,000 industrial sites covered by the scheme^[xi]. Yet, a study by the Institute for Climate Economics^[xii] found that it was renewable energy becoming more cost-effective, not the ETS, which caused the fall. And, in a 2016 survey of German firms, few companies thought the scheme strong enough to cut emissions. The London School of Economics and Centre for Climate Change Economics and Policy estimated the UK needs a minimum carbon price of £40 per tonne of carbon (tCO₂) to reach net-zero emissions by 2050^[xiii]. The current price of ETS permits, at roughly £25/tCO_2, is too low for firms to bother cleaning their production processes.

Moreover, the present arrangements are overly complex: the ETS is jumbled with a mess of domestic policies. For example, fossil fuel-based energy production faces both the ETS and UK Carbon Price Support scheme, while implicit subsidies from the capacity market counter both^[xiv]. The Energy Technologies Institute^[xv] argues mixed price-signals confuse firms and undermine the government’s ability to reduce emissions.

Clearing the deck with a carbon tax is a better choice. It has intrigued the Treasury, who are reportedly interested in a proposal from the Zero Carbon Commission^[xvi]. The commission – formed of the executive director of Greenpeace, the former head of the banking regulator, an ex-Vice President at BP, and multiple climate researchers – was established to put substance to the net-zero target. They advocate^[xvii] a tax of £75 per tonne of carbon by 2030 as enough to reach the net-zero target while raising £27 billion in revenue.

A carbon tax is like fuel, alcohol or tobacco duties. The government taxes these goods to increase their prices. The higher prices discourage people from buying them while raising government revenue. This is a Pigouvian tax, after Arthur Pigou who first formulated the idea^[xviii]. A £75/tCO₂tax is greater than the estimated carbon price of £40/tCO₂ needed to reach net-zero emissions by 2050. Unlike the ETS, the price is fixed, certain, and large enough to make firms cut emissions. Plus, it increases government revenue, apposite when the deficit is approaching £400 billion.

Yet, a tax is not a given. There are good reasons for the Chancellor to opt against it. Foremost is politics. Taxes are generally unpopular. Firms facing higher costs will pass them onto the public, especially on energy and gas bills. Living costs would rise for most people. People notice when the pound in their pocket plunges in worth: 72% may claim they support carbon taxes now^[xix], but that will undoubtably drop as rising bills fall through the letterbox. In 2000, the UK was rocked by protests over rising fuel duty. Lorries blockaded petrol stations and parts of London^[xx]. Food was rationed and the NHS placed on red alert. Fuel duty has been frozen since 2010^[xxi], but it would be just one household bill to rise under a £75/tCO₂tax. Increasing living costs is a brave move for any chancellor.

The Chancellor could lower other taxes while raising the carbon tax, using a visible cut in income tax to buy support for a less visible rise in living costs. But with debt-to-GDP at its highest since 1960^[xxii], the Treasury’s attraction to a carbon tax is primarily based on plugging the deficit. They are unlikely to embark on a giveaway.

The second issue is operational. A carbon tax is a new policy. Few other major economies have tried it, besides a short-lived Australian experiment from 2012 to 2014^[xxiii]. It requires clearing a mess of old policies and rapidly establishing a new framework for reducing carbon. Domesticating the ETS is an easier alternative favoured by the Department for Business, Energy, and Industrial Strategy (BEIS), who would be responsible for running the scheme. Ambition points to a carbon tax, caution points to a trading scheme. The Chancellor will likely cave to pressure from BEIS, missing his chance to define the UK’s climate agenda.

The Conservatives clearly believe the perception of tackling climate change is a vote winner. They set an ambitious target when they agreed to net-zero emissions by 2050. Achieving it requires more than platitudes and will be less popular in practice than principle. Rishi Sunak has a choice: the ineffective path of least resistance, or a carbon tax. Which he picks will show whether the government’s green turn is electoral fluff or real commitment.

The views expressed in this article are the author’s own and may not reflect the opinions of the St Andrews Economist.

^[i] https://www.ft.com/content/6c112691-fa2f-491a-85b2-b03fc2e38a30

^[ii] https://www.ft.com/content/6c112691-fa2f-491a-85b2-b03fc2e38a30

^[iii] https://www.bloomberg.com/news/articles/2020-10-12/u-k-government-split-over-how-to-charge-polluters-after-brexit

^[iv] https://www.ipcc.ch/site/assets/uploads/sites/2/2019/06/SR15_Headline-statements.pdf

^[v] https://www.investopedia.com/terms/p/paris-agreementcop21.asp

^[vi] https://www.ipcc.ch/

^[vii] https://www.gov.uk/government/news/uk-becomes-first-major-economy-to-pass-net-zero-emissions-law

^[viii] https://news.sky.com/story/uk-emission-targets-wont-be-reached-by-2050-think-tank-says-12131927

^[ix] https://www.forbes.com/sites/howardgleckman/2018/10/10/bill-nordhaus-the-nobel-prize-climate-change-and-carbon-taxes/?sh=4d15c1b96a03

^[x] https://www.euractiv.com/section/emissions-trading-scheme/news/the-european-carbon-market-is-having-a-hard-time-being-effective/

^[xi] https://www.euractiv.com/section/emissions-trading-scheme/news/the-european-carbon-market-is-having-a-hard-time-being-effective/