Carbon tax or carbon trading? Watch the side effects!

My own translation of an edited comment published originally in German on Klimareporter. Last revision on September 11, 2020. The National Emissions Trading System is now enacted and will be introduced in 2021.

The member states of the European Union have set themselves ambitious climate control targets up to the middle of the century: the emission of harmful greenhouse gases is to drop by 80 to 95 percent compared to 1990.

The core instrument for achieving this goal is the European Emission Trading System (ETS). Under this system, an "allowance" - a tradable permit - must be presented for each CO2-equivalent ton of greenhouse gas emitted.

The number of allowances, and thus the volume of emissions, is capped by an upper ceiling which is gradually being reduced. Trading the certificates ensures that greenhouse gases are saved where it is cheapest.

If all climate harming activities were covered by emissions trading, we would not need to worry about reaching the climate control targets, provided that the cap is lowered accordingly.

But they aren't. For example, while electricity generation and parts of manufacturing are included, such key sectors as transportation, buildings and agriculture are left out. Initially, there were practical reasons for this, since most polluters in these sectors are not large corporations, but small-scale actors such as motorists or homeowners.

Controversy about the right instrument

Nevertheless, these sectors still account for more than half of total greenhouse gas emissions. There is consensus that immediate action is warranted if the self-imposed climate control targets should be met.

But how? This is exactly what the planned Federal Climate Action Law is all about. After the European elections, Federal Minister of the Environment Svenja Schulze (SPD) pressed for concrete action. Of controversy, accompanied by extensive media coverage, has since been her carbon tax proposal.

According to the proposal, a tax or levy is to be imposed on the emission of each ton of CO2, which would make the combustion of fossil fuels such as gasoline, diesel, heating oil or natural gas more expensive. This should encourage people to consume less of it and use alternatives such as electric cars or more efficient heating systems instead.

The Bundestag disagrees. While the AfD is known for doubting any need for action, the SPD, the Greens, and the Left Party are largely in favor of the tax - provided that appropriate social compensation measures are in place. On the contrary, the FDP advocates an expansion of the EU ETS. The Christian Union's position has so far been inconsistent, with a tendency towards the FDP proposal.

This week, the CSU expressed its support for a national emissions trading system. According to media reports, the heads of the Christian Union fraction followed on Wednesday. Previously, Chancellor Angela Merkel had for the first time clearly advocated emissions trading. A national system could later be linked to the European system.

Emissions trading makes electrification ineffective

Remarkable about the debate on carbon pricing is how detached it is from the rest of national and European climate control policies. These include an extensive array of further measures in the aforementioned sectors. The Climate Action Law bill also refers to a “package of measures”.

One example of this is the electrification of the transportation and building sectors, which is being vigorously pursued. Such electrification is critical because renewable energies can typically only be used in the form of electricity. According to the German government, the promotion of electric mobility or electricity-based fuels and heat storage, for example, makes “important contributions to climate control”.

However, the actual climate impact of these measures depends largely on the type of carbon pricing instrument used, as the author recently explained together with his colleague Grischa Perino at the Annual Meeting of European Environmental and Resource Economists in Manchester.

If the approach of expanding emissions trading were to be followed, the measures would have no climate effect, since the transportation and building sectors would then fall under the cap. More electric cars would then merely create a “waterbed effect”: pressing on it moves the air to another location, but without changing the overall amount of air in the bed.

Carbon tax can be embedded in existing climate strategy

If, on the other hand, the scope of existing emissions trading were to be maintained and a carbon tax (or levy) introduced in the remaining sectors - including transportation, buildings and agriculture - the efficacy of further measures in these sectors would remain intact.

This is simply because the emissions there stay variable instead of being capped. So if a gasoline engine is replaced by an electric car, this will actually avoid CO2 emissions, regardless of - and this is a key point - how much power the electric car consumes and how this power is produced.

How can that be? Well, the electricity producers are subject to emissions trading, and that's where the cap comes into play: If more electricity is demanded, the producers must either meet this demand with green electricity or buy additional allowances that involve corresponding CO2 savings by the seller. Consequently, every kilowatt hour of electricity that enters the battery of an electric vehicle is effectively CO2-neutral.

The carbon tax is therefore more in tune with other climate policy measures - such as the promotion of electric mobility - than emissions trading. This does not mean, however, that the tax is fundamentally the better instrument.

The agony of choice

In principle, emissions trading has strengths in controllability and political transparency. However, it renders any further measures - including voluntary efforts by individuals - ineffective. Consequently, the FDP proposal reads as a fundamental approach: go for universal emissions trading, cancel everything else!

Nevertheless, it begs the question of how realistic such a fundamental reform of climate policy in Europe is and whether we can afford to wait for it. Even if the carbon tax is perhaps not the first best instrument in principle, it could at least be integrated into the existing climate policy landscape relatively smoothly and quickly.

In a statement on carbon pricing by the European Association of Environmental and Resource Economists, which has now been signed by around 1,700 economists, this is exactly what has been thought of. "Global climate change is a serious problem calling for immediate and ambitious action." it says. "In parallel to the EU ETS, a carbon tax should be adopted to reduce the greenhouse gas emissions in transport and housing."

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