Putting a price on carbon

Share:

The green premium is the additional cost of choosing clean technology over one that emits a more significant amount of greenhouse gases.

To get to net zero by 2050, green premiums must be eliminated or reduced. This is to incentivise the development of clean products and most importantly increase the consumption of environmentally friendly products.

The average retail price for a gallon of jet fuel in the United States over the past few years has been around $2.22, while advanced biofuels for jets cost around $5.35 per gallon. The Green Premium is the difference between the two, which is $3.13, or an increase of more than 140 percent. (reference https://www.gatesnotes.com/Energy/Introducing-the-Green-Premiums).

The additional cost of 140% would drive most airlines away from choosing biofuels and towards picking the cheaper option which is harmful to the environment.

How can we lower the green premium?

Well, there are two main ways. A supply-side innovation can cause the price of the green product to decrease. In the case of aircraft fuel, some more efficient technology would be developed in order to reduce the cost of manufacturing advanced biofuels. This would inherently reduce the price which in turn would reduce the green premium. This might cause more airlines to shift their consumption towards the environmentally friendly option.

The other way is to increase the cost of the damaging product. In this case, a fee or tax would be applied to the aircraft fuel which would essentially ‘Level the playing field’ and reduce the green premium. It is this option I want to explore further.

How can we put a price on carbon?

Whilst there are a number of ways this can be done, 2 policies seem to strike headlines. The first is a carbon tax. The second is an emissions trading scheme.

Carbon Pricing implementation globally:

source(https://www.c2es.org/content/carbon-tax-basics/)

Carbon Tax

A carbon tax is simply a price emitters must pay on every ton of GHG( Greenhouse gas) they release. The idea is that this will increase business costs of production which will make the end product more expensive to disincentivise its consumption and reduce the green premium. Furthermore, businesses might switch to green technology in order to reduce their emissions and avoid paying this tax.

Emissions Trading Scheme

“Emissions trading, also known as ‘cap and trade, is a cost-effective way of reducing greenhouse gas emissions. To incentivise firms to reduce their emissions, a government sets a cap on the maximum level of emissions and creates permits, or allowances, for each unit of emissions allowed under the cap. Emitting firms must obtain and surrender a permit for each unit of their emissions. They can obtain permits from the government or through trading with other firms. The government may choose to give the permits away for free or to auction them.

Firms that expect not to have enough permits must either cut back on their emissions or buy permits from another firm.”

reference(https://www.lse.ac.uk/granthaminstitute/explainers/how-do-emissions-trading-systems-work/)

Whilst the government is intervening, It is doing so by creating another market for permits. This allows for the role of supply and demand to incentivise firms to invest in green technology or not. Overall it gives them more choice, as they can continue to pollute as long as they are willing to buy up all of the necessary permits.

Which is better?
Well like most things in economics, it depends. There are clear benefits and drawbacks to each which I will discuss.

Carbon Taxes: Under carbon taxation, governments can provide certainty over future emissions prices by specifying the future trajectory of tax rates (for example, in Ireland the carbon tax is slated to rise by €7.50 a year to reach €100 per tonne in 2030). With an ETS it depends on the market rate and usually, the prices of a permit tend to be quite volatile.

Allowance Price Volatility in ETSs

uncertainty would be a bad thing as it can deter private innovation in, and adoption of, clean technologies especially those with high upfront costs as they would require more of a commitment.

Carbon taxes are also easier to administer. Saving money on the budget would allow the government to invest in other green technology which can overall boost the process of net zero.

Under an ETS firms will want to reduce their emissions so they can sell as many permits to other firms as possible. The selling of permits to other firms will allow firms to increase their profit. This could promote the development of smaller firms and businesses. These will develop in an environmentally sustainable way as the goal would be to use as few permits as possible.

A concern to both would be the deployment. It is important with a carbon tax to not set the rate too high as too high would cause a significant shock to the economy and might end up leading to cost-push inflation. Too low would be ineffective and not incentivise firms to switch to green tech. As a result, there can be some level of government failure involved with these policies.

Similarly, with an ETS it is important to give out enough permits as too little will lead to the permits skyrocketing in price and thus causing a cost-push inflationary effect. Too many permits and the price of permits will be ineffective and provide no incentive for firms to switch.

Overall which policy you use depends on the country. You can use a combination of these policies but the ability of a carbon tax being much easier to administer lends itself to a developing nation where this is more likely to be important. The green premium must be reduced and we cannot rely on technology to ‘come and fix’ everything for us. We need to use policies in order to accelerate the process of getting to net zero and a carbon tax or ETS would be crucial in getting us there.