Variants of the UK’s Emission Trading scheme (“ETS”), a carbon emission pricing scheme, have been adopted by many countries, including European countries, even though it is fundamentally flawed. The EU-ETS and now the UK-ETS are simply a shambolic and dishonest tax on electricity use, Gordon Hughes writes.
The analysis of emission taxes and trading in the electricity market is a classic example of how the simple analytical models of economic theory get misapplied when transferred to a setting for which the implicit assumptions are simply wrong.[1] The idea goes back to a brilliant economist who taught at Cambridge in the 1930s – A. C. Pigou. He suggested that certain kinds of damaging externalities – actions by one individual that affect the welfare of other people – could be dealt with by imposing corrective taxes (known as Pigouvian taxes) on the activities that give rise to the externalities.
In the case of environmental externalities, and in particular CO2, the standard theory suggests that a tax equal to the marginal damage per tonne of CO2 (“tCO2“) would reduce CO2 emissions in an efficient manner. Note that the theory does not refer to eliminating all emissions of CO2, just to balancing the external costs of emitting CO2 against the benefits of using coal or gas to generate electricity. This analysis gives rise to a large but very controversial literature focusing on calculating the “social cost of carbon,” i.e. the external damage per tCO2 emitted.
Estimates of the “social cost of carbon” tend to rely on the use of models that attempt to capture the interactions between economic and environmental variables looking forward to 2100 or 2200. The results are extremely sensitive to small variations in assumptions and have become extremely politicised. Estimates vary from $10 to $200 or more per tCO2. Anyone who reads the Wikipedia article on the “social cost of carbon” will get a clear sense that this is an area in which prior convictions outweigh all other considerations.
The standard theory implies that we should use an environmental tax – a fixed amount per tCO2 – to deal with environmental externalities. This argument was modified by Martin Weitzman, who pointed out that we might not have any good idea of the damage caused by an externality, but we might be willing to say that we want to reduce emissions by, say, 80%. In such a case, he argued that a permit trading system would be more efficient than a tax. The total number of permits issued would be equal to 20% of existing emissions and the price of traded permits would reveal the tax or penalty per tonne of emissions.....<<<Read More>>>.....
