Tuesday, March 25, 2008

Denmark's Carbon Success

The Danish appear to have been remarkably good at reducing emissions while maintaining strong growth. The New York Times reports:
Everyone seems to be talking about a carbon tax. ... The idea is that polluters should pay for the environmental damage they cause. Slap a tax on carbon, the theory goes, and you will get fewer carbon emissions, more revenue for government and energy independence, all at the same time. No wonder people from both sides of the political divide have come out in support of it.

But a carbon tax isn’t a new idea. Denmark, Finland, Norway and Sweden have had carbon taxes in place since the 1990s, but the tax has not led to large declines in emissions in most of these countries — in the case of Norway, emissions have actually increased by 43 percent per capita. ...

The one country in which carbon taxes have led to a large decrease in emissions is Denmark, whose per capita carbon dioxide emissions were nearly 15 percent lower in 2005 than in 1990. And Denmark accomplished this while posting a remarkably strong economic record and without relying on nuclear power.

What did Denmark do right? There are many elements to its success, but taken together, the insight they provide is that if reducing emissions is the goal, then a carbon tax is a tax you want to impose but never collect.

This is a hard lesson to learn. The very thought of new tax revenue has a way of changing the priorities of the most hard-headed politicians... But if we want lower emissions, the goal of a carbon tax is to prompt producers to change their behavior, not to allow them to continue polluting while handing over cash to the government.

How do you get them to change? First, you prevent policy makers from turning the tax into a cash cow. Carbon tax discussions always seem to devolve into gleeful suggestions for ways to spend the revenue. ...

Denmark avoids the temptation to maximize the tax revenue by giving the proceeds back to industry, earmarking much of it to subsidize environmental innovation. Danish firms are pushed away from carbon and pulled into environmental innovation, and the country’s economy isn’t put at a competitive disadvantage. So this is lesson No. 1 from Denmark.

The second lesson is that the carbon tax worked ... because it was easy for Danish firms to switch to cleaner fuels. Danish policy makers made huge investments in renewable energy and subsidized environmental innovation. ...[T]he tax gave companies a reason to leave coal and the investments in renewable energy gave them an easy way to do so... The key was providing easy substitutes. ...

[A] carbon tax has been promoted almost as a panacea — just pop in the economic incentives and watch them work their magic. But unless steps are taken to lock the tax revenue away from policymakers and invest in substitutes, a carbon tax could lead to more revenue rather than to less pollution.

An increase in gasoline taxes ... would likewise be the wrong policy for the United States. Higher gas taxes would raise revenue but do little to curb pollution.

Instead, if we want to reduce carbon emissions, then we should follow Denmark’s example: tax the industrial emission of carbon and return the revenue to industry through subsidies for research and investment in alternative energy sources, cleaner-burning fuel, carbon-capture technologies and other environmental innovations.

This makes perfect economic sense. At present, income elasticity of demand for oil is relatively inelastic (estimated at 0.3 by some economists), meaning that price increases (a carbon tax) would not be met with a reduction in the quantity of oil consumed. Denmark's policy, however, provides for such inelasticity and works to reduce it - by creating substitutes. Substitutable goods, in this case more renewable forms of energy, make demand more elastic and thus allow taxes to have a greater effect in reducing consumption. Instead of ruminating on all the ways governments can redistribute a carbon tax bonanza, the responsible and indeed only effective approach is to use carbon tax revenue to subsidize renewable energy.

The other, perhaps more popular, policy prescription proposed is the cap-and-trade system, whereby firms are given carbon allowances. Under this system, firms can buy or sell their carbon credits if they wish to pollute more, or if they pollute less than their allowance. Such a system has many problems. As Harvard economist N. Gregory Mankiw writes,
Cap-and-trade systems are also relatively inefficient, for two reasons. First, they encourage utilities to pollute more before the cap-and-trade system is put into effect in order to "earn" pollution rights. Second, they waste the opportunity to use the Pigovian tax revenue.
Under a cap-and-trade system, the government does not raise revenue from carbon emissions as in a carbon tax scheme, and thus would be required to raise other taxes in order to properly subsidize renewable energies. A carbon tax reduces emissions and subsidizes renewable energy in one fell swoop.

As the Danish have proved, economic growth and lower emissions are not mutually exclusive. The world's reliance on oil today is simply a result of it being the most convenient and cheapest form of energy. If government subsidies allowed the cost of other forms of energy to approach that of oil, and if government taxes allowed the price of oil to simulteanously increase so as to approach that of other energy sources, the world's dependence on oil would wither away. It seems paradoxically simple, given the current raging debate on energy, that something as simple as a tax is the solution.

[Addendum (for Carol): Of course, a carbon tax is not all peaches and rainbows. As with any tax, the cost is ultimately born by the consumer, which lowers living standards.

(click on image to enlarge)

As the graph (which I made myself, I proudly add) shows, a carbon tax certainly decreases oil consumption, but at the cost of lower individual utility. After the tax, the consumer moves from indifference curve U2 to indifference curve U1, representing a lower level of utility. The detrimental effects of a carbon tax can be assuaged by providing a rebate, but that would limit the amount of government revenue able to be used to subsidize other forms of energy, and thus limit the efficacy of the tax. Consequently, as with all taxation, a trade-off exists. The present threat to the environment is sufficiently great, however, to warrant a temporarily lower (ceteris paribus, of course) standard of living, at least in countries rich enough to afford it. In my opinion.]