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What is a Carbon tax and Whatare Emission Trading Schemes

Why carbon pricing policies are necessary

Climate change can be described as a ‘market failure’ since the current measure of measuring economic growth do not account for the negative externalities to the environment and consequently, the cost of these externalities to the society. This is simply due to the fact that policy intervention is required to correct the possible harmful effects of climate change. If countries had to face the effects of climate change proportional to their emissions, then there would have been a market driven response to the problem and countries would have acted to reduce their emissions.  Some of these policy interventions include ‘carbon taxation’ and ‘emissions trading’. 

The prime reason for the existence of policy levers such as carbon pricing is that they provide an impetus to technological innovations to reduce the social costs of climate change. Australia has one of the highest amounts of Green House Emissions in the world. Climate and these policy interventions drive the market to pay for the social costs or impose checks (caps) on the negative externalities that result from economic activity. Additionally, they provide structures so that those responsible for social ‘diseconomies’ or negative externalities would compensate for it.

Australia has a target of a reduction of emissions that are 5% of the 2000 levels. (Department of Environment and Energy, Commonwealth of Australia , 2016). This reduction is a percentage and “The expected effect of the tax is to reduce overall domestic emissions below projected ‘business as usual’ levels, rather than reducing the absolute level of emissions.” (Robson, 2014)

Emissions reduction policies in Australia have been subject to much debate in the last decade since efforts to reduce Green House Gas Emissions are in direct juxtaposition with the economic growth of the country. The Carbon Tax was implemented in Australia was introduced in July 2011 with details on a ‘Carbon Tax’ and “Emission Trading Scheme” and was effective from July 2012. (Nash, 2011)

The absence of such policy measures implies that there will be no efforts for adaptation and mitigation of climate change and emissions would be allowed in a ‘business as usual scenario’.There would no effort to combat and reduce effects of climate change such as floods, droughts etc. which could have serious impact on growth and GDP. Thus, the consequences of this market failure would be borne by the society. These costs could include direct damages caused changing climatic patterns, increased health care costs due to the effects of global warming and lack of clean air, the amount of impact on the life and livelihoods of vulnerable communities such as fishing communities, loss of future growth due to diminishing availability of natural resources, disruptions caused in the economy due to extreme temperatures etc. (Thomas, 2017). At the time of its introduction, the carbon pricing system received support from experts being labeled as good although it did not receive wide support from the public. (Nash, 2011)(Roy Morgan Research, 2011). The Carbon Tax was scrapped in 2014 following much debate.(Taylor, 2014)

Carbon tax and Australia's Green House Gas Emission target

Climate change, as mentioned above is a market failure since the market does not provide valuation and a pricing mechanism for some critical natural resources like clean air, water etc. but provides for subsidization of fossil fuels. Additionally, the negative externalities of GHG emissions are not taken into account by the market.

A diseconomy or a ‘negative externality’ mathematically implies the difference between the ‘Marginal Private Cost’ and the ‘Marginal Social Costs’ i.e when the society incurs the cost for a good that is not paid by the producer of an economic good. MPC refers to the private cost of the producing the last unit of economic good or service to the last consumer. The ‘Marginal Social Cost’ is a dollar valuation of the impact that the society must bearfor the production of the last unit of good or services. Negative externalities imply that the production of a good or servicehas a malevolent effect on the society or cause inconvenience to the public.  (Lipsey & Chrystal, 2011) 

According to the World Bank, a country can take several paths to pricing carbon. A carbon tax is simply a tax that is levied on the Green House Gas Emissions of any project.  According to the World Bank “A carbon tax directly sets a price on carbon by defining a tax rate on greenhouse gas emissions or – more commonly – on the carbon content of fossil fuels.”(World Bank, 2017)

According to World Bank, carbon tax and ETS are similar; the difference between the two being that a carbon tax set or pre-determines the price of the carbon emissions while an ETS would leave the market to set the price of carbon emissions.(World Bank, 2017)

The instrument of carbon pricing being chosen would depend on the emission reduction goals set by the government and the path it chooses to take. The path chosen will depend largely on the economic circumstances of a country.(World Bank, 2017)

Arrow treated carbon as an economic good, thus, treating Greenhouse Gas emissions as an economic good.  The harmful results (mentioned above) of the production of greenhouse gases, therefore, can be deemed to be the social costs of carbon pricing. (Arrow K. J., 2007)

On the other hand, the impact on GDP is the social cost of mitigation of climate change and reduction in greenhouse gases. The benefits of the reduction of GreenHouse Gases are the benefits that are to be accrued in the future. (Arrow K. J., 2007)

Debate surrounding emissions reduction policies in Australia

According to Arrow “The benefits of reduced GHG emissions last for centuries, but mitigation costs are borne today.”(Arrow K. J., 2007) This implies that investment in the benefits of mitigation of greenhouse gases for the future must be borne and made by present generations. Economic projects often take into consideration the ‘discount rate’ analysis of investments made in the present for benefits which would be received in the future. Arrow applied the same analysis to the costs versus benefits if Green House Gas mitigation. (Arrow K. J., 2007)(Frederick, 1999).

In Arrow’s analysis, ‘δ’ is the ‘discount rate’ or “the rate at which society (i.e., the social ‘planner’) discounts the utility of future generations i.e. the rate at which the rate at which society would trade consumption in year t for consumption in the present (measured by Net Present Value of Consumption.”(Arrow K. J., 2007)

Arrow gave the formula:

δ = p + gη


p = social rate of time preference or how much the society favours present consumption of an economic good to future benefits.

 g = Consumption growth rate or the “projected growth rate of consumption

η = the diminishing marginal rate of social utility or the dollar value of the social benefits of the last unit of goods consumed.

According to Arrow, the more of consumption (total carbon consumed in a society) that a generation has, the less social benefit (utility) they may derive from it i.e. the benefits derived go on decreasing (Arrow, et al., 2011). For example, GHG emissions are a result of producing the basic goods for a society as well as non-essential goods. Some amount of GHG emissions are necessary and can be allowed while carbon emissions above a certain quantity can prove to be disastrous. Our society has to make a trade off between emissions and goods produced in the society.

Additionally, the present value of GHG emissions (let us measure this by GDP or economic growth) may be inversely related to the benefits accrued in the future from emission reductions. In the diagram below, the total present value against the rate of benefits that may be derived in the future is traced on the curve. The curve is concave to the origin because this rate of returns gained from sacrificing consumption (i.e. the rate at which present gains are transformed in future gains) in present for the future consumption keeps diminishing. In the context of a society, as consumption rises, its social benefits tend to diminish and the total social value of consumption tends to have diminishing returns. (Arrow, et al., 2011) 

Carbon tax and Emission Trading Scheme

Using this analysis, (Robson, 2014) gave the following discount rates for the costs and benefitsof carbon taxation. He summarized the costs as a percentage of the total GDP today based on the discount rate. He considered the highest possible rates and the discount rate accorded by the government. 

In theory, a carbon tax is a good solution and justified because it provided a “credible price signal” and would encourage investment in alternative sources of energy.(Robson, 2014) However, as Arrow’s model suggests, uncertainty reduces the credibility of this “price signal”. Robson (2014) believes that the prevailing price signals were not strong enough due to the addition of the uncertainty factor. This has been a point of much debate in the country.

It is important to note that in addition to carbon pricing, there are indirect forms of pricing carbon too, such as taxes on fossil fuels, incentives to low-carbon technologies etc.(World Bank, 2017)

Carbon pricing helps in the monetary valuation of damages done to environment and in the abatement of pollution. Abatement refers to the measures taken to reduce GHG emissions (Organization for Economic Co-operation and Development, 2001). The upward sloping market (MC) curve is the marginal cost of abatement. The downward sloping curves are the marginal benefits of reduction in GHG emissions. The upper solid line MSB is the marginal social benefit from less pollution. While the lower Marginal Private Benefit line is the private benefit to the consumers.(Samuelson & Nordhaus, 2004)

Let us assume that a carbon tax is imposed. For this tax, the dollar value of the negative externality caused by GHG emissions is $35 per tone of carbon emitted. The appropriate emission tax would be AUD 35. This is called the internalizing of the externality.  In calculating the private costs, the firm would therefore account for these fees. The firm would, therefore, have to either make its technology more carbon efficient or price its goods in way that the emission fees are accounted for. The firm will allow for Marginal Costs to rise only up to a point where they equal the firm’s marginal revenue. This is point E in the diagram. Calculating the emission fee would require achieving equilibrium where Marginal Social benefit and Marginal Social Costs are equal.

Let us assume that in the above diagram, the government limits the production of emissions from a sector at 40,00tonnes annual. Equilibrium will be when private costs (emission tax + Private costs). If the firm emits less than 4000t tonnes a year, then it can trade off its emissions and reduce its marginal costs. If a firm has more emissions then it can buy more emissions. However, then it must buy emissions. However, the firm cannot operate at a level where marginal costs are greater than marginal revenue. Hence, the firm will be incentivized to reduce emissions to point E. (Samuelson & Nordhaus, 2004)

The economic concept of negative externalities and carbon pricing

“The arguments that proponents of the cap and trade schemes achieve abatement of emissions at ‘least cost’ since one the abatement targets are fixed, industries do not have the pressure to reduce emissions further. Thus, industries have an incentive to make their process more efficient.(Robson, 2014)

Australia’s ‘Carbon tax was introduced in February 2011 by Kevin Rudd government.

Currently, the cap and trade system has four broad variations. (Parliament of Australia, 2010)

‘Cap and Trade System

There are trade-able permits that allow a set amount of emissions on each permit.

‘Baseline and Credit’system

A baseline of ‘allowable emissions’ (in quantity are created and credit emissions must be purchased for all emissions above this baseline.

‘ Project based Emissions Market

Clean development Mechanism based credits can be purchased by projects within the country or outside the country via Joint Implementation Project

Hybrid Schemes

A combination of the above schemes

According to a poll conducted in 2011, many Australian consumers were against the tax as they believed that the tax would not help drastically reduce the total amount of carbon dioxide in the market.(Roy Morgan Research, 2011)

  • A majority of those surveyed also believed that the price of carbon over $23 dollars is very high. Only 15% of those surveyed believed it should be higher.
  • A majority of respondents also believed that a carbon tax was not the best solution towards an economy that priced carbon like a market good and that the tax would affect the world carbon dioxide emissions.

Subsequently, the tax has been a major talking point during elections.

In the above mentioned table, fugitive emissions are emissions that are released in the process of mining, extracting and transporting fossil fuels and not emissions that are released from burning them. The representation of fugitive emissions is important since the mining sector is an important sector of the economy and since there is plenty of debate regarding whether the fugitive emissions should be the responsibility of the producers or the consumers.  Similar arguments can be made regarding agricultural and industrial products. As the world presses Australia to reduce its emissions, Australia could argue that the driver of these emissions is the demand for these goods and services which are consumed outside of the country. The same could be said of the mineral resources of the country such as coal etc. (Lenzen, Murray, Sack, & Weidmann, 2006)

One of the main effects of the tax has been the increase in prices of electricity, depicted in the diagram below. However, electricity prices continued to rise even after the tax was revoked. This is simply because of the limits put on coal and gas mining in the country.  Currently, Australia has one of the highest costs of electricity per unit in the world.(Carabott, 2017). High electricity prices affect the economy in the near term. Currently, there is a debate in the country on whether such high electricity prices should be allowed to continue given that it might affect the GDP.

The graph mention above and the table clearly points out that electricity related emissions in Australia are will stabilize around 2030 as the demand for electricity may not grow any higher and there may be a reduction in the emission- intensity of electricity production due to technological progress.(ACIL Allen Consulting, 2016) Hence, decreasing electricity emissions is not the absolute priority.

Different methods of pricing carbon

On the other hand, the high prices of electricity will have an immediate effect on the well being of the population. Hence, the government must adopt a strategy which sacrifices neither the emission reduction targets not the present well being of its population.

It has been observed that theprice of electricity has grown in spite of the tax being revoked. This suggests that the demand of electricity is growing at a very high rate and all measures must be taken to cope up with the demand.(Morton, 2017)

Australia would need to reduce electricity price, in order to maintain growth in the near term. Hence, the government could increase the supply of fossil- fuel based electricity by increasing the supply of gas-fired electricity plants. (Morton, 2017) In this analysis, it is also important to note that a majority of energy produced in Australia is from coal fired plants and the emission intensity of these plants, is generally, higher than gas- fired plant. (Morton, 2017)

One of the solutions that has received plenty of support is the adoption of an emission intensity based system for production of electricity (Morton, 2017). However, the government has been reluctant to do so. Adoption of a carbon intensity program would encourage power plants to either use better technology or cleaner fuels like gas instead of coal.


Carbon tax for businesses averaged at14.5%. Australian businesses have been largely affected by the carbon tax because they could not pass on the tax to their consumers. Thus, the incidence of carbon taxation fell on businesses, thereby, affecting their incomes. (Robson, 2014)

In an attempt to ease the pain of the introduction of carbon taxes , the Australian government planned to decrease the income tax to some extent. At the time of the introduction of the tax, the Australian Government modeled future GDP to find that the GDP of the country would permanently, with these costs (or the GDP sacrificed) growing over time. Based on the discount rate used, the However, Robson, (2014) is of the opinion that these the price / benefits of the carbon tax in the future were undervalued .

The carbon tax had two broad effects over the bedget of the government- it had the effect of increasing the revenues from taxation for the government and should have helped generate additional revenues of the government.On the other hand, the tax was introduced with cuts inpersonal income and policy provisions for additional spending and tax cuts on the compensation to individuals and indutries affected negatively by the tax.(Robson, 2014)

Discount rate analysis of investments in the benefit of reducing Greenhouse Gas emissions

The rise of electricity prices in Australia caused several proponents to suggest emergency intensity scheme.

ACIL Allen Consulting. (2016). Electricity emissions modelling for Australia’s emissions projections. Brisbane: ACIL Allen.

Arrow, K. J. (2007, June). Global Climate Change:A Challenge to Policy. Economists' Voice.

Arrow, K. J., Cropper, M. L., Gollier, C., Groom, B., Heal, G. M., Newell, R. G., et al. (2011). How Should Benefits and Costs Be Discounted in an Intergenerational Context? The Views of an Expert Panel. Washington, DC: US Environmental Protection Agency.

Carabott, M. (2017, August 7). Australians paying the World's Highest ELectricity Prices. Retrieved Spetember 2, 2017, from Leading Edge Energy:

Department of Environment and Energy, Commonwealth of Australia . (2016). Australia’s emissions projections 2016. Australia: Commonwealth of Australia .

Frederick, S. (1999). Discounting, Time Preference, and Identity. USA: Department of Social and Decision Sciences, Carnegie Mellon University.

Holderhead, S. (2016, December 5). Energy Intensity Scheme - instead of Carbon Tax pushed for Australia's Struggling Electricity Market. Retrieved August 31, 2017, from The Advertiser:

Lenzen, M., Murray, J., Sack, F., & Weidmann, T. (2006). Shared Producer and Consumer Responsibility: Theory and Practice. Ecological economics, 27-42.

Lipsey, R., & Chrystal, A. (2011). Economics. Oxford: Oxford University Press.

Morton, A. (2017, March 08). Energy crisis: Wholesale power prices have doubled since the carbon tax was axed. Retrieved August 31, 2017, from The Sydney Morning HEral:

Nash, E. (2011). Australia's Carbon Tax. World Wild Life Fund.

Organization for Economic Co-operation and Development. (2001). Glossary of Environment Statistics. New York: Organization for Economic Co-operation and Development.

Parliament of Australia. (2010, November 19). Emissions Trading. Retrieved September 2, 2017, from Parliament of Australia:

Riley, G. (2005). European Economy in Focus. BerkShire (UK) : Tutor 2 u online.

Robson, A. (2014). Australia's Carbon Tax: An Economic Evaluation. Economic Affairs.

Roca, F. (2013, November 27). Australia's Population Set to Double to 46 Million by 2075, Australian Bureau of Statistic Projections Set to Slow. Retrieved August 31, 2017, from ABC News:'s-population-set-to-double-by-2075/511775

Roy Morgan Research. (2011). Global Warming and Carbon tax. Melbourne: Roy Morgan Research.

Samuelson, P., & Nordhaus, W. (2004). Economics: Seventeenth edition. New Delhi: Tata McGraw Hill.

Stern, S. N. (2007, November 29). Stern: Climate Change A 'MArket Failure'. (A. Benjamin, Interviewer)

Taylor, L. (2014, July 17). Australia Kills off Carbon Tax. Retrieved September 2, 2017, from The Guardian:

Thomas, V. (2017, July 12). The Danger of Dismissing Market Failures. Retrieved August 30, 2017, from Brookings Insitute: htttp/

World Bank. (2017). Partnership for Market Readines: Carbon tax Guide - A Handbook for Policy Makers. Washington DC: World Bank Group.

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