Faculty of Economics and Business

The University of Sydney

Individual Assessment Cover Sheet Electronic submission

Last name:

Vu

First Name:

Quynh Huong

ID Number:

308128834

Email:

quvu9306@uni.sydney.edu.au

Unit code: ECOS3011_________ Unit name: _Public Finance

Tutors name (if applicable):_____________________Tutorial day/time:___________________

Full assessment title:___Essay on carbon emission reduction Methods Word count of assessment:_1415_________________________________________________

Due date:_05___/___10___/__2010__ _02__/_10__/_2010

Time & date submitted:__19.30____

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Executive summary The threatening global warming has become an increasingly important matter to policy makers. In Australia, it is estimated that under a high emission scenario, average temperature across Australia are expected to rise by up to 5 degree by 2070 (Carbon pollution reduction scheme pg 10).. This will strongly affect Australias agriculture, energy security, ecosystem, coastal community.Reducing carbon emission has emerged to be a major debate among politicians besides other important national economic and security issues. This paper will evaluate three main methods of reducing carbon dioxide : a tax on carbon emission, a cap and trade scheme and public investment or subsidy for renewable energy scheme. Each method has its own advantages and disadvantages in efficiency and equity issue, the Government should consider these issues in designing the best method for Australia. Evaluation of policies 1. Market based policy Market based policy includes two main methods : a tax on carbon emission and cap and trade scheme for Co2. The first method internalises externalities in to the price system, while the second one controls the total quantity permitted. 1.1 . A tax on carbon emission A corrective or Pigouvian tax works to bring the marginal social benefit equal to the marginal private cost at the efficient out put level ( Abelson 2008). Thus the value of the tax needs to equal the marginal damage cost at the efficient level of output of the externalities ( Abelson 2008). The tax is efficient as it encourages firm to produce at the efficient level of output, yet provides incentive for firm to achieve that level at least cost, as firm will continue seeking for most efficient production method that could reduce carbon emission. Some politicians even argue about the possibility of of carbon emission

Pigouvian tax to yield a double dividend, in the sense that the revenue collected from the carbon tax could offset other taxes if budget target remains the same, thus reduce distortions caused in other part of the economy ( Ploeg & Bovenberg 1994). However, there are some issues that the Government need to consider when using Pigouvian tax as a method to reduce Co2. Firstly, the determination of the unit tax (or effluent fee) remains a problem as measuring accurately the marginal damage cost is a difficult matter. The second problem regards to the distribution of the revenue collected from the tax- an equity problem. There is no guarantee that the victims of the externalities is the one that receive the compensation. In their model, Cropper and Oates (1992, pg 7) found that compensation of victims is not permissible, as if victims are compensated for the damages they suffer, they will no longer have the incentive to undertake efficient levels of defensive measures. This the job of the Government, to make sure that the revenue is used for the right purposes. The imposing of a corrective tax will surely affect the market, as producers can pass on the cost to consumers, thus causes distortion in the product market. This problem could be enhanced when operating in an uncompetitive market, or in the extreme case- a monopoly market. There is a possibility that the imposition of a Pigouvian tax on a monopolist could reduce, instead of raise social welfare, as the welfare gains from reduced pollution could not be offset by the welfare lost due to reduction in production of the monopoly ( Cropper & Oates 1992). Under this circumstance, if the government is not capable of issuing a first-best situation such as providing a unit subsidy to out put equal to the difference between marginal cost and marginal revenue at the socially optimum level of output, the Government could choose a second-best option to set the effluent fee equal the tax on a perfectly competitive market minus the welfare loss from the reduced out put from the monopoly (Cropper & Oates 1992).

1.2 Quantity control ( cap ) and trade scheme for Co2

As an alternative to the corrective tax, the Government can set a maximum quantity for carbon emission and let the market determines the price. The trading system has several advantages. It directly controls the quantity of the pollution- which is not always certain in the case of the Pigouvian tax. It produces a given reduction in pollution at least cost ( Abelson 2008, pg 239), as firm with low cost control will introduce control first, and sell permits to firms with higher control costs. Moreover, it also provides continuous incentive for firms to search for ways to reduce pollution ( Abelson 2008). The trading market ensure a cost effective out come, as even in the case that the government can not accurately determine the cost of Co2, as long as the firms themselves can assess whether it is cheaper either to buy permits or to reduce emission( Yale 2008, pg 5). It is also independent of how the permits is

distributed among firms (which is normally determined by historical date and could be inaccurate), given the incentive for firm to trade until their marginal cost equalise ( Coarse 1960).

Another major advantage of the trade scheme for carbon emission is its flexibility when determining the price of carbon, especially the world of growth and inflation. Changing the whole fee system is extremely costly (in the case of a Pigouvian tax), when a system of marketable permits could automatically adjust itself to growth and inflation (Cropper and Oates 1992).

However, there are also issues with this method. Firstly it carries an efficiency cost as the government forgoes the revenue thus have to rely more on ordinary distortionary taxes. The forgone revenue is inframarginal and therefore would

have yielded revenue at lower efficiency cost than ordinary taxes (Bovenberg, Goulder & Gurney 2005, pg 3).

Secondly, there is also concern over the equity matter of this method. It should not be a free distribution of Co2 emission, as it goes against the Polluter Pays Principle on the ground that those who use societys scarce environmental resources should compensate the public for their use (Cropper & Oates 1992, pg 15)

There is an issue that both of the two methods under the market based instrument category have to face, it is the problem of spatial differentiation, i.e different locations have different level of affect from pollution. This call for effluent fee according to location with tax system , or zone market for the trading system. However in practice, these are hard to conduct due to its complexity, thus needs Government attention to minimise the negative effect of the problem and ensure the equity of the method. 2. Public investment Public investment in or subsidies for renewable energy schemes is another option for government in the war against carbon emission. Recently, there has been many research on possible replacement for carbon emission, including hydro power, wind power, photovoltaicThese sources of power have become attractive as most of them are zero-emitting technology ( Bradley & Jones 2002). Although this policy is less likely to cause any distortion to the market, it does not ensure an efficiency level of carbon emission. The Research and Development could take years to finish, and the implementation, i.e changing the method of production to using the new energy could be unsuccessful if not well managed (Whittington 2002).

There is also an equity matter here, as the government uses tax payers money to invest in the new energy while big corporations that are responsible for the emission does not share the desirable burden. When the new energy has been fully developed, those big firms will be the most benefit one, as these new energy could help them reduce the cost of carbon emission . However, this issue could be reduced if the government uses tax hypothecation- take the revenue collected from the corrective tax to fund the research and development of the new energy. If the government could successfully implement both of the two methods- a corrective tax and effective use of the revenue for R&D activities, this will improve both the efficiency and equity matter of the two method. Conclusion As analysed above, each method has its own strength and weaknesses. Whether implementing one, or more than one method, it needs careful planning and good administration to ensure successful implementation. The implementation of a carbon emission system needs to be finished in near future time, due to the urgency of the global warming problem and its serious affect to the present and future generation of Australia.

Reference List Ploeg, F. V. D & Bovenberg, A. L. 1994, Environmental Policy, Public Goods and The Marginal Cost of Public ,The economic Journal, [Online], Available : JSTOR Abelson, O. 2008, Public economics Principle and Practice, McGrawhill, Australia

Cropper, M. L. & Oates, W. E. 1992, Environmental Economics: A Survey, Journal of Economic Literature [Online], Available : JSTOR

Coarsem R.H. 1960, Economics 1

The problem of social cost,

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Yale, E. 2008, Taxing Cap-and-Trade Environmental Regulation, [Online], Available : JSTOR

Bovenberg, A.L. , Goulder L. H, & Gurney, D.L. 2005, Efficiency Costs of Meeting Industry-Distributional Constraints Under EnvironmentalPermits and Taxes, The RAND Journal of Economics, [Online], Available : JSTOR

Bradley, M. J. & Jones, B. M. 2002 , Reducing Global NO x Emissions: Developing Advanced Energy and TransportationTechnologies, Ambio, Vol. 31, No. 2, [Online], Available : JSTOR

Whittington, H.W. 2002, Electricity Generation: Options for Reduction in Carbon Emissions, Philosophical Transactions: Mathematical, Physical and Engineering Sciences, Vol. 360,No. 1797, Carbon, Biodiversity, Conservation

and Income: An Analysis of a Free-MarketApproach to Land-Use Change and Forestry in Developing and Developed Countries, [Online], Available : JSTOR