CO2 tax? Emissions trading? Both!

Article published in Frankfurter Allgemeine Zeitung, 15 August 2019 (Translation by the authors)
By Frank Jotzo and Andreas Löschel

What is better, a CO2 tax or an emissions trading system? Opinions in politics and business are sharply divided on this question in the current discussion in Germany about the introduction of CO2 pricing in Germany for sectors that are not covered by the EU emissions trading system which covers power stations and industrial plants. This expansion would cover mainly the buildings and transport sector. Environmental economists by contrast are generally relaxed about whether to use a tax or trading, as both instruments do the same thing. There is even a middle course - a carbon tax that is gradually being converted into an emissions trading scheme, as tested earlier in Australia.

A CO2 tax and an emissions trading system both create an economic incentive to reduce emissions and thus save costs. If the level of a CO2 tax is equal to the price in an emissions trading scheme, then both are equally effective in reducing emissions.

However, we do not know in advance what the price under emissions trading will be, because it results from the interplay between supply and demand for emissions certificates. If the emission target is easy to achieve, the price will be lower; if the emissions target is demanding, the price will be higher. This can only be predicted to a limited extent; the market price depends on many factors, such as technological or economic development. Emissions trading therefore assures what future emission reductions will be achieved, but not at what price. The reverse problem exists with the CO2 tax: policymakers set the price, but it is unclear what emissions level will result from it.

So the question for policy is this: What is important - to achieve a given target with certainty or to make the CO2 price predictable? The answer in Germany's current debate about carbon pricing in the sectors outside the EU emissions trading scheme is ultimately "both".

And fortunately, it is possible to structure emissions trading in such a way that it allows the price to be controlled by government, and thus resemble a tax. Most emissions trading systems have a maximum price at which additional certificates are issued in the market to stabilise the trading price at the upper limit. Many trading systems also have a minimum price below which no new allowances are issued, so the market price is supported at that level.

When introducing a CO2 price for the buildings and transport sectors, it can make sense to have complete price certainty in the beginning in order to protect consumers from unpleasant surprises. Later on, a trading system may be preferable in order to achieve a given emissions target with certainty. It was precisely these considerations that played a role in the design of Australia's carbon pricing mechanism introduced in 2012. The solution at that time was a "fixed-price" emissions trading system.

Climate policy regulation in Australia was designed as emissions trading, but for an introductory period of three years the certificate price was set by government. Contrary to standard emissions trading schemes where a fixed quantity of certificates is issued every year, during the first three years there was to be no limit on the quantity of allowances that could be bought directly from the government at a predetermined price. The effect was similar to that of a CO2 tax, but the system already included all the infrastructure of a certificate trading scheme and could be converted into emissions trading without legislative changes. All that needed to be done was move from selling certificates at a fixed price to auctioning a fixed quantity of certificates.

The CO2 price was set at A$23 (in 2012 about 18 euros) per ton of carbon dioxide equivalent when the "fixed-price emissions trading system" was introduced in Australia. It rose by about one dollar per year. The start of emissions trading via a fixed price scheme thus avoided the risk of an initial cost shock. A change of government in Australia prevented the transition to emissions trading and the planned integration of the Australian system into EU emissions trading system.

Applied to Germany, this means that two questions in particular need to be answered: First, what should the initial fixed price be and how should it develop over time? Second, how should the transition to an emissions trading system be structured and with which other sectors and countries should the German emissions trading system in the building and transport sector be linked?

A survey of economists on the IFO/FAZ panel of German academic economists gives an indication of opinions on this issue. The median CO2 price that the economists suggested is around 75€/tCO2 for the year 2030. A correspondingly lower fixed price, e.g. of 50€/tCO2, would have to be set for 2020, rising e.g. by 2€ annually. A majority of the economists surveyed advocate extending the EU emissions trading system to the non-ETS sectors. Therefore, a comprehensive integration into the EU emissions trading system should be negotiated in parallel to the introduction of the German fixed price. If this does not succeed, however, then the participants in the panel of economists favour a CO2 tax over a purely German emissions trading system in the building and transport sector. The fixed price would then remain until the expansion of the EU emissions trading scheme becomes possible.

The Australian CO2 price did not survive long. This was not because of the design of climate policy, but because of a profound political split on climate policy. But if there is fundamental agreement on a market-based approach to climate policy, then a fixed-price emissions trading system would be a good way of introducing national CO2 pricing. In this way, Germany could avoid the cost risk of introducing CO2 pricing and would later be able to switch to an emissions trading system and thus be sure to achieve a chosen emissions target. It would be a wise compromise.

Frank Jotzo is Professor of Climate and Energy Economics at the Australian National University in Canberra. He was involved in the analysis for the design of the Australian emission price system.

Andreas Löschel is Director of the Centre for Applied Economic Research at the University of Münster and, since 2011, Chairman of the Expert Commission on the Federal Government's "Energy of the Future" Monitoring Process.


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