Carbon Conundrum: How to Save Climate Change Policy from Government Failure
The Institute of Economic Affairs, 2022
135 Pages Posted: 19 Jan 2023
Date Written: August 9, 2022
Both the UK and the EU have made commitments to achieve carbon neutrality by 2050. Political leaders all over the world have promised ‘new green deals’ that involve embracing large-scale government intervention. These policies lead to substantial resources being allocated on the basis of politicians’ own technological preferences, rather than according to the principles of economic and technical efficiency.
Energy sources are both taxed and subsidised. In principle, environmental taxes and subsidies should reflect externalities. However, in practice, policy is chaotic with tax treatment reflecting the nature of the fuel, whoconsumes the fuel and for what purpose the fuel is used. In some countries, renewable energy receives large subsidies with little or no regard to the environmental benefit they actually deliver. Furthermore, fossil fuels are generally subsidised too. In the UK, that happens by an exemption from the general rate of value added tax.
On average, oil products are taxed at €405 per tonne of oil equivalent in the UK and €334 in the EU27, as compared with €135 and €101 for natural gas and €112 and €84 for coal. This is despite the fact that coal, not oil, poses the largest environmental challenges as far as climate change is concerned.
Energy sources, including those that are taxed and including fossil fuels, are also heavily subsidised. In 2018 energy subsidies were as high as €500 per head in the UK and €355 in the EU27. Most subsidies were given to renewable energy sources, the production of which was subsidised by €448 per tonne of oil equivalent on average in the UK and €320 in the EU27. Subsidies were higher for solar photovoltaics (€1,468 per tonne of oil equivalent in the UK and €2,019 in the EU27), followed by wind power (€961 and €743, respectively). Hydro power and bio-energies received, on average, much lower subsidies. These differential subsidies to different forms of renewable energy sources are wasteful and inefficient. Subsidies to fossil fuels were generally intended to support consumption rather than production. On average, oil, natural gas and coal received €130, €61 and €86 per tonne of oil equivalent in subsidies in the UK and €320, €47 and €27 respectively in the EU27.
If we net off taxes and subsidies, we find that, on balance, renewables are heavily subsidised, while fossil fuels have greater taxes levied on them than they receive in subsidies. However, there is no coherent pattern. The net effect of taxes and subsidies leads to substantially greater net taxes on oil than on natural gas while coal is taxed the least. The level of net taxes on energy sources does not, in any way, relate to the externalities from the energy source. If the EU-sponsored estimates of external costs from energy sources is taken as a benchmark, it can be said that all energy sources are either under-taxed or over-subsidised.
It is clear that taxes and subsidies on energy sources are not designed as a rational tool of environmental policy. They are part of a broader industrial policy that reflects the individual preferences of policymakers and the producer and consumer interest groups that influence them.
This means that current green policies are more costly than they need be. A rational system that taxed energy sources according to the damage caused by their emissions would ensure that greater levels of carbon reduction would be possible for a much lower economic cost. It would also make use of decentralised information, as individuals would be able to reduce carbon emissions in the way that was least costly for them.
Climate change is by no means the only externality from the use of energy. Many other externalities have a local, not a global, nature. The problems are not significantly different from a range of other scenarios where economic activity by one party has an impact on another party. Externalities with a local impact do not justify either taxes or subsidies at the national level. They require a legal, institutional and constitutional framework which allows the maximum scope for preferences to be expressed through various bargaining and charging mechanisms at the local level.
Decarbonisation has been established as a key policy objective for the UK and the EU. Economic efficiency, including efficiency of capital allocation, are especially important in this process given the immense costs involved. For this reason, the government should stop its policies of trying to pick winners, subsidising fossil fuels and subsidising renewables and levy a carbon tax proportional to emissions. Estimates of the damage caused by emissions may vary and those used by the EU are contestable. Thus, there is room for debate on how big a carbon tax should be. However, this is the most efficient mechanism available for reducing carbon emissions.
The proceeds of a carbon tax should be used directly to reduce the tax burden in other areas. Welfare benefits would be uprated as a result of the impact of a carbon tax on prices. The aim of a carbon tax is to price carbon and not to increase the tax burden.
The invasion of Ukraine by Russia does not change the argument. Indeed, it makes it more important that we adopt policies that lead to the efficient consumption and production of energy.
Keywords: climate change policy, climate change, carbon, government failure
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