Tuesday, June 24, 2008

Carbon leakage effects leak away

As is well known the global external costs of greenhouse gas emissions (GGEs) are ignored for Prisoner’s Dilemma reasons. This means that even if all countries would be better off with an agreement to cut their GGEs it makes sense for individual countries top defect from such an agreement. They can then either enjoy the benefits of other countries cutting GGEs without incurring the emission reduction costs themselves or derive benefits from joining other countries in not cutting back.

This provides a hindrance to negotiating an agreement to cutting back global GGEs.

Another claimed obstacle is the existence of carbon leakage effects. These were the source of Australian and US opposition to ratifying the Kyoto Protocol. Simply put the claim is that if Australia enacted strict quotas on carbon emissions or hefty taxes on these emissions then our aluminium smelting (and other) industries would relocate in countries such as China where they would pollute at perhaps even higher levels than when in Australia. Thus the global environmental situation would not have been improved but unemployment would have risen in Australia.

These types of effects mean that unilateral moves to control GGEs won’t work.

One response to such effects is to levy such things as carbon taxes on a destination basis. Thus Australians would be taxed on the aluminium they consumed (whether imported from a country not levying such a carbon tax or produced locally) not the aluminium they produce. Most of our energy exporting firms would then be exempt from carbon taxation though tariffs would be imposed on the import of carbon intensive goods not taxed in their country of origin. This would be a type of retaliatory tariff as more recently advanced by authors such as Joe Stiglitz – I provided a consulting report to Environment Australia urging such tariffs 10 years ago.

Recent studies discussed in The Economist suggest we should not be over-concerned with the leakage phenomenon. The authors of “Leveling the Carbon Playing Field” argue that with respect to carbon leakages:

‘the damage would be small.... Energy makes up less than 1% of the cost of making cars, furniture or computers. Even some energy-intensive industries, such as power generation, should not be much affected. Since they have no foreign competition, they could pass on extra costs to their customers.

Only a few industries—metals, paper, chemicals, cement and the like—are both global and profligate enough to be at risk. These accounted for just over 3% of America's output in 2005 and less than 2% of its jobs. Much the same is true in Europe: those industries, plus refining, account for less than 5% of output and an even smaller share of jobs....

Even those supposedly vulnerable industries do not seem to have wilted in the face of a carbon price....(the authors) cannot even detect any impact on aluminium, which is as energy-intensive and widely traded as any good. ...a shuttered smelter in Germany reopened in 2007, despite the rising cost of emissions.

There are many explanations for this resilience. One is that booming demand for aluminium and other commodities has kept all manufacturers profitable. Product specifications that vary from country to country, meanwhile, help to protect refiners from foreign competition. And Europe has handed out so many free permits to pollute that the costs of meeting its emissions cap have been negligible so far.

But putting a price on carbon may still do some harm in the future.... Europe is planning a tighter cap and fewer free permits. Many blueprints for emissions-trading in America call for no free allocations whatsoever. What is more, the biggest effects may come not in the short term, as factory closures, but later, as lower investment in new plant.

A study sponsored by Resources for the Future, an American think-tank, has tried to describe how American industry would meet a carbon price, albeit one of just $10 a ton—much less than the European price of over €25 ($39). Based on economic modeling, it concludes that industrial output would fall by less than 1%. The hardest-hit industry would be metals, but even that would shrink by only 1.5%. Better yet,
the damage could be offset by granting energy-intensive firms enough free permits to cover just 15% of their emissions.

Another study under way at the Pew Centre on Global Climate Change, another think-tank, sizes up a $15 carbon price using data on the past effects of rising energy prices on industry. It concludes that output would fall by 2% or less in 80% of cases. Paper and glass would face a bigger contraction, of 5%. Still, even the most vulnerable industries would not suffer the Armageddon that lobbying groups are predicting.

That is important, since it suggests that the politicians are over-reacting, and that their remedies may actually make matters worse. A carbon tariff....would be hard to implement. Customs officials would either have to assess the emissions embedded in imports, an impossibly complicated task, or make arbitrary assumptions, a recipe for a trade war. Moreover, it would do nothing to protect exports of energy-intensive goods from cheap competition.

Many studies also point out that carbon caps could bring benefits, in the form of factories making windmills, say, or solar panels. But these are even harder to quantify than the costs—and so they are even easier for the politicians to ignore.’

This last point sounds suspect. Investments incurred to meet the effects of GGEs are a cost not a source of income and are so regarded in such studies as the Stern Review. But the overall argument is sound.


drwoood said...

Very good post Harry,

My understanding is that price related factors that influence the carbon leakage associated with the reduction in production of a particular good are the price-elasticity of supply, the price-elasticity of demand, and the percentage of production of that good that is from countries that are reducing their greenhouse emissions in such a way that it affects production of that good.

A related factor is the amount of capital investment in an industry. Industries like aluminium production have huge capital requirements and relocating it overseas would require huge amounts of capital.

It seems to me that the prisoners dilemma issue is central to carbon leakage. I think climate policy in an individual country should be as much about resolving the prisoners dilemma as it is about its direct impact on emissions. One way of doing this is by providing examples of policies that work and can be replicated elsewhere. It would be a more efficient outcome for most countries to not worry about carbon leakage and reduce their greenhouse gas emissions that it would be if countries simultaneously reduced their emissions but tried to avoid carbon leakage by providing free permits to TEEIs or a similar policy.

It seems to me that emissions from fossil fuels that we export is a very similar issue. Suppose for example that we apply a carbon tax the coal that we export (possibly to countries that are not mitigating). This may reduce that quantity exported. The increase in the international price could lead to increased coal production elsewhere. How significant this effect would be would depend on price-elasticities of supply and demand, and on the size of our share of world coal production. Conversely if we continue to export coal as much as before, without internalising the social cost of carbon in any way, then are we free-riding in a prisoners dilemma?

sexy said...