Country CO2 Emission Responses to Carbon Taxes and Trading

1. Country CO2 Emission Responses to Carbon Taxes and Trading H. H. Stokes**, C. D. Tallarico*, and R. F. Kosobud** * Associate Professor of Economics, Dominican University, ** Professors of Economics, University of Illinois at Chicago

2. Overview • Goal of research: Design a politically feasible international response to the leading global externality, anthropogenic climate change. • Making use of existing scarce data, the focus of this study is to perform a comparison of two control measures, carbon trading and carbon taxes. • Both control measures, if implemented properly, can reduce the cost of constraining carbon emissions. The authors preliminary econometric model indicated that gasoline prices, a surrogate carbon tax, across countries proved statistically significant in reducing emissions. • The absolute value of the elasticity of CO2 with respect to our measure of a carbon tax was found to be greater for higher income countries. • Differences in elasticities between high and low per capita income countries suggest that differential tax rate might be considered. • This finding suggests that an aggregate cut in emissions could be achieved with differential tax rates, lower for countries with lower per capita income, and higher for higher per capita income countries.

3. Motivation • CO2 emissions arise from the use of fossil fuels, fertilizer, cattle feed, as well as from other sources located in almost all of the countries of the world. Many questions remain about the measurement and verification of these emissions. • A fraction of greenhouse gas emissions are accumulated into long-lasting concentrations and dispersed throughout the upper atmosphere with a number of feedbacks and lags of varying length. • Increased concentrations trap heat in the upper atmosphere depending upon climate sensitivity, again with lags of varying length. • This trapped heat, or global warming, results in a variety of climate changes ranging from temperature, precipitation, storm, and sea changes, among others, that takes place with lags, sometimes of long duration, and with regional variations. There could be winners and losers in these changes that complicate international negotiations. • Climate change can affect people, plants, and species causing harms that are at present not well documented, nor measured. Lags of varying length are clearly discernable in this area also • . • Control of climate change is as yet uncertain, and contentious, although a wide range of such controls has been under study including the two analyzed in this study. It will take international cooperation of a high order to negotiate acceptable agreements on the use and design of these control measures.

4. Past Evidence on Cap & Trade • The cap-and-trade approach has gained support among environmentalists, perhaps because the cap seems to imply a known reduction in pollution, and by the business community, perhaps because tradable permits are likely to be given away freely, as in most designs. The successful operation of the U. S. sulfur dioxide market is often cited as an example (Ellerman et. al. 2003). • Recent proposals of the Obama administration to auction permits has run into “blowback” from the business community that prefers allocations. Should the goal of emissions reduction be linked with the goal to raise tax money? This issue will not be discussed further here.

5. How does system work? • The EU Emissions Trading Scheme for CO2 control began in January 2005 and the 23 country members of this market comprised the largest cap-and-trade program yet established. • The overall annual allocation of permits was for a little over two billion tonnes of CO2, each permit was worth one tonne, and about 95% were allocated freely. • Emitters are free to trade or use permits to the point of cost effectiveness. The difficulties such a market can encounter were evident in the design phase. Benchmarking of emissions to determine country allocations proved troublesome for lack of data, both available and verifiable, and was mostly given up to be replaced by current emissions as a reference point. • The target for country emissions was set by negotiation ending in a significant variation between the Kyoto target or cap and current emissions, with some countries required to reduce emissions from current levels and some countries allowed to increase their emissions

6. What happened • The permit price plunged to less than ten euros per permit in 2006 but has climbed to over twice that amount currently, a figure closer to the marginal cost of reducing emissions by one tonne. • A debate has ensued about whether there was an over-allocation of permits or abatement, which has yet to be fully resolved. Much opinion has concluded that perhaps both were outcomes of the market. • What may be most significant is that 23 sovereign countries, members of the EU, came to a commitment to limit their emissions to the Kyoto target. Our objective is not to evaluate the market design, but to ask the question whether or not in the short time since 2005 any significant reduction is CO2 emissions has occurred that could be attributed in a statistical sense to the cap-and-trade market.

7. The problem as we see it • There is as yet no explicit carbon tax system that includes a number of countries. What is close to an implicit carbon tax is the tax on gasoline that most countries have levied. • Some countries have subsidized these prices in what amounts to a negative tax. It is difficult to separate out the tax rate for each of our countries, but the range of final prices from .04 to 1.9, when normalized around the mean, indicate that tax rates play an important role in the final price of this internationally traded fuel. • The cost-effectiveness argument is the same as for tradable permits, emitters are free to pay the tax or find alternative modes of transportation. Admittedly only the transportation sector is heavily influenced by this price, but it may serve as an indicator for the future role of carbon taxes in a more general sense.

8. Some Reasons for Public Support of Cap-and-Trade? • Environmentalists: Cap seems to imply a known reduction in pollution. • Business Community: Tradable permits are likely to be given away freely. • Goal of program: Reduce emissions not raise tax revenue.

9. Model • OLS, GAM and Recursive Models were used to investigate possible omitted variable bias. General case: m pollutants, n countries, p explanatory variables.

10. A General Additive Model (GAM) attempts to fit a polynomial to right hand side variables. These smoothed series will tend to lower e’e if there is nonlinearity in that variable. A diagnostic test is performed by restricting each right hand side variable to be linear and making a test on whether e’e increased significantly taking account of the degrees of freedom. Goal: Did the assumption of linearity bias the estimated coefficients?

11. If the variables in the model are scaled by their means then the estimated coefficient is the elasticity. Does the estimated elasticity differ by country per capita income? Recursively estimated coefficients for sorted data are used to investigate this possibility.

12. Data Used • Gasoline Prices - Fuel price per liter • GDP - GDP, ppp 2003 • Total Population - Population 2003 • CO2 Emissions - Carbon dioxide 2004 • Average GDP Growth - Growth for 2000-2003 • Kyoto Trading - Agreed percent reduction • CDM Recipient - > 0 => recipient • CDM Donor - > 0 => donor

13. CO2 Emissions • Gasoline Prices (-) • Gross Domestic Product(+) • Total Population(+) • Average Growth of GDP(+) • Kyoto Trading Mechanisms(?) • Clean Development Mech., Recipient (-) • CDM Donor (-)

19. Conclusions • Empirical evidence is consistent with the position that an aggregate cut in emissions could be achieved with a differential tax rate that was lower for lower per capita income countries than for higher per capita income countries. • The optimum tax rate increase is where at the margin the reduction in CO2 emissions is the same. • Quandt Likelihood ratio tests suggests high (low) income countries have per capita income greater (less than or equal to) $4,647. • As of yet there is no explicit carbon tax system that includes a number of countries. (Fuel tax an implicit carbon tax)

20. Topics for Future -Gasoline tax heavily impacts transportation sector. Should this sector “pay the cost.” -Obama proposal to auction permits uses cap-and-trade to both raise revenue and reduce emissions. This proposal impacts many more sectors. Is this model politically feasible? Do elasticities differ by per capita income within the US or across countries for this expanded approach?