Originally published: November 2021
‘Internalising externalities’ is something economists worry a lot about. It sounds like economic jargon, but at its heart is an important question: how do you make the free-market work when a transaction has negative side effects the producer or consumer don’t care about?
Socialism commonly looks at these negative side effects (‘externalities’) as evidence that free markets don’t work, and that economic activity should be brought under state control. More often than not though, there are ways of ‘internalising’ the externality such that those involved are forced to factor in the externality, and its harmful effect on the wider community, into their decision-making. Typical ways of doing this are fines, taxes, subsidies, and criminal sanctions.
An externality of buying (and consuming) cigarettes, for example, would be added pressure on the NHS and the resultant burden on all taxpayers. The Government has, however, largely ‘internalised’ this externality by adding a hefty tax onto tobacco products. The tax removes the externality by (a) reducing the number of cigarettes consumed (due to the higher price threshold) and (b) raising tax revenue to pay for the additional healthcare needs of smokers.
So, how does this all relate to climate change? Well the primary cause of climate change – adding CO2 and other greenhouse gases to the atmosphere – is a large, negative externality that is involved in almost all the economic transactions we engage in on a daily basis, from our daily commute to turning on the stove. This externality is acknowledged, but dealt with incredibly inconsistently, and almost never to the extent that it is fully internalised. Let’s take fuel as an example. Aviation fuel is taxed at almost half the level of petrol, while heating fuel actually gets a VAT discount.
A much better option than this current smorgasbord approach is a single, flat tax on each tonne of CO2 (or CO2 equivalent) produced. Tim Harford wrote in the Financial Times about the transformative effect such a tax, set at the right level, could have on everyday decision-making. One example he makes is that British consumers would no longer be left guessing as to whether British strawberries (which need artificial heating but little travel) are better for the environment than Spanish strawberries (which benefit from good weather but must be flown in) – the impact of the strawberries’ emissions would already be factored into their price at the shops. Consumers’ desire for a good deal alone would direct them away from the more expensive high carbon produce and towards ‘greener’ fruit.
On the supply side, companies would be incentivised across the board to reduce their carbon emissions and to develop low-carbon, or even negative-carbon, technology. Crucially though, they would be incentivised to start with the lowest hanging fruit and the highest emission activities, and not with whichever product, activity, or technology happens to have an imperfect tax or subsidy randomly assigned to it that year. Companies that didn’t reduce their carbon emissions would end up with a higher cost base than competitors and would ultimately become uncompetitive.
But what about imports? It’s often pointed out that the UK’s (and other developed countries’) reduction in CO2 emissions over the last 30 years is partially (and only partially – genuine improvements have also been made) due to the off-shoring of production. For every T-shirt factory that has moved from the UK to India there is a reduction in UK emissions, but no reduction in global emissions (indeed, often there is an increase). Wouldn’t a UK carbon tax make this situation worse?
The best solution is a global carbon tax, imposed consistently and reliably across the world. However, assuming this is not possible in the short term, a ‘carbon import tax’ would be a reasonable proxy that a ‘coalition of the willing’ could employ in the interim.
A carbon import tax could be applied to all products coming from countries that haven’t signed up to a global carbon tax. The level would be based both on the estimated energy required to produce a given product and the average emissions level of the country the product was produced in. Producers that could prove significantly lower emissions than estimated (e.g. their manufacturing uses only renewable energy) could apply to be exempt from all or part of the tax.
This tax would have three main benefits:
1) It would incentivise global companies to consider national carbon emissions when deciding where to build a factory, and also to find ways of reducing their own emissions, even if there is no local incentive to do so
2) It would create a fairer system for domestic producers forced to compete against imports from countries that don’t have an equivalent domestic carbon tax
3) It would incentivise countries like China and India, whose economies still largely depend on exports to the developed world, to factor the global externality of carbon emissions into policy making to a much greater degree than they currently do
And it is this third point that is most important. Domestic carbon reduction is important and commendable, but the even if the UK were to eliminate emissions tomorrow, it would barely make a dent on global emissions when India announces a ‘net-zero date’ of 2070. However, by coming together with other major global importers, such as Japan, Canada, the EU, and the US, to agree a carbon import tax, we can effectively force other countries to reduce their emissions, appealing not to their morality or goodwill, but directly to their economic interests.
And that’s the beauty of ’internalising the externality’ of carbon emissions via a carbon tax – be it a global carbon tax or domestic carbon taxes allied with a carbon import tax – it forces consumers, producers, and even governments to take into account their impact on global warming purely by being rational economic actors. Done well, a carbon tax is in fact the capitalist’s solution to climate change – not tying back fingers of the invisible hand, but rather increasing its dexterity.
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