CARBON TAX AND CAP AND TRADE VERSUS CARBON TAX OR CAP AND TRADE IN EUROPE

1. JORNADA DE CO2 Y FISCALIDAD:
Cuestiones Actuales
CEU
Instituto de Disciplinas y Estudios Ambientales
UNIVERSIDAD CARDENAL HERRERA
IMPUESTO SOBRE EL CARBONO Y LIMITACION DE
EMISIONES VS. IMPUESTO SOBRE EL CARBONO O
LIMITACION DE EMISIONES
Guillermo G. Ruiz Zapatero
Valencia December 15, 2009
All opinions expressed here are those of their autors

2. SCIENCE CULTURE
ON C02 SOURCES AND SINKS

3. GLOBAL WARMING A TALE OF TWO CULTURES
A tale of two cultures (Nordhaus)
The natural sciences are doing an admirable job of describing the geophysical
aspects of climate change. The science behind global warming is well established.
Designing an effective political and economic strategy to control climate change will
require the second culture the social sciences to analyze how to harness our
systems to achieve our climate goals effectively and at low cost.
The design of policy instruments: quantity-based or price-based constraints
The quantity approach embodied in the Kyoto Protocol (it will be useful to call it the
Kyoto model (European Trading Scheme in Europe)) will not accomplish the goals
of those who would like to slow climate change. As currently designed, it is both
inefficient and ineffective and should be supplemented or replaced (Nordhaus).

4. INCONVENIENT ECONOMIC TRUTHS
Emissions of carbon dioxide are externalities, i.e., social consequences that are not
accounted for in the market place. They are market failures because people do not
pay for the current and future costs of their emissions.
If economics provides a single bottom line for policy, it is that we need to correct this
market failure by ensuring that all people, everywhere, and for the indefinite
future face a market price for the use of carbon that reflects the social costs of
their activities.
Raising the market price of carbon provides strong incentives to reduce carbon
emissions through four mechanisms . First, it provides signals to consumers
about what goods and services produce high carbon emissions and should
therefore be used more sparingly. Second, it provides signals to producers about
which inputs (such as electricity from coal) use more carbon, and which inputs
(such as electricity from wind) use less or none. It thereby induces producers to
move to low-carbon technologies. Third, high carbon prices provide market signals
and financial incentives to inventors and innovators to develop and introduce
low-carbon products and processes which can eventually replace the current
generation of carbon-intensive technologies . Finally, and most subtle of all, the
use of carbon pricing economizes on the information requirements that market
participants need to undertake each of these three tasks. Of course, without a
strong price signal, there is simply no hope for making the vast number of
decisions in a remotely efficient manner.

5. WARMING AS GLOBAL PUBLIC GOOD
Economics leads to a second important truth about climate-change policies. The
analytical basis for an efficient global-warming policy is extremely simple. Because
global warming is a global public good, everyone, everywhere must face the
same price.
The European Trading Scheme (ETS) covers only about half of EU emissions.
The most controversial policy question : the decision whether to rely primarily on
quantity-based or price-based constraints
Relative advantage of a cap-and-trade system (such as is embodied in the Kyoto
model and the ETS), or a carbon tax system (such as is used for limiting gasoline or
cigarette consumption).
System of harmonized domestic taxes on carbon emissions. Conceptually, the
carbon tax is a dynamically efficient Pigouvian tax that balances the marginal social
costs (ANNEX I: Nordhaus) and marginal social benefits of additional emissions.

6. CAP AND TRADE (ETS) SHORTCOMINGS
There is no experience zero with international cap-and-trade systems.
Quantitative limits have proven to produce severe volatility in the market price of
carbon under an emissions-targeting approach. The volatility arises because of the
inelasticity of both supply and demand of permits.
The volatility of CO2 allowances in the EU ETS was large: in the period from October
2008 to February 2009 alone, ETS carbon prices varied between 9 and 24 per ton
of CO2 (also see ANNEX II : Metcalf).
It should be emphasized that the volatility of allowances is not due to policy errors. It
is inherent in this kind of instrument.
International counterproducti ve effect: A higher domestic price of carbon leads to an
increase in the social cost of production beyond the point at which the domestic
cap or ceiling is reached (Gros: Why a cap-and-trade system can be bad for your
health ).Differences in carbon intensities.
Whatever initial target we set is almost sure to prove incorrect for either taxes or
quantities
The cap-and-trade approach is a poor choice of mechanism. It is untested in the
international context; it has been unable to attain anything close to universal
participation; and it has the inherent flaws just described

7. IT IS TIME TO DECIDE ON TAX VS CAP&TRADE
Despite its clear advantages carbon tax has not been the preferred policy
option.Only a few countries, mainly in north europe, apply the tax.
Path dependence could make that option harder at a later stage
To design durable and effective international economic systems is difficult. They are
complex ecosystems, full of hidden prey and predators, with many unforeseen
results. History is littered with failed institutions. You need only look today at the
wreckage of the current financial system.
So, if the Kyoto model (European Trading Scheme) turns out to be another failed
model, it has lots of company.
But it would be better to recognize and change it now, rather than in one or two more
decades of ineffective and inefficient efforts to slow emissions (Nordhaus).
That is the alternative the EU, its member states and citizens are alltogether facing
now and such decision should not be neither avoided nor postponed

8. THE EUROPEAN COMPROMISE BETWEEN CARBON TAX
AND THE ETS (CAP&TRADE)
MAIN FEATURES OF THE PROPOSAL A MENDING DIRECTIVE 2003/96:
Distinction between CO2 related taxation (EUR/kgCO2) and general energy consumption
taxation (EUR/GJ)
Exemption of CO2 related taxation for activities subject to and not excluded from the
Community scheme within the meaning of Directive 2003/87/EC (ETS) (art. 14.1.d))
Exemption of energy products and electricity issued to produce electricity (only from
general energy consumption taxation) (art.14.1.3)
Exemption of fuel for the purposes of navigation within Community waters (art. 14.1.c))
As regards CO2 related taxation, the tax shall not apply to energy products that are
biomass
Only differentiated rates depending on consumption levels could be applied to CO2 related
taxation, provided that they respect the minimum levels (art. 5)
Minimum levels of taxation applicable from 1 January 2013 to motor fuels (articles 7.1 and
7.2 (0,03 /kg CO2) and article 8.2 (0,01 /kg CO2)) and to heatings fuels (0,01 /kg CO2)
Minimum levels of taxation applicable from 1 January 2013 to electricity (nil)

9. THE EUROPEAN COMPROMISE BETWEEN CARBON TAX
AND THE ETS (CAP&TRADE)
MAIN FEATURES OF THE PROPOSAL A MENDING DIRECTIVE 2003/96 (II):
TOTAL O PARTIAL EXEMPTI ONS OR REDUCTIONS IN THE LEVEL OF TAXATION TO
Electricity from the origins specified in article 15.1.b) (solar, wind, wave, tidal or
geothermal;hydraulic origin; biomass, methane from abandoned coalmines;fuel cells)
Energy products and electricity used for Combined Heat and Power generation (articles
15.1 c) and d))
Energy products and electricity used for the carriage of goods and passangers by rail,
metro, tram and trolley bus
Fuel used for navigation on inland waterways
Natural gas in members states in which the share of its in finally consumption was less than
15% in 2000
Energy products and electricity used for non business activities of households and
charitable organizations

10. THE EUROPEAN COMPROMISE BETWEEN CARBON TAX
AND THE ETS (CAP&TRADE)
MAIN FEATURES OF THE PROPOSAL A MENDING DIRECTIVE 2003/96 (III):
Tax reductions (provided minimum levels are respected on average) on products ussed for
heating purposes or for the purposes of article 8 (2)(b) (stationary motors) and (c) (plant
and machinery used in construction) in the following cases:
Energy intensive business (article 17.1.a)
Agreements or tradable permit schemes to achieve environmental protection or
improvements in energy efficiency (article 17.2, 3, 4 and 5). Tradable permit schemes shall
mean other permits than those traded in the ETS.
Until 31 december 2020, Member States shall exempt from CO2 related taxation the use of
energy products for purposes other than those referred in article 7, in a unit subject to
qualifiying expenditure (article 17.a):
The amount of the exemption shall not exceed 70% of the qualifiying expenditure
Qualifiying expenditured shall be capital expenditure leading to a reduction of at least 20%
of CO2 emissions
Proof of the reductions achieved through the capital expenditure

11. ISSUES RAISED BY BUSINESS EUROPE: NO TAXATION OF
INSTALATIONS COVERED BY THE ETS
1. No taxation of installations covered b y the ETS (Article 14.1.d) )
No carbon tax on installations covered by the ETS whether or not allowances are allocated free of
charge
Background
Under the EU ETS, full auctioning of emission allowances will be phased in from 2013.
Installations from sectors deemed to be exposed to a significant risk of carbon leakage will receive
relatively more free al lowances than other sectors. Free allowances will in principle be allocated based on
product-specific benchmarks for each relevant product.
The starting point for the benchmarks is the average of the 10% most efficient installations in a sector.
The benchmarks will be multiplied by historical production to calculate the amount of free allowances to
be allocated and in order to ensure a declining cap, a correction factor will be applied.
For carbon leakage sectors, the free allocation will be multiplied by a factor 1 (100%) while for other
sectors the allocation will be multiplied by a lower figure (0,80 in 2013,and reduced every year to reach
0.30 in 2020). Nevertheless, exposed sectors are not 100% exempt from the auction costs.
Because of the over-all EU CO2 cap, a nd the fact that the benchmarks will be stringent, the ETS is not for
free also for the most efficient installations.

12. ISSUES RAISED BY BUSINESS EUROPE: NO TAXATION OF
INSTALATIONS COVERED BY THE ETS
BUSINESSEUROPE position
There must be no CO2 tax on installations/final energy consumption (electricity) covered by
the ETS (including free allowances): CO2 taxation on EU ETS installations would raise
production costs without generating additional emission reductions. Therefore, installations
and final energy consumption (electricity) already covered by the ETS must be exempted
from the CO2 tax to avoid economic inefficiencies.
A CO2 tax on EU ETS installations that receive free allowances to compensate for carbon
leakage will create the negative effect on competitiveness that free allocation aims to avoid.
Even when receiving (partly) free allocation of allowances, the installations will face a price
on carbon emissions: the cap on emission allowances will decrease by 21% until 2020 and
companies outside a narrow efficiency benchmark will have to partly buy their allowances
already in 2013.
Exemptions from a carbon tax for ETS installations as foreseen for the revision of the
Energy Tax Directive should not be challenged by the State Aid guidelines.

13. ISSUES RAISED BY BUSINESS EUROPE: NO TAXATION OF
OTHER COVERED BY EM
2. No taxation of installations covered by equivalent measures (article 17.1.a) and
b))
Mix of equivalent measures to the carbon tax at the national level to (a) allow small
installations to opt out from ETS and (b) cover emissions from non-ETS sectors
Background
The term equivalent measure is normally used with reference to the ETS Directive
(2009/29/EC, art. 27) which stipulates that small installations can be excluded from the ETS
if they are subject to equivalent measures or measures that will achieve equivalent
contribution to emission reductions . According to point 11 of the pre-amble Such
measures could include taxation, agreements with industry and regulation.
Under the current Energy Tax Directive, Member States may apply tax reductions in favour
of energy intensive businesses and where agreements are concluded with undertakings or
associations of undertakings, or where tradable permit schemes or equivalent
arrangements are implemented, as far as they lead to the achievement of environmental
protection objectives or to improvements in energy efficiency.

14. ISSUES RAISED BY BUSINESS EUROPE: NO TAXATION OF
OTHER COVERED BY EM
BUSINESSEUROPE position
Voluntary agreements between industry and government at national level are the preferred
equivalent measure for European business. To mirror the ETS Directive, such voluntary
agreements should lead to commitments for concerned industries in terms of CO2 reduction
(which implies a monitoring and penalties system).
Where national schemes have been proved to meet challenging energy and emission
targets, e.g. Climate Change Agreements, they should be approved as equivalent
measures.
Companies exempt from the ETS, and subject to other equivalent measures than taxes,
should be exempted from a CO2 tax.
Small installations not covered by the ETS Directive, as they do not reach the thresholds
in Annex I should also be eligible for equivalent measures and exempted from the carbon
tax.
Where national schemes for reducing emissions in the non-ETS sectors are in place,
countries should be allowed to opt out of from the EU CO2 tax framework.
Existing national CO2 tax regimes should be recognised as equivalent for emissions
covered by the Energy Tax Directive framework as long as they respect the ETD provisions.
Some Member States have high energy taxes on environmental grounds. If national
energy tax rates are above the combined EU minimum of energy and carbon taxation,
this should trigger exemption from the carbon tax.

15. ISSUES RAISED BY BUSINESS EUROPE: MIRROR FREE
ALLOCATION IN TAX SYSTEM
3. Mirror free allocation in tax s ystem
How can the free allocation of emission allowances for ETS installations be replicated in
the European framework for carbon taxation?
BUSINESSEUROPE position
To mirror the EU ETS free allocation, they propose the following options:
For small installations from ETS sectors: Exempt sectors on the ETS carbon
leakage list from carbon taxation. Ideally, tax reductions for individual installations
would be in line with the % of free allocation from sectoral or sub-sectoral benchmarks
or other fall back options. Given that allocation of emission allowances to installations
in carbon leakage sectors is not completely free, the reduced CO2 tax might be
computed based on the estimated ETS cost (e.g. % of allowances the ETS
companies will have to buy).
For installations from non-ETS sectors: develop quantitative criteria that allow to
identify which non-ETS sectors are exposed to the risk of relocation under a carbon
tax and exempt them based on the efficiency of the processes.
Implement a transitory period for installations covered by the carbon tax and
not exposed to carbon leakage in line with ETS auctioning rules: a linear increase
with 20% of CO2 tax in 2013, 70% in 2020 and 100% in 2027. Further exemptions
might be needed to prevent distortions of competition in specific situations.
BUSINESSEUROPE believes there is no case for abandoning certain exemptions
such as the existing Energy Tax Directive exemption for mineralogical transformation
to ensure that these sectors remain competitive compared to sectors receiving free
allowances under the ETS.

16. ISSUES RAISED BY BUSINESS EUROPE: MIRROR FREE
ALLOCATION IN TAX SYSTEM
Additional observation: the ETS covers installations, but the Energy Tax Directive (ETD)
makes reference to processes. This could limit the efficient combination of the ETS and the
ETD.
They urge the Commission to consider alternatives to avoid creating excessive compliance
requirements for companies and governments. This issue has been considered in the draft
of the French finance bill: installations of energy intensive industries or industries using
biomass as fuel are exempted from the French carbon tax provided that they will be
subjected to ETS in 2013.

17. ISSUES RAISED BY BUSINESS EUROPE :USE OF OFFSET
MECHANISMS
4. Use of offset mechanisms
How can the use of offset mechanisms for ETS installations be replicated?
Background
Companies can convert international carbon credits from Joint Implementation projects or
through the Clean Development Mechanism into allowances that can be used for
compliance under the EU ETS. Moreover, 50% of EU ETS auctioning revenues should be
earmarked to environmental improvements through incentives for eco-innovation, carbon
capture and storage projects, renewables or reforestation (Art. 10.3 ETS).
BUSINESSEUROPE position
A similar offset mechanism should be envisaged for a carbon tax to ensure cost efficiency
and a level playing field. Therefore, we strongly support to keep Art 17a of the draft
proposal for revision of the ETD which foresees an exemption from CO2- related
taxation for CO2-reducing investments (up to 70% of investment). International offset
could be implemented through widening the scope of this article also to international
emission reduction projects. With regard to respecting the Treaty s freedom of
establishment, article 17a should also allow for offsetting the carbon tax by reducing
emissions in installations in another Member State.

18. ISSUES RAISED BY BUSINESS EUROPE: EXPECTED
ADMINISTRATIVE COSTS
5. Expected administrative costs
On the basis of the current draft for revision of the Energy Tax Directive: what are the
expected administrative costs
BUSINESSEUROPE position
A high level assessment indicates an additional administrative cost of at least 50 M (one-
off to reset the systems) and additional cost of product analyses of some 1,5 M / year if
the reporting fundamentals change from volume and weight to CO2 factors and
GJ . Mitigation of some of these costs is possible if the Commission would provide
Standard conversation factors and reporting system fundamentals would not need to be
changed to cope with "CO2 factors" and "GJ" rather than with volume and weight. These
costs do not include the potential additional compliance and pre-financing burden that
occurs from the fact that the carbon tax is introduced next to the EU ETS. According to the
Commission, the carbon tax will be handled like an excise duty, e.g. collected by the
supplier for the tax authority.
It is unclear how the supplier should make the difference between different sizes of
installations, one inside ETS and one outside when providing the company with
energy. Moreover, in case where the tax would be recovered by energy suppliers,
important changes in current reporting and invoicing systems might be required since the
scope of consumers subject to the taxation might evolve and exemptions / derogation
processes must be entered into existing IT systems.

19. ISSUES RAISED BY BUSINESS EUROPE: EXPECTED
ADMINISTRATIVE COSTS
It is therefore not possible for the Commission to conclude so quickly on the non-
issue of administrative costs and detailed impact assessments should therefore be run to
analyze the question in depth.
Moreover, on the basis of such assessments, appropriate measures should be designed in
order to provide for cost recovery mechanisms or upfront exemptions for fuel and energy
supplies to sectors covered by the EU ETS. A refund mechanism would require such
sectors to pre-finance the carbon tax. This is a cost that most installations are either already
bearing through the EU ETS or should not have to bear to avoid carbon leakage. Such
inefficiencies should be avoided, especially in the current financial climate. Finally, a
transition period would be needed in order to allow companies sufficient time to implement
the new modalities.

20. PROVISIONAL CONCLUSIONS (I)
PRICES ( CARBON TA XES) OR QUANTITIES (CAPS) BUT NOT BOTH
CARBON TAX SEEMS A BETTER POLICY TO REDUCE CARBON EMISSIONS
THROUGH SIGNALS TO CONSUMERS, PRODUCERS AND INNOVATORS AND
TO ECONOMIZE ON THE INFORMATION REQUIREMENTS THAT MARKET
PARTICIPAN TS NEED (Nordhaus)
COORDINATION OF CARBON TAX AND ETS IS A COMPLEX, DIFFICULT AND
COSTLY TASK
COORDINATION OF CARBON TAX AND ETS SENSIBLY PROPOSED BY
BUSINESSEUROPE WOULD LEAVE A RESIDUAL CO2 TAXATION -COMPARED
WITH THE INITIAL TAXABLE BASE- AND HIGH AD MINISTRATIVE COS TS
UNILATERAL CAP & TRADE (ETS) WITH HIGHER DOMESTIC CARBON PRICE
LEADS TO AN INCREASE IN THE SOCIAL COST OF PRODUCTION BEYOND
THE POINT AT WHICH THE DOMES TIC CAP IS REACHE D (Gros)
A CARBON PRICE WOULD NEED BORDER TAX ADJUSTMENTS. THE BTA
GIVES THE OTHER C OUNTRIES INCENTIVE TO ADOPT A CARBON POLIC Y

21. PROVISIONAL CONCLUSIONS (II)
A CARBON TA X COULD BE BETTER ADJUSTE D THROUGH TIME (Nordhaus)
A CARBON TAX WOULD ALSO NEED TO ADDRESS THE PHASING OUT OF
FOSSIL-FUEL SUBSIDIES: SUBSIDISED PRICES ARE ALSO PART OF THE
PROBLEM
A CARBON TA X SHOULD BE USED TO FINANCE TAX REDUCTIONS IN INCOME
TAX (A GREEN E MPLOYMENT TAX SWAP?; Metcalf))

22. ANNEX I
Figure 1. Central case and uncertainty bands for social cost of carbon
The figure shows the central case and the current uncertainty bands for the social cost of carbon (SCC) at different
dates in the future. The square and circle in the center of the bars are respectively the certainty equivalent for the
SCC and the mean SCC for the 100 runs in a Monte Carlo uncertainty analysis. This is for the base no-controls
case for the DICE-2007 model. (Source: William Nordhaus, DICE model.)

23. ANNEX II
Figure 2. Volatility of Prices under a Cap-and-Trade Regime
This figure shows the history of two contracts under the EU Emissions Trading Scheme. The volatility is
representative of trading prices for allowances under cap-and-trade systems. (Source: Gilbert Metcalf, A
Proposal for a U.S. Carbon Tax Swap, Hamilton Project.)

24. ANNEX III: Policies to Cut Emissions
I. Traditional regulations
II. Direct subsidies for certain technologies
III. Economic incentives (price per ton CO2 )
A. Cap-and-trade permit system
B. Carbon tax

25. ANNEX IV: Comparing a Tax vs. Cap-and-Trade
Source: Prof. Don Fullerton: Choice of Climate Policy in the EU
OR: a vertical supply curve
(a fixed number of permits)
Price
(in per ton)
A tax, per unit of pollution,
imposes a price, like a flat
supply curve
Demand ( willing to pay
for the right to pollute)
Quantity (millions of tons)

26. ANNEX V: Comparing a Tax vs. Cap- &-Trade
A carbon tax can be equivalent to a cap and trade permit system, IF:
If government sells the permits at auction (so that the revenue is the same)
And if policymakers know exactly where is the demand curve ( certainty )

27. ANNEX VI: Comparing: What if demand is not known for sure?
Source: Prof. Don Fullerton: Choice of Climate Policy in the EU
A fixed quantity of permits, leads to
uncertain price, and costs for firms
Price
A tax, leads to uncertain
amount of pollution
Quantity of pollution

28. ANNEX VII: Comparing a Tax vs. Cap-and-Trade
Source: Prof. Don Fullerton: Choice of Climate Policy in the EU
Normally firms are prohibited
from colluding to restrict output
and raise price. With permits,
Price they are required to restrict
output (and raise price)
Fixed pollution per unit output
(tons carbon per Kwh). The
demand for electricity is a
demand for pollution
MC + carbon tax
Marginal Cost
Restricted number of permits Demand
Quantity of coal-fired electricity

29. ANNEX VIII: Relative Carbon Intensities. Source: Gros
Countries carbon intensities
CO2 intensity of CO2 intensity of
exports GDP 2005
EU27 0.47 0.43
USA 0.72 0.53
China 2.46 2.43
India 2.67 1.78
Brazil 1.05 0.5
Russia 3.85 4.4

30. ANNEX IX: Effect of ETS with higher carbon intensity abroad.
Source:Gros

31. ANNEX X: Bibliography
Businesseurope: Contribution to the revision of the Energy Tax Directive . Position
Paper. November 5, 2009
Fullerton, D.: Choice of Climate Policy in the EU . November 30, 2009
Gros, D.: Why a cap-and-trade system can be bad for your health . VoxEU,
December 5, 2009
Gros, D.: Why the EU needs a border tax on carbon .VoxEU, December 9, 2009
Hansen, J.: Cap and Fade .New York Times, December 6,2009.
http://www.nyti mes.com/2009/12/07/opi nion/07hansen.html?_r=1
Komanoff & Rosenblum: Carbon Taxes First . www.carbontax.org
Nordhaus, W.: Economic Issues in Designing a Global Agreement on Global
Warming . Copenhagen March 10-12,2009
Melillo,J.M.: Terrestrial Ecosystem Model
http://ecosystems.mbl.edu/staff/melillo.html;
http://ecosystems.mbl.edu/TEM/index.html
Ruiz Zapatero, G.¨: Los biocarburantes y el Impuesto sobre Hidrocarburos a la luz
de las últimas propuestas de la Comisión Europea .Cuadernos de Energía nº 20,
Abril 2008,páginas 93-106.
http://www.deloitte.com/view/es_ES/es/industrias/energia/cuadernos-de-
energia/index.htm