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Carbon taxes

Sustainability

Carbon taxes need to explode to deal with the ‘mother of all externalities’

Published 28 March 2022 in Sustainability • 4 min read

Increasing the scope and price of carbon taxes is the most effective tool to reduce greenhouse gas emissions, says Professor Karl Schmedders.

“Climate change is not the result of people being nasty or evil who want to ruin the planet. The key message is when we do good things there’s a by-product that is bad and we need to put a price on that by-product,” said IMD Professor of Finance Karl Schmedders.

Schmedders was speaking during a session called the “The Economics of Climate Change”, part of a two-day special program for the MBA class of 2022 on “The Science of Sustainability.”

If the world is going to make headway in getting emissions to net zero, we need to start paying for more of the CO2 emissions produced as a side effect of economic activity. As researcher Richard Tol acknowledged: “Climate change is the mother of all externalities.”

Take the example of the global cement production, which uses vast amounts of energy to heat limestone. Despite its massive carbon footprint, demand for cement continues to grow. Between 2011 and 2013, China produced more cement (6.6 gigatons) than the United States did in the entire 20th Century (4.5 gigatons.)

One approach taken by policymakers to try to remedy the problem is to introduce carbon taxes (that assign a price to the pollution) and quotas (which aim to limit the quantity of production.) The aim is to produce less and force manufacturers to consider greener sources of production by pushing up the cost of polluting.

An example is the European Union’s cap and trade system which sets a cap on how much greenhouse gas pollution can be emitted each year and assigns an allowance to companies. Firms can then buy or sell these permits depending on how much CO2 they emit.

The system is not without its flaws. Tesla was able to make billions of euros from selling its green credits to other carmakers, even though a Tesla car being driven in a country like Germany, for example, is not particularly green given the country’s reliance on brown coal for its electricity.

A further downside of such a system is carbon leakage whereby companies move high-polluting activities to countries outside the EU and then import the products back into the bloc.

“What they didn’t understand in Brussels and Berlin is that carbon can travel the world without a passport. That’s the problem in carbon leakage,” said Schmedders.

Tesla carbon taxes
Tesla was able to make billions of euros from selling its green credits to other carmakers.

Game changer

To try to fix this problem, the EU is introducing the Carbon Border Adjustment Mechanism where importers to the EU will buy carbon certificates corresponding to the carbon price that would have been paid if the goods been produced within the bloc.

“If CBAM comes, it changes the game around the world,” said Schmedders.

Countries such as Brazil – where hydropower accounts for around 65% of its electricity generation – may find that their steel exports will become more competitive, because imports from China and India will cost more.

Outside the European Union, other countries are looking to increase both the scope and size of carbon taxes. For example, Singapore wants to raise the prices of its carbon tax to $25 per ton by 2025 from just $5 currently.

What they didn’t understand in Brussels and Berlin is that carbon can travel the world without a passport. That’s the problem in carbon leakage.
- Karl Schmedders

There are currently 64 carbon pricing initiatives in force across the globe, according to the World Bank.  Last year, China launched it national emissions trade scheme, making it the world’s largest carbon market.

The moves have caught the attention of investors.  Tribeca Investment Partners, which manages $3.2 billion in assets, has purchased $100 million of carbon credits, betting that the price will increase as demand from business grows to offset their CO2 emissions.

There are also emerging innovative approaches to offset greenhouse gases. IntellSol, a sustainable start-up founded by IMD EMBA graduates, aims to reduce the CO2 emissions in Ghana by getting companies in richer countries to pay for it. Its Energy Transition Accelerator Model (ETAM) aims to price the benefits of installing solar panels on the roofs of households and local businesses – such as reduced emissions from burning wood, as well as the social benefits including greater female participation in the workforce – and then issue blockchain-based certificates to sell onto corporations and governments in industrialized countries committed to climate action.

Authors

Karl Schmedders - IMD Professor of Finance

Karl Schmedders

Professor of Finance at IMD

Karl Schmedders is Professor of Finance at IMD. In his research, he applies numerical solution techniques to complex economic and financial models, shedding light on relevant market issues and industry problems. He is also Director of IMD’s new online certification course for structured investment products in partnership with Swiss company Leonteq, teaches in the Advanced Management Concepts (AMC) and Executive MBA programs, and is an advisor on International Consulting Projects in the MBA program.

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