Thursday, March 10, 2011

Carbon pricing: The really simple explanation

I've really, really simplified this and used an 'ideal' model but the principles are the same and it will serve for comparative purposes.

Assume that both Company A and Company B produced widgets at $10 retail. The widgets are identical - apart from their production method.

Assume that the most efficient carbon use for the production of widgets is 1 unit of carbon.

First, let's examine the effect of a carbon price:

Assume 1 unit of carbon is priced at $1

Company A makes a widget that takes 10 units of carbon and pays the carbon price of $10 for its widget which now retails at $20 (the original $10 plus the carbon price).

Company B uses a less carbon intensive method to produce its widgets which only take 1 unit of carbon and pays the carbon price of $1 for its widget which it can retail at $11.

All of the money that the government collects from the price on carbon is used for compensating consumers - let's assume that the redistribution is $1 per person in compensation. All of this compensation coming from the price on carbon and not from the budget. This is important because things that are paid for out of the budget have to be funded by one of three things: tax, cuts or borrowing (deficit)

Now, our average consumer is used to paying the non-carbon priced price of $10 for their widget. They have received $1 in compensation for the government so they now have a potential spend of $11 for widgets.

Now if they buy the $11 widget they are no more worse off than before the carbon price and Company A has a rather imperative reason to reduce the price of their widget - for example, by reducing its carbon use.

Now let's look at "direct action" aka a carbon reduction subsidy:

Direct action pays polluters to reduce their carbon use.

Company A requires $100 in capital costs (with a $20 p.a subsidy to keep their carbon use at this level) to change its production process to bring its carbon use down to the ideal 1 unit of carbon. These costs are now subsidised by the government (funded from either tax, borrowings or cuts).

Now Company A is not going to pass the subsidy to the consumer because its going to use the money in its carbon reduction scheme - we might get a few dollars handed on, but essentially subsidies don't significantly reduce prices (they might decrease the rate of price increases but one only needs to look at subsidies for private schools to see this not working).

Company B doesn't need any money to bring it to its peak efficiency of 1 unit of carbon.

So at the supermarket both Company A and Company B's products still cost $10 - except that, thanks to the fact that there is no price signalling to the consumer, the consumer has no way of knowing that Company A's widget cost the budget bottom line $100 with a recurrent budgetary cost of $20 p.a.

Direct action is expensive. It either means cuts, taxes or borrowing, there's no way around it. And no amount of bleating about "great big new taxes" by the opposition is going to change this economic reality.

So next time you hear the opposition going on about "direct action" ask yourself: "how much are they going to borrow?", "what are they going to tax?" or  more likely, "what are they going to cut?"