Column : Taxing carbon

Written by Michael Walton | Michael Walton | Updated: Nov 20 2008, 05:48am hrs
Does Indias corporate sector have an interest in a carbon tax, now There are major issues of international equity around this contentious topic. Rich countries should indeed pay for action to deal with climate change in line with their contribution to the problem. But lets focus on the narrower question of what is in Indias self-interest.

There are good reasons for early action to make carbon emissions expensive, around irreversibilities, capabilities and credibility.

First, investment in the capital stockin power stations, factories, vehicles, buildings or forest managementhas irreversible effects. With existing incentives, investment choices will be carbon-intensive. Now it is very, very likely that there will be a global deal in the next ten years that has a much higher, explicit or implicit, price of carbon. India risks being landed with a capital stock that is at best high cost at future prices, at worst obsolete. Retrofitting or premature replacement is costly.

Second, the capability to do new things is driven by practice. The more Indian industry explores low carbon-technologies, the more it will be competitive for a huge set of production opportunities at home and abroad. Conversely, if there is not real depth in new technologies, the benefits of future innovation will go to industries from other countries. In the UK, it is already reckoned that British industry may have missed the boat on getting to the frontier of coastal wind technologies. Parts of the Indian corporate sector are already moving heavily into green technologies, but this could be marginal to the whole economy in the absence of strong incentives.

Third, there is an issue of credibility over future policy change. A countrys capital stock shapes its structure of interests. This isnt a developing country issue: look at the United States and Europe. High-carbon industries, that face high adjustment costs and lack low-carbon capabilities, will have a future interest in lobbying against change, when the economic costs of failure to adjust will be much higher. The sooner India starts acting, the easier the future political economy.

Isnt it odd to be raising issues of the cost of carbon in the wake of the financial crisis Lets look at arguments against action.

A first argument is that you dont want a higher tax when the economy is slowing down. This makes no sense. In the short run, the ministry of finance should make decisions over the size of the overall deficit on macroeconomic grounds. Other, more distorting, taxes can be reduced, or spending raised, to achieve a sound deficit target.

A second argument is that higher carbon taxes hurt the competitiveness of Indias productive sectors. This is also wrong. A carbon tax is a relative price that will lead to shifts in production choices, technologies and product mixes. But overall competitiveness will depend on economy-wide developments, in the real exchange rate, infrastructure, logistics, the pace of industrial innovation and so on.

A third argument, which is really interesting, is that if India moves on to a more carbon-saving path it will lose out on future entitlements on carbon emissions under a global deal. This is based on the reasonable current view that poorer countries should have no restrictions on carbon emissions until they hit a developmental threshold. This highlights a possibly huge flaw in the design specifics in current thinking. It would be better if international designs rewarded earlier action by India and other countries, rather than providing incentives for maximising carbon production until a graduation point is passed.

I suspect such a path would be a bad idea in any case. The consumer preferences of importing countries will increasingly penalise carbon-intensive production. There are already anecdotes of importing companies (even Walmart!) demanding low-carbon products. In another decade the information base for both consumer awareness and certification will be an order of magnitude greater than today. Moreover, it is not clear that holding out is a better negotiating position within a global deal than credible, early domestic action.

A final point. Why a carbon tax-effected via rationalising energy taxes and a whole range of other measuresrather than regulation, subsidies, or an internal cap and trade These can all be made to be equivalent in a perfect world. At a global level there are indeed big advantages of a cap and trade system, since we care a lot about getting the quantity of emissions right, and cap and trade is more reliable, and much more feasible, than a global carbon tax. It also has the major advantage of providing a mechanism for transferring resources to developing countries during a transition in which they benefit from carbon trading with no caps. But in a domestic Indian context, most alternatives would require a regulatory apparatus that is highly efficient and thoroughly immune from influence. That looks like a good case for price-based mechanisms.

The author is at the Harvard Kennedy School, the Institute of Social & Economic Change, and the Centre for Policy Research