Q&A: An EU carbon tax, more effective than the ETS?

Carbon allowances on Europe's Emissions Trading Scheme (ETS) hit new lows this week, reinforcing doubts about the system's usefulness as a driver of investment in low-carbon sources of energy.

Some commentators have said a tax could be more effective, but a major downside of that for the European Union is that the bloc would almost certainly fail to agree on it.

The following looks at the pros and cons of a tax versus a market-based scheme.

Why could the EU not agree on a tax?

Agreement on an EU-wide tax requires unanimity from all 27 member states, which tend to regard tax as a matter of national sovereignty.

How difficult would unanimity be?

"In one word: impossible. Finance ministers like the UK Treasury will not give tax-raising powers to Brussels any time soon or even contemplate EU-wide coordinated taxes," Samuel Fankhauser, co-director of Grantham Research Institute at London School of Economics, said.

The European Wind Energy Association (EWEA) is among those who say a tax could in theory be more effective but that given the circumstances, the ETS was the bloc's best hope of making the polluter pay and inspiring investment in low carbon sources.

"It's better quality legislation," Christian Kjaer, chief executive officer of the European Wind Energy Association, said referring to tax.

The ETS, by contrast, is "a very, very complicated system open to all kinds of compromises and shortcomings, which would not happen if it were a tax", he said. "But without the ETS, there probably would have been nothing."

What about criticism the ETS amounts to a tax?

Some of those from the aviation sector who have been extremely critical of EU law requiring all airlines using EU airports to offset their emissions under the ETS have said that it is a tax and that it breaches national sovereignty.

Europe's highest court, the European Court of Justice, in a ruling in December said the EU legislation did not contradict international law. It also dismissed the idea the ETS was a tax.

"It would be unusual, to put it mildly, to describe as a charge or tax the purchase price paid for an emission allowance, which is based on supply and demand according to free market forces," Advocate General Juliane Kokott said.

Can the ETS be strengthened and what are the obstacles?

The collapse of carbon allowances on the ETS to a low just above 6 euros on Tuesday means it is far below the levels needed to spur investment in a low carbon economy.

Debate on the need to intervene to cut a huge surplus of allowances in the carbon market has been intense in the European Parliament, with strong backing from some sectors of industry, which want allowance prices to be high enough to justify technology such as carbon capture and storage.

One of the arguments from opponents is that intervention would make the ETS a tax because it would have the effect of fixing the level, rather than letting the market decide.

The Commission has said any setting aside of allowances to provide support would be a one-off dictated by the depth of recession, which has added to the surplus of permits to pollute.

Within the EU, Poland is the most opposed to anything that would drive up the carbon price. Given its dependency on carbon-intensive coal, it argues its economy would suffer from higher costs to offset emissions from power generation.

Tax versus ETS?

A tax and an ETS can have the same effect depending on the design, analysts say. Both can provide sources of revenue, and legislative clauses can stipulate how they should be spent.

The EU law does not insist ETS money should be used on the environment, although member states are encouraged to spend it on green projects.

Within the EU, so far only Germany has come up with legislation to earmark ETS cash for environmental purposes. Even so, campaigners complain, some of the money compensates big power users or subsidies new coal plants on the basis they are more efficient than older ones.

Industry and some analysts argue an advantage of a tax is relative economic certainty.

An ETS, meanwhile, can provide a level of pollution certainty by establishing an emissions cap.

"With taxation you know what the economic burden is but not how emissions will react. With emissions trading, it is the other way round," Fankhauser said.

"So it depends on which type of uncertainty you are more comfortable with, over cost or over emissions. There is no obvious answer to that question."

Emissions trading can include measures, such as distributing free allowances, that make it less painful to industry but which have generated windfall profits for big utilities.

The next phase of the ETS from 2013 addresses that issue by insisting on the auctioning of most allowances, rather than free handouts. That has generated political opposition and intense lobbying for exemptions.

Is tax the future?

Not necessarily.

So far the ETS covers heavy industry, the power sector and since January international aviation.

Going forward, the Commission is looking at shipping, with the inclusion of maritime emissions in an ETS one of four policy options under consideration. A fuel or carbon tax is also mooted.

For the forestry and agriculture sectors, however, an ETS is considered unlikely so far. Draft proposals would require only that EU member states monitor and report changes in land use.

Non-governmental organisation FERN is among those highly critical of the ETS, and it has campaigned for forestry, which absorbs as well as adds to emissions if burnt, to be treated differently.

This article was originally published by Reuters. Republished with permission.