The carbon tax – just another tax?

Buzzwords abound in the technical field. Some are rapidly absorbed and before you know it everyone is using them. The latest buzzword doing the rounds is “externalities”, which, with its associated catchphrase “internalizing the externalities” has spread rapidly into common usage, so much so that both were used recently by prominent internationally recognised speakers, one an economist, and the other scientist at two unrelated events in this country on the same day.

The catchphrase also appears in the discussion paper on proposed carbon taxes issued by the Treasury late last year, where it was used as an explanation for introducing said taxes. The stated reason behind the tax is said to be “ to complement the regulatory efforts of the South African government in addressing environmental issues”. The stated aim of the tax is twofold: to reduce the amount of carbon dioxide emissions by imposing a punitive price on incremental emissions of carbon dioxide, and to facilitate the move to “a low carbon future”.

Study of the paper, however, reveals that as the proposed tax diverges significantly from these principles of “internalising the externalities”, this goal is unlikely to be achieved, and quite possibly, the real goal is the creation of a perpetual source of revenue. i.e. just another tax.

Pigovian economics and externalities

The principle on which the proposal is based is derived from Pigovian economics. Explained briefly, where a business activity causes a situation which affects the quality of life of the population external to the business (a good example would be air or water pollution), the cost of rectifying the situation (the externality), should be borne by the business (internalising the costs) and not by the population affected. This is achieved by imposing taxes on the business causing the problem, which then has the choice of either paying the tax and letting the authorities rectify the problem, or applying measures internally to remove the problem, thus avoiding the tax. Implicit in this philosophy, however, is that revenue collected from taxes will be used to counteract the effects of the external problems or degradation caused, which should ideally result in a "revenue neutral" tax, where all the money collected from taxation goes to fixing the problem. The advantage of a revenue neutral tax is that it can easily be varied or even removed if necessary without impacting on the fiscus.

While this theory presents a simple uncomplicated picture, the reality is somewhat different. One of the basic problems is in determining the cost of the externalities, and in the case of carbon taxes this is far from simple, as the externality are we looking at is the effect on the climate of carbon dioxide emitted into the atmosphere by man-made or anthropogenic sources using fossil fuels. Emissions from anthropogenic sources such as power stations are believed to contribute to climate change, or climate instability, or global warming, which are the externalities in this case. Natural sources which both emit and absorb CO₂ and are not considered damaging.

The Treasury quite rightly states that it is very difficult to attach a cost to the externalities in the case of fossil fuel based power generation. It is also very difficult to determine what the externalities are, and there are a number of competing theories all vying for acceptance. In spite of this uncertainty, World opinion is that it is a good idea to reduce anthropogenic CO₂ emissions, and the South African  government has subscribed to this opinion.
Instead of basing the tax on the cost of the externalities, which is indeterminate, Treasury has decided to use market forces in the form of a “price signal” to the power generation industry, in the form of a tax on fossil fuels. In theory the price signal should have two effects:

• To make the cost of generation using fossil fuels more expensive than other means, thus encouraging a move to non-fossil fuel based systems.

• To encourage the move to “clean fossil fuel” technologies on existing plant, which effectively reduce CO₂ generated and prevent emission into the atmosphere.

Both of these solutions cost more than generation with ordinary coal, and will only be considered if the “price signal” exceeds the cost of implementing the solution. The choice of a price signal rather than an actual cost represents a divergence from the principles stated in the beginning i.e. internalising the cost of rectifying the situation.

Not only are the externalities difficult to determine, but it is also difficult to determine the extent of CO₂ emissions by various users, and treasury has instead opted to use the much easier metric of the consumption of the fossil fuels themselves as a proxy on which to base taxation.

This sounds very nice in theory, and in a competitive generation market with numerous players, may well work. It is difficult however to see how applying a tax could reduce CO₂ emissions in the South African electricity generation industry. As mentioned by Treasury, the industry is an oligopolistic one with basically a single player, namely Eskom, dominating the market. There are two other factors which inhibit the effectiveness of any of the proposed measures:

• The mix of generation technologies in the generation portfolio is under control of the Department of Energy through the Integrated Resource Plan, which controls how much and what type of technology is used. The utility cannot deviate from this plan. The only sector which is not controlled by the IRP is own-generation i.e. privately owned plant generating electricity for own use. There is thus no mechanism by which a utility could unilaterally change generation technologies.

• The price of electricity is regulated by Nersa, who fixes the price that utilities may charge, both through the MYPD and the REFIT tariffs. The price of electricity is determined by a system known as the “rate of return” method, where the utility is allowed a “reasonable” return on investment over and above the costs of generating electricity. In determining costs, all factors including capital and operating costs are taken into account. This includes the cost of fuel. If the tax is to be applied to coal as an excise tax at the point of delivery then it will simply increase the fuel costs which the utility uses in its price application, and will result in a direct increase in the price of electricity. There is no way that the regulator can disallow this, as it is an input cost and not a tax on the utility. The cost of the tax and its administration will be passed on to the consumer as a surcharge, and there is no financial incentive for the utility to reduce emissions or reduce the use of fossil fuels. In addition the utility will make a “reasonable return” on the surcharge. If the utility installs measures to reduce CO₂ emissions, or changes to non-coal technologies, this will increase the production cost, and the increase will be passed on to consumers.

Whether the utility pays the price of the tax on fuel, or installs mitigation measures, the consumer will carry the cost.

The only party in this whole scenario that will be affected by the tax will be the consumer. What options are open to the consumer then? Energy saving is already on the cards because of the increasing cost of electricity and other DSM initiatives. All that's left is to go for own generation – the best option for the small to medium consumer is rooftop solar- some are already going that route. The tax document however makes no provision for any subsidy for this, although this is quite common in a number of countries who are far down the GHG emissions reduction road, so the consumers will have to bear the cost of this themselves.

Options

Let's assume that the utility and the other parties involved in controlling the IRP do decide to respond to the price signal and attempt to reduce the cost of electricity to the consumer. This could be achieved if the means of reducing CO₂ emissions can be implemented at a cost below the level of the tax, which is one of the underlying principles of the process. What means are available to achieve this?

Clean coal

Eskom is certainly not going to close down the fleet of coal fired power stations overnight, nor are they likely to do so in the medium term. Power stations being built today need to operate for 30 years or mores to recover costs. The one option open is to go for “clean coal” technology, which prevents CO₂ generated from entering the atmosphere.

What the utility could do is install carbon capture equipment to reduce emissions, which will earn tax credits which could offset the increase in capital and operating costs. In spite of the fact that ongoing development of carbon capture systems is resulting in more efficient systems which can be retrofitted to existing plant, the cost of plant remains high, and it incurs additional operating costs, all of which will serve to increase the cost of generation, which under the regulated scheme, will be passed on to the consumer. Current estimates of the cost of carbon capture are in the region of  $25+.$30/t (R15.+.R200/t) At the proposed rate of tax it would be cheaper to pay the tax. There are several pilot plants in operation around the world, and results look promising, but full scale commercial plant is still several years in the future. Remember also that these costs are estimates – the cost of sequestration is an unknown and may be far higher than estimated. Estimates range up to €100/t for transport and sequestration.

The process has its own externalities. Carbon capture is only one stage of the process. One has to do something with the CO₂ once it has been collected. The original CCS scheme proposed sequestration or burying of carbon in geological formation or at the bottom of the sea, and a survey has already been done in this country on possible sites. Despite assurances that this is safe, the long term effects of CO₂ sequestration are unknown, and must be considered as an additional high risk externality generated by the mitigation process. Pure CO₂ is lethal and accidental release of a huge amount of CO₂ at ground level could have results more devastating than an accident involving nuclear power, and some commentators are of the opinion that the process carries the same risk as nuclear fuel disposal. Another aspect which has not been investigated in any depth is the effect of CO₂ on subsurface micro-organisms which abound in the rocky structures below the surface. The subsurface rock structure is not sterile, but teems with life. The University of the Free State has just started a study together with several other institutions on the subject.

Ironically, this is one area where market forces come into play in an unforeseen way, for it seems that rather than being a pollutant that needs to be disposed of, CO₂ is a very useful compound which is used in many industrial processes, and a market is developing for captured CO₂. Within the power industry itself there are pilot projects running or proposed that use the intermittent output from wind or solar power farms to convert “waste” CO₂ into useful liquid or gaseous hydrocarbons, which are then re-used as fuel or feedstock for the chemical industry. Various other plans to “recycle” captured CO₂ are emerging, and one could see that the market value of this “pollutant” could exceed the tax on its generation. So in fact what started out as a mitigation measure may have spawned a useful side industry, and could do away entirely with the need to “bury the waste”.

Nuclear

Nuclear must be the prime contender as an alternative for coal for baseload generation, as it is capable of running at a high load factor forever. Disadvantages are the long build times and high capital costs, although developments are reducing build times.

Nuclear has its own externalities which should be taken into account when comparing technologies. The extent of these will depend on which side of the nuclear fence you stand. Discounting the well orchestrated emotional objection to nuclear from certain quarters, and the huge amount of disinformation spread about the nuclear industry, safety of nuclear power and the issue of waste disposal remains a real concern and carries a significant external cost. When looking at externalities of nuclear power, we need to take developments in the field of design, operation and waste handling into account. Recycling of nuclear waste to recover almost all of the energy in the fuel is a new development, reducing actual waste to a very low levels. New types of reactor and fuels other than uranium are also pushing towards cleaner nuclear power, and many of the old objections are no longer valid.

Natural gas

Natural gas is enjoying an upsurge in popularity as a fuel for generation in many parts of the world. One of the reasons is the availability, new resources being discovered regularly. The prime reason though is that natural gas produces much less CO₂ than coal for the same amount of energy produced, and the other factor that gas turbines or gas engines can be ramped up and down faster than the steam turbines used in coal fired and nuclear stations, making the introduction of variable sources such as wind much easier. South Africa does not have much of a natural gas resource at the moment, but there are known reserves in field off the east and west coasts of Southern Africa which could be exploited, and exploration of the Karoo basin for shale gas is planned. The externalities here are also unknown.

Renewables

The idea of capturing energy from a source which never runs out, using equipment which runs at low or no cost, is a seductive one, and has fascinated people ever since the need for power arose. Current renewable energy systems have come close to this ideal, and the vision of the entire world powered from this source is constantly being held up to us.

The big unknown factor with renewables is the externalities. Despite claims that renewable energy is benign and has no negative effects, the long term effects of installing huge amounts of Renewable energy are unknown and allowance should be made for future effects due to factors other than CO₂ associated with Renewable energy when comparing technologies. Treasury and others have chosen to ignore such possibilities.

One could list a few: Wind turbines are visually intrusive, kill birds and are said to emit low frequency vibrations which can affect health. Biofuel production uses land that could be used for production of food. Land based solar absorbs energy which would otherwise have been used by the biosystem. Distributed generation will incur costs in reengineering the transmission network. Unfortunately these effects are either ignored or played down when considering renewable energy.

What happens to the tax revenue ?

This is the crucial question that indicates a total diversion from the argument advanced by treasury at the start of the document for using the Pigovian model. There is no intention to ringfence revenue from the tax for any projects aimed at reducing energy use or CO₂ emissions, although there is a loose statement that some of the money may be allocated to this purpose. In this case it is unlikely that the carbon tax will ever be removed as it constitutes a steady stream of revenue into the future.

Can a tax on carbon be effective?

It is unlikely that any significant reduction in CO₂ will take place and the tax will simply increase costs. Besides which it is a self defeating system, in that if it is successful, revenue will reduce and eventually disappear, something that no government wants. One must assume that any reduction resulting from the tax will be minimum and that a new source of revenue has been found.

How does one measure the effectiveness of the tax other than in revenue volumes? Counties that have implemented carbon taxes and have reported decreasing emissions are quick to point out that many other factors played a role in this result, and it is almost impossible to assign a portion of the results to any particular factor. The Treasury document makes mention of the difficulty of measuring actual emissions- how much more difficult will to be to prove reductions in emissions due to the application of a tax, when so many other forces are at play. The real drivers towards a low fossil fuel, low emission, or carbon neutral future will come from quarters other than punitive financial measures. One of them is the known fact that fossil fuel reserves will not last forever, and the price is going to increase.

In proposing a carbon tax, the Treasury has ignored the fact that the country which has experienced the largest growth in renewable energy generation systems and which had until recently the largest installed base of these systems in the form of wind and solar, achieved this without having a carbon tax. The USA, instead of punitive taxation, opted for a system of tax based incentives, concessions and subsidies to persons and organisations installing renewable energy systems, and in doing so reduced CO₂ emissions by millions of tons without collecting a single dollar in taxes.

My view is that whatever way you choose to look at it, this will be just another tax!