2.8.3 Strengths and limitations of government policies to correct externalities Notes

Sweden's Carbon Tax

Introduction

In 1991, Sweden introduced a carbon tax to address the negative externalities associated with greenhouse gas emissions. This policy aimed to incentivize reductions in carbon dioxide (CO₂) emissions by imposing a tax on fossil fuels used for heating and transportation.

Policy Implementation

The initial tax rate was set at SEK 250 per metric ton of CO₂, equivalent to approximately $40 at that time. Over the years, the tax rate increased significantly, reaching SEK 1,190 ($126) per metric ton by 2019, making it one of the highest carbon taxes globally. The tax primarily targeted sectors such as heating and transportation, with certain industries receiving exemptions or reduced rates to maintain international competitiveness.

Challenges in Measuring Externalities

Determining the appropriate tax rate posed challenges due to difficulties in accurately quantifying the social cost of carbon. Setting the tax too low could result in insufficient emission reductions, while a too high tax might impose undue economic burdens. Additionally, the effectiveness of the tax depended on the availability of viable alternatives to fossil fuels for consumers and businesses.

Degree of Effectiveness

Between 1990 and 2018, Sweden achieved a 27% reduction in greenhouse gas emissions, despite significant economic growth during this period. The most substantial emission reductions occurred in heating residential and industrial buildings, attributed to the carbon tax and a shift towards CO₂-free electricity production through hydropower and nuclear power. However, the tax's effectiveness was somewhat limited by exemptions granted to certain industries, which may have reduced the overall potential for emission reductions.

Consequences for Stakeholders

Short-Term Impacts:

• Consumers: Faced increased costs for heating and transportation fuels, leading to higher household expenses, particularly affecting low-income households.
• Producers/Firms: Industries reliant on fossil fuels experienced higher operational costs, potentially reducing profitability and competitiveness, especially in energy-intensive sectors.
• Government: Generated additional revenue from the tax, which was not earmarked for specific purposes but contributed to the overall government budget.
• Society: Initial resistance to the tax due to increased living costs and concerns over economic impacts.

Long-Term Impacts:

• Consumers: Benefited from improved air quality and environmental conditions resulting from reduced emissions.
• Producers/Firms: Encouraged to innovate and invest in energy-efficient technologies, leading to long-term cost savings and enhanced competitiveness in a low-carbon economy.
• Government: Established a reputation as a leader in climate policy, demonstrating that economic growth can be compatible with emission reductions.
• Society: Experienced overall environmental and health benefits from sustained emission reductions, contributing to global climate change mitigation efforts.

Questions:

1. Define the term negative externality and explain how the carbon tax aims to address it.
2. Explain, using the case study, the challenges of measuring the social cost of carbon when designing a carbon tax.
3. Evaluate the effectiveness of Sweden’s carbon tax in achieving its objective of reducing greenhouse gas emissions, considering both short-term and long-term impacts.
4. Discuss the impact of the carbon tax on stakeholders, including consumers, producers, and the government, in the context of equity and efficiency.

European Union Emissions Trading System (EU ETS)

Introduction

Launched in 2005, the European Union Emissions Trading System (EU ETS) is the largest and longest-running carbon market in the world. It was created to address the negative externalities of greenhouse gas emissions by setting a cap on total emissions from power plants, factories, and airlines operating within the EU. Firms could then trade emission permits, creating a market-based approach to reducing pollution.

Policy Implementation

The EU set an overall cap on emissions, which gradually decreased over time to ensure reductions. Firms received or purchased emission allowances (permits), with each permit granting the right to emit one ton of CO₂.

• If firms emitted less than their allowances, they could sell surplus permits for profit.
• If firms emitted more, they had to buy additional permits or face penalties.
• Over time, free allocations were reduced, and more permits were auctioned to enhance market efficiency.

Challenges in Measuring Externalities

Determining the appropriate cap level was difficult:

• A cap set too high risked making the system ineffective, as firms could pollute without constraint.
• A cap set too low imposed heavy restrictions, risking economic slowdown.
  Additionally, fluctuations in permit prices sometimes created uncertainty for firms, making it harder to plan long-term investments in low-carbon technologies.

Degree of Effectiveness

Between 2005 and 2019, emissions from sectors covered by the EU ETS fell by 35%, even as the EU economy grew. The system contributed to significant reductions in power sector emissions, largely by encouraging a shift away from coal and boosting investment in renewables.
However, effectiveness was limited in early years due to an over-allocation of permits, which drove prices too low to incentivize real change. Reforms, such as the Market Stability Reserve (2019), were introduced to tackle this issue and stabilise permit prices.

Consequences for Stakeholders

Short-Term Impacts:

• Consumers: Faced higher energy prices as firms passed on the cost of purchasing permits.
• Producers/Firms: High-emission industries faced increased costs; however, firms with lower emissions could profit from selling unused permits.
• Government: Incurred administrative costs to establish and monitor the system, but also generated revenue from permit auctions.
• Society: Saw initial reductions in pollution, though uneven across industries.

Long-Term Impacts:

• Consumers: Benefited from improved air quality and reduced health risks.
• Producers/Firms: Incentivised to innovate, invest in renewables, and adopt cleaner production technologies, gaining competitive advantages in green markets.
• Government: Enhanced reputation as a global climate leader, showing that emissions reduction could be aligned with economic growth.
• Society: Experienced sustained environmental improvements, contributing significantly to the EU’s climate targets and the global fight against climate change.

Questions

1. Define the term negative externality and explain how tradable permits aim to address it.
2. Using the case study, explain the challenges of setting an effective emission cap in a permit trading system.
3. Evaluate the effectiveness of the EU ETS in reducing emissions, considering both its early limitations and later reforms.
4. Discuss the impacts of tradable permits on stakeholders, including consumers, producers, and the government, in terms of equity and efficiency.

Paris Agreement (2015)

Introduction

The Paris Agreement, adopted in 2015 under the United Nations Framework Convention on Climate Change (UNFCCC), is a landmark international treaty aimed at limiting global warming to well below 2°C above pre-industrial levels, with efforts to limit it to 1.5°C. It represents one of the most significant attempts at global cooperation to address the negative externalities of greenhouse gas emissions.

Policy Implementation

Each participating nation submits Nationally Determined Contributions (NDCs), outlining their emission reduction targets and climate actions.

• Unlike previous agreements, the Paris Agreement does not impose legally binding emission targets; instead, it relies on voluntary commitments.
• Nations are required to update their NDCs every five years, with the expectation of progressively higher ambition.
• A global transparency framework monitors progress and holds countries accountable through reporting and review mechanisms.

Challenges in Measuring Externalities

• The non-binding nature of NDCs creates enforcement challenges, as countries may fail to meet their commitments without facing penalties.
• The free-rider problem persists: some countries may benefit from global climate action while contributing little themselves.
• Measuring progress is complex, as nations differ in economic development, energy mix, and climate vulnerability, making it difficult to create uniform standards.

Degree of Effectiveness

The Paris Agreement has achieved significant global participation, with 196 parties signing and committing to climate action. It has increased momentum for renewable energy investment and climate policy worldwide.
However, progress toward limiting warming to 1.5°C remains insufficient. Many countries have missed or delayed implementing their NDCs, and global emissions continue to rise. The effectiveness of the agreement depends heavily on the willingness of nations to strengthen their commitments and invest in sustainable development.

Consequences for Stakeholders

Short-Term Impacts:

• Society: Gains early progress toward environmental goals through increased awareness and policy initiatives.
• Government: Enhances international credibility through participation and cooperation.
• Producers: Some industries face sudden regulatory adjustments as countries implement new climate policies.
• Government: Bears high costs to negotiate, coordinate, and implement agreements.

Long-Term Impacts:

• Society: Benefits from global environmental improvements and reduced climate risks.
• Producers: Gain opportunities to lead in sustainable markets by innovating and shifting to clean technologies.
• Government: Faces challenges in sustaining commitments, ensuring compliance, and balancing climate goals with economic growth.
• Society: Long-term climate mitigation improves health, food security, and resilience against extreme weather.

Questions

1. Define the term free-rider problem and explain how it applies to the Paris Agreement.
2. Using the case study, explain the challenges of ensuring compliance in international agreements.
3. Evaluate the effectiveness of the Paris Agreement in addressing climate change, considering both its successes and limitations.
4. Discuss the impacts of international climate agreements on stakeholders, including governments, producers, and society.

Do you want me to now build similar CGPA-style case studies for regulations, subsidies, and awareness campaigns so that you have one real-world example for every policy tool?

Germany's Renewable Energy Act (EEG) Subsidies

Introduction

In 2000, Germany enacted the Renewable Energy Sources Act (Erneuerbare-Energien-Gesetz, or EEG) to promote the adoption of renewable energy and reduce greenhouse gas emissions. The EEG introduced a feed-in tariff system, providing subsidies to energy producers to encourage investment in renewable technologies such as wind, solar, and biomass. This policy aimed to mitigate the negative externalities associated with fossil fuel-based energy production, including air pollution and climate change.

Policy Implementation

The EEG established guaranteed feed-in tariffs for renewable energy producers, ensuring fixed, premium prices for the electricity they generated over a 20-year period. This financial incentive reduced investment risks and made renewable energy projects more attractive to producers. The costs of these subsidies were distributed among electricity consumers through a surcharge on their energy bills.

Challenges in Measuring Externalities

Quantifying the environmental benefits of the EEG subsidies involves assessing reductions in greenhouse gas emissions and improvements in air quality resulting from increased renewable energy production. Additionally, evaluating the economic impact on consumers, who bear the cost of subsidies through higher electricity prices, is essential to understand the policy's overall effectiveness.

Degree of Effectiveness

The EEG has been instrumental in transforming Germany's energy landscape. By 2020, renewable energy sources accounted for approximately 45% of Germany's electricity consumption, a significant increase from around 6% in 2000. This shift contributed to a substantial decrease in carbon dioxide emissions from the power sector. However, the policy also led to higher electricity costs for consumers, sparking debates about the economic burden of the subsidies.

Consequences for Stakeholders

Short-Term Impacts:

• Producers: Benefited from stable, long-term revenue streams, encouraging investment in renewable energy projects.
• Government: Faced challenges in balancing the promotion of renewable energy with managing the financial impact on consumers.
• Consumers: Experienced increased electricity prices due to the EEG surcharge, leading to concerns about energy affordability.
• Government: Established a foundation for a renewable energy transition, boosting Germany's global reputation as a climate leader.

Long-Term Impacts:

• Producers: Established a strong renewable energy sector, positioning Germany as a leader in renewable technology and innovation.
• Government: Achieved significant progress toward environmental goals but continues to address the economic implications of the subsidies.
• Consumers: Benefit from a cleaner environment and reduced health risks associated with fossil fuel pollution, though higher energy costs remain a concern.
• Government: Struggled with the rising economic burden of sustaining subsidies and addressing equity concerns in energy pricing.
• Consumers: Experienced persistently higher electricity prices due to the EEG surcharge, raising concerns about affordability and energy poverty.

Conclusion

Germany's EEG subsidies have effectively incentivized producers to invest in renewable energy, leading to substantial environmental benefits. While the policy has been successful in reducing negative externalities from fossil fuels, it also highlights the importance of carefully considering the economic impacts on consumers. Ongoing adjustments to the EEG aim to balance environmental objectives with economic sustainability.

Evaluation Questions

1. Define the term negative externality and explain how fossil fuel-based energy production exemplifies this concept.
2. Analyze the impact of Germany's EEG subsidies on renewable energy investment by producers.
3. Evaluate the effectiveness of feed-in tariffs in reducing greenhouse gas emissions.
4. Discuss the economic implications of the EEG subsidies for consumers and how these might affect public support for renewable energy policies.