“API Geoeconomic Briefing” is a weekly analysis of significant geopolitical and geoeconomic developments that precede the post-pandemic world. The briefing is written by experts at Asia Pacific Initiative (API) and includes an assessment of burgeoning trends in international politics and economics and the possible impact on Japan’s national interests and strategic response. (Editor-in-chief: Dr. HOSOYA Yuichi, Research Director, API & Professor, Faculty of Law, Keio University)

This article was posted to the Japan Times on July 4, 2021:

https://www.japantimes.co.jp/opinion/2021/07/04/commentary/japan-commentary/japan-carbon-tax/

API Geoeconomic Briefing

July 4, 2021

Why a carbon tax would help Japan achieve its green ambitions

OYA Shin,
Senior Research Fellow, Asia Pacific Initiative (API)

 

 

 

Japan should find its own path to carbon neutrality while being aware of its own strengths, such as combining carbon-neutral fuels with high-efficiency combustion engines.

That’s according to Toyota Motor Corp. President Akio Toyoda, speaking as chairman of the Japan Automobile Manufacturers Association during a news conference on April 22.

He argued that banning gasoline-powered vehicles would lead to loss of jobs for people manufacturing such cars and also could cause Japan to lose the strengths it has nurtured, including fuel injection technology.

On the following day, Honda Motor Co. President Toshihiro Mibe announced that the carmaker would aim to stop selling new gasoline-powered vehicles worldwide by 2040 and replace them completely with electric and fuel-cell vehicles.

Which one of them is right? We don’t yet know.

The trend can be seen not only in the automotive industry. The steel industry is looking into hydrogen direct reduction steelmaking, through which steel is made from iron ore using hydrogen instead of cokes to reduce iron oxides.

Whether this method is the way to go depends on whether clean and low-cost hydrogen can be obtained in mass quantities.

To move forward with decarbonization amid uncertainties, it is important to have a carbon pricing scheme which is technology-neutral and encourages companies to come up with new ideas.

Carbon pricing is a scheme to make greenhouse gas emitters bear the financial costs by setting prices according to the amount of carbon dioxide emitted.

There are two major forms of carbon pricing — emissions trading and carbon tax.

Emissions trading, also known as a cap-and-trade system, can bring about the same level of revenues as a carbon tax, if the initial distribution of emissions allowances is decided completely through auctions.

There are some major differences between the two:

• Price fluctuations: In a cap-and-trade system, the prices of emissions permits change according to economic situations and that can have a negative impact on companies’ investment, research and development. There are ways to reduce fluctuations by allowing companies to “bank” allowances to use in future periods or “borrow” from future years’ emissions. Price caps or floors can be set on the allowances. While a carbon tax does not offer the same degree of certainty in emissions reductions as cap and trade, there is a so-called “ratchet mechanism” that will adjust the tax upward in the following year if the emissions reductions were lower than the national target.
• Complementary policies: Robert N. Stavins, a Harvard University professor who heads the Harvard Project on Climate Agreements, writes that if a complementary regulatory policy is introduced along with a cap-and-trade scheme, there could be three negative impacts.

1. If the complementary policy is binding, there will be no additional reduction in emissions by the targeted source but rather a relocation, or leakage, of emissions to other sectors under the overall cap.
2. The cost-effectiveness of emissions reductions will not be equalized between sources targeted by the policy and those which are not, making the scheme inefficient.
3. Allowance prices will be suppressed, raising concerns about the ability of the system to reduce emissions or encourage technological change.
   When a carbon tax is paired with complementary policies, the emissions-leakage effect and allowance price suppression will not occur, Stavins says.

• Transaction costs: An emissions trading scheme involves trading of allowances, creating transaction costs. But if the system is designed properly, transaction costs can be minimized.
• Macroeconomic factors: Cap and trade is a counter-cyclical policy instrument, in that demand for allowances increases and allowance prices rise when an economy is booming. The opposite happens during a recession. At the same time, in the case of cap and trade, even if technological innovations take place, they will only lead to falling allowance prices with no additional reduction in emissions.
• Policy complexity: A cap-and-trade system is more complex than a carbon tax because it requires initial distribution of allowances, auctions and other necessary rules.

As of last year, a cap-and-trade system had been introduced in 31 countries and regions and a carbon tax was in place in 30. Deciding which is better as a carbon pricing instrument is difficult.

However, in order to achieve a high level of emissions reduction, it is important to introduce a system that is not negatively affected by complementary policies.

A system based on a carbon tax would serve better, considering it is compatible with complementary policies, simpler in design and offers price stability and high predictability.

 

Carbon taxes around the world

Japan introduced a tax in 2012 to enhance measures to reduce carbon dioxide emissions, which is similar to carbon tax. But the tax rate, although incrementally increased in three stages, is low at ¥289 ($2.6) per ton of emitted carbon dioxide.

The revenue from the tax is put in a special account to be used exclusively for efforts to mitigate global warming, including measures to boost energy conservation, use of renewable energy and cleaner use of fossil fuels.

The country also has the petroleum and coal tax and the gasoline tax, although they were not introduced to cope with climate change.

If Japan were to introduce a carbon tax, it would be necessary to reorganize related taxes and measures.

According to the Institute of Energy Economics, Japan think tank, the carbon tax rate in major countries in yen terms per ton of emitted carbon dioxide is ¥15,470 in Sweden, ¥6,912 in Norway, ¥3,100 in Denmark, ¥11,140 in Switzerland, ¥5,930 in France, ¥2,870 in the United Kingdom and ¥3,010 in British Columbia, Canada.

Sweden introduced its carbon tax together with income and corporate tax cuts and allocated the revenue for use on general spending. Norway also allocated the carbon tax revenue as general funds to finance income tax cuts.

Denmark introduced the tax — with revenue going toward general funds — along with subsidies and reduced employers’ pension and social contributions for companies with a voluntary agreement on energy efficiency.

Switzerland redistributed roughly two thirds of the revenue to citizens and companies and allocated the rest to funds to improve energy efficiency in buildings.

France used much of its earnings to finance a tax credit for competitiveness and employment and the rest to fund transportation infrastructure and renewable energy.

The U.K. put the money into the general budget, and British Columbia in Canada made the tax revenue-neutral so that the funds are returned in such forms as corporate income tax cuts.

The United States has not introduced a carbon tax and is unlikely to do so in the near future. However, three carbon tax bills were introduced in Congress in July 2019, and there are some common characteristics in the bills, according to an analysis by Chad Qian of the Tax Foundation, a U.S. tax policy nonprofit organization.

The bills would impose a low tax of $15, $30 or $40 per ton of carbon dioxide, which would then be increased each year.

Two of the bills include a ratcheting mechanism to increase the tax by a higher rate if emission goals are not reached.

All of the bills would be levied in the upstream process of production and include a border adjustment mechanism which would introduce a charge equivalent to a carbon tax on imports of emissions-intensive products from countries with weaker carbon policies.

All of the bills stated that much of the revenue — ranging from 70% to 84% — would be distributed back to low- and middle-income households in the form of monthly dividends or a reduction in the payroll tax. One of the bills allocated 20% of the revenue to be spent on various infrastructure programs, including climate adaptation.

One of the bills, named the Stemming Warming and Augmenting Pay (SWAP) Act, said the government would be prevented from regulating greenhouse gases under the Clean Air Act for 12 years following the bill’s enactment.

This was included to gain support from industries, reflecting growing voices among high-emitting sectors that prefer a carbon tax over direct regulations.

In March, the American Petroleum Institute, the oil and gas industry’s largest trading group, endorsed a carbon pricing policy, saying it would “advocate for sensible legislation that prices carbon across all economic sectors while avoiding regulatory duplication.”

Because there is a need to significantly cut carbon emissions, regulatory steps should be implemented together with a carbon tax, and authorities must be cautious about committing to excluding regulatory measures.

 

Self-motivation

More people are becoming aware of the need for decarbonization, taking such actions as purchasing eco-friendly products even if they are more expensive, or buying bonds and shares in companies eager to reduce carbon emissions.

However, companies’ disclosure of information related to climate change is not sufficient enough to further encourage such behavior.

In such a situation, it is a welcome news that there is a global move to step up disclosure of such information, and Japan is also moving to revise its corporate governance code.

Both the people’s self-motivation to bear the costs of decarbonization (“voluntary internalization”) and the government’s policies including a carbon tax and other regulatory measures (“institutional internalization”) are necessary to achieve decarbonization.

There are reasons why decarbonization cannot be achieved only by voluntary internalization.

Currently, we have an assumption that environmental, social and governance (ESG) investing produces the same level of returns as non-ESG investments. But the sad truth is that if environmental targets get higher, returns from ESG investments will be subordinated.

While some put up with low returns, many ESG investors will start thinking whether they should continue to endure the loss, known as the opportunity cost — which other people do not suffer — for the sake of protecting the global environment.

In order to fill this unfortunate gap, or negative externality, it is necessary to introduce institutional internalization measures such as carbon tax and regulations. Voluntary internalization and institutional internalization are mutually reinforcing and have a synergistic effect.

A carbon tax adversely affects the global competitiveness of companies that produce carbon-intensive traded goods. Moreover, there is the issue of carbon leakage, by which businesses transfer production to other countries with less strict emission constraints, resulting in failure to reduce worldwide emissions.

The best way would be to introduce the same level of regulations and carbon pricing policies worldwide, but if that is difficult, it is necessary to have a border adjustment mechanism that is consistent with the rules of the World Trade Organization.

It is also important to take economic growth into account. The government often says it will work on introducing carbon pricing that contributes to economic growth, but this shouldn’t be interpreted as no carbon pricing steps being taken unless they directly work to raise the growth rate.

Compared with other methods, a carbon tax poses less negative impact on economic growth from the perspective of efficiency. Still, the efforts to adjust and internalize negative externality coming from carbon emissions have negative effects on growth rate because carbon emissions are a kind of hidden debt that are not considered when calculating gross domestic product.

Investments and employment related to emissions reduction could outstrip negative effects in the long run, but we cannot take that for granted.

More than anything, Japan’s international pledge to go carbon neutral by 2050 does not limit its commitment to achieve the goal only if it contributes to economic growth.

 

New ideas

Apple Inc. founder Steve Jobs loved to quote Wayne Gretzky, a retired Canadian ice hockey player who said, “I skate to where the puck is going to be, not where it has been.”

The government’s most important growth strategy regarding decarbonization is to clearly show where the puck is going to be.

Prime Minister Yoshihide Suga has declared Japan will cut carbon emissions to net zero by 2050, and Japan has codified the pledge in law.

The next step is to swiftly present a system to achieve the goal, such as the rate for a carbon tax and how it will be raised over the years.

Going back to the strategies of Toyota and Honda, it is hard to say which is better technologically. But a company’s future is certainly determined by whether it succeeds in tackling decarbonization.

The government, rather than seeking the right technology itself, should present a goal and a system to internalize carbon emissions. It should make clear that emissions come with high costs and encourage companies and individuals to come up with new ideas and take action.

The faster they act under a clear system, the more advantageous companies will be regarding international competition.

The government also shouldn’t forget about assisting people who will be forced to transition.

Instead of avoiding changes, the government must facilitate paradigm changes and work to bring out dynamism in companies and people.

What is important is not where the puck has been, but where the puck is going to be.

 

Disclaimer:
The views expressed in this API Geoeconomic Briefing do not necessarily reflect those of the API, the API Institute of Geoeconomic Studies or any other organizations to which the author belongs.