Petrol Pump

A coalition of leading economists, world leaders and other respected figures on the world stage, have called for a massive carbon tax – of around $100 a ton on carbon emissions – to fight climate change. The rationale behind such a move is misunderstood. The implications are significant.

The Carbon Pricing Leadership Coalition, which is fronted by a panel including German Chancellor Angela Merkel, Chilean President Michelle Bachelet, Ethiopian Prime Minister Hailemariam Desalegn, Mexican President Enrique Peña Nieto, Canadian Prime Minister Justin Trudeau, Governor Jerry Brown of California, Mayor Eduardo Paes of Rio de Janeiro and until recently François Hollande of France, has called for a tax equating to $100 a ton on carbon emissions by 2030, but to start moving towards that level within a few years.

Most of the media immediately fail to grasp why the idea is being proposed.

Sure, the headline reason is clear – it is to stop climate change. But why a carbon tax?

A carbon tax is not about raising money – the money raised from such a tax can be spent on whatever governments want to spend it on.

The tax is about ensuring price fully reflects the true cost of carbon fuels. Price, according to economic theory, is set where demand equals supply. It marries how much something costs with how much people want it. But when there is an external cost, not borne by the supplier, this equation breaks down, and creates a less than optimal outcome.

So, a tax, which is paid for each unit of carbon fuel burned, addresses that – at least it does in theory. By doing this, consumers can make a choice. They can carry on burning fossil fuels

Because, despite the cost, it is worth it, or they can look at alternatives.

Some say that the proceeds of the carbon tax can be spent on renewables – but this is not necessary, a tax on carbon emissions will lead to the private sector investing in renewables – although a case could be made for using the money to spend on carbon capture – as this may be less commercially viable.

But what would it mean? What are the implications of a carbon tax? How might this affect the oil price?

This is not an easy question to answer as it depends on how the oil is used. If it is used to make plastic, for example, then carbon emission are much less.

But this article suggests we may assume that on average, a barrel of oil, once used, accounts for around 317 kilograms of carbon dioxide – roughly a third of a ton.

So, a $100 a ton tax on carbon emissions, based on current usage, equates to around $34 a barrel, which at the moment would increase the oil price by around two-thirds.

This would hit oil companies, depending on what economists call the price elasticity of demand. If demand is inelastic, meaning consumers will pretty much pay whatever they have to for petrol, without changing their habits, then the tax will simply be passed onto the customer. If demand is elastic, and consumers are very sensitive to price, then most of the tax will paid for by the producer – eating into profits.

It does seem as if in the short run, price elasticity of demand for oil is quite inelastic, but elastic in the long run. So, a carbon tax would have little effect on the profits of oil companies short-run, but a massive effect, long-run.

President Trump may not be a fan of such a tax, but if the evidence to support the idea of manmade climate change mounts, a carbon tax will become inevitable and in the long run, the oil companies will take a big hit, one that may even threaten the existence of some of them.