Box 11 Setting A Tax On Emissions The Dilemma Of The Discount Rates

Climate change will intensify as global temperatures rise with increasing concentrations of GHGs in the atmosphere. Economic growth fueled by the burning of fossil fuels will continue to add emissions to an atmosphere whose absorptive capacity has already been exceeded.

Estimation of the global economic costs of climate change and particularly the marginal costs of a unit of CO2e emissions is important in that it signals the optimal tax that should be imposed. What makes this exercise difficult is that emitters are separated in time from the consequences of their emissions; the current generation bears the costs of the climate benefits felt by future generations.

Economists typically discount the future taking trends in the long-term bond rate together with the expectation that people in the future will be better off than they are today. Studies of the costs of climate change commonly discount the future at a rate of 3 percent.

Recently, however, there has been much argument about rates as result of the Stern Review (Stern, 2006), in which discount rates employed were very low, thus generating high estimates for the cost of future emissions. Stern argues that discounting techniques that apply to changes at the margin where one project is being compared with another should no longer apply to costing global changes at a global scale. Moreover, recognition that relatively poor people will be most impacted by climate change is another reason why discount rates should be eased.

the underlying assumptions in climate models can also change the size of damage costs. An example is provided by Nordhaus. In 1999 he estimated the optimal tax to be US$2.50, but in his 2007 study the optimum tax had risen to US$7.50 per tonne of CO2e (Nordhaus, 2007: 62).1 The latter estimate is still lower than the mean of study estimates reported by Tol (2007), however, due to the fact that Nordhaus applies a relatively high discount rate of 4 percent to future damage costs.

One way of overcoming the problem of uncertainty of the optimum tax would be to introduce a tax at a modest level and then to adjust it upwards while monitoring the impact on GHG emission levels. It is expected that

Table 1.1 Present cost of $100 in 100 years' time at various discount rates

Discount rate %

Present value $

4.0

1.98

3.0

5.20

1.0

36.97

0.1

90.47

the tax would need to be increased by some 2.4 percent yearly, simply to keep pace with the increase in the marginal social cost of carbon emissions (IPCC, 2007: 822). Nordhaus suggests rises from US$9.30 per tonne of CO2e in 2010 to $11.40 in 2015, $24.50 in 2050 and $56.40 in 2100.

While taxes are unwieldy on a global scale they are a more feasible option for adoption by individual countries in meeting their national targets. Tax harmonization is relatively easy within a country and the direct flow of tax revenues, which are then available to assist adjustment among sectors of society affected by the tax, is attractive to governments. Within countries that adopt taxes, tax rebates or subsidies can apply to the CO2e reductions achieved by reforestation.

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