Carbon taxes, externalities and other policy instruments

Aggregate economic models typically assume a uniform price elasticity of demand for energy across broad groups of energy users, if not the whole economy, and also assume a uniform elasticity across all sizes of price changes. The case of the aluminium industry demonstrates the invalidity of these assumptions. Aluminium smelters typically embody state-of-the-art technology at the time they were built. Apart from trivial adjustments, efficiency improvements can only be made by building a new smelter. Thus a smelter's price elasticity of demand for electricity is virtually zero up to a certain size price increase, while beyond that size, the elasticity becomes infinite. That is, the smelter shuts down because it is uneconomic to operate.

It is important to distinguish between a carbon tax which is imposed as a proxy for environmental costs not yet internalized; and a carbon tax imposed as an instrument to achieve a pre-determined level of emission abatement to respond to climate change. The two are identical only in a world of perfect markets. It is difficult to argue in principle against the full internalization of environmental costs. But the cost of climate change is potentially so pervasive that the costs of the greenhouse effect (and the economic benefits of avoiding it) simply cannot be expressed in monetary units. These fundamental issues cannot be pursued here, where the point is simply that different criteria may be used to assess policy instruments and options for achieving greenhouse gas abatement.

Given the nature and extent of the 'efficiency gap' in the market for energy services, it is quite likely that a level of carbon tax sufficient to put half of Australia's aluminium smelters out of business would still not be sufficient to induce some small-scale industrial and commercial businesses to make efficiency improvements having a payback of only a few months. Such an outcome would be neither fair to the aluminium smelters nor efficient for the Australian economy. Carbon taxes have many advantages (Pearce 1991), particularly when careful consideration is given to their place in overall fiscal policy But in the real, imperfect world, the carbon tax should be combined with other, more precisely aimed policy instruments to achieve emission abatement of greenhouse gases.