Carbon Arbitrage

Well I'm back, time to delve into the intriguing world of arbitrage! 

Arbitrage is a financial term used to describe the exploitation of differences between markets. The example I gave last week was British Columbian drivers crossing the border to refuel their cars in an attempt to avoid a state carbon tax (Elgie and McClay, 2013). This also represents a really important hurdle in implementing carbon taxes on a global scale (Withagen and Halsema., 2013)

Scaling the issue up, unless there is strong cooperation between states, competitive taxation can lead to a similar result as observed in British Columbia. In the globalised economies we live in today, capital is extremely mobile and able to exploit advantageous taxations schemes across the globe, at the detriment to less competitive nations (Drezner, 2002). This reasoning is often used by nations to justify their opposition to a carbon tax, making such a scheme difficult to implement. Take for example the USA. 

In August 2013, the House of Representatives passed an amendment requiring 'the administration to receiveapproval from Congress before implementing a carbon tax'. From my rather basic understanding of US politics (correct me if this is wrong), this effectively translates into a blocking of any attempt by Obama to implement such as scheme. So what was the justification? This is from a press release by representative Scalise:

“President Obama’s plan to impose a tax on carbon would cause household electricity rates to skyrocket while destroying millions of American jobs. … The House sent a strong bipartisan message to President Obama that a tax on carbon would devastate our economy and he needs to drop any idea of imposing this kind of radical regulation"

If this is the case with market leaders like the USA, what about emerging economies where competitiveness is even more important to their economies. Both India and China have refuted the notion of a strict Carbon Tax (Oster, 2010): arguing that the loss competitiveness would cripple the development of their economies.

Underlying this stance on Carbon Taxation is the ‘race to the bottom principle’ (Drezner, 2002). This is the socio-economic phenomena where competition between states in an increasingly globalised world results in a trend towards increased deregulation to remain attractive.

Simply, Carbon taxation schemes come at a cost to economic competitiveness. 

Australia : a recent example of a failed Carbon Tax

Australia was one of the first non-EU countries to adopt a Carbon Pricing strategy. First proposed in 2007 and implemented in 2011, the tax was repealed in June this year. Amongst the issues created during this period, a loss of industry competitiveness was pivotal to the tax repeal (Splashand Lo, 2012). In 2013, J.P Morgan estimated that the tax had reduced the trading value of major Australian Employers BHP and Rio Tino PLC by 6% (Taylor and Hoyle, 2014), losses that translated into growing unemployment rates.

Source

The short-term  costs of carbon taxes therefore can be substantial for states that try and implement them in isolation. And ultimately it is often short-term economic changes that translate into policy, as seen in Australia.

The issue of arbitrage also limits the actual value of carbon taxes as a means to reduce emissions. Carbon leakage refers to the spill-over of emissions to countries with less strict emission regulations (IPCC, 2007). Carbon taxes may provide an effective means to reduce an individual nation’s emissions, but arbitrage simply allows this reduction to spill-over into increased emissions elsewhere.

So then Arbitrage is clearly a substantial hurdle in the way of effective carbon tax implementation. In my next post I’m going to talk about some of the approaches we can take to meet this challenge.