BA207B Business and Public Policy

Haas School of Business Fall 1998

Final Exam

BA207B – Business and Public Policy

Professor Rui de Figueiredo

Format. The examination is open book. You may use the reader and syllabus materials, any handouts from class, and any notes you have taken in class or in preparation for class. You may not, however, use any other materials, e.g., to inquire beyond information presented in the exam itself. The examination consists of one case and three questions. Weights for questions vary as shown.

Logistics. The exam is attached. It will also be available from the class website. The exam will be available at the end of class on Thursday, December 3. It is due no later than Monday, December 7, at 12 Noon. You should drop it off in either the box outside Professor de Figueiredo’s office or under his door. The office is F545 in the Faculty Wing of the Haas School. Also, please be sure to check email over the weekend, as Professor de Figueiredo might pass on clarifications to the class. You are responsible for making sure you are on the course email list and checking for any emails.

Honor Code. You are not to discuss the examination with anyone except Professor de Figueiredo.

Length and formatting requirements. Answers are to be typed and must not exceed seven pages. This total includes any figures or exhibits, which may be hand-written or drawn. Number your pages, and print the final copy on standard 8.5 x 11-inch paper, using 12 point font, and 1.5 or double spacing. (Exhibits, if any, may deviate from these guidelines, within reason.) Although seven pages is the maximum length, you are neither required nor expected to write that much. Be certain to put your name, the class name, your section, and your student ID number on the exam.

GOOD LUCK!

The European Union Carbon Tax[1]

Whether and to what extent global warming is occurring are subjects of considerable scientific uncertainty, disagreement, and debate, but during the 1990s scientific evidence increasingly supported the global warming hypothesis. The principal contributor to global warming is believed to be the burning of carbon-based fuels, principally coal, petroleum, and natural gas.

A European Union (EU) Joint Council of Energy and Environment Ministers declared in 1990 that the member states would by the year 2000 stabilize CO2 emissions at the 1990 level. Because of projected economic growth, stabilization would require a reduction in emissions of approximately 10 percent. Some of the reductions required to stabilize emissions were anticipated to come from improved energy efficiency induced by the current prices of fossil fuels. These “no regrets” conservation measures were estimated to reduce emissions by 5.5% by 2000, leaving reductions of 5% to be accomplished by other measures. In October 1991 the European Commission issued a draft directive informing the members states of its plans to propose a variety of measures to reduce CO2 emissions (see Table 1 for a summary of the voting shares in the institutions of the EU and other demographic characteristics). These measures included R&D programs as well as a carbon and energy taxes to achieve the remaining reduction of 5%. The proposed carbon/energy tax was intended to reduce carbon emissions by making fuels, and particularly carbon-based fuels, more costly, and thereby inducing conservation and the substitution of less carbon-intensive fuels.

The Commission operates under collective responsibility but frequently defers to an individual commissioner if the issue is not controversial. The lead commissioners for this issue were DG XI (environment) and DG XII (energy), but this was not an uncontroversial issue. Mr. Carlo Ripa di Meana, EU commissioner for the environment, pushed for a formal proposal by June 1992 in time for the Rio Earth Summit. Mr. Jacques Delors, President of the Commission, also supported the tax and the leadership position it would give the European Union at Rio. Mr. Antonio Cardoso e Cunha, EU commissioner for energy, supported the taxes because they would promote energy efficiency rather than on environmental grounds.

The Commission proposal involved specific (per unit) taxes that would impose half the burden on carbon-based fuels and the other half on energy. Since emissions of CO2 are difficult to measure by source, the taxes would be applied to inputs rather than emissions. The proposed carbon tax would begin at $3 per barrel of oil and increase by $1 a year for the next seven years, reaching $10 a barrel. (The $10 per barrel tax is equivalent to a tax of $75 per ton of carbon.) An equivalent tax would be applied to coal and natural gas. The energy tax would apply to all energy sources except for renewable sources. The energy tax was included to satisfy environmentalists who opposed a pure carbon tax, since it would provide incentives for the expansion of nuclear power. Countries, such as Germany, Greece and the United Kingdom, with carbon-intensive energy supplies, also favored an energy tax. The Commission estimated that the full tax would increase the price of natural gas for industry by one-third, hard coal by 60 percent, and gasoline by 6 percent.[2]

Two EU countries, Denmark and the Netherlands, and two European Free Trade Association (EFTA) countries, Finland and Sweden, already had imposed a carbon tax.[3] Denmark’s carbon tax averaged $16 per ton of carbon for individuals’ consumption and $8 per ton for industry. Energy-intensive industries, however, could be granted an exemption of up to 100% of the tax. The Netherlands’ carbon tax was $12.50 per ton. The tax in Sweden was $62 per ton of carbon, and in Finland the tax was $6.50 per ton.[4]

Neither Japan nor the United States had a carbon tax in 1992. The Japanese government argued that its regulations already set standards that were at least as strong as those that the EU carbon tax would achieve. Presidential candidate Bill Clinton had pledged during his campaign to address the global warming issue using efficient means, including taxes on carbon and/or energy. The Congressional Budget Office estimated that to stabilize CO2 emissions a tax of $100 per ton of carbon would be required.[5] Representative Pete Stark of California introduced a bill to impose a tax of $15.00 per ton on coal, $3.25 per barrel of oil, and $0.40 per MCF of natural gas. The European Commission urged the member states of the European Union to make every effort to ensure that other OECD countries, in particular Japan and the United States, adopt measures similar to its proposed carbon/energy tax.

The carbon/energy tax would affect production and consumption decisions throughout the European Union and would affect the competitiveness of EU businesses, particularly those that use energy-intensive technologies. Mr. Ripa di Meana, however, argued that “This is a chance to update European industry and make it a leader in a green-oriented market.” To lessen the impact on the international competitiveness of European companies the Commission proposed to at least partially exempt from the tax industries that employ energy-intensive production processes. The tax would ultimately be borne in large part by individuals and would have the greatest impact on those who use energy, and particularly carbon-based fuels, intensively. Since lower-income individuals spend a higher portion of their income on energy, the tax would be regressive.

A carbon/energy tax would also generate substantial revenue for governments. The Commission, however, suggested that the carbon tax should be “fiscally neutral,” although Mr. Ripa di Meana argued that a portion of the tax revenue should go to developing countries to stop deforestation. Fiscal neutrality would require that any additional revenue generated by the tax should be offset by fiscal incentives or reductions in other taxes. Since the individual member states rather than the European Union would receive the revenue from the tax, each member state would determine its own use of the revenue. Under EU law the member states would also be responsible for the implementation of the tax.

The EU legislative process required that the imposition of a carbon tax be decided under a unanimity rule. More realistically, some bargaining among the member states would likely be involved with compensation given to certain countries that would otherwise be substantially impacted by the tax. As part of its annual budget, the European Union provided grants of structural funds to countries and to regions within countries for economic development. Typically, these funds are provided by richer countries to poorer countries. In 1992 these funds were approximately 19 billion ECU ($25 billion). The budget and thus the amount and allocation of structural funds were decided by a complicated legislative procedure similar to the cooperation procedure and involve decisions on proposals and amendments by qualified majority of the Council of Finance Ministers.

In December 1991 the EU Joint Council of Environment and Energy Ministers endorsed the Commission’s report unanimously. Denmark, Germany, Italy, Belgium, and the Netherlands came out clearly in favor of the proposal, whereas the poorer southern countries led by Spain, along with Luxembourg, were concerned about how the tax burden would be divided. Although the relevant Ministers of energy and environmental matters in the United Kingdom expressed agreement in principle, its Conservative government opposed tax hikes and, more generally, was skeptical about intrusive EC actions. France endorsed the report and supported the proposed taxes, but it wanted to tilt the tax more towards fossil fuels. A few days later the EU finance ministers took note of the proposal and asked for a detailed study on the practical details of the tax.

The Economics of Emissions Control in the European Union

Before the Commission presented its proposal for meeting the Union-wide stabilization target, it commissioned a study of the costs and benefits of CO2 emissions reduction. Although emissions were to be stabilized by the year 2000, the Council requested that the study analyze the effects in the year 2010 because the stabilization target was to hold indefinitely and some investments in energy conservation would take a number of years before they were fully implemented. Table 2 outlines the “base-case” scenario that was predicted to occur in 2010 if no EU-wide emissions control took place. Column 1 of the table shows 1988 CO2 emissions, for 10 EU countries, for comparison purposes (Ireland and Luxembourg are omitted from the analysis because they have the lowest CO2 emissions in the EU, and because important data were not available for them). Not surprisingly, the largest and wealthiest countries -- France, Germany, Italy, and the UK -- had the highest levels of CO2 emissions in 1988. However, the projected growth in emissions for 1988-2010 exhibits a very different pattern. The poorest countries -- Greece, Portugal, and Spain -- were predicted to emit 52, 82, and 35 percent more CO2 by 2010 if no additional controls were put in place, compared to declines in emissions in France, Germany, and the UK. The declines were projected to result from increased energy efficiency.[6]

Thus, if emissions were to be stabilized in 2000 and beyond, the Commission had to make a proposal that achieved a 143 ton reduction in CO2 in the year 2010 (143=2,819 - 2,676). One efficient, i.e., cost-minimizing, means to obtain this reduction was through an equal tax on CO2 emissions in all EU countries. An equal tax induces efficient emissions control across countries because it gives polluters in each country the incentive to abate up to the point at which the marginal cost of abatement equals the emissions tax. As a result, the marginal cost of reducing pollution in any one country would equal the marginal cost of reducing pollution in every other country -- in other words, no polluter would be able to abate any more cheaply than any other polluter, which is the condition for efficient abatement. The tax that achieved the target reduction of 143 tons of CO2 was calculated by researchers to be approximately $75/ton of carbon at an exchange rate of $1.30/ECU.[7]

Costs and Benefits of a Carbon/Energy Tax

The relative impact of a carbon tax would be greatest on the lower income countries. The tax would reduce their growth rate in addition to imposing high costs of abatement. The countries that would be most severely affected were Greece, Italy, Portugal, and Spain. A reduction in CO2 emissions by the European Union would be a public good for other countries, since all countries would benefit from the reductions. The benefits for individual EU member states would be roughly proportional to population. Germany would derive the greatest benefit from environmental protection, and the top four countries in terms of benefits would be Germany, France, Italy, and the United Kingdom. Economists estimated that for the EU member states as a whole, the ‘benefits’ of reduced emissions would slightly exceed the costs of lower growth (which was why the Commission had proposed the tax); and roughly half the countries would be net beneficiaries.[8]

The effects of the tax on industry was predictable. The trade association Euroelectric, representing the EU electricity industry, opposed the tax and argued for voluntary conservation measures. Electric power generators, Electrabel (Belgium), Endesa (Spain), PowerGen (United Kingdom), RWE (Germany), Scottish Power (United Kingdom), Union Fenosa (Spain), and VEAG (Germany), pointed to the uncertain effects of the imposition of a tax and proposed a series of conservation measures as well the export of energy efficient technologies to Eastern Europe. In addition to the efforts of the coalition and the trade association, individual power generation companies also lobbied to prevent the adoption of the tax.

The European Coal and Steel Council Consultative Committee also opposed the tax and argued for the voluntary programs and payments to developing countries to stop deforestation. Within countries opposition also developed. For example, in France fourteen major companies, including Electtricite de France, Renault, Rhone Polenc, Total, Elf Aquitaine, Pecincy, and Unisor Sacilor, organized “Business for the Environment” to oppose the tax. In exchange, the coalition offered help in cleaning up toxic wastes.

Chemicals is one of the premier industries in Europe. The industry is energy-intensive, and the petrochemical component of the industry uses petroleum feedstocks. The industry thus would be significantly impacted by a carbon tax. The chemical industry pointed to the success of voluntary measures. The managing director of Montedison Primary Chemicals, Giorgio Ports, stated that since 1974 the European chemicals industry had reduced by 35 percent the energy usage per unit of output and that another 15 percent reduction would be achieved by the year 2000.[9]

As is the case in many European industries, the chemical industry in each country is represented in domestic political affairs by an association that includes most of the companies operating in that country. These national associations act on behalf of their members within their countries. The associations in the individual countries are organized into a pan-European association CEFIC that acts at the level of the European Union. As the importance of the European Union governmental institutions has grown relative to that of the governments of the member states, individual companies had begun to take actions independently of their national and pan-European peak associations.

Table 1

The Institutions of the European Union

Country

European

Commission / Council of
Ministers /

European

Parliament /

GDP

($b) /

Population

(m)

Belgium

171

Denmark

France

1000

Germany

1333

Greece

Ireland

Italy

959

Luxembourg

0.5

Netherlands

249

Portugal

Spain

487

915

Total

567

5415

345

Table 2

CO2 Emissions (million tons) with No Further Abatement

12 EU Countries

1988 / Projected, 2010[10]
Belgium / 109 / 110
Denmark / 61 / 60
France / 374 / 370
Germany / 718 / 677
Greece / 84 / 127
Ireland / 39 / 42
Italy / 399 / 489
Luxembourg / 3.6 / 3.8
Netherlands / 146 / 165
Portugal / 28 / 51
Spain / 196 / 265
UK / 522 / 505
Total / 2,679 / 2,865

Exam Questions

20 points. Analyze the economic consequences of the carbon tax and their relationship to political preferences.
40 points. Develop and defend a prediction of the outcome of the carbon tax, including the role, if any, of structural funds and EU institutional features.
40 points. As Vice-President of Government Affairs of a French chemicals company that is heavily dependent on petroleum feedstocks, what effects do you anticipate from the proposed carbon/energy tax? What objectives and strategy should your company adopt to address the carbon/energy tax?

[1] This case is a major revision and expansion by Professors Baron, Diermeier, and Kessler, Graduate School of Business, Stanford University, of the case “European Union Carbon Tax,” Management Institute for Environment and Business and the London Business School. The case has been graciously provided by the Graduate School of Business, Stanford University.

[2] The percent increase is low because gasoline is already very heavily taxed.

[3] In 1995 Austria, Finland, and Sweden joined the EU.

[4] Poterba, James M. “Tax Policy to Combat Global Warming: On Designing a Carbon Tax,” in Global Warming: Economic Policy Responses, Rudiger Dornbusch and James M. Poterba, eds., MIT Press, Cambridge, MA, 1991: pp. 71-98.

[5] The United States had imposed a tax on CFCs as a means of speeding the elimination of their production. In addition to contributing to ozone depletion, CFCs are greenhouse gases and contribute to global warming.

[6] For example, CO2 emissions in the United Kingdom in 1992 were below the emissions levels in 1972.

[7] See “Reaching a CO2-Emission Limitation Agreement for the Community: Implications for Equity and Cost Effectiveness,” European Economy, Special Edition No. 1, The Economics of Limiting CO2 Emissions, Directorate-General for Economics and Financial Affairs, Commission of the European Communities, 1992.

[8] This assessment was based on a sophisticated economic technique which estimates the benefits of a cleaner environment in monetary terms so that comparisons to economic costs can be made.

[9] The Economist, May 9, 1992.

[10] Source: Coherence (1991), “Cost-effectiveness analysis of CO2 reduction options,” Synthesis report and country reports for the Commission of the European Communities, DG XII, May 1991.