Are Government Attempts to Reduce the Impact of Climate Change Beneficial or Harmful to UK Firms? To see more of our products visit our website at Sheila Pugh

Economic activity releases carbon dioxide and other greenhouse gases into the atmosphere. Rising temperatures will harm future generations as land is flooded, crop yields fall and fresh water supplies are lost. These costs are negative externalities as they are not included in the free market price for energy and other goods. The lack of incentives for the free market to internalise these costs has been called “the greatest and widest ranging market failure ever seen.”

They could scale back GDP growth, but this would reduce living standards and is not considered a credible option. The mix of goods and services produced could change to less energy intensive industries, e.g. rail travel could replace air travel. Producers and consumers can use less energy by improving energy efficiency, e.g. by insulating homes. Energy could be produced in new ways to reduce emissions, e.g. by switching from coal and oil to wind and nuclear.

By putting a price on carbon emissions and so increasing the cost of producing energy. This must reduce the income of the current generation in the same way as if the oil price had permanently increased. The increase in the cost and price of energy relative to that of other goods will rise, and the relative price of fossil fuels which produce C02 will increase compared to the price of carbon free energy. These relative price changes will result in producing some ‘winners’ and some ‘losers’.

The imaginary economy of GoGreen produces four goods: electricity, electricity generating equipment, tomatoes and carrots. Initially power stations use cheap coal and emit large amounts of CO2. The tomatoes are grown in greenhouses heated by electricity. The carrots are planted in the open air. The government sign an international agreement to cut their emissions by 50% in twenty years time. To do this they plan to put a price on CO2 emissions which will reflect their cost to future generations.

The government decides on a carbon tax on all emissions of CO2. This tax raises the cost of generating electricity from coal, as power stations now have to pay for their emissions. Some electricity companies now find it profitable to switch to wind power, whilst others find it cheaper to install new equipment to lower emissions and thus taxes. In all cases the cost of producing electricity is now higher than before.

The carbon tax raises electricity costs and shifts the supply of electricity to the left. Profits, as reflected by producer surplus, will fall. Tomato growers now face an increase in costs as they pay more for electricity. This shifts their supply curve to the left, raises the price of tomatoes, are reduces the producer surplus earned by tomato growers.

The higher tomato price means that the relative price of carrots has fallen. Consumers will now substitute carrots for tomatoes. The demand for carrots shifts to the right, raising their prices and increasing the amount of producer surplus earned by carrot growers. Companies manufacturing electricity generating equipment will now find it more profitable to make wind turbines than coal-fired generators. Those specialising in wind turbines see an increase in their producer surplus while those specialising in coal equipment see a fall.

The carbon tax successfully cuts CO2 emissions by reducing the amount of energy consumed and by changing the way in which energy is produced. Demand shifts to low carbon goods (carrots and wind turbines). ‘Losers’ are the energy producers (electricity companies) and the producers of carbon intensive goods (tomato growers and coal- generating equipment firms). ‘Winners’ are the low carbon producers of carrots and wind turbines.

The 2008 Climate Change Act committed the UK to reducing greenhouse gas emissions by 80% in 2050 compared with their 1990 level. Plus, an important EU target, requires that 15% of all the UK’s final energy consumption must be from renewables by The policies to achieve these are: Setting a price on CO2 emissions thus giving an incentive to switch to low carbon production. Subsidising research, development and deployment of low carbon technologies such as offshore wind farms and electric cars. Changing the behaviour of firms and households to undertake energy saving investments such as insulation.

This ‘cap and trade’ scheme works by setting a maximum total amount of emissions of CO2 from firms participating in the scheme. Permits to pollute or emit CO2 are issued up to this maximum. Firms can trade the permits with each other and face the choice of either buying permits and continuing to pollute, or selling permits and reducing their emissions. Firms will choose the cheaper option for them, but either way costs will rise above their level before the scheme was introduced. The final impact on firms will depend on the extent to which they pass this cost on to consumers in higher prices.

Industries often lobby against climate change policies because they are afraid that the increased costs will put them at a competitive disadvantage relative to foreign firms. But how valid are these claims? The percentage share of energy in total costs is small for many firms. Some industries with relatively high energy costs such as cement, also have high transport costs and their output is often not traded internationally. Around sixty per cent of UK trade is with the EU so most foreign competitors are part of the same scheme.

A high price of CO2 emissions will raise demand for carbon-saving technology such as solar power, electric cars, wind turbines and carbon capture and storage for fossil fuels. But the current carbon price is not high enough to be sure of stimulating enough new research and investment in carbon-saving technology to meet targets. Some benefits of research are external to the firm doing the investing, and can be copied by other firms. There will be external economies of scale if high tech firms grow in clusters and share information. Thus the UK government is giving subsidies and tax concession to firms to develop low carbon technology. The profits of these firms will increase as a result of such policies.

Government failure can arise when policy decisions are taken after being influenced by the lobbying of special interest groups instead of with regard to maximising society’s economic welfare. Climate change policies give firms huge opportunities to capture the potential benefits provided by particular policies. An example of this is generous allocation of free permits in the EU Emissions Trading Scheme. Another example is the large subsidies given to firms and households to install renewable energy which makes these investments immensely profitable.

Climate change policies aim to transform economies from high carbon to low carbon ones. This involves putting a price on carbon and increasing the cost of energy production. Firms producing energy or energy intensive goods will subsequently have lower profits. The increase in demand for low energy intensive goods and technology which reduces emissions will raise the profits for firms producing these goods. But, there is a net cost to current generations, where the costs to the ‘losers’ must exceed the gains to the ‘winners’. It is future generations that will receive the benefits from preventing global warming.

With the aid of two diagrams, show how the switch in demand from coal generating equipment to wind turbines affects price, output and producer surplus. Should the EU ETS be extended to cover all CO2 emissions? What difficulties might be encountered? It is sometimes suggested that countries should adapt to climate change, for example by building flood defences, instead of trying to prevent global warming. How might adaptation affect UK firms?