Carbon Tax — Changing the Conversation
By: Florencia Malau
Tags: Carbon Tax, Climate Change, Industry 4 0, Climate Crisis, Decarbonization

In more than 100 years since the first research of greenhouse effect was conducted, the movement to raise awareness toward climate issue has never garnered attention in the amount like it has during the last two decades. Nevertheless, the massive worldwide public outcry was still an understatement in comparison to the actual issues we are facing at hand. The earth has reached its warmest temperature in more than 11,000 years. The United Nations Framework Convention on Climate Crisis (UNFCCC) along with the Intergovernmental Panel on Climate Change (IPCC) have predicted that if the earth keeps warming beyond the temperature of 1.5°C, the impacts would be catastrophic and most likely, irreversible. The world leaders subsequently decided to commit to keep the Earth temperature below 1.5°C. This concern led to the Paris Agreement, ratified in late 2015, in which each participating country committed to a specific target of Nationally Determined Contribution (NDC) to reduce their carbon emissions.

What We Have Done Isn’t Enough

It has been nearly five years since the initiative has taken place and most of the committed countries have not done meaningful change, including Indonesia. Out of 29% (unconditional) and 41% (with international support) carbon emissions reduction targeted by 2030, Indonesia’s carbon production trend shows the opposite results. The biggest portion of the emissions increase is caused by the energy sector (excluding forestry land use and peat fire causes).

National GHG Emissions by Sector in 2016 (Ministry of Environment and Forestry, 2018)

Indonesian government has indeed taken steps to reduce carbon emissions by working on a policy framework since 2010. But the results exhibit that the efforts aren’t sufficient to reach the NDC target in less than 10 years. On the other hand, carbon tax is widely acknowledged by economists as the right instrument in tackling the issue for Indonesia, especially with the support of rapid technology development as the country is entering the Industry 4.0 era. Therefore, I wrote a paper to analyse the potentials of carbon tax implementation in solving the climate crisis issue in the terms of reducing carbon emissions amid the rapid growth of Industry 4.0.

Through conducting review of articles and journals on carbon tax as well as the role of Industry 4.0 to achieve climate crisis mitigation, I have concluded how carbon tax can significantly reduce our carbon emissions. The finding of this paper are discussed using the relevant theories in the analysis chapter afterwards. For the purpose of the research, the carbon tax implementation is focused on the energy sector.

This writing will address three main points. The first one aims to address the underlying rationale behind the implementation of carbon tax by discussing the role of tax and the economic efficiency of government driven increase in carbon prices to reduce carbon emissions. The second point discusses the foreseeable effects of carbon tax implementation in Indonesia. In this section, the discussion is divided into two parts including the explanation on the existing framework of carbon tax and the study case of carbon tax in Mexico and how it relates to Indonesia. Finally, the analysis looks at the possibilities of Information, Communication and Technology (ICT) development brought by the Industry 4.0 era and how it will eventually benefit the implementation of carbon tax.

Underlying Rationale Behind Carbon Tax

As stated by the Green Fiscal Commission (2009), there are at least three ways to achieve carbon emissions targets that have been set, namely energy efficiency, increased investment in the renewable energy sector and reduced demand for fossil fuels. The results of the Green Fiscal Commission analysis also shows that an increase in the price of fossil fuels is the right economic condition that will simultaneously achieve those three aspects. The same thing was stated by Arlinghaus (2015) and Martin et al. (2013) that regulations for carbon prices will effectively reduce carbon emissions because rising prices will directly reduce demand. Furthermore, of the two approaches to increase the price of fossil-based fuels, market-driven and government-driven, government intervention through taxation is a safer approach we can use. This will minimise the occurrence of unwanted incentives for the creation of fossil-based substitution fuels. (Green Fiscal Commission, 2009)

The argument for an increase in the price of fossil-based fuels is also in line with the externalities theory (production of an item which has a negative impact on society will naturally have an impact on prices). Price increases are a form of social cost compensation that is generated and ultimately suppresses the production of these goods. The goal is to reach the ideal equilibrium. Said negative impacts should occur in the case of carbon emissions as a result of burning fossil fuels and cause negative externalities, not only to the environment but also will have an effect on social aspects (IPCC, 2018). Since the beginning of the industrial innovations, humankind has not been able to restore the earth and return to the ideal equilibrium.

To overcome this, Mankiw said that market based policy is one of the most effective and efficient ways to overcome negative externalities from carbon emissions. One of the instruments that can be used by the government is a fiscal instrument which is tax given it’s functions as a regulating instrument. This will allow government to regulate the level of carbon emissions through the imposition of a carbon tax.

How to Implement Carbon Tax?

To be able to understand a carbon tax design framework, there are at least three important points that must be considered; the scope, point of taxation, and tax rates. I’ve written a lengthy analysis regarding how to explain and give description of the carbon tax design framework using the design made by Bordoff and Larsen in 2018. The important thing is how government has to mix and match this policy in order to support government revenue in a local level instead of harming existing tax law on fuel-based energy. The answer is simple: do both (Note that the simplicity doesn’t necessarily apply in practice). Existing tax on fuel-based energy is not a contradicting policy with carbon tax. In fact, the existence of carbon tax should go hand-in-hand with said “energy tax” to be able to reach it’s fullest potential in decarbonising the economy.

The next question that will arise is whether carbon tax should be implemented in a state or local level. I’d argue since the NDC goal is a national target, state government should have the authority to exercise carbon tax. It is just not the place for local government to be given the burden of implementing carbon tax. This is a national issue and we should not spend our time to debate on “who” should take responsibility but rather “when” we should take it.

Predicting Foreseeable Effects

The next thing we should look at is the effects of carbon tax once it’s been put to practise. We can learn from Mexico as one of the few countries that has implemented carbon tax before the Paris Agreement took place. Mexico’s step later became an international spotlight and was considered a brave step for the Mexican government. It is important to highlight that both Indonesian and the Mexican economy have strong dependence on oil revenues. Moreover, considering Indonesia’s characteristics are almost the same as Mexico — at least in the social and economic structure as a middle income country (although Mexico is slightly more in the upper side of the spectrum) with 40% of Indonesia’s population are considered as poor households (ADB, 2015), we can say that Indonesia will experience problems that are more likely the same as those experienced by Mexico. Therefore, it is only relevant for us to look at the country’s energy reform to decarbonise it’s major resource of revenue.

The early initiative of the Mexican government clearly shows that there is a political will to reduce carbon emissions. The impact of implementing carbon tax as part of an overall energy reform in Mexico (see Table below) from the environmental aspect shows that there was a reduction of 1.8 million tCO2 (approximately around 0.38% of the total Mexican carbon emissions in 2014) (EDF, 2015). It is a major progress in the first year alone. This result was achieved by imposing the highest carbon tax rate on diesel fuel (2.3% per tCO2).

Carbon Tax Rate Scheme in Mexico (Cottrell & Falcao, 2018)

Addressing the Critics and Public Outcry

Some critics note that this level of emission reduction is still not enough. Caspedes (2015) in Cottrell and Falcao (2018) states that this criticism departs from the fact that not enough investment is coming into the renewable energy sector as a cheap alternative to offset rising fossil fuel prices. One of the major contributing factor is the carbon tax rates are too low to attract investment. At the same time, fossil subsidies which were gradually lifted then sparked public protests in January 2017 with a 20% increase in fuel prices.

Public outcry in Mexico is a result of impacted domestic income per Mexican household which 34.8% of the population consists of groups with lower middle income class. Aside from most popular arguments, Cottrell and Falcao (2018) analyse that these significant price increases apparently occur outside the influence of carbon tax rates which are considered still too low to affect the community. This rising fuel prices in early 2017 should be the result of the other factors such as oil price fluctuations as well as inflation and continuous deregulation. This condition also shows that the Mexican government does not allocate carbon tax revenues of approximately 1 billion USD per year (Arlinghaus, 2017) as compensation for affected poor households or for other programs that encourage economic growth. Critics target the Mexican government which in this case should be able to utilise the 1 billion USD per year from carbon tax revenues to improve the economy through other instruments. If we see this from the macroeconomic aspect, there is no significant effect even though the industry is quite resistant on the grounds that competitiveness will decrease. There is not strong enough reason to prove negative impacts of carbon tax in business competitiveness (Cespedes, 2015).

The Case for Indonesia

To this day, Indonesia has succeeded in reducing subsidies on fossil fuels including fuel and diesel subsidies since 2014, reducing subsidies on LPG gas cylinders and shifting electricity subsidies to focus only on the poor since 2017. In comparison with Mexico, these actions should impact the households who initially received said subsidies. However, report from the ADB (2015) shows that the Indonesian government has successfully shifted the social impact through diverting the original expenditure to finance fossil fuel subsidies to fund pro-poor investment instead. The allocation of government spending by 119% was distributed to the health sector (which result an increase of 53%) and education (increase of 11%). This condition can be utilised by the Indonesian government to implement carbon tax with rates according to the scheme of Mexico or the majority of other EU countries (Note that these schemes should always be adjusted to the conditions of Indonesia). If it starts from the energy sector, at least per 2021 Indonesia has begun to move to graph and reduce GHG production towards the NDC 2030 target.

What Are the Possible Setbacks? Will This Affect the Poor?

A potential problem that arises is the unavailability of sufficient investment funds for the renewable energy sector in a short time. If this does happen, as in the case of Mexico, it will be possible to reduce carbon emissions that are not too significant to reach the target.

Regarding social impacts, it is actually very unlikely that poor households will be affected by carbon tax. Chancel and Piketty (2015) say that the highest carbon emission contributor in the population spectrum is 10% of the world’s richest people who are responsible for 40–51% of total carbon emissions, while 50% of the poorest population is only responsible for 11–15% of carbon emissions. It can be concluded that carbon tax will have more impact on populations with high income so that the issue of social equity is not a major factor. On the other hand, from an economic standpoint, state revenue that will be increased from carbon tax can be beneficial to continue pro-poor investment in order to guarantee the poor or preferably encourage economic growth with the development of renewable energy, especially by entering the Industrial 4.0 era.

Using Tech to Help

The Industrial Revolution 4.0 as proposed by Schwab (2016) marked an era in which all scientific, economic and industrial disciplines were affected by a series of new technologies that erased the boundaries of the physical, digital and biological world. According to Mrugalska and Magdalena (2017), Industry 4.0 will make it easier to manage, predict and adjust outcomes both socially and in terms of business on a business model. The production chain will be further optimized through various technological and software developments offered in the Industrial 4.0 era.

In line with that, Wang et al. (2016) also added that production activities will produce better quality, more efficient, and save costs by maximising the use of ever-evolving technology. Therefore, it can be concluded that Industry 4.0 has a positive effect on the efficiency of the production of goods and services in the industry through the use of technology that is developing very fast. But not only in terms of production efficiency in the industrial sector, the use of technology can also be utilised to facilitate the implementation of carbon tax in an effort to reduce carbon emissions. Various technological developments in the Industrial 4.0 era such as the Energy Management System, Energy Monitoring and Demand Response System can be useful to compensate the costs arising from carbon taxes with energy efficiency. Thus, the implementation of carbon tax in Indonesia and analysis of its potential in the Industrial 4.0 era will assist the government in tackling the climate crisis especially in the effort to reduce carbon emissions for the fossil-based energy sector.

Carbon Tax is Effective to Decarbonise the Economy

The key findings have shown that implementation of carbon tax has positive impacts in at least three main aspects. In the environmental sector, carbon tax has proven to be efficient in reducing the carbon emissions through increase in prices which subsequently led to reduction in market demand. This leads to the economic aspects, in which carbon tax is the most efficient economic instrument and barely harms the competitiveness of industries so long as the carbon tax revenue is allocated to boost investments in the renewable energy sector. Lastly, the finding shows that since the most carbon emitters are the richest 10% individuals, the implementation of carbon tax should not harm middle to lower income households in the slightest. To bolster the potentials of carbon tax, new Industry 4.0 technologies such as Energy Management System, Energy Monitoring and Demand Response System are proven to be useful. These technologies allow the increased cost burden emitters have to bear to be compensated by the efficiency of energy use. This will result in a more environmentally friendly industry.

Based upon the analysis, it became evident that carbon tax is the proper instrument to aid Indonesia in achieving its carbon emissions reduction target by 2030. However it is imperative for the government to create an ideal carbon tax design. Fortunately, frameworks from various international organizations and countries that have previously implemented carbon tax are available. Indonesia can make use of these frameworks and make the appropriate adjustments to its current situation by conducting further research. It is also crucial for the government to take into consideration the hybrid approach, which is carbon tax implementation through inclusion of other instruments such as the Emissions Trading System to achieve targets efficiently. Furthermore, based on the study case of other countries such as Mexico, it is of great importance to allocate revenue efficiently, preferably to boost investment in renewable energy. It is necessary to conduct further research to explore every prospective instruments capable to mitigate climate crisis. However, given the short amount of time left to achieve carbon emissions target in order to keep the Earth’s temperature below 1.5°C, immediate response needs to be taken right away, and carbon tax seems to be the most suitable answer.