The Price of Carbon for Petrol

by Stubborn Mule on 2 July 2008 · 11 comments

Commenting on my petrol prices post, Mark Lauer suggested that excise on petrol should in fact be increased to deal with negative externalities:

Personally I think we should be increasing the excise. It represents the many negative externalities that car use in our society creates: carbon emissions, use of space for (larger) roads; materials, construction and maintenance of (larger) roads; particulate pollution; deaths and injuries from road accidents, and so on, all of which scale with mileage and hence fuel use. And our understanding of all these factors is moving in the direction of increased disutility. Hence the charges should be increased.

I’ve been thinking about petrol and carbon emissions a bit over the last few weeks, so this is as good a prompt as any to put down my thoughts here on the Mule. I should also point out that I have Mark to thank for the back of the envelope calculation that I’ll discuss here.

When there is no cost to polluting, the result is a market failure and the two main approaches to addressing this failure are taxation and “cap and trade” schemes. Under a tax scheme, a fixed price is imposed per unit of pollution. While this should decrease the amount of pollution, the extent of the reduction cannot be known ahead of time. Over time, if reductions are insufficient, prices can be increased. In the case of a cap and trade scheme, a cap is set on the amount of pollution allowed each year and permits are created that entitle the bearer to emit a share of this cap. These permits can then be traded and so the price of a permit is set by the market. In this case, the amount of pollution reduction is known in advance, but the price is not.

Current Australian Government policy for dealing with carbon dioxide emissions is the introduction a cap and trade scheme. The details of the scheme are yet to be finalised. For example, it has not yet been decided how the scheme will be applied to petrol: will it apply to drivers, car manufacturers, refiners or retailers? And, of course, the price of carbon dioxide emissions is not yet known. Estimates range from $5 to $50 per tonne of carbon dioxide. One price indication was given by a recent Westpac and AGL transaction for emissions at $19 per tonne. The question then is, given this range of emissions prices, what would the impact on petrol prices be?

Petrol is a mixture of hydrocarbons, mostly octane, and so is mostly made up of carbon and hydrogen. In a combustion engine, the carbon in petrol combines with oxygen in the air, producing carbon dioxide emissions. Here are the key facts for Mark’s back of the envelope calculation:

  • the density of petrol is 0.74 kg/litre
  • octane has 8 carbon atoms and 12 hydrogen atoms
  • the atomic weights of hydrogen, carbon and oxygen are 1, 12 and 16 respectively

So, the atomic weight of octane is 8 x 12 + 12 x 1 = 108 and so carbon makes up approximately 8 x 12 / 108 = 89% of petrol by weight. Also, the atomic weight of carbon dioxide is 12 + 2 x 16 = 44 and so every kilogram of carbon combusted produces 44 / 12 = 3.7 kilograms of carbon dioxide. Putting it all together, this means that burning 1 litre of petrol produces 0.74 x 0.89 x 3.7 = 2.4 kilograms of carbon dioxide emissions. Armed with this information, we can now calculate the increase in petrol prices that would result for different prices for carbon dioxide emissions, assuming the cost of emissions was passed on to petrol.

So, the AGL/Westpac price would imply an increase of almost 5 cents per litre and unless the price of carbon emissions comes in very low, we can expect the increase in prices to be bigger than any savings that may arise from the FuelWatch scheme. Of course, the current excise is 38 cents/litre but explanations of the purpose the excise generally focus on the wear and tear caused by road use rather than the cost of carbon emissions.

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{ 10 comments… read them below or add one }

1 Michael Michael July 2, 2008 at 1:52 pm

Is there not another key difference between the taxation approach and the cap and trade approach – namely, who gets the profits. I’m no man of markets – duh – but the ETS isn’t ultimately going to mean any revenue for the government, is it? Instead, the money-makers would cowboy traders, who walk about in their ten-gallon hats and their blackberries, no?

2 Mark July 2, 2008 at 2:16 pm

I was going to correct you michael michael, but I note 90.84 kg-of-carbon-dioxide hats doesn’t have the same ring to [their blackberries], no?

3 stubbornmule July 2, 2008 at 2:36 pm

@Michael Michael: there is no reason that the Government cannot generate revenue from a cap and trade scheme. It depends on how the credit as allocated. If they are simply given to existing emitters (known as “grandfathering”) there is no revenue for the Government. However, the other approach is to auction the credits, which does generate revenue. If prices subsequently increase in the secondary market, the Government doesn’t benefit from that but the next time there is an auction the Government would be likely to see higher prices.

What the Government does with the revenue is another question. Swan has indicated that all revenue would be used to provide assistance to affected households and industries. Depending on how this is done, it could defeat the whole purpose of the scheme!

Also, with all the sensitivity to petrol prices, the Government is looking like they may back out of passing all the costs onto fuel.

4 Michael Michael July 2, 2008 at 3:00 pm

Nice response – although I hope to good god that that emoticon was an unhappy accident to do with some manner of colon and a stray parenthesis. In honour of @Mark’s midrashing, too, surely it should be called a 90.48kg-hat-and-trade scheme, no?

5 stubbornmule July 2, 2008 at 3:18 pm

@Michael Michael: the emoticon was a side-effect and will be corrected!

6 Mark L July 3, 2008 at 2:20 pm

> the two main approaches to addressing this failure
> are taxation and “cap and trade” schemes

Well… the two main free-market-oriented approaches anyway, which are the only kind of approaches considered mentionable in this day and age. One can also, among other things, (i) subsidise development or use of alternatives (which we are doing), (ii) use marketing to influence behaviour non-economically (which won’t alone be effective enough in this case, and would turn Rudd into a hypocrite after the Workchoices advertising stoush), and (iii) regulate directly to either ration or restrict. Note: Use of conjunction here is intentional.

7 stubbornmule July 3, 2008 at 3:01 pm

@Mark: Fair point: I really should have said something like “the two most widely discussed approaches”. Certainly these are the approaches that most economists would favour, but perhaps that’s because they don’t really understand marketing. After all, homo economicus should not really be influenced by marketing, so it shouldn’t exist. But it does! Maybe I should re-read “Predictably Irrational” as there is plenty of material there to suggest other non-classical ways of influencing behaviour.

8 stubbornmule July 15, 2008 at 9:04 am

I’ve been syndicated over on the ANZ section of The Oil Drum.

9 Daniel November 19, 2009 at 4:38 am

Due to the fact that the 2.4kgCO2 per litre of petrol is largely comprised of free oxygen, perhaps a tax on the amount of oxygen sequested from the atmosphere would be a more simpler notion to pass onto the ill informed community for taxing emissions.

10 stubbornmule November 19, 2009 at 10:01 am

Daniel: I can see the headlines now: “Taxing the very air we breathe!”.

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