Carbon Emissions Trading and Environmental Protection: International Evidence

Devastating wildfires ravaging the forests in Australia, the rapid rise of sea levels due to melting ice sheets and record-breaking heatwaves in Europe—these are just a few of the detrimental impacts climate change has had on our planet. 

So, what triggers climate change? 

Greenhouse gas emissions, mainly carbon dioxide, are the leading cause of the predicament we are in. Posing a crucial risk to the economy, climate change is now at the top of government policy agendas worldwide. 

Alongside Professor Jennie Bai from Georgetown University, Professor Hong Ru from Nanyang Business School wrote a thought-provoking paper on climate change titled Carbon Emissions Trading and Environmental Protection: International Evidence. 

When asked about the motivations for the research, Professor Hong Ru remarked, ‘Climate change is a huge risk for the welfare of the entire human population, such as global warming. Governments across the globe have introduced many existing and proposed policies to reduce greenhouse gas emissions. Hence, I feel that understanding these policy implications is crucial.’

Carbon tax v. emissions trading system 

The paper analyses the implementation of two government policies that mitigate climate change, namely carbon tax and emissions trading system (ETSs), also known as cap and trade or even carbon trading. More importantly, the paper seeks to address the research question of whether ETSs work to reduce greenhouse gas emissions and what the underlying channels are. Above all, the aim of the two researchers was to investigate the impact of ETS implementations on emissions, the usage of renewable versus fossil fuel energy and the effects of carbon trading versus a carbon tax. 

To better understand how these two policies reduce carbon emissions, we must look at what they entail. With an ETS, the policy involves setting a total cap or limit on carbon emissions, which makes companies switch to low-emission or renewable energy sources. In contrast, a carbon tax establishes a price directly on carbon emissions so that companies are charged a certain amount for every tonne of emissions produced. However, it can be argued that setting a tax does not reduce carbon emissions since the cost can be partially transferred to end users or consumers. 

Professor Hong Ru mentioned, ‘Carbon tax is normally imposed on the power plant. As we pay our electrical bills, the power plant can pass through part of the carbon tax costs to consumers. Hence, this could mitigate the original agenda to reduce carbon emissions and usage of fossil fuels since the power plant might not have a strong incentive to switch to renewable energy.’ 

How do we determine which policy is more effective in reducing carbon emissions? 

To determine the effectiveness of the policies, Professor Jennie Bai and Professor Hong Ru created an international dataset from the Refinitiv database by collecting ETS policy events from the 100 largest countries by GDP as of 2020. They found that the ETS implementations substantially reduced emissions. After launching an ETS, countries have reduced greenhouse gas and carbon dioxide emissions by 12.1% and 18.1%, respectively. 

In addition, such emissions reduction is associated with increased usage of renewable energy, such as wind and solar power. For example, after ETSs were implemented, electricity produced from high-carbon fossil fuels such as coal dropped significantly by 23.70% and the usage of renewable energy increased by 61.59%. 

Carbon tax has had a minor influence on the usage of renewable energy; however, they are not as effective as ETSs. A comparison of the policies shows that carbon taxes have led to reduced emissions but have had a smaller impact than ETSs. However, such a reduction in emissions also occurred before the tax adoption. 

‘Personally, I feel that ETS is more effective than a carbon tax, as it is a cap-and-trade system where the government can establish a hard ceiling of the total carbon emissions. Whereas carbon tax can be passed down to the end users and some firms could shift the carbon emissions to other unregulated areas,’ added Professor Hong Ru. 

When probed on the implications behind his research, Professor Hong Ru claimed, ‘Our findings in this paper have substantial policy implications. It is well-known that environmental policies could be effective or not, depending on many other factors. Understanding the channels of how these policies could reduce pollution or emission is important, for instance, switching from fossil fuel to renewable energy.’ 

Should countries still adopt a carbon tax? 

While some countries have adopted both an ETS and a carbon tax, other countries have chosen to adopt one policy only. In Singapore, our government introduced a carbon tax in 2019 but has yet to adopt an ETS. Notably, we were the first Southeast Asian country to implement a carbon tax. Since 2019, the carbon tax has been set at S$5 per tonne for greenhouse gas emissions until 2023. With the Carbon Pricing (Amendment) Bill passing in November 2022, Singapore will progressively raise its carbon tax in the coming years (Mohan & Koh, 2022).

In Singapore, the country’s emissions have declined since it adopted the carbon tax in 2019. With the rising carbon tax, the government foresees a further decline in our carbon emissions in the future. Only time will tell if this will be the case. 

‘One thing we find interesting in this paper is that both carbon tax and ETS work for some countries but fail in other countries. For instance, when the European Union launched the cap-and-trade system in 2005, it was not successful in the first phase, but it proved to be powerful in the second phase and so forth’, Professor Hong Ru commented, in reference to the performance of the policies. 

This shows that each policy could act very differently in different periods within the same country, possibly because of a country’s external factors, such as inflation or social trends. 

Why has Singapore not yet adopted ETS? 

With the recent introduction of a carbon tax, it might not be long before Singapore implements a carbon trading system as well. According to the findings of this paper, an ETS could prove to be a very powerful tool for Singapore in reducing carbon emissions. 

‘I feel that Singapore is in the position to lead this cap-and-trade system in the ASEAN region and hopefully in the global market. I mean we are a leading trading and financial hub, so why not become an ESG hub, right?’ proclaimed Professor Hong Ru. 

How can we play a part in fighting climate change? 

Along with corporations and governments, it is every individual’s responsibility to help fight climate change and protect our planet. As citizens, we can also play a part in reducing our carbon footprint (total amount of greenhouse gas emissions) generated from our daily consumption and activities. It is especially important to imprint this concept from a younger age to ensure a sustainable future for future generations. 

Having said that, to get citizens to perform a specific action, the government needs to be involved, because its role is to persuade its people. 

‘As a trained economist, I believe that the government must design an incentive system that incentivises citizens to do something. If you ask people to voluntarily do something, it could be difficult,’ Professor Hong Ru declared as he reflected on the government’s influence in helping fight climate change. 

Hong Ru is an Associate Professor of the Banking & Finance division at Nanyang Business School, Nanyang Technological University. His research interests include financial intermediary, Chinese economy, corporate finance, and household finance. 

This research paper is a joint work with Professor Jennie Bai from Georgetown University.