2st Economics Commentary

John Chan

IB Economics HL

2 ECONOMICS COMMENTARY (FINAL DRAFT)

John Chan

ND

Title of Article: Green tax to hit air passengers Date of Article: 6th September 2011 Author of Article: Charlotte So Source: South China Morning Post Date written: 17th November 2011 Word Count: 750 words Section of syllabus: S1

2st Economics Commentary

John Chan

Green tax to hit air passengers Carriers face a US$400m bill on flights to Europe next year due to levy on carbon emissions and cost will 'inevitably' be passed on to customers. airlines including Cathay Pacific are likely to have to pay up to US$400 million a year for their carbon emissions on European routes from January - a cost likely to be passed on to passengers. The green tax, imposed by the European Union in an attempt to lower greenhouse gas emissions, would mean an extra cost of US$8 per passenger on average. That figure was based on a total of 2.5 billion passengers and the 650 million tonnes of carbon dioxide emitted globally by carriers last year, said Andrew Herdman, general director of the Association of Asia Pacific Airlines. A Cathay Pacific spokesman said yesterday: "It is inevitable that the increased costs will be passed on to the passengers." Carbon credits, which are used to offset the carbon emissions, traded at an average of !15 (HK$166) to !20 per tonne on the European market last year. It is estimated that the carbon footprint of one passenger on a round trip from Hong Kong to London - a total of 19,244 kilometres - is about 1.4 tonnes of carbon dioxide. The extra cost seems affordable, but airlines operate on thin margins. Global airlines made US$18 billion in net profit last year, their best year since 2000. That translates into a profit of approximately US$7 per passenger, compared with the US$8 in carbon pricing per ticket. In three out of the past 10 years, when airlines turned a profit, their margins were between 1.1 per cent and 3.2 per cent. "The airlines industry is so competitive that any difference in the margin translates into market share gain and market share loss," said Herdman. "That's why we are demanding fairness in the scheme and are against any kind of distortion in the rules." Cathay agreed that a price should be put on the carbon footprint, but not through a "territory system", said John Slosar, chief executive of the airline, at a press conference last month. Airlines, which account for 2 per cent of global carbon emissions, protested against the EU scheme because it charged for the entire flight, even if the flights are over non-EU territories. This scheme penalises carriers operating at hubs far away from Europe, while benefiting those nearer, such as Middle East airlines. US carriers have sued the EU in the European Court of Justice for including airlines in the emissions trading scheme. A panel of judges will publish an opinion on October 6. The US case is key because its arguments focus on the legitimacy of the EU applying its emission scheme to all airlines. A ruling in favour of the US carriers would apply to others.

2st Economics Commentary

John Chan

Air China and other mainland carriers have also threatened to sue. Herdman predicted the lawsuit would eventually turn into political disputes between governments and would need to go through the International Civil Aviation Organisation, a specialised agency of the United Nations that governs airlines. These political battles could be solved only by bilateral discussions between governments, he added. Under the EU scheme, airlines are granted 85 per cent of their carbon emissions for free and need to buy the remaining 15 per cent through auctions, based on their traffic figures for last year. Those that cannot come up with a quota sufficient to cover their emissions will be subject to penalties equivalent to 100 per tonne of emissions. (586 words)

2st Economics Commentary Commentary:

John Chan

In an attempt to reduce carbon emission, the European Union established a trade permit scheme, which may require airlines to buy permits to emit CO2. Known as cap and trade or carbon credit, trade permit is a market-based solution to counter negative production externalities. The cap and trade scheme will be implemented starting 2012, although airline companies are reluctant to comply. Depending on the size of the airline, each firm is allowed to pollute up to certain amount, which is known as the cap. If it exceeds the cap an airline must buy credits in the market to pay for the extra emission, which is know as trade. Trade permits are a market based solution as opposed to a tax to force airlines or any industry with negative externalities that are cost in the form of negative side-effects borne by the third party that is not part of the transaction to internalize spillover cost in their business model. Currently the price of one tonne of CO2 is $166/HK and the estimated carbon pricing is $8 per passenger. According to the article, the cost would inevitably be passed on to the consumers. The distribution of incidence among producers and consumers depends on the elasticity of demand that is the measure of responsiveness of quantity demanded to change in price. This is illustrated in the graphs below:

Fig. 1

Fig. 2

In Figure 1, the demand is elastic. The producer burden is therefore greater than the consumer burden. In Figure 2, the demand is inelastic. The consumer burden is therefore greater than the producer burden. As the airline industry is highly competitive, the demand curve is likely to be elastic, which means airline companies would receive a greater burden from the trade permit scheme.

2st Economics Commentary

John Chan

The theoretical model behind the permit scheme is to help producers achieve allocative efficiency that is the production of a good or service that is achieved when social marginal benefit equals social marginal cost. Producing at a level higher than what is socially desirable, producers are over allocating their resources, creating allocative inefficiency. Trade permits correct this inefficiency by causing the shift from S1 to S2, which reduces the negative externalities caused by the airline industry. This is illustrated in the graph below:

Fig. 3

In Figure 3, as a result of the trade permit scheme, the supply curve shifts from S 1 to S2, which indicates the marginal social cost that Is the sum of marginal private cost and externality. At point P1 and Qm, there is market failure because the market does not take the externalities into account and the scheme forces the market to take externalities into consideration. According to the article, the spillover cost of the airline industry is equivalent to US$400 million. The resulting effect of the cap and trade scheme is a higher price of airlines tickets and a lower quantity demanded. Price increases from P1 to P2 while quantity demanded decreases from Qm to Qopt. Consumers will pay an average of $8 USD extra marked by (P2 - P1) in the graph, depending on their cost function. As a result of the decrease in quantity demanded, airlines will experience reduced profit margins.

2st Economics Commentary

John Chan

Airlines operate in an industry that is has a highly competitive, monopolistic market structure that has many competing firms who differentiate for competition where companies have little pricing power and therefore are price-takers that can not significantly affect the market price by altering its rate of production and sales. In the article, Cathay Pacific protests that the imposition of the permit scheme may affect the companys market share that is the percentage of a markets total sales that is earned by a particular company as it runs on a thin profit margin. The reduced profit margin is illustrated in the graph below.

Fig. 4 In Figure 4, area P1E1Qd10 is greater than P2E2Qd20, which represent the original and new total revenue that is the payments firms receive when they sell goods or services over a given period of time respectively. This indicates that the total revenue of the producer is reduced by (E1Qd1Qd1E2 P2E2XP1). A trade permit is effective in limiting carbon emission and improving allocative efficiency of firms. However, there is strong opposition from airlines, arguing that such a measure is bad for business and would slow down economic growth. There is also great difficulty in its implementation as more airlines threaten to sue and would reduce direct flights to Europe to avoid extra cost.