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Pricing Carbon: Where We’ve Been, Where We Are And Where We May Be Going

By Climate Guest Contributor on November 12, 2012 at 9:50 am

"Pricing Carbon: Where We’ve Been, Where We Are And Where We May Be Going"

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by Robert Stavins, via An Economic View Of The Environment

The recent demise of serious political consideration of an economy-wide U.S. CO2 cap-and-trade system and the even more recent resurgence in interest among policy wonks in a U.S. carbon tax should prompt reflection on where we’ve been, where we are, and where we may be going.

Lessons

Almost fifteen years ago, in an article that appeared in 1998 in the Journal of Economic Perspectives, “What Can We Learn from the Grand Policy Experiment?  Lessons from SO2 Allowance Trading,” I examined the implications of what was then the very new emissions trading program set up by the Clean Air Act Amendments of 1990 to cut acid rain by half over the succeeding decade.  In that article, I attempted to offer some guidance regarding the conditions under which cap-and-trade (then known as “tradable permits”) was likely to work well, or not so well.  Here’s a brief summary of what I wrote at the time:

(1)  SO2 trading was a case where the cost of abating pollution differed widely among sources, and where a market-based system was therefore likely to have greater gains, relative to conventional, command-and-control regulations (Newell and Stavins 2003). It was clear early on that SO2 abatement cost heterogeneity was great, because of differences in ages of plants and their proximity to sources of low-sulfur coal. But where abatement costs are more uniform across sources, the political costs of enacting an allowance trading approach are less likely to be justifiable.

(2)  The greater the degree to which pollutants mix in the receiving airshed or watershed, the more attractive a cap-and-trade (or emission tax) system will be, relative to a conventional uniform standard. This is because taxes or cap-and-trade can – in principle – lead to localized “hot spots” with relatively high levels of ambient pollution. Some states (in particular, New York) tried unsuccessfully to erect barriers to trades they thought might increase deposition within their borders.  This is a significant distributional issue.  It can also be an efficiency issue if damages are nonlinearly related to pollutant concentrations.

(3)  The efficiency of a cap-and-trade system will depend on the pattern of costs and benefits. If uncertainty about marginal abatement costs is significant, and if marginal abatement costs are quite flat and marginal benefits of abatement fall relatively quickly, then a quantity instrument, such as cap-and-trade, will be more efficient than a price instrument, such as an emission tax (Weitzman 1974).  With a stock pollutant (such as CO2), this argument favors a price instrument (Newell and Pizer 2003).  However, when there is also uncertainty about marginal benefits, and marginal benefits are positively correlated with marginal costs (which, it turns out, is a relatively common occurrence for a variety of pollution problems), then there is an additional argument in favor of the relative efficiency of quantity instruments (Stavins 1996).

(4)  Cap-and-trade will work best when transaction costs are low (Stavins 1995), and the S02 experiment showed that if properly designed, private markets will tend to render transaction costs minimal.

5)  Considerations of political feasibility point to the wisdom of proposing trading instruments when they can be used to facilitate emissions reductions, as was done with SO2 allowances and lead rights trading, less so for the purpose of reallocating existing emissions abatement responsibility (Revesz and Stavins 2007).

(6)  National policy instruments that appear impeccable from the vantage point of Cambridge, Massachusetts, Berkeley, California, or Madison, Wisconsin, but consistently prove infeasible in Washington, D.C., can hardly be considered “optimal.”

Implications for CO2 Policy

In the same article, I noted that many of these issues could be illuminated by considering a concrete example:  the “current interest” in applying cap-and-trade to the task of cutting CO2 emissions to reduce the risk of global climate change.  Some of the points I made in this regard in my 1998 article were:

(a)  The number of sources of CO2 emissions are vastly greater than in the case of SO2 emissions as a precursor of acid rain, where the focus could be placed on a few hundred electric utility plants.  Feasibility considerations alone argue for market-based instruments (cap-and-trade or taxes) to achieve meaningful reductions of CO2 emissions.

(b)  The diversity of sources of CO2 in a modern economy and the consequent heterogeneity of emission reduction costs bolster the case for using cost-effective market-based instruments.

(c)  As the ultimate global-commons problem, CO2 is a truly uniformly-mixed pollutant.  With no concern for hot spots, market-based instruments present none of the problems that can arise in the case of localized environmental threats.

(d)  Any pollution-control program must face the possibility of emissions leakage from regulated to unregulated sources. This would be a severe problem for an international CO2 program, where emissions would tend to increase in nonparticipant countries. Furthermore, it raises concerns for the emission-reduction-credit (not cap-and-trade) system in the Kyoto Protocol known as the Clean Development Mechanism (CDM).  Such an offset system can lower aggregate costs by substituting low-cost for high-cost control, but may also have the unintended effect of increasing aggregate emissions beyond what they would otherwise have been, because there is an incentive for adverse selection: sources in developing countries that would reduce their emissions, opt in, and receive credit for actions they would have taken anyway.

(e)  Although any trading program could potentially serve as a model for the case of global climate change, I argued that the trading system that accomplished the U.S. phaseout of leaded gasoline in the 1980s merited particular attention. The currency of that system was not lead oxide emissions from motor vehicles, but the lead content of gasoline. So too, in the case of global climate, great savings in monitoring and enforcement costs could be had by adopting input trading linked with the carbon content of fossil fuels. This is reasonable in the climate case, since – unlike in the SO2 case – CO2 emissions are roughly proportional to the carbon content of fossil fuels and scrubbing alternatives are largely unavailable, at least at present.

(f)   Natural sequestration of CO2 from the atmosphere by expanding forested areas is available (even in the United States) at reasonable cost (Stavins 1999).  Hence, it could be valuable to combine any carbon trading (or carbon tax) program with a carbon sequestration program, although this will raise significant challenges in regard to monitoring and enforcement.

(g)  In regard to carbon permit allocation mechanisms, auctions would have the advantage that revenues could be used to finance reductions in distortionary taxes.  Free allocation could increase regulatory costs enough that the sign of the efficiency impact could conceivably be reversed from positive to negative net benefits (Parry, Williams, and Goulder 1999).  On the other hand, free allocation of carbon permits would meet with much less political resistance.

The Necessity of Market-Based Instruments:  Cap-and-Trade or Carbon Taxes

I concluded that developing a cap-and-trade system for climate change would bring forth an entirely new set of economic, political, and institutional challenges.  At the same time, I recognized that the diversity of sources of CO2 emissions and the magnitude of likely abatement costs made it equally clear that only a market-based instrument – some form of carbon rights trading or (probably revenue-neutral) carbon taxes – would be capable of achieving the domestic targets that might eventually be forthcoming.

In other words, my conclusion in 1998 strongly favored a market-based carbon policy, but was somewhat neutral between carbon taxes and cap-and-trade.  Indeed, at that time and for the subsequent eight years or so, I remained agnostic regarding what I viewed as the trade-offs between cap-and-trade and carbon taxes.  What happened to change that?  Three words:  The Hamilton Project.

The Making of an Advocate

For those of you who don’t know, the Hamilton Project is an initiative based at the Brooking Institution that – according to its web site – “offers a strategic vision and produces innovative policy proposals on how to create a growing economy that benefits more Americans.”

In 2007, the Project’s leadership asked me to write a paper proposing a U.S. CO2 cap-and-trade system.  I responded that I would prefer to write a paper proposing the use of a market-based CO2 policy, describing the two alternatives of cap-and-trade and carbon taxes.  I explained that I was by no means opposed to the notion of a carbon tax, having written about such approaches for more than twenty years.  Indeed, I noted, both cap-and-trade and carbon taxes would be good approaches to the problem; they have many similarities, some tradeoffs, and a few key differences.

The Hamilton Project leaders said no, they wanted me to make the best case I could for cap-and-trade, not a balanced investigation of the two policy instruments.  Someone else would be commissioned to write a proposal for a carbon tax.  (That turned out to be Professor Gilbert Metcalf of Tufts University – now on leave at the U.S. Department of the Treasury – who did a splendid job!)  Thus, I was made into an advocate for cap-and-trade.  It’s as simple as that.

Giving It My Best Shot

I argued in my Hamilton Project paper (which you can read here) that despite the tradeoffs between the two principal market-based instruments that could target CO2 emissions, the best (and most likely) approach for the short to medium term in the United States was a cap-and-trade system, based on three criteria:  environmental effectiveness, cost effectiveness, and distributional equity.  Although my position was not simple capitulation to politics, I argued that sound assessments of environmental effectiveness, cost effectiveness, and distributional equity should be made in a real-world political context.

I said that the key merits of the cap-and-trade approach were, first, the program could provide cost-effectiveness, while achieving meaningful reductions in greenhouse gas emissions levels.  Second, it offered an easy means of compensating for the inevitably unequal burdens imposed by a climate policy.  Third, it provided a straightforward means to link with other countries’ climate policies.  Fourth, it avoided the political aversion in the United States to taxes.  Fifth, it was unlikely to be degraded – in terms of its environmental performance and cost effectiveness – by political forces. And sixth, this approach had a history of successful adoption and implementation in this country over the past two decades.

I recognized that there were some real differences between taxes and cap-and-trade that needed to be recognized.  First, environmental effectiveness:  a tax does not guarantee achievement of an emissions target, but it does provide greater certainty regarding costs.  This is a fundamental tradeoff.  Taxes provide automatic temporal flexibility, which needs to be built into a cap-and-trade system through provision for banking, borrowing, and possibly cost-containment mechanisms.  On the other hand, political economy forces strongly point to less severe targets if carbon taxes are used, rather than cap-and-trade – this is not a tradeoff, and is why virtually no environmental NGOs have favored the carbon-tax approach.

In principle, both carbon taxes and cap-and-trade can achieve cost-effective reductions, and – depending upon design — the distributional consequences of the two approaches can be the same.  But the key difference is that political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs, as some low-cost emission reduction opportunities are left off the table.  But political pressures on a cap-and-trade system lead to different allocations of the free allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.

I concluded that proponents of carbon taxes worried about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax would be sensitive to the same political pressures, and should be expected to succumb in ways that are ultimately more harmful:  reducing environmental achievement and driving up costs.

Of course, such positive political economy arguments look much less compelling in the wake of the defeat of cap-and-trade legislation in the U.S. Congress and its successful demonization by conservatives as “cap-and-tax.”

A Political Opening for Carbon Taxes?

Does the defeat of cap-and-trade in the U.S. Congress, the obvious unwillingness of the Obama White House to utter the phrase in public, and the outspoken opposition to cap-and-trade by Republican Presidential candidate Mitt Romney indicate that there is a new opening for serious consideration of a carbon-tax approach to meaningful CO2 emissions reductions?

First of all, there surely is such an opening in the policy wonk world.  Economists and others in academia, including important Republican economists such as Harvard’s Greg Mankiw and Columbia’s Glenn Hubbard, remain enthusiastic supporters of a national carbon tax.  And a much-publicized meeting in July at the American Enterprise Institute in Washington, D.C. brought together a broad spectrum of Washington groups – ranging from Public Citizen to the R Street Institute – to talk about alternative paths forward for national climate policy.  Reportedly, much of the discussion focused on carbon taxes.

Clearly, this “opening” is being embraced with enthusiasm in the policy wonk world.  But what about in the real political world?  The good news is that a carbon tax is not “cap-and-trade.”  That presumably helps with the political messaging!  But if conservatives were able to tarnish cap-and-trade as “cap-and-tax,” it surely will be considerably easier to label a tax – as a tax!   Also, note that Romney’s stated opposition and Obama’s silence extend beyond disdain for cap-and-trade per se.  Rather, they cover all carbon-pricing regimes.

So as a possible new front in the climate policy wars, I remain very skeptical that an explicit carbon tax proposal will gain favor in Washington, no matter what the outcome of the election.  Note that the only election outcome that could lead to an aggressive and successful move to a meaningful nationwide carbon pricing regime would be:  the Democrats take back control of the House of Representatives, and the Democrats achieve a 60+ vote margin in the Senate, and the President is reelected.  A quick check at Five Thirty Eight (Nate Silver’s superb election forecast website at the New York Times) and other polling web sites makes it abundantly clear that the probability of such Democratic control of the White House and Congress is so small that it’s hardly worth discussing.

What About Fiscal Policy Reform?

A more promising possibility – though still unlikely – is that if Republicans and Democrats join to cooperate with either a Romney or Obama White House to work together constructively to address not only the short-term fiscal cliff at the end of this calendar year, but also the longer-term budgetary deficits the U.S. government faces, and if as part of this they decide to include not only cuts in government expenditures, but also some significant “revenue enhancements” (the t-word is not allowed), and if (I know, this is getting to be a lot of “if’s”) it turns out to be easier politically to eschew increases in taxes on labor and investment and therefore turn to taxes on consumption, then there could be a political opening for new energy taxes, in particular, (drum roll ….) a carbon tax.

Such a carbon tax – if intended to help alleviate budget deficits – could not be the economist’s favorite, a revenue-neutral tax swap of cutting distortionary taxes in exchange for implementing a carbon tax.  Rather, as a revenue-raising mechanism – like the Obama administration’s February 2009 budget for a 100%-auction of allowances in a cap-and-trade scheme – it would be a new tax, pure and simple.  Those who recall the 1993 failure of the Clinton administration’s BTU-tax proposal – with a less polarized and more cooperative Congress than today’s – are not optimistic.

Nor is it clear that a carbon tax would enjoy more support in budget talks than a value added tax (VAT) or a Federal sales tax.  The key question is whether the phrases “climate policy” or “carbon tax” are likely to expand or narrow the coalition of support for an already tough budgetary reconciliation measure.  The key group to bring on board will presumably be conservative Tea Party Republicans, and it is difficult to picture them being more willing to break their Grover Norquist pledges because it’s for a carbon tax.

Research

Even if the much-ballyhooed political opening for carbon taxes is largely illusory, the opening for policy wonks is real.  And here is where action is happening, and should continue to happen.  At some point the politics will change, and it’s important to be ready.  This is why economic research on carbon taxes is very much needed, particularly in the context of broader fiscal challenges, and it is why I’m pleased to see it happening at Resources for the Future, Harvard University, and elsewhere.

Bottom Line

I would personally be delighted if a carbon tax were politically feasible in the United States, or were to become politically feasible in the future.  But I’m forced to conclude that much of the current enthusiasm about carbon taxes in the academic and broader policy-wonk community in the wake of the defeat of cap-and-trade is – for the time being, at least – largely a manifestation of the grass looking greener across the street.

Robert N. Stavins is the Albert Pratt Professor of Business and Government, Director of the Harvard Environmental Economics Program, and Chairman of the Environment and Natural Resources Faculty Group. This piece was originally published at his blog, An Economic View Of The Environment, and was reprinted with permission.

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15 Responses to Pricing Carbon: Where We’ve Been, Where We Are And Where We May Be Going

  1. CW says:

    Excellent post. Couldn’t agree more with the last two paragraphs in particular.

    Find it odd to contemplate that we might just have gone from “We can’t introduce this tax because it’ll ruin us financially!” to “We’re ruined financially so we need this tax!”

    Is it possible that such a non-ideal way for the tax to be introduced (i.e., as new revenue, not as a revenue-neutral intervention to spur environmental innovation and emission reduction) might have been the best way to sell it all along? Those Tea Party types and the like minded always figure it’s about revenue anyways, and at least it would link the tax to debt reduction in their minds, something they do see as important (at least when Democrats are in power).

  2. BillD says:

    What about a hybrid of carbon tax and cap and trade. The cap and trade works better for fewer sources and seems especially appropriate for electricity generation by utilities. For fuels bought by consumers, such as gasoline, we would just need to add a tax onto the cost of the fuel, since other options don’t seem plausible. Both a carbon tax and a cap and trade system should be effective in favoring renewable, nonfossil fuels and in encouraging energy efficiency.

    • riverat says:

      The simplest way to implement a carbon tax would be at the source. Where the fossil fuel comes out of the ground or at the point of import. Then just let the added cost percolate up through the supply chain.

  3. Leif says:

    A Nation that places NO VALUE on Earth’s life support systems, places NO VALUE on LIFE! Price Carbon. Stop profits from polluting the commons. Bring distributed green energy production to the communities. Bring profits to the communities. Not profits to the polluters. Money is not the operative word her. Survival for Earth’s Life Support Systems and a livable earth for the Kidders IS!
    There is no such thing as clean coal. Ship it over to China “WE the People” still get the pollution and the climatic disruption, the ecocide fossil barons still get the profits.

    I have a $120/T charge for home garbage, $50 for compost makings! Waste water fees, even “rain run off” is not free to this person. (Guide lines here?) Corpro/People deserve a bulk rate of free? They piss all over themselves at the thought of $25/ton for toxins! In fact they get my tax subsidy support in the process! Get real…

    Corporations are people now yet don’t respect the fiduciary common law of not polluting your neighbors land. For profit or otherwise!
    The GOP do not fund abortion. Fine. A precedent. Why must I fund, with my TAX DOLLARS, the ecocide of the PLANET!
    What is a fair price to dump tons of toxins in the pristine waters and air of the commons? Corporations are “People” now. Does not “WE the PEOPLE” mean ALL of us?
    Stop profits from the pollution of the commons.

    Both power and money have been conscripted by the ecocide fossil Barons… Distributed Green Energy gives both power and money back to “We the People!”

  4. Much better framing than “revenue neutral carbon tax” is to call it a “carbon-funded tax cut”.

    BC has a successful and popular income tax cut that was funded 100% by a carbon-pollution fee. Oddly, the conservative government that brought it in decided to call it a “carbon tax”. This framing hides the BENEFIT they delivered (“tax cut”) while pushing the COST they imposed (“tax”) to the front and center.

    The result of this framing is that the left decided to run an election campaign featuring an “axe the tax” slogan. They lost in this case, because the carbon tax is popular…but it was divisive. The point is that it would be much harder for the political opponents to run a campaign on “axe the tax cut”. Conversely, it is much harder for proponents to sing the praises of “revenue neutrality” (except to policy geeks) than it is to lavish praise on “income tax cuts”.

    I believe the framing path to bring rank-and-file GOP on board is to emphasize the “tax cut” half and de-emphasize the “pollution fee” part in the naming and framing.

    GOP leaders should argue for a big “income tax cut” for biz and individuals that is paid for by a “carbon pollution fee”. “Hey, we are the party that is bringing you a tax cut solution to climate change.”

    Whatever the terminology, the essential point of selling a “revenue neutral carbon tax” is to put your best foot forward by including the “tax cut” terminology in whatever phrase is used to describe it. I personally like: “carbon-funded tax cut”.

    As Joe points out over and over, framing matters.

  5. Mike Roddy says:

    Thanks for this detailed summary, Robert, but I disagree that opposition to cap and trade is a result of framing, since Republicans will call it “cap and tax”.

    Cap and trade for CFC’s and SOx was quite different, because it is more easily measured and offsets were not so pervasive. A carbon tax is preferable to cap and trade because it is straightforward, and less easily gamed.

    When the Chicago Board instituted cap and trade schemes, some of the offsets made things worse. The classic example was traders felling forests and then profiting from tree farms that replaced the, claiming offsets for the carbon the new trees were respirating. The science was already poor, and then became corrupted.

    The other problem, of course, is that cap and
    trade became a profit center for banks. This affected the corruption of the monitoring methodology. A carbon tax is simpler, reducing the opportunities for gaming it, and eliminating yet another costly source of revenue for investment banks.

    Opposition to a carbon tax mostly comes from the fossil fuel companies and their spokesmen. Are we so afraid of them that they will continue to dictate the public dialogue?

  6. DRT says:

    This discussion is all about carbon taxes and cap & trade, but I hope we are really talking about GHG taxes or GHG cap & trade in terms of CO2 equivalents.

  7. DRT says:

    “Natural sequestration of CO2 from the atmosphere by expanding forested areas is available (even in the United States) at reasonable cost (Stavins 1999).”

    There has been discussion on this site regarding the demise of, or at least significant strain on North American forests due to ground level ozone. So wouldn’t it be wise to include the precursors to ozone in any GHG tax, fee & dividend, or cap & trade scheme.

  8. Paul Klinkman says:

    How about total greenhouse gas emission pricing? If your natural gas company can get zero methane leakage at the well, at the pipes and at the end-user then you should profit. If your scummy gambling natural gas company gets dry fracking wells all day that leak kilotons of natural gas (methane) into the air, then Uncle Sam has a tax bill for you to pay.

  9. DRT says:

    Any GHG tax, fee & dividend or cap & trade program needs to include a tariff on the GHG content of imports.

  10. Merrelyn Emery says:

    Any proposal should be designed to integrate with the growing international scheme. Australia has modified its trading system to fit with the EU’s and Korea is looking to join. China’s provincial experiments will go national pretty soon and should also hook up. May not be ideal but is working and it would be another tragedy if the USA stood apart from this move, ME

  11. dick smith says:

    Now can we hear a real pro-carbon tax advocate like Shi-Ling Hsu who has written eloquently and persuasively on the merits of a carbon tax.

    There are many policy reasons (not even touched on here) WHY the wonks support a carbon tax. That might be helpful information, doncha think?

  12. Peter Wood says:

    Good article. What is important is that both emissions trading and carbon taxes put a price on greenhouse gas emissions. This is a highly effective approach to reduce emissions for the six reasons that Prof Stavins outlines. In practice, many approaches to pricing carbon pollutions a hybrids of cap-and-trade approaches and carbon tax-like approaches – for example, many cap-and-trade schemes have price containment measures that make them behave economically more like a carbon tax.

    Stavins mentions that carbon taxes can lead to exemptions, while cap-and-trade schemes end up giving away some allowances for free instead. It is possible to avoid this issue if instead of having a carbon tax, allowances are issued at a fixed price or allocated freely. This is exactly how the first three years of Australia’s emissions trading scheme works, before transitioning into a flexible price cap-and-trade emissions trading scheme. In both phases, permits are allocated in the same way (except that in the flexible-price phase, permits are auctioned instead of sold at a fixed price).