Yes, Carbon Fees Plus Rebates Create Incentives to Reduce CO2 Emissions

I appreciate that environmentalists don’t like super-simplistic economic models that assume perfect competition and perfect information. I don’t like them either. And consequently, I agree that though a “cap and dividend” scheme in which you auction CO2 emissions permits and then rebate the money to taxpayers makes sense in a simplistic model it’s not the optimal policy for the real world. That said, a lot of environmentalists seem to me to take this far too far in the other direction, and start arguing that these models don’t tell us anything about human behavior and that price incentives won’t do anything without explicit subsidies and regulatory mandates.

Hence you get this kind of misguided argument from Sean Casten who thinks “cap-and-dividend provides no incentive to reduce CO2” (emphasis in the original):

Because a tax on your competitor does not make you wealthier. This is so obvious it shouldn’t need repeating. And yet it is perniciously present in the cap-and-dividend debate. Raising the cost of generating power from coal does not suddenly enhance the economic incentives to build a solar panel any more than losing your job makes it easier for your neighbors to finance an addition to their home. If we want to provide an incentive for carbon reduction, make an explicit payment per ton of carbon reduced; don’t simply bank on hopeful theories about how costs will ripple through the system as higher prices and profit margins. Maybe that happens in the long run — but in the long run, we’re all dead.

This is nuts. Consider ways I might create economic incentives to build more Pepsi plants. One thing I might do is offer a subsidy—”if you open a Pepsi plant, I’ll give you some money.” Another thing I might do, however, is slap a $0.50 tax on Coke products. If you do that, some people will just increase their Coke expenditures and decrease their spending on non-Coke items. But some people will decrease their Coke consumption. And some of those people will replace their Coke consumption with close substitutes for Coke—Pepsi, in other words. That increased demand for Pepsi creates the incentive to build more Pepsi plants. And this incentive isn’t created “in the long run” it exists from the minute the new policy is announced. The only lag involved is simply that it may take a while to actually build the new plant, but the logistical issues involved with that will exist with any policy tool. The point, however, is that taxing Coke and rebating the money to the public is a perfectly workable way of reducing Coke consumption.

Back to climate policy, the main issue with price-only policies is that if you want to inspire substantial changes in behavior through this lever then the tax is going to have to be quite high. But for a bunch of fairly obvious reasons, any kind of greenhouse gas tax is very likely to be phased in rather slowly over time. Which means that in the short term it’s vital to take advantage of all the low-hanging fruit that’s out there in terms of efficiency and other things a cap-and-dividend plan isn’t going to capture. On top of that, any realistic view of the market for electricity & heat or the forces impacting people’s decisions about housing & transportation will immediately lead you to the conclusion that the status quo does not consist of unregulated competitive markets so it’s insane to not look at changing the regulations in a more ecologically sustainable direction.