Thursday, February 16, 2017

Is the US Ready for a Carbon Tax?

  • While the Trump administration seeks to undo CO2 regulations, a group of former Republican officials has proposed a new, market-based emissions plan.
  • This "carbon tax" looks simpler than EPA's Clean Power Plan or previous cap-and-trade legislation, but not simpler than the pre-Obama status quo.
The idea of taxing the carbon content of energy--and presumably the goods and services produced with it--is back in the news. A group of Republican "wise men" has floated it as an alternative to the regulation-based approach to emissions that the Obama administration pursued after its preferred "cap & trade" legislation died in the Congress.

Reduced to its basics, a carbon tax is a focused version of a consumption tax, based on usage rather than income or valuation. The level of the tax would be set by law, either as a fixed amount per ton of emissions or at an initial rate with preset future increases. What can't be known with certainty in advance is just how much a given level of carbon tax would reduce actual emissions.

This contrasts with the method of setting a price on carbon preferred by many other economists and environmental groups, called "cap & trade." In this approach, the government sets a cap, or maximum level, on emissions for a designated sector or the economy as a whole, while parties subject to the cap are allowed to trade emission allowances and credits with each other under that cap. Thus policy makers set the level of emission reductions, and allow the market to find the resulting price on carbon. In principal, that ought to be more efficient than the simpler carbon tax, because market forces should drive participants with low costs of cutting emissions to make the deepest reductions and then sell their excess cuts to others, for less than it would cost the latter to reduce by that amount.

From the late 1990s until 2009 or '10 I was convinced that cap & trade was the better approach to pricing emissions. However, the experience of watching the US Congress attempt to design a cap-and-trade system for the US economy cured my certainty. As I have described at length, the inclination of legislators to help favored companies, industries and sectors, combined with the extraordinary temptations created by the sheer scale of the revenue such a system would channel through the government's hands, revealed practical problems that look insurmountable in the real world, at least under our political system.

In fairness, cap-and-trade is currently used to promote emissions reductions in various jurisdictions, including California, the mainly northeastern states participating in the Regional Greenhouse Gas Initiative, and the European Union. From what I have observed, all of them have experienced technical difficulties involving the allocation of free allowances, inadequate liquidity, and other issues. The biggest practical problem is that the carbon prices these systems have tended to deliver might be characterized as the opposite of a Goldilocks price; i.e., they are typically high enough to generate substantial revenue, creating strong constituencies for their continuation, but too low to influence behavior very much.

For example, California's emissions credits currently trade at around $13 per metric ton of CO2, equivalent to $0.10 per gallon of gasoline containing ethanol. Would an extra $1 per fill-up make much of a difference in how much you drive, which car to buy when you replace your current car, or whether to sell your car (or forgo buying one) and take public transportation?

Moreover, California's emissions have been essentially flat since the state implemented cap-and-trade in 2012. However, since 2002 the state's electric utilities--historically the highest emitting sector--have operated and invested under a Renewable Portfolio Standard requiring them to increase the share of renewable energy in their generation mix to 20% by 2010, 33% by 2020, and now 50% by 2030. I suspect that accounts for most of the 7% drop in emissions since 2002, while the impact of a carbon price equivalent to 0.6 cents per kilowatt-hour (kWh) is likely lost in the noise. Of course a carbon tax would create its own political and practical complications.

First, consider how a carbon tax would affect different energy sources. As with cap & trade, a carbon tax should have its biggest impact on the highest-emitting forms of energy. In practice that would compound the current disadvantages for coal compared to abundant, low-priced natural gas and rapidly growing, essentially zero-emitting renewables like wind and solar power. At least on the surface, that seems at odds with the stated goal of the Trump administration to attempt to rescue the US coal industry and the communities that depend on it.

Like cap & trade, a carbon tax would also require a significant amount of new bookkeeping to track the path of "embedded emissions"--the CO2 and other greenhouse gases emitted at each step of a product or service's supply chain--through the economy. Some of this is already done voluntarily by companies participating in various sustainability reporting efforts, but it would be new for many others. The EPA, Department of Energy, and numerous non-governmental agencies have done much work to quantify such emissions, but a carbon tax would require a level of rigor and audit trail consistent with the creation of what amounts to a shadow currency within the economy.

A carbon tax also raises similar questions of how to spend the resulting revenue that have bedeviled cap & trade. At the current US emissions and assuming few sources were exempted, the proposed $40 per metric ton initial carbon tax would raise around $275 billion per year. That's 8% of this year's federal budget. It doesn't take a cynic to guess that the first inclination of any Congress enacting such a tax would be to hang onto this money to fund new programs, reduce the federal deficit, or some combination, rather than returning it to taxpayers as former Secretaries Baker and Schultz and the economists who back them suggest.

Their proposal would require that the proceeds of the carbon tax be rebated to essentially the same people who would be paying it at the gas pump or in their gas and electric bills. This sounds similar to the "Cap and Dividend" approach to cap & trade proposed by Senators Cantwell (D) and Collins (R) a few years ago. Their bill had the great advantage of simplicity, requiring just a fraction of the 1,427 pages of the 2009 Waxman-Markey cap & trade bill, the main purpose of which seemed to be to redistribute vast sums of money outside the tax code. But like W-M, it went absolutely nowhere.

Like it or not, that's my best guess of the fate of the current carbon tax idea, too. The biggest challenge facing a carbon tax today is that it would not be running as a simpler, more market-oriented alternative to prescriptive legislation or complex EPA regulations. After all, the administration's intention appears to be to eliminate the EPA's main emissions-reduction regulation, the Clean Power Plan, not to replace it.

And although the new US Secretary of State, Mr. Tillerson, is on record numerous times in support of a carbon tax, that position seems to have been put forward mainly in preference to cap & trade, rather than on its own merits in the absence of any other strict climate policy.

A carbon tax would raise the effective price of energy commodities in which we appear to have a global competitive advantage, at least for now. The current proposal may rebate the carbon tax on exports, but most economic activity starts and ends within this country. And as noted in the NY Times op-ed by Dr. Feldstein and the other economists backing this measure, the revenue recycling to consumers would be on an equal basis, rather than proportional to usage, so there would be winners and losers as with any redistributive taxation. Lower-income Americans driving older cars seem likelier to come out on the short end of that than wealthier consumers driving new cars that meet rising fuel economy standards.

Ultimately, we must ask why President Trump or his team would want to impose a new tax on US consumers and businesses to address a problem that has probably just become an even lower priority for them than it was. Notwithstanding Mr. Trump's demonstrated unpredictability, the simplest answer seems to be that he wouldn't.