A Primer on Carbon Pricing for the U.S.A.

The U.S. is poised to take aggressive, belated action on climate change. That will mean passing legislation to reduce greenhouse gas emissions. Here’s a primer on how that can be done right—based on what we have learned since the flawed cap-and-trade proposal Congress contemplated in 2009.

1. Carbon pricing is essential.

The centerpiece of decarbonization has to be carbon pricing: making carbon (i.e., carbon-dioxide-emitting fuels, aka fossil fuels—coal, oil, and natural gas) less available and more expensive. Right now carbon is effectively subsidized, to the tune of $8 per metric ton[1]. The cost of carbon needs to be much higher, and it needs to rise over time until carbon is no longer competitive with other energy alternatives.

What about spending on those other alternatives? There is an enormous about of work to do under the heading of a “Green New Deal”: R&D on new technologies, investment in new energy and transportation infrastructures, etc. But the price signal is just as important, or even more important. When the price signal is in place, it will provide all the right incentives to undertake that R&D and make those investments. The Green New Deal will run downhill.

On the other hand, if the U.S. fails to establish a rising price signal to disincentivize carbon use, decarbonization will risk failure, regardless of how much we invest in alternatives to fossil fuels. This is because of the problem of rebound. If I turn in my gas-guzzling SUV for a bicycle, the price of gasoline goes down by a little bit, and that makes it a little bit more attractive for others to use more of it. If an entire state or region converts its electricity sector to be powered entirely by renewables, the price of coal and natural gas will go down by a lot, and that will encourage others to use a lot more of them.

2. Cap or Fee? Cap FTW.

There are two ways to send the needed price signal. One is to establish a schedule of gradually rising prices. The other is to set up a cap-and-permit system and gradually reduce the number of permits. In one case we limit demand for fossil fuels by controlling the price (and letting the supply adjust accordingly) and in the other case we limit demand for fossil fuels by controlling the supply (and letting the price adjust accordingly).

Both approaches are in use today. (The 63 carbon pricing systems around the world today are about evenly split between the two.) In the abstract, the two types are mathematically equivalent. But in practice they have their pros and cons.

The most important difference is that a cap-and-permit system can be designed to accurately hit science-based carbon emission reduction targets. A carbon fee system cannot. We can only guess how high prices need to be set to hit emission reduction targets. Energy demand is notoriously inelastic, so it will take a large bump in price to get a little bit of emission reduction. With a cap-and-permit system, the emission reduction is guaranteed and the price will settle in the exact right place, with no guessing.

Politically, a cap-and-permit system might also be an easier sell to the public than a carbon fee system, because a carbon fee gives the appearance of a tax.

A cap-and-permit system is admittedly more complex to administer than a carbon fee system. But that will pose no problem for the U.S., which has long been at the forefront of environmental permit systems (like sulfur dioxide regulation under the Clean Air Act) and large public auctions (like broadband license auctions and carbon permit auctions for power plants in the northeastern states). And as noted above, over 30 other nations and jurisdictions already manage cap-and-permit systems.

3. Build it upstream.

The simplest and soundest way to design a cap-and-permit system (or a carbon fee system) is to regulate carbon at the point where it first enters the economy—oil and natural gas at the well head, coal at the mouth of the mine, or any imported fossil fuel at the border. It is simplest because it involves regulating just a few thousand energy companies, not hundreds of thousands of energy-consuming businesses or hundreds of millions of individual consumers. It is soundest because those upstream energy companies will be the group that is best equipped to understand carbon markets, forecast demand, and participate in auctions.

4. Auction permits.

There are several reasons why it is important to auction the permits rather than (say) giving them away. First, the auction will establish a market price for carbon. Second, an auction is the only truly fair and defensible way to allocate the permits. (Giving them away based on historical emissions simply rewards past pollution, and giving them away on any basis at all will invite accusations of favoritism.) Third, with auctions there is no need for permit trading, and hence no room for speculative activity – see #6 below. Fourth, the revenue will be needed for other purposes—see #8 below.

The auction process can be carefully designed to prevent gaming. Very good models are available. (A simple ascending clock model will do the job.)

5. Set border adjustments.

To ensure a level playing field for U.S. companies, we should levy tariffs on imports from countries that don’t have comparable carbon pricing, and rebate carbon revenues to support exports destined for those countries. (If trading partners have carbon pricing that is stricter or laxer than ours, we can apply tariffs and rebates proportionally to ensure that the playing field stays level.)

6. No secondary markets!

“No secondary markets” means permits are non-tradeable. This might be the most surprising part of this proposal, since when most people think of carbon cap-and-permit systems they think of “cap and trade,” and since every single one of the 30+ carbon cap-and-permit systems in operation today allows trading, and since standard terminology for these programs is emissions trading systems. But allowing permit holders to buy and sell them complicates the system unnecessarily, it opens up opportunities for gaming and speculation, and it makes energy more expensive for the consumer. The cap-and-trade system that was considered in Congress in 2009 was ultimately rejected in part because the public rightly understood that it could turn into a boondoggle for Wall Street. In a tradeable permit system, all the broker and consultant fees and all the net profits made by players in secondary markets would be built into the cost structure of the company that eventually redeems the permits, and those costs would be passed on to consumers. Effectively, consumers will be subsidizing all that unnecessary activity. Further, secondary markets can be gamed—like one or more companies attempting to corner the market and fix the price.

The usual justification for secondary markets is that (a) they ensure efficient allocation of permits and (b) they establish market prices. But a well-designed auction system already does both of those things. Many existing cap-and-permit systems are hamstrung by the fact that permits are given away for free instead of auctioned. Yes, if permits are given away for free, then secondary markets are necessary to fix the botched initial allocation. But if permits are properly auctioned, secondary markets and all their dangers and costs can be entirely eliminated.

In a permit system with no secondary markets, there are things that can be done to help make sure things go smoothly. For example: Auctions can be held fairly regularly, so participants don’t have to forecast demand too far into the future. And participants can be allowed to bank some permits (i.e., hold them over from period to period) so they needn’t fear buying too many.

7. No offsets!

Offsets are eco-friendly things that carbon users can do in place of buying a permit (or paying a fee), like planting trees.

Experience has shown that offset systems are rarely effective (once you have planted an acre of trees, who is to say they won’t burn down or otherwise release their carbon back into the atmosphere within a few years or decades?) and that they are susceptible to abuse (e.g., double-counting). The purpose of a carbon pricing system is to actually reduce carbon emissions. Offsets just muddy the waters and reduce the system’s effectiveness.

This is not to say that planting trees and other activities that sequester carbon are a bad idea – far from it. It’s just that these should be undertaken in addition to reducing emissions, not instead of it.

8. Recycle the revenue back to households as dividends.

The handful of energy companies that buy and redeem permits will pass the cost of the permits on to their customers. For them, permits will simply be another cost of doing business. Ultimately, it will be consumers who pay the higher costs. There are two important facts about those higher costs: First, they are equivalent to a regressive tax, since low-income households spend a larger percentage of their budgets on energy than wealthy households (despite using less energy). Second, under a truly effective carbon pricing program we could well see energy prices that are much higher than historical prices. This is a consequence of the price inelasticity of demand, mentioned above. (Of the 63 carbon pricing programs in existence around the world today, with the modest price increases they have introduced, none have been really effective—yet—in reducing carbon emissions to meet science-based targets. They should be seen more as proof-of-concept.)

The upshot is that carbon pricing will place a huge burden on households, and we cannot reasonably expect poor or even middle-income households to shoulder that burden unaided. Help will be required. The most natural place for this help to come from is the carbon pricing system itself: the auction revenues (or fee revenues in a fee-based system). The easiest and fairest and simplest and most effective way to accomplish the goal is to issue equal per-capita dividends from the net revenues. (Possibly full shares for adults and half-shares for children.) Numerous studies have shown that issuing equal per capita dividends turns the regressive carbon pricing system into a progressive income recycler—it helps ensure that the carbon pricing system does not punish the poor, but rather lifts them up.

Furthermore, the uniformity of dividends ensures that they introduce no perverse incentives for individuals to use more carbon. It leaves cost reduction as the main incentive. Those who decarbonize most quickly—by reducing energy consumption and by switching to alternative sources of power—will get to keep more of the savings from their dividends.

9. Recycle 100%!

A lot of interest groups will want a slice of the carbon pricing system revenue pie. There are certainly a legitimately beneficial public goods that the money could be spent on, including the whole range of climate-related goods that come under the heading of the Green New Deal. But we don’t know how difficult the energy transition will be for households, so it would be premature to say that X% can be safely allocated to other purposes. Furthermore, if we decide up front that 100% of the revenue will be recycled as dividends, that will forestall lots of difficult negotiation and renegotiation about how else the money will be used and what percentage these competing uses will claim.

Don’t the climate-related Green New Deal priorities deserve funding? Yes, they do. But they don’t need to be funded out of carbon pricing program revenue or other regressive taxes. They can be funded by borrowing, or by a wealth tax, or even by new money creation, just as they would be if carbon pricing wasn’t on the table.

10. Make the dividends highly visible.

One mistake that nearly all existing carbon dividend programs make is that they hide their light under a bushel. The dividends are buried within other transactions, taking the form of tax reductions (as in Canada) or utility bill rebates (as in California) or even health insurance premium credits (as in Switzerland). Better would be to take a page from the Alaska Permanent Fund and mail physical checks to households (or alternatively, make electronic deposits directly into bank accounts). Alaskans see that they are receiving their dividends from the Permanent Fund, and that makes them a strong political constituency for ensuring that the money that is rightfully theirs (as co-beneficiaries of the state’s oil wealth) continues to flow to them. In order for the carbon pricing system to survive and fulfill its mandate regardless of which party is in power, the system will need a powerful constituency among the public. Dividends – highly visible dividends —can help make that happen.

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Note: This blog post is specifically addressed to the policy debates in the U.S. in early 2021. The principles discussed above can be applied in other nations and jurisdictions as well. Feasta has long advocated for GlobalCapCarbon as an equitable way to manage decarbonization globally. National programs could be linked and federated to achieve that goal.

Thanks to Peter Barnes, James Boyce, Michael Sandler, and Caroline Whyte for reviewing this post.

Reference

1. Carbon Pricing: Effectiveness and Equity by James Boyce, page 54

Featured image: Sky by Mehmet Goren. https://www.freeimages.com/photo/sky-1383279