Carbon taxation 101: Is using the price signal a good way to help with global warming? Or will pigs fly first?

Climate change has not been a high priority for the Trump administration so far, but the issue itself continues to simmer in many ways and in many places—in research, at the state and city level, and internationally. In the United States, the public is willing to say it is concerned about global warming—but has proved less than eager to adopt measures that are costly and/or inconvenient.

That is one reason that the idea of a “carbon tax” continues to surface. In February, for example, a group of Republican notables, including former Secretaries of State James Baker and George Schulz; former Treasury Secretary Hank Paulson; and former White House economists, Greg Mankiw and Martin Feldstein, called for a national climate tax. They and others have launched the Climate Leadership Council (CLC) to sell the idea (niftily re-branded as a “carbon dividend”).  On the other end of the political spectrum, Bernie Sanders also favors the idea.  And the non-partisan Congressional Budget Office, whose task is to evaluate and cost economic policies, concluded in 2008, “A tax on emissions would be the most efficient incentive-based option for reducing emissions and could be relatively easy to implement.”

I’m not going to bet the house on a carbon tax happening any time soon. Indeed, I’m not sure I would bet the spare change in my left pocket.  But because the idea is out there, and has been for some time, I thought it was worth explaining.

1.  What is a carbon tax?

It is a tax that is based on the carbon content of fuels.  For simplicity’s sake, a carbon tax would likely be imposed chiefly on producers, such as mines, refineries, and oil and gas wells; of course, those costs would be passed on down the line, to users and consumers. Coal, which is the most carbon-intensive, would pay a higher carbon tax than, say, wind or nuclear, which would pay nothing at all.  Natural gas would be somewhere in between.  The effect, then, is to improve the economic position of lower-carbon energy sources, narrowing the price differential compared to fossil fuels, which tend to be cheaper.  A tax of $15 per ton would bring in about $80 billion, or about $250 per American household; the CLC proposed a $40/ton levy.

2.  Has anything like this been done?

Yes, to a limited extent.  Britain imposed one in 2013, with the levy set to rise slightly ever year to 2030.  But it quickly had to recalibrate, freezing the tax at 2015 levels (￡18 per metric ton) because of concerns it was putting industry at a competitive disadvantage.  Technically, this is called a “carbon price floor”; really, it’s a tax.  And it does seem to be working as intended, with greenhouse-gas emissions from the power sector falling much faster since 2013 than before.

Canada is on the verge of introducing a national carbon tax, starting at $10 a ton, and rising another $10 a year until it maxes out at $50.  British Columbia and Alberta already have one, and under the plan announced May 18, those provinces who do not institute some kind of carbon price by the end of 2018 will have one imposed.  Australia had one, and then repealed it. Mexico, Portugal, and a number of Scandinavian countries already have one, and South Africa may start one this year.

In a larger sense, though, the idea of using the price signal to promote environmental goals goes back a long way.  One of the most successful examples dates to the early 1990s, when the United States implemented a “cap and trade” system to reduce emissions of sulphur dioxide.  Emissions were “capped” at a given level, and then reduced year by year.  To meet their requirements, emitters could trade their allowances with each other; the idea is that cuts could be made at the least cost, and with maximum flexibility to polluters.  That was the principle. And in practice? It worked beautifully.  Emissions fell further than anyone predicted, or even hoped, and at less cost.

There have been efforts to apply the cap-and-trade idea to greenhouse-gas emissions, such as Europe’s Emissions Trading System, which began in 2005.  The ETS suffered from the EU’s low economic growth and the granting of emission rights to many users; as a result, the permit price for carbon has been too low to encourage fuel-switching.  Also, there is no off the shelf, relatively economic, technology that one can deploy to take carbon out of a power plant. Still, the idea is very much alive.  The EU is working on improving the ETS, and China is may introduce a cap-and-trade system this year.

All told, the World Bank estimates that the carbon pricing in some form covers 13 percent of global emissions, three times as much as a decade ago.

3.  Why do people support a carbon tax?

“Externalities” is a fancy word meaning “a side effect that isn’t nice.”  Regardless of one’s view on global warming, it is undeniable that the externalities for coal, for example, include particulates and air pollution.  What a carbon tax does, in effect, is to price these externalities.  In 2014, Yale economist William Nordhaus estimates the “social cost of carbon” at $18.60 a ton.  In terms of using it as an approach to deal with global warming, it effects change in a gradual way, so that companies and industries can adjust, allowing emitters to reduce emissions at relatively low costs, compared to known alternatives.

It works in concert with prevailing energy trends, specifically, the increased efficacy, efficiency, and competitiveness of renewables.  Done right, it provides the long-term certainty businesses need to make good investment decisions. Finally, it is relatively simple to administer—and when it comes to energy policy, simplicity is very much a virtue.  Essentially, the argument is that the price signal is powerful, purposeful, and easy to comprehend—so why not use it?

4.  Why do people oppose a carbon tax?

There are three kinds of arguments.

The first has to do with economics.  Critics note that a carbon tax is another tax and therefore simply hands more economic power to governments.  Also, such a tax would likely be regressive, meaning that it affects lower-income earners disproportionately. Another concern is that higher costs would hurt energy-intensive industries.  There are ways to deal with these issues.  Many carbon-tax plans attempt to deal with the equity issue by seeking to be “revenue-neutral”; as much money as a carbon tax collects is recycled back to households through tax credits, refunds, or dividends, as Canada is planning to do.  And it might be possible to deal with the competitive issue by repealing costly regulations or providing other kinds of tax relief, or by imposing a tax on energy-intensive imports.  

The second argument has a largely environmental basis.  A carbon tax, critics note, does not cut emissions to a designated level as other policies (such as cap-and-trade) seek to do.  Therefore, one cannot know to what extent it will deliver.   

Third, a carbon tax does not work for all emissions.  For example, few households or other small-scale consumers can be expected to change their habits because of a carbon tax (unless it is truly massive, which is not going to happen).  That leaves a significant chunk of emissions relatively untouched.

5.  What are its prospects?

In the short term in the United States, pretty dim.  Indeed, some people might say that flying pigs are more likely (see image).  The idea of a carbon tax does have support from right-of-center thinkers such as the CLC and even from the oil and gas industry, including Exxon’s new CEO, Darren Woods.  (Exxon’s former CEO is now Secretary of State Tillerson, and he’s a fan, too.)  But policy papers don’t make policy, and if there is enthusiasm for a carbon tax among Congressional Republicans, who control both houses, it is of the quiet variety.

Ditto for the Democrats.  The left-of-center Brookings Institution is in favor and so are economically-oriented think tanks like Environmental Defense and Resources for the Future.  One possibility is that if tax reform in general begins to advance, carbon taxation could be called in to play; that is what happened in Sweden.  Another is that states or regions might take the initiative; the PJM Interconnection, for example, which coordinates power transmission in 13 states and Washington, DC, recently floated the idea.

The long-term prospects may be more promising. In a sense, other countries are doing the experimentation on this one, and if the idea works well, the United States can learn from their experiences—on how high the initial level should be; whether and how fast to raise it; how to deal with equity and competitiveness issues.  The power of example can be compelling.  If, on the other hand, carbon taxes don’t appear to work, that would also be telling.

It is a solid economic principle that if you want less of something, tax it.  That is why the idea of a carbon tax is not going away.  The question is how much Americans want to pay to get less carbon.  The response so far has been to do limited or “no regrets” policies or to accept changes via regulations that are difficult to see or cost.  But if the country ever decides to work toward deep emissions cuts, it’s hard to see how pricing carbon is not part of the effort.