Carbon Taxes Versus Carbon Markets

What's the best way to limit emissions?

Ronald Bailey | May 24, 2007

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Under most of the trading schemes proposed on Capitol Hill, the federal government will be handing out a valuable asset—tradable permits—to firms for free, as is currently done with the successful sulfur emission permits. The U.S. Climate Action Partnership (USCAP) agrees that a significant portion of allowances should be “initially distributed free to capped entities.” Last year, William Fang, deputy general counsel and climate director for the Edison Electric Institute, came out strongly for free permits in his congressional testimony.

And who can blame businesses for wanting the federal government to allocate them free permits? A 2003 analysis from the Congressional Budget Office (CBO) estimated that initial allowances could be worth $100 billion annually. Granting allowances will be a substantial financial windfall to many companies. Windfalls from allowance allocations are an issue in Europe. Before the market collapse in April 2006, the consultancy IPA Energy estimated that permits granted to British and German utilities fattened their bottom lines by 1 billion euros and 6 to 8 billion euros respectively.

One way to correct for this be the cap-and-auction method. Auctioning permits is very much like imposing a carbon tax. In this case, the government sets an overall emissions limit and emitters have to buy allowances from the government every year. The chief difference between a cap-and-auction scheme and a carbon tax is that the price of the allowances will vary from year to year. The CBO calculated the income effects of a 15 percent cut in carbon emissions: the average household in the lowest one-fifth of income earners would pay about $560 per year more and households in the highest quintile would pay $1,800 per year; however, $560 represents 3.3 percent of the average income of households in the lowest fifth, while $1,800 is just 1.7 percent of income for households in the top fifth.

If the federal government were to return all of the net auction revenues as an equal lump sum rebate to every household, it would more than fully offset the burden that increased prices would impose on the lower two income quintiles. Their household incomes would rise by $310 and $140 respectively. However, none of the cap-and-trade proposals on Capitol Hill incorporate this kind of comprehensive compensation. Instead, any auction revenues would be dispensed by Congress in the form of R&D energy subsidies.

Like permits, there’s a lot of promise—and potential for abuse—in the idea of transnational “offsets.” These are arrangements in which, for example, an emitter in a rich country could earn emission permits by installing technology that produces lower levels of GHG for an inefficient emitter in a poor country. Everyone wins, right? Unfortunately, experience shows that such offsets are often phony. For example, The New York Times reported that in one recent offset deal, emitters in Europe paid a Chinese chemical company $500 million to abate its emissions of the potent greenhouse waste gas trifluoromethane, also called HFC-23, which, molecule for molecule, has a warming effect almost 12,000 greater than CO₂. The cost of an incinerator to burn up the gas? Only $5 million. The Chinese company (and government) got a windfall of $495 million, and the European companies gained abundant allowances to emit CO₂, when protecting the atmosphere could have been done a lot more cheaply. Currently, two-thirds of the payments for such international offset projects are going to abate HFC-23.

The other option is to tax all kinds of carbon at the wholesale stage, as far upstream as possible. Utilities and refiners who take raw coal and oil as inputs would pay a tax on these fuels. The extra cost would get passed downstream to all subsequent consumers. Like prices for permits set in carbon markets, carbon taxes would encourage conservation and innovation. Since the tax is levied on how much carbon a fuel contains, it would make fuels like coal less attractive compared with low-carbon fuels like natural gas or even renewable energy like solar and wind power.

Carbon taxes also avoid the baseline quandary that bedevils carbon markets. For example, signatories to the Kyoto Protocol are supposed to cut their emissions of greenhouse gases by 7 percent below what they emitted in 1990. Why? That goal has no relationship to any specific environmental policy objective. In fact, achieving the cuts specified by the Kyoto Protocol goals would reduce projected average global temperatures by only about 0.07 degrees Celsius by 2050. And, as the stalled international negotiations about what to do after the Kyoto Protocol expires in 2012 show, it is very difficult to set new baselines. Also, where should baselines be established for rapidly growing economies like China and India, whose energy use and emissions are expected to more than double by 2030? Under the Kyoto Protocol, the natural baseline is what emissions would be without any restraints. However, calculating or predicting what a country’s emissions will be 20 to 30 years in the future is impossible to do with accuracy.

Under a pollution tax scheme, says William Nordhaus, the Yale economist who has been the leading advocate of this approach, “The natural baseline is a zero-carbon-tax level of emissions, which is a straightforward calculation for old and new countries. Countries’ efforts are then judged relative to that baseline.”

Another advantage is that the tax could be phased in to poor countries once average incomes reach a certain threshold. For example, carbon taxes might start to kick in when national income reaches $5,000 per capita, slightly higher than China’s current level. More generally, having a defined tax rate makes it easy for firms in developed and developing economies alike to predict the future impact of climate policy on their bottom line—something that is considerably harder to do when the government is handing out permits every year.

A tax avoids the messy and contentious process of allocating allowances to countries internationally and among companies domestically. Nordhaus says that carbon markets are “much more susceptible to corruption” than are tax schemes. “An emissions-trading system creates valuable tradable assets in the form of tradable emissions permits and allocates these to different countries,” writes Nordhaus. “Limiting emissions creates a scarcity where none previously existed and in essence prints money for those in control of the permits.”

A carbon tax also offers less opportunity for corruption because it does not create artificial scarcities and monopolies. Of course, governments can engage in chicanery by dispensing tax breaks and subsidies to favored companies and industries. But Nordhaus analogizes carbon allowances to quotas in international trade and carbon taxes to tariffs: overall, it’s been a lot easier to manage tariffs than quotas.

The main objections to using carbon taxes to limit the emissions of CO₂ are that such taxes have never been used internationally, that they are politically difficult to establish because consumers and businesses dislike taxes, and that they do not establish an actual firm limit on emissions.

Although businesses—especially utilities involved in the SO₂ market—might initially prefer a carbon market, the price stability promised by carbon taxes should eventually win most companies over. Taxpayers can be brought on board if carbon taxes are used, for instance, to reduce their payroll tax burdens. “The great political advantage of carbon taxes is that they raise large revenues which governments can use to reduce other unpopular and more distorting taxes, or finance popular spending programs,” says Robert Shapiro, who served as undersecretary of commerce for economic affairs under President Clinton and is now a private consultant. As for establishing precise limits on emissions, taxes can be adjusted over time to achieve whatever limits policymakers decide best balance the costs of climate change with the benefits of economic progress. Nordhaus suggests that the optimal carbon tax trajectory, balancing costs and benefits, would start with a tax of about $17 per ton, rising to $84 in 2050 and $270 in 2100. Economist Paul Portney, former president of the Resources for the Future think tank and now dean of Arizona University’s Eller College of Management, proposes starting with a $5-per-ton tax on carbon and raising it by $5 per ton every other year. The first year would raise $9 billion in revenues for the Treasury, rising to $25 billion by 2010 and $75 billion by 2020. A $25-per-ton carbon tax translates into a 5 percent increase in average electricity rates and a boost of about 6 cents per gallon of gasoline.

As the end of the Bush administration approaches, few doubt that the United States will start limiting its greenhouse gas emissions after 2008. But what that will mean for individual companies, the economy as a whole, and ultimately the planet remains to be seen.

Ron Bailey is science correspondent for reason. This article originally appeared at American.com.

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Copenhagen Treaty, Cap and Trade… Will international organizations govern you? :: Lib links to this page. Here’s an excerpt:

…the “cap and trade” (cap and tax) bill passed before he goes to Copenhagen. Our goal should be to send him to Denmark empty-handed. Cap and trade should be defeated because . . . It hasn’t worked in Europe It probably isn’t the best way to control carbon emissions, assuming you believe that’s important The climate models that supposedly justify cap and trade have been consistently…