Carbon: Tax, Trade, or Deregulate?

Something is going to be "done" about global warming, so what should it be? A debate.

On August 11, 2005, Ronald Bailey, reason's science correspondent and the author of such enviro-skeptic books as Eco-Scam: The False Prophets of Environmental Apocalypse, wrote the following words at reason online: "Anyone still holding onto the idea that there is no global warming ought to hang it up. All data sets—satellite, surface, and balloon—have been pointing to rising global temperatures. In fact, they all have had upward-pointing arrows for nearly a decade."

Although there are still plenty of free market thinkers who aren't yet ready to "hang it up," the center of the debate has shifted in recent years from contested science to proposed policy. And with the prospect of an anti–global warming crusader—either Barack Obama or John McCain—joining forces with a Democratic Congress carrying years of pent-up environmentalist frustration, significant new global warming regulation isn't a matter of "if" but "how much."

Assuming that humanity is contributing to the carbon-fueled warming of the planet, what, if anything should governments do? That question, it turns out, is just as contested among skeptics of environmental hysteria as the famous "hockey stick" graphs in Al Gore's movie An Inconvenient Truth. So we discovered last October, when we matched Bailey on a climate change panel with Lynne Kiesling, a senior economics lecturer at Northwestern University (and former director of economic policy at the Reason Foundation) and Fred L. Smith, president and founder of the pro-market Competitive Enterprise Institute, which in 2002 published a Bailey-edited book entitled Global Warming and Other Eco-Myths.

Bailey painfully concluded that climate change "is a real problem" and reluctantly favored a tax on carbon. Kiesling pointed to the difficulty of assigning property rights to the atmosphere and tentatively came out for a "cap and trade" system of creating a market for pollution credits above a government-imposed ceiling. Smith robustly rejected both ideas in favor of private innovation. The debate, held at a reason-sponsored conference in Washington, D.C., was moderated by Matt Welch.

Click here to watch Lynne Kiesling, Ronald Bailey and Fred L. Smith debate climate change at the at the Reason in DC conference.

Lynne Kiesling: From an economic perspective, the problem of climate change is twofold. First, there are incomplete and uncertain property rights in the air. It's ludicrous to imagine us each walking around with a bubble over our heads so that we can only breathe and use the privatized air sphere around us. Second, there's a large number of affected parties. In the limit, some would argue the entire planet is affected.

When a common-pool resource is shared by millions of diverse individuals, defining the use rights over that resource is really hard and costly. This is the kind of situation in which decentralized market processes have trouble even emerging. In this imperfect world, we're considering two imperfect alternative policies: a carbon tax and cap and trade.

Our experience with common-pool resources, ranging from agreements to share the team of oxen in the medieval village to the development of the sulfur dioxide acid rain program in the 1990s, tells us that effective policy focuses on reducing transaction costs and better defining property rights so that private parties can engage in mutually beneficial exchange. That's the logic behind the carbon cap-and-trade policy.

Like all policies in such a complex area, it's got problems itself. How do you allocate carbon permits? There's the knowledge problem: How do we know how many carbon permits is the right number? Also, as a policy instrument, it's prone to political manipulation. Electric utilities are already seriously jockeying to make sure they're playing a part in getting the rules written and that they're involved in determining the allocation mechanisms if such a policy comes into place.

Another problem is that unlike with sulfur dioxide, the likely participants are really heterogeneous. When we were dealing with sulfur dioxide, it was mostly large-scale central-generation power plants, a pretty homogeneous bunch.

A carbon tax is also prone to some of these problems, particularly the knowledge problem and the political manipulation problem. The benefits to a permit market that have been shown in other situations are that defining property rights and reducing transaction costs does a better job of taking advantage of diffuse private knowledge. It's also more likely to induce the process that's at the foundation of economic growth, which is innovation. So I tend to come down on the side of cap and trade, although it's not a ringing endorsement.

People are already doing this voluntarily. I encourage you to look up a group called the Chicago Climate Exchange, or CCX. CCX is a global carbon permit financial market, and it's got a nice portfolio of instruments. They've got spot permit markets. They've starting to do futures now. The entrepreneur behind this, Richard Sandor, has also talked about doing funky derivatives. The participants got together voluntarily and negotiated to determine the number of permits that they were going to have. There were participants on both sides—carbon producers and carbon sinks—so you had this multilateral stakeholder negotiation to determine the number of permits in the market.

Finally, I think most people fail to realize that the abysmal job we do of pricing electricity contributes substantially to our energy use. The only resources that are priced as badly as electricity in our economy are highways and water.

Retail competition and choice for consumers would increase the offering of time-differentiated dynamic pricing, which shifts resource and electricity use across time. Research shows that this promotes conservation and more efficient use of electricity, increases offerings of green power to consumers who want to choose a green power option, and increases the incentives to develop and adopt technologies, such as price-responsive appliances, that enable private individuals to control their own energy use.

So the message from me is this: It's a complicated, imperfect world, and the policies we can adopt that induce innovation and harness diffuse private knowledge will be the most effective for this long-term problem.

Ronald Bailey: Before we began this session, Fred Smith asked me would it be all right if he referred to me as a commie symp. I think that might be a little harsh. I hope I can persuade you of that.

I stand before you as somebody who's been reporting and writing on environmental issues for over 20 years. To the extent that I'm known at all, I've been known as someone very skeptical of all kinds of environmentalist dooms. My first book was called Ecoscam: The False Prophets of Ecological Apocalypse. It pains me to have concluded, following the scientific data, that one of the dooms is a real problem.

As Lynne very ably pointed out, one of the problems with global warming is that it exists in a commons—that means the atmosphere is very hard to divide up and make into private property.

When you have an environmental commons, we typically have two ways of handling that problem. One is that we privatize it. In many environmental issues, we're moving in that direction. Fisheries, for example, are being privatized. Forests are being privatized. Water resources can be privatized as well.

The problem with air pollution—and global warming is a form of air pollution—is that I don't see a good, easy way to privatize it. The transaction costs are too large. And if you can't privatize it, you have to regulate it. So now the question is: What's the least bad way to regulate? And that is why I've come out in favor of a carbon tax.

As a good libertarian, I thought I would like cap and trade. The problem is I've been watching the European attempt to do this, and it's a complete disaster. The governments, not surprisingly, cheat constantly. Their carbon market collapsed a year ago because the governments allocated more permits for carbon emissions than were necessary to cover what was being emitted, so naturally the price went to zero. And if the Europeans can't pull this off, how could you expect the world to pull this off?

I understand the diffuse knowledge problem—how markets can and, in fact, do marshal that kind of information in very good ways. The problem is that there's no baseline for the rest of the world.
Idiotically, the Kyoto Protocol set it at 7 percent below what was emitted in 1990 for the 36 countries that signed the treaty. Well, how are you going to do that for China and India? We don't know what they're going to be emitting in 30 years. So I come out in favor of the tax because you have a baseline. You have a way of internationally monitoring that. The baseline is a zero tax and from that, you can build up. You could start the tax low and, as you gain more information about what the atmosphere is likely to do, you could adjust the tax over that time.

For consumers, for inventors, for innovators, a tax offers price stability in a way that the cap-and-trade markets don't. For example, in the sulfur dioxide market, sulfur permits have ranged in price from $50 a ton to over $1,000 a ton. And for sulfur dioxide, it's a smaller market. A carbon market would encompass the world.

Fred L. Smith: What's the best way of addressing whatever risks there are in global warming? Should the risk of catastrophic global warming justify abandoning our general preference for freedom over coercion? Should we free market advocates champion carbon taxes or carbon rationing, some form of suppressing energy use, or should we favor economic liberalization?

We've been working on that issue for two decades now. In that early period, I noticed that the catastrophists, the global warming alarmists, had to have answers to three questions positively.

First: Does the science indicate significant evidence of imminent catastrophe? That is, is the earth warming significantly in a human-relevant way? Is the 0.7 degree centigrade increase over the last century offset or not by the 1,800 percent increase in wealth over that same period?

Second: Is the warming impact negative or positive overall? I note in passing that more people seem to retire to Florida and Arizona than Lake Woebegone.

Third: Can the political tools now available realistically restrict carbon use? We may endorse economic suicide. Europe may join us, but should we expect India and China to go back to the Stone Age just because of our political elites?

Over the last decade, I think the evidence for all those questions has moved against the global warming catastrophists. There is evidence that there has been some warming, moderate amounts, but the idea that we're facing imminent catastrophe has weakened. Our ability to do anything about CO2 increases for the next half-century is now obviously nonexistent. And the tensions we could create by pushing the world into some form of energy rationing, I think, are underestimated. Recall that in World War II, one of the incidents that pushed the war party into power in Japan was an energy boycott on that Asian nation. We are going to do that again with China. It doesn't make a lot of sense to me.

Shouldn't we be asking whether the risks of global warming are more or less than the risk of global warming policies?

The costs of energy rationing are not trivial. Energy is what makes it possible to have mobility, to have labor-saving technology, to have lives that are comfortable, to have hope for the future. Energy rationing would lead to slower economic and technological growth, a darker, less human-friendly world. The trillions we're talking about spending over the next generations on global warming could go to much better causes, could save lives and inspire hopes today.

But we've been told—we've heard it from Ron, at least—that we must do something. Perhaps. But why must that something be the expansion of state power over our lives? Why do we limit ourselves to taxes or rationing? There are other alternatives out there.

We could do some more R&D. We could mitigate. What about mirrors in space? What about fertilizing the oceans? Those of us who have looked at NASA and so forth are not overly enamored with government's ability to underwrite those kind of policies, but we should be equally optimistic about government's attempt to tax in this academic-blackboard economic way.

Resiliency is what we should be talking about. Not whether taxes or quotas are the better way to suppress freedom, but how we can use the global warming concerns to advance an agenda of freedom. How do we find ways of accelerating economic and technological progress? How do we liberalize the economies of the world? How do we expand the institutions of liberty even into the air sheds?

We can free biotechnology. I'm sure Ron and I both agree with that. If the world is hotter, colder, wetter, drier, we're going to need the ability to modify our crops much more than we have today. Freeing biotechnology from the regulatory straitjacket it's in today would be a way of doing that.

As Lynne said, we could complete the job of freeing our electricity system, not just for pricing electricity but also for incentivizing the grid to be smarter and more robust so we can free the trapped electricity that sits idle throughout America. Move fire, storm, and other insurance out of the government subsidy range and put it back into the private sector so we can guide people away from living in high-risk areas.

Unilateral free trade. Extend property rights to water. Liberalize energy exploration. Cuba can drill off the coast of Florida; why can't America? Where is nuclear power? Certainly Al Gore hasn't mentioned it. Eliminate the corporate income tax. Accelerate the turnover of capital goods and equipment. That would mean a much more efficient world to live in.

Our agenda is the agenda of freedom, not the agenda of some form of a rational economic suicide pact.

It is understandable that many people grow weary. I know people very close to me who have grown weary in this fight. We get a bit depressed when we realize that logic is for losers in the political process. It's hard to be the dissident at the cocktail parties. Any of you who have had the situation where your friends look at you and shake their heads sadly and walk away know how hard it is, but our challenge remains to speak truth to power, to find ways to make good policy good politics.

I chaired a global warming panel in Bucharest earlier this year. There are some European think tanks that have withdrawn from this battle also. It's too costly, they say. It's too difficult to resist the consensus. We have to give up a little bit. To them, I'll argue as I do to you today, that we must fight; we must continue to risk. The loss of freedom in the global warming debate is far too great. That is our duty. That is our challenge.

For events of this type have happened before. In August 1914, European nations found themselves trapped in a consensus, a set of entangling treaties that forced them to move in an inexorable way towards disaster, towards World War I. Edward Grey, the British foreign minister, noted, "The lamps are going out all across Europe. We shall not see them lit again in our lifetime."

Today, fears about global warming are pushing the world towards disaster. This time the threat is not just to the lamps of Europe but to the lamps of the world. Energy suppression, if it happens, might last for many lifetimes.

Statist intellectuals still dominate the global warming debate. We economic liberals are few, but we few are the thin line resisting those who would return us to the Dark Ages. This is not any time to go wobbly.

Matt Welch: Lynne, could you speak to Ron's critique of cap and trade? Is it basically a great idea in theory that you're wishing might work someday 20 years in the future? Is Europe really a catastrophe, and what's keeping it from working?

Kiesling: Just because Europe can't implement this doesn't mean the idea is bad. The E.U. carbon scheme is a poster child for what can happen when you have too centralized and too politically motivated a process for allocating the permits. The E.U. decided how many permits each country would have, then each country then got to allocate them among their industries as they saw fit. This was the most politicized process imaginable. With a good market design and good testing and good analysis, we could do better.

It does highlight the important fact that political manipulation is going to happen in whatever policy we choose. But I wouldn't throw the idea out just because the E.U. can't do it. There's a lot of stuff the E.U. does really badly.

Smith: I have one strong procedural difference with both Ron and Lynne on this. The argument is that when you have a common property resource, your choices are either to privatize that resource, move towards institutions of liberty, or politicize it in some enlightened way as Lynne and Ron have talked about. But Ronald Coase said there's always a third option, that the costs of transaction in that area are much higher than the failure to have transaction in that area and therefore we should allow evolution to proceed and see what creative solutions emerge. That is basically what we should be doing in the global warming area.

European taxes are just as bad as European cap and trade, and American taxes aren't anything to write home about either. The idea that a tax policy will emerge through the political process unsullied is unlikely. Energy taxes in Europe and the United States are already a mess. If we raise them, they'll be a bigger mess.

Bailey: One of the problems is that the new energy technologies are very unlikely, in my judgment, to arise merely because we ignore carbon dioxide. If it were already easy to create low-carbon energy, inventors would have done it. It would be here now.

If you look at the projections from the International Energy Agency, the amount of energy the world will be using in the next 30 years or so is going to get much vaster. China is building one coal-fired plant a week, and they're probably going to ramp it up to two a week. Those plants are going to be there for 50 years. If you think that carbon dioxide is a problem now—

Smith: And if you think energy rationing—

Bailey: Fred, when we privatize a forest, is that lumber rationing? When we privatize the fisheries, is that fish rationing? We have people pay for what it is that they use.

If you could persuade me, which you have failed to do with your rhetoric, that we can in fact repair to markets to get this done, I would be more than happy to do that. I don't want the lights of the world going out. But I also wonder, by the way—this is a question you've never answered when I've asked you several times—what temperature rise over the next century would in fact cause you to worry about humanity's ability to adapt?

Smith: Over 20 degrees, certainly.

Bailey: How about—

Smith: Not 0.7.

Bailey: Not 0.7, but 6.

Welch: Ron, you mentioned at the beginning, sort of in jest, that it pains you to come to the conclusion that global warming is a problem. Is that a scientific approach, to be pained by the results? Has there been a mind-set to debunk when looking at this issue, and has that caused conclusions that were wrong?

Bailey: Yes, in some cases. I did not want this information to go in that direction. And I had good reason, given my career, to expect that it wouldn't. The environmentalists have been wrong about the population problem. They were wrong about trace exposures to synthetic chemicals causing cancer. They were wrong about running out of natural resources. I've happily and joyfully reported this for years and annoyed a lot of people.

I, against my values, have decided that this is a problem. I would really like to be persuaded that classical liberalism and markets and so forth have a way of solving this problem. I'm still waiting for Fred's proposal. I don't think it can be done voluntarily around the world. The voluntary carbon markets are tiny—

Kiesling: It's very unscaled.

Bailey: Right. And if you don't have an economic incentive to participate in those carbon markets, like a tax or like a cap-and-trade permit, most people aren't going to do it. Why would they? Why would they spend money that they don't have to spend?

Kiesling: In this case of Chicago Climate Exchange, the biggest participants are Ford Motor and American Electric Power—the largest coal-fired generation owners in the country. So for them, it's a strategic action. They're hoping to forestall regulation but also it's a P.R. and reputation capital building exercise.

Smith: I think one of the problems our movement has is we're a think tank movement. We believe that if we just go out and talk to everybody for a few hours they'll become libertarians. That's not a wisely thought-through process, and it misses the whole point. Most people are—have to be—rationally ignorant. Our challenge is to make them understand that for their values, freedom is better than coercion. It's why I think we have to recognize that where there are risks of global warming, there are also risks of global warming policies. I see nothing in Ron that represents any understanding of that balancing.

Welch: Following up on that, Fred, do you see some kind of political market value therefore in, for lack of a better word, Al Gore jokes? Is that a way to get the message across because at some point you realize you just want people to feel that they're all part of the anti–Al Gore team more than being persuaded by your logic?

Smith: Ridicule is a very important tool. It's one that has to be wielded very carefully. The difference between ridicule and being mean is very close, and I think sometimes libertarians are far too easily led into being mean. We win the debate and we lose the audience. I think ridicule by other people is damn useful. Every time liberals make fun of Gore, I love it. When we make fun of Al Gore, I get very nervous.

Bailey: And then you make fun of Al Gore.

Audience question: Ron, what entity would collect the carbon tax? Local government? Federal? The United Nations? And what would that money be spent on and how would it reduce actual CO2 usage?

Bailey: No, it would not be a U.N. tax. I'm channeling William Nordhouse, the Yale economist who does a lot of work in this area. Basically it would be a globally harmonized tax, but the money would be collected by each country and spent by the governments in each country.

In the ideal world, you would recycle that money by reducing other taxes, so the overall tax level in the country would not increase. What you would be doing is incentivizing people to conserve energy but also incentivizing people to innovate, to find new ways to produce energy that people would want using low-carbon technologies or carbon-sequestering technologies.

It's a deep, dark secret, but back in the 1970s, during the glorious era of the Jimmy Carter administration, I was a regulator for three years.

Kiesling: You've seen the dark side.

Bailey: I've seen the dark side. I worked for the world's most boring regulatory agency, the Federal Energy Regulatory Commission.

Kiesling: I knew he was going to say FERC when he said "boring."

Bailey: And I think I understand some of the problems that go with regulation. My intellectual disdain for government was honed into a white-hot hatred after that experience. One of the things I got to regulate was the synfuels plant that you may all remember was being built in North Dakota. At the time, it was the world's largest construction project. It cost $2.1 billion to build. It never produced any natural gas of any sort. That money, by the way, would have grown at 5 percent interest to $6.5 billion had it not been wasted.

Government does not innovate. So by creating a carbon tax you would encourage private people to marshal the information in response. So carbon tax is a price, to figure out better ways to make energy, low-carbon energy. I don't know what those energies will be. I'm sure the government doesn't know either, and I don't want them wasting the money doing it.

Smith: I should point out that we have that experiment going on today. Europe—500 million people—experiences gasoline taxes in England of $8 a gallon. We experiment with $2.50, $3 a gallon. Yet one doesn't find these new technologies rushing out of Europe. How high does—

Kiesling: Actually, that's incorrect. All of the new diesel engines—

Smith: Oh, no. Diesel has nothing to do with the economics. Diesel has to do with the low tax of diesel and the fact that the air pollution laws don't ban diesel in Europe. It's not the energy taxes. It's regulatory policy.

Bailey: So, Fred, are you saying that human beings are not clever enough to come up with low-carbon energy?

Smith: I'm saying that technocratic social engineering projects aren't the best way to free the creative energies of mankind.

Bailey: Unfortunately, Fred, you haven't shown a path for evolution to this. I'm sorry. I realize that you believe that somehow the invisible hand will take care of a commons problem always, but commons problems are solved by creating property.

Smith: Government.

Bailey: And the government helps create property, defends property. It's an institution.
It's not a great institution. Right now all the big emitters are coming to Washington and begging for free permits so they can get tons of money, basically, and extract it from our pockets—which is another reason I don't like cap-and-trade systems. They want the government to create an asset for them worth hundreds of billions of dollars.

Welch: I have to impose my liberty here. The panel will be in the back alley after this, but the rest of us have to go to lunch now, which is next door.