The Case for a Carbon Tax to Control Climate Change (Part I)

Finally, the United States is prepared to act on climate change.

The American people support significant action and believe it's an urgent matter, which is why the House of Representatives passed climate legislation in June 2009 and the Senate is preparing to consider it.

The current legislation, however, embodies a cap-and-trade approach to addressing greenhouse gases. Most economists and many environmentalists, at least privately, no longer support this approach, especially compared to the alternative of a refundable, carbon-based tax.

Their concerns were only heightened by the rampant horse-trading to win votes for the Waxman-Markey bill in the House, which substantially weakened its effective cap on emissions.

Whatever plan the U.S. Congress ultimately approves, with whatever flaws it contains, will become the U.S. response to climate change for a decade or more. That's why many environmental groups and businesses (again, at least privately) are giving further consideration to the alternative of carbon taxes.

Both approaches rely on higher prices for carbon-based fuels to encourage people and businesses to prefer less carbon-intensive forms of energy and technologies. They also spur companies to develop new technologies and less expensive ways of generating low-carbon or carbon-free energy.

A carbon-based tax does so directly by applying a levy based on the carbon content of the fuel. Cap-and-trade does it more indirectly, providing energy producers and distributors with limited numbers of permits to produce greenhouse gas emissions — that's the cap part — and then allowing trading in those permits to determine the price of the carbon contained in the energy.

While cap-and-trade and a carbon-based tax are both forms of usage fees for using carbon, their different approaches lead to different economic outcomes. Under cap-and-trade, the price of carbon depends on the relationship between energy demand and the supply of permits. But while the supply of permits in any year is fixed by the cap, the demand for energy shifts all the time.

So, when that demand increases unexpectedly — because the summer is hotter than predicted or the winter colder, or the economy is stronger than anticipated — the price of the permits will rise sharply.

The same kind of volatility occurs when demand shifts downward, because the summer is cooler than expected, the winter milder or the economy slower. In that case, the price of the permits would fall sharply. Economically, this introduces a new layer of price volatility in energy, and such additional domestic volatility would often amplify the price swings in international energy prices we already live with.

Such additional price swings are unequivocally bad for an economy. In fact, economists link the onset of many of the downturns of recent decades with steep energy price increases — including the onset of the current recession in late 2007.

This volatility is equally troubling environmentally: It means that cap-and-trade cannot provide a predictable price for carbon, which undermines the basic strategy of getting people to shift away from carbon-based fuels.

This drawback is even more important for businesses, considering the large investments they will make to redo their energy infrastructure or, critically, to develop new climate-friendly fuels and technologies. If they can't know or predict what the price of carbon will be, it becomes much harder to figure out whether large investments make economic sense — and so we would get less of those investments.

This volatility and the analysis based on it are not simply thought experiments. The prices for the permits in the U.S. acid rain program, America's only foray thus far into cap-and-trade, have moved up and down an average of 17% per month since the program began in the early 1990s. And in the first three years of the European Trading Scheme, its permit prices similarly moved up and down by an average of more than 20% per month.

Most cap-and-trade advocates point to the prospect of linking future emissions trading programs in the United States and other countries to create a global system, but this would only increase the likelihood of even greater global volatility in energy prices.

The contrast to a carbon usage fee is clear: By definition, the carbon tax provides a known price for carbon which can be set at whatever level scientists believe will enable us to meet the necessary goal of reducing greenhouse gas emissions.

Supporters of cap-and-trade counter that the carbon tax approach lacks a cap, so if the summer is hotter or the winter colder than expected, emissions will increase with rising energy demand. That's correct — but every carbon tax proposal includes provisions to adjust the tax rate periodically to ensure that we stay on a path of sustainable emissions reductions.

The Waxman-Markey bill which passed the U.S. House limits the potential volatility of its permits and the energy prices that lie underneath them, but in the wrong way. It provides so many exceptions, exemptions and offsets that its cap would ensure very little emissions reductions for at least a decade.

For example, the greatest producers of greenhouse gases in the United States are large utilities, which use the cheapest and most carbon-intensive fuel, coal, to generate most of their electricity. Yet under the House-passed bill, electric utilities pay nothing for their permits, sharply reducing their incentives to reduce their emissions.

In fact, the bond ratings of large U.S. coal companies improved when the bill passed, as investors concluded that it would not threaten their future profits.

Why did the House give coal and many other greenhouse-gas emitting producers a free (or reduced-price) pass? One reason is that they could: Cap and trade is very complicated and little understood by the public, creating an ideal environment for horse-trading by special interests.

Members also know well that Americans hate rising energy prices, and only a small minority — here and everywhere else — would be willing to bear additional costs today to avoid larger costs down the road. To reduce most people's costs of addressing climate change, they sacrificed the program's potential environmental effectiveness.

With the House passing a climate program that's too weak to protect the climate, they will delay real action at potentially enormous costs for everyone.

Editor’s Note: You can read Part II here.