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

In contrast to cap-and-trade, carbon usage fees are relatively transparent, making it harder for greenhouse gas-producing interests to finagle sweetheart deals at the climate's expense.

Equally important: A carbon-based tax addresses people's resistance to bearing additional costs directly.

In most versions, the revenues are recycled as tax relief — for example, through cuts in the payroll tax or lump sum payments to households. In this way, the strategy can change the relative price of different forms of energy based on their effects on the climate, without making people poorer.

This refundable feature protects families, especially lower- and middle-income households, as well as the overall economy.
In theory, cap-and-trade could auction all of its permits — as President Obama urged — and return the proceeds to households as well. In practice, the Waxman-Markey bill gives away 85% of its permits, providing great windfalls for greenhouse-gas producers and failing to protect most households.

Moreover, a carbon tax can work at least as effectively to reduce emissions as any cap-and-trade program with teeth. In 2008, I completed a study through the U.S. Climate Task Force that used the National Energy Modeling System (NEMS) — the computer simulation used by the U.S. Energy Department to forecast energy markets and the economy — to test the effectiveness of carbon usage fees.

We found that a revenue-neutral carbon-based tax equal to $50 per ton of CO2 would reduce emissions over the next 20 years a little better than last year's Lieberman-Warner cap-and-trade plan bill — which was much stronger than the current, Waxman-Markey version. And it did so without reducing GDP or costing jobs.

The current financial crisis highlights another important difference between the two approaches. Cap-and-trade creates a trillion dollars or so in new financial instruments — the permits — that would be traded on financial markets. This spells trouble.

To begin, those permits would quickly become the focus of large-scale speculation, because speculators make their money off of price changes, and cap-and-trade inherently and inevitably produces high price volatility.

This market also would be very vulnerable to insider trading and manipulation, because every large utility and energy producer would become aware before anyone else of shifts in energy demand, which in turn will produce shifts in the price of the permits.

Perhaps that explains why many large energy companies with major trading operations in energy futures are strong supporters of cap-and-trade, along with Wall Street. Other large energy companies less involved in trading futures prefer a carbon-based tax approach.

The House bill makes such insider trading and manipulation illegal, although it would already be illegal under current securities law. After everything that has happened in the capital markets and the economy, aren't there serious doubts that we lack the capacity to effectively monitor markets with millions of complicated trades?

In any case, there is no conceivable rationale for deliberately creating a trillion dollars in new financial instruments. These would quickly produce derivatives and derivatives of those derivatives, and we now know the economic risks such markets can pose when their underlying asset is basic to the economy — like mortgages and energy — and subject to large price swings and bubbles.

Cap-and-trade's international prospects are also discouraging. While the Kyoto Protocols, our only international agreement on climate change, are based on cap-and-trade, they haven't produced actual greenhouse gas reductions.

The reason is a version of the same dynamic that neutralized the potential effectiveness of the House-passed legislation. In order to secure broad international support, the agreement formally exempted every developing nation and used various stratagems to provide an effective pass for most advanced countries.

Even so, many countries went even further for powerful domestic interests — Germany, for example, has exempted new coal-fired plants from its cap. The only countries that would have been forced to take more drastic action under Kyoto either withdrew (the United States and Australia) or reinterpreted their obligations to reduce them (Japan and Canada).

Furthermore, the large developing nations (including China, now the world's biggest greenhouse-gas emitter) reiterated this past month that they will never accept caps on their emissions.

At least in principle, carbon taxes should be more appealing to governments in places such as China, India and Brazil, since fast-growing developing nations all need substantial new revenues to help finance the enormous infrastructure and educational investments required for modernization.

In truth, it is unlikely that the world will agree to a single global strategy for climate change, especially when such universal agreement eludes us in virtually every other area. The best prospect is an agreement on national emission goals that allows each nation to determine how best to meet its goal.

As they do so, the advanced nations — which already are committed to reducing their emissions — should consider again the self-evident failure of Europe's cap-and-trade experiment, especially compared to the carbon-based taxes used across much of Scandinavia, which now has the world's lowest, per-capita greenhouse gas emissions.

Sweden, which currently holds the presidency of the EU, recently called on other EU countries to enact their own carbon taxes. It noted that since the tax was enacted in 1990, the country's carbon emissions have fallen 8% while its GDP has increased 48%. In France, President Sarkozy is also considering a carbon tax on fuel.

For more than a decade, cap-and-trade has been the policy embodiment of that public commitment to address climate change. It has served its purpose as a symbol — but now that we turn to the business of actually reducing emissions, cap-and-trade is no longer good enough.
The best option — and it's not even a close call — is the policy promoted by Al Gore in his Nobel lecture: A revenue-neutral carbon-based tax.

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