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Carbon Taxes Versus Carbon Markets: What’s the Best Way to Limit Emissions?

Friday, May 18, 2007

Cap-and-trade markets have greater political momentum, but most economists favor a carbon tax. Here’s our guide to the debate.

Policymakers and businesses are now trying to figure out the best way to limit the emissions of greenhouse gases, especially carbon dioxide, which is produced by burning fossil fuels such as coal, oil, and natural gas. Why impose limits? Because accumulating scientific evidence indicates that the increased concentration of greenhouse gases in the atmosphere is causing average temperatures to rise globally. This increase could trigger significant disruption of the world’s climate by the end of this century. Although there remain serious uncertainties about the magnitude of the human role in climate change, there is a growing consensus that emissions need to be reduced.

The battle now is over how. The two leading approaches are carbon markets and carbon taxes. Surprisingly, a great many free marketeers favor higher taxes on carbon-emitting fossil fuels over a cap-and-trade carbon market, including former Federal Reserve chairmen Paul Volcker and Alan Greenspan, former chairman of President Bush’s Council of Economic Advisers Gregory Mankiw, and former Duke Energy CEO Paul Anderson. A Wall Street Journal Survey in February 2007 found that 54 percent of economists favor a carbon tax over all other approaches.

Earlier this year, ExxonMobil laid out a set of principles for reducing carbon emissions, including maximizing the use of markets, ensuring a uniform and predictable cost of carbon across the economy, minimizing complexity to reduce administrative costs, and providing transparency to companies and consumers. ExxonMobil’s vice president for public affairs, Ken Cohen, noted in a conference call with environmental and energy bloggers in January, “Most economists who have looked at this issue would come away saying a carbon tax makes the most sense. It’s the most efficient policy. The most sector-neutral. It doesn’t favor or disfavor one part of the economy over another.” Cohen added, “We do look seriously at carbon tax proposals, but…the devil is in the details.”

Most environmental groups like cap-and-trade systems because they set firm limits on actual emissions.

While carbon taxes are preferred by many policy analysts, proposals for carbon markets dominate Capitol Hill. For example, Senator John McCain, one of the leading Republican candidates for president, said in February that “any responsible climate change measure must have rational, mandatory emission reduction targets and timetables,” and it “must utilize a market-based, economy wide ‘cap-and-trade’ system.” McCain is a co-sponsor, with Senator Joe Lieberman, of the Climate Stewardship Act, which would establish a nationwide limit on greenhouse gas emissions and then issue permits to emit greenhouse gases. The McCain-Lieberman bill ambitiously aims to cut greenhouse gas emissions by almost 60 percent below what they would otherwise have been in 2030. Companies that have low emissions could sell their emissions rights to companies that find it expensive to reduce their own emissions.

Business leaders see the policy handwriting on the wall and are rushing to help shape the emerging greenhouse gas (GHG) emissions regulatory scheme to their own best advantage. A government-created market in emissions permits would be particularly responsive to this kind of gamesmanship. In January, the U.S. Climate Action Partnership, consisting of ten big companies with a total market capitalization of $750 billion, including DuPont, Alcoa, General Electric, and BP America, issued a “blueprint for a mandatory economy-wide, market-driven approach to climate protection.”

Also in January, the Electric Power Supply Association, the lobby group that represents competitive power suppliers that account for 40 percent of the generating capacity of the U.S., acknowledged that “regulatory and legislative processes are moving forward seriously and with speed.” In February, the power-industry lobby group, the Edison Electric Institute, came out in favor of “federal action or legislation to reduce greenhouse gas emissions that...involves all sectors of the economy, and all sources of GHG.”

The United States currently maintains a robust cap-and-trade market in sulfur dioxide permits.

Cap-and-trade schemes for reducing pollutants have a lot going for them. First, many businesses favor them. Second, we already have an American example of a similar market that works. Third, carbon markets are accepted under international treaties and already exist abroad. Fourth, most environmental groups like cap-and-trade systems because they set firm limits on actual emissions. And, fifth, in theory at least, the flexibility of carbon markets enables businesses to figure out the least expensive way to reduce overall emissions.

The United States currently maintains a robust cap-and-trade market in sulfur dioxide permits which advocates of a GHG market hold up as a shining example. Sulfur dioxide (SO2) is emitted by power producers when they burn coal that contains sulfur. Since SO2 is noxious to breathe and contributes to acid rain, Congress in 1990 enacted legislation requiring emissions from electric utilities to be reduced to 8.95 million tons by 2010 (emissions were 17.5 million tons in 1980). Each year, the Environmental Protection Agency issues permits that allow a smaller and smaller amount of SO2 emissions.

So far, those emissions are down to about 10.5 million tons annually. According to one estimate by the EPA, by 2010, the annual cost of the reductions to electric utility companies, their customers, and shareholders will be about $3 billion, while the annual benefits—including lower mortality and fewer hospital admissions from respiratory illnesses; improved visibility; cleaner soil, lakes, and streams; and reduced damage to buildings—will exceed $100 billion. Even if these figures are exaggerated, the SO2 cap-and-trade system appears to be a major success.

The American SO2 market served as the model for the European Union’s Emissions Trading Scheme (ETS), established two years ago to meet the EU’s commitment to reduce GHG emissions under the Kyoto Protocol. Countries set a limit on how much carbon dioxide businesses and participating enterprises will emit and then allocate permits to them. The permits can be bought and sold on an open market. Manufacturers, for example, that can cheaply abate their emissions will have some permits left over. The cheap abaters can then sell their extra permits to other emitters that find it more expensive to reduce emission. In this way, a market in pollution permits finds the cheapest way to cut emissions. “Innovators can invest in technology to produce and sell excess credits,” said Jonathan Lash of the World Resources Institute (WRI). “Cap-and-trade creates a market that chooses the best options.”

From the point of view of environmental activists, the greatest strength of a carbon market is that it sets an overall specific limit on carbon emissions. As Craig Hanson, deputy director of the People and Ecosystems program at WRI, notes, “What the environment cares about is the amount of emissions and the concentration of greenhouse gases in the atmosphere. Setting limits on emissions is a policy that addresses that problem directly.” Matthias Duwe, the director of the Climate Action Network in Europe, explained his group’s support for carbon markets by saying, “Environmental effectiveness is what counts. What we want is absolute reductions in emissions. Sending signals to business is secondary.”

Governments have every incentive to cheat. If they issue enough permits, their electricity companies will be able to generate power without adding to their costs—or the costs of their customers. And low energy costs give a nation’s businesses a competitive advantage over businesses in other countries.

Despite this enthusiasm, after more than two years of operation, the EU’s carbon trading market is not working. The ETS covers the output of about 12,000 big emitters, whose CO2 amounts to roughly half of the European Union’s total emissions. While the EU’s 25 governments individually determine the number of permits they will issue, the ETS system directs the handing out of allowances, based on historical emissions, for each factory or other enterprise. Initially, allowances to emit CO2 traded for around 10 euros per ton. A year later, the price for allowances had risen to 30 euros per ton. At that price the market was being widely hailed a success, as higher prices would be an incentive for companies to work seriously at cutting their emissions. Then, in May 2006, an audit showed that several EU governments had issued permits for 66 million tons more CO2 than was actually being emitted. Everyone realized that the supply of permits was not scarce, so the price of carbon promptly collapsed to less than 9 euros per ton. By February 2007, an allowance to emit a ton of CO2 could be had for less than a euro.

The woes of the EU’s carbon market are not over. In October 2006, all of the European Union countries forwarded their proposed National Allocation Plans for carbon dioxide emissions to the European Commission. It turns out that all of the countries, except the U.K., allocated permits for emissions that averaged about 15 percent above actual current levels. The EC’s environment commissioner, Stavros Dimas, warned: “If member states put more allowances into the market than are needed to cover real emissions, the scheme will become pointless, and it will be difficult to meet our Kyoto targets.” In other words, if there is no scarcity of carbon permits, then the permits are worthless, and there is no carbon market.

Many commentators argue that the last two years of turmoil are just the shakeout phase of a carbon market that will soon be robust. But the travails of the ETS highlight the fact that governments have every incentive to cheat. If they issue enough permits, their electricity companies will be able to generate power without adding to their costs—or the costs of their customers. And low energy costs give a nation’s businesses a competitive advantage over businesses in other countries.

Is there an objective, scientific way to allocate emissions permits? Not really. The process is inherently political. Chuck Chakravarthy and John Rhoads, energy consultants for Accenture, are blunt in a January article in Public Utilities Fortnightly. “Early winners will be the companies best able to shape regulations,” they warn. They urge utility executives to lobby now for emission allocations that will position them “for maximum economic value as compared with competitors.” There’s a huge amount of money at stake. At the height of the EU carbon market, for example, the allowances were worth about $50 billion.

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.

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.

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.”

Companies have a strong incentive to understate their emissions so they can sell allowances. On the other hand, buyers have no impetus to uncover the seller’s fraud once they have invested in false permits.

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.

Ronald Bailey is the science correspondent for Reason magazine.

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