AEI Slams Cap, Touts Tax

The American Enterprise Institute issued a concise report (June 2007) comparing carbon caps with carbon taxes for combating climate change. AEI’s clear verdict: “carbon-centered tax reform — not GHG [greenhouse gases] emission trading — is the superior policy option.”

On SO2 Trading as a Model for CO2 Cap-and-Trade

There has been significant volatility in [SO2] emission permit prices, ranging from a low of $66 per ton in 1997 to $860 per ton in 2006… Over the last three years, SO2 permit prices have risen 80 percent a year, despite the EPA’s authority to auction additional permits as a
“safety valve” to smooth out this severe price volatility.

Several other aspects of the SO2-trading program are of doubtful applicability to GHGs. First, SO2 trading was only applied to a single sector: … coal-fired power plants … a comprehensive GHG emissions-trading program will have to apply across many sectors beyond electric utilities, vastly complicating a trading system.

Second … reducing SO2 emissions did not require any constraint on end-use energy production or consumption. Coal-fired power plants had many low-cost options to reduce SO2 emissions without reducing electricity production. CO2 is different: it is the product of complete fuel combustion. There is no “low-CO2 coal,” and the equivalent of SO2 scrubbers does not yet exist in economical form. [A]ny serious reduction in CO2 emissions will require a suppression of fuel combustion. This is going to mean lower energy consumption and higher prices, at least in the intermediate term.

Even though confined to a segment of a single sector of energy use, the SO2 emissions-trading regime was far from simple. There were complicated allocation formulas to distribute the initial emissions permits. [Even so,] establishing allowances and accounting systems for GHG emissions across industries is going to be vastly more difficult and highly politicized.

Volatility

The favored solution to these problems is to over-allocate the number of initial permits both to ease the cost and to encourage the rapid start-up of a market for trades. This was the course the European Union took with its Emissions Trading System (ETS), and it has very nearly led to the collapse of the system. Because emissions permits were over-allocated, the price of emissions permits plummeted, and little — if any — emissions reductions have taken place because of the ETS. The over-allocation of initial permits merely postpones both emissions cuts and the economic pain involved. Economist Robert J. Shapiro notes:

As a result of all of these factors and deficiencies, the ETS is failing to reduce European CO2 emissions. [T]he European
Environmental Agency has projected that the EU is likely to achieve no more than one-quarter of its Kyoto-targeted reductions by 2012, and much of those “reductions” will simply reflect credits purchased from Russia or non-Annex-I countries [developing countries], with no net environmental benefits.

As economist William Nordhaus observes:

We have preliminary indications that European trading prices for CO2 are highly volatile, fluctuating in a band and [changing] +/- 50 percent over the last year. More extensive evidence comes from the history of the U.S. sulfur-emissions trading program. SO2 trading prices have varied from a low of $70 per ton in 1996 to $1500 per ton in late 2005. SO2 allowances have a monthly volatility of 10 percent and an annual volatility of 43 percent over the last decade.

Nordhaus points out the ramifications of such volatility, observing that “[s]uch rapid fluctuations would be extremely undesirable, particularly for an input (carbon) whose aggregate costs might be as great as petroleum in the coming decades,” and that “experience suggests that a regime of strict quantity limits might become extremely unpopular with market participants and economic policymakers if carbon price variability caused significant changes in inflation rates, energy prices, and import and export values.”

Nordhaus is not alone in this concern about price volatility. Shapiro similarly observes:

Under a cap-and-trade program strict enough to affect climate change, this increased volatility in all energy prices will affect
business investment and consumption, especially in major CO2 producing economies such as the United States, Germany, Britain, China and other major developing countries.

Cap Reform Unlikely

It is possible that the defects of previous emissions-trading programs could be overcome with more careful design
and extended to an international level, though this would require an extraordinary feat of diplomacy and substantial refinements of
international law. Even if such improvement could be accomplished, it would not provide assurance against the prospect that the cost of such a system might erode the competitiveness of the U.S. economy against developing nations that do not join the system.

Advantages of a Carbon Tax

Most economists believe a carbon tax (a tax
on the quantity of CO2 emitted when using energy) would be a superior policy alternative to an emissions-trading regime. In fact, the irony is that there is a broad consensus in favor of a carbon tax everywhere except on Capitol Hill, where the “T word” is anathema. Former vice president Al Gore supports the concept, as does James Connaughton, head of the White House Council on Environmental Quality during the George W. Bush administration. Lester Brown of the Earth Policy Institute
supports such an initiative, but so does Paul Anderson, the CEO of Duke Energy. Crossing the two disciplines most relevant to the discussion of climate policy–science and economics–both NASA scientist James Hansen and Harvard University economist N. Gregory Mankiw give the thumbs up to a carbon tax swap. [Note: pro-tax statements by all six individuals are collected here.]

There are many reasons for preferring a revenue-neutral carbon tax regime (in which taxes are placed on the carbon emissions of fuel use, with revenues used to reduce other taxes) to emissions trading.

[The AEI report goes on to catalog the advantages of carbon taxing, under these nine headings:]

• Effectiveness and Efficiency
• Incentive Creation
• Less Corruption
• Elimination of Superfluous Regulations
• Price-Stabilization
• Adjustability and Certainty
• Preexisting Collection Mechanisms
• Keeping Revenue In-Country
• Mitigation of General Economic Damages

[The AEI report, which was authored by Kenneth P. Green, Steven F. Hayward, and Kevin A. Hassett, ends as follows:]

A cap-and-trade approach to controlling GHG emissions would be highly problematic. A lack of international binding authority would render enforcement nearly impossible, while the incentives for cheating would be extremely high. The upfront costs of creating institutions to administer trading are significant and likely to produce entrenched bureaucracies that clamor for ever-tighter controls on carbon emissions. Permit holders will see value in further
tightening of caps, but will resist efforts outside the cap-and-trade system that might devalue their new carbon currency. Higher energy costs resulting from trading would lead to economic slowdown, but as revenues would flow into for-profit coffers (domestically or internationally), revenues would be unavailable for offsetting either the economic slowdown or the impacts of higher energy prices on low-income earners.

A program of carbon-centered tax reform, by contrast, lacks most of the negative attributes of cap-and-trade, and could convey significant benefits unrelated to GHG reductions or avoidance of potential climate harms, making this a no-regrets policy. A tax swap would create economy-wide incentives for energy efficiency and lower-carbon energy, and by raising the price of energy would also reduce energy use. At the same time, revenues generated would allow the mitigation of the economic impact of higher energy prices, both on the general economy and on the lower-income earners who might be disproportionately affected by such a change. Carbon taxes would be more difficult to avoid, and existing institutions quite adept at tax collection could step up immediately. Revenues would remain in-country, removing international incentives for cheating or insincere participation in
carbon-reduction programs. Most of these effects would remain beneficial even if science should determine that reducing GHG emissions has only a negligible effect on mitigating global warming.

A modest carbon tax of $15 per ton of CO2 emitted would result in an 11 percent decline in CO2 emissions, while raising non-coal-based energy forms modestly. Coal-based energy prices would be affected more strongly, which is to be expected in any plan genuinely intended to reduce GHG emissions. A number of possible mechanisms are available to refund the revenues raised by this tax. On net, these tools could significantly reduce the economic costs of the tax and quite possibly provide economic benefits.

For these reasons, we conclude that if aggressive actions are to be taken to control GHG emissions, carbon-centered tax reform–not GHG emission trading–is the superior policy option.