Choose a Carbon Fee, Not a Cap and Trade Regime

Summary.   Burning fossil fuels generates carbon dioxide as waste whose socioeconomic costs to humanity are not accounted for in the price of the fuel.   Reducing our dependence on fossil fuel use and mitigation of emission of greenhouse gases have led to valuing carbon either by a fee or use of a cap and trade mechanism; the additional value would limit consumption.  A carbon fee is easy to implement legislatively or administratively, and has been effective in reducing demand for fossil fuels.  Cap and trade regimes are in place in many jurisdictions around the world.  They are administratively complex and bureaucratically onerous, and can be unsuccessful in curbing fossil fuel use.  This post expands on these factors, and concludes that lowering the use of fossil fuels is best accomplished by imposing a fee on carbon.

 

Introduction. 

Human activity generates waste.  Significantly, as we burn more and more fossil fuels to produce the energy that powers modern life, we emit more and more carbon dioxide into the atmosphere.  This substance, an important greenhouse gas, is being released as the waste product of our energy economy.

 

It is imperative to treat manmade carbon dioxide as a cost-bearing waste product because of the harmful effects of the global warming that it produces.  These harms carry enormous costs with them.  Properly accounting for these costs would make it more acceptable to make the investments needed to reduce greenhouse gas emissions.
 

Policy directed toward reducing dependence on fossil fuels and mitigating greenhouse gas (GHG) emissions has long grappled with the alternative policies of imposing a carbon fee on fossil fuels and creating a cap and trade regime.  These may be viewed as policies that affect, respectively, the demand for, and the supply of, fossil fuels.  A carbon fee levies an added cost on fossil fuels directly.  The fee is passed through directly to the consumer, affecting demand. Cap and trade mechanisms, on the other hand, place upper limits on the emission of carbon dioxide (CO₂). 

This post reviews examples of both mitigation mechanisms.  Upon consideration we support the use of a carbon fee in preference to a cap and trade mechanism for mitigation.

A carbon fee is imposed on fossil fuels directly in accordance with the amount of CO₂ produced when burned.  The fee is imposed and collected at, or close to, the source of the fuel.  The value of the fee is then passed along as the fuel is transformed (petroleum to gasoline, for example), and/or transported (all fuels), and is ultimately paid by the consumer.  The level of the fee is set by policymakers, and typically is envisioned to start low and rise periodically until it reaches an intended level.  It is seen that a carbon fee is conceptually and operationally easy to implement.  Clearly the fee operates to constrain demand.

Under cap-and-trade major emitting facilities are allotted allowances each of which licenses the release of a fixed amount, say 1 ton, of CO₂ and other GHGs.  An administrative agency determines the total number of allowances (the cap) and the allotments for each period.  The cap is reduced year by year, thus constraining fuel consumption.  Ideally the emitters would pay for the allowances, frequently through an auction, but at the outset in many regimes they are distributed at no charge.  In any case, as the program matures markets are ultimately set up to auction annual allowances, and for trading them, thereby establishing a price for emissions.  The market price on carbon established in this market deters fossil fuel use. 

There are many problems with a cap-and-trade regime that make it difficult to succeed.  For example, if the supply of allowances is too high or the market demand is too low, their price will fall and the objective of reducing the rate of emissions of CO₂ will be discouraged.  For these and other reasons discussed below, operation of a cap and trade regime is complex, if not cumbersome.  A cap and trade regime may be intricate and top-heavy to administer.

Both cap and trade and a carbon fee assign a monetary value to the waste stream that emissions of CO₂ and other greenhouse gases represent.  This has not been done historically; CO₂ has not been considered to be a waste product of our energy economy whose disposal had to be priced into the cost of the fossil fuels.
 

Examples of using a carbon tax.

In Australia, Prime Minister Julia Gillard’s government enacted a carbon fee program in 2011.  Initially the carbon fee is US$23.15 per ton of carbon; much of the revenue is to be applied as compensation to businesses and consumers (“cap and rebate”).  After six months of operation, the electricity generation segment of Australia’s energy economy reduced its carbon emissions rate by 8.6%.  Emissions were 7.5 million tonnes lower in the second half of 2012 than for the same period in 2011.  This arose from a decrease in demand and an increase in residential rooftop solar panel use and increased energy-efficiency.   Some coal-burning facilities ceased operating, while more power came from increased hydroelectric generation.  The long-term goal is to reduce emissions by 33 million tonnes per year by 2020.

Gasoline fees are very effective in affecting drivers’ travel habits.  The graphic below, characterizing how per capita fuel use reflects the size of the gasoline fee,

 

Sources: New York Times presenting data from the U. S. Department of Energy and the World Bank; http://www.nytimes.com/interactive/2012/09/11/business/Fuel-Taxes-and-Consumption.html?ref=business  

shows that per capita use of fuel for driving in developed countries decreases as the amount of the gas fee increases.  The U. S. has the lowest gas fee, which is correlated with the highest amount of fuel used per capita (horizontal scale). As the gas fee increases (vertical scale), it is seen that most of the benefit appears to be attained by a fee level of about US$2.20 per U. S. gallon.  In Great Britain, where the gas fee is even higher, Ford, the American car maker, sells a model of its compact Focus whose efficiency is 72 miles per U. S. gallon.  In contrast, a Focus model sold in the U. S. gets only 33 miles per U. S. gallon.  Clearly, automakers already have the technology and capability to mass produce highly fuel efficient cars.  This shows that the current state of technology is sufficient to garner significant improvements today.

Gasoline prices affect consumption.   In the U. S. the price of gasoline has fluctuated considerably in recent years for reasons that do not include imposition of a carbon fee.  The Washington Post reported on April 17, 2012 that higher gas prices had led to reduced consumption, and to a move toward the purchase of more fuel-efficient vehicles.

A review of various studies of the interrelationship between price and consumption concluded that “we can be reasonably assured that a rise in gas fees, all else being equal, will cause consumption to decrease”. 

Examples of using cap and trade.

In the U. S. the Regional Greenhouse Gas Initiative (RGGI) encompasses nine northeastern states.  RGGI controls only for emissions from fossil fuel plants that generate electricity, and affects only larger power plants.  RGGI created a CO₂ cap and trade program, with the goal first of stabilizing and subsequently reducing the overall emissions from these plants.  Each state’s base emission amount was established at the outset, and is remaining fixed at that level from 2009 through 2014.  Starting in 2015, the allowances for each state are to be reduced by 2.5% per year, so that by 2018 the emissions will be 10% below the starting level.  Auctions for emission allowances occur quarterly.  RGGI estimates that the auction price increases the cost of electricity to the consumer by only 0.4% to 1%.

In its 19th auction, almost 38 million CO₂ allowances were sold, garnering about US$106 million, or US$2.80 per allowance.  The cumulative amount from all auctions is about US$1.2 billion.  The proceeds are used to rebate portions of electricity bills to consumers, invest in the region’s renewable energy economy, including job training for environmental jobs, and similar objectives.  RGGI has already invested in improvements that will produce significant reductions of CO₂ emissions and save the need for generating major amounts of electricity, as well as the thermal energy needed to drive the generators.

European Union (EU). Even before the entry into force of the Kyoto Protocol in 2005, the European Commission established its greenhouse gas emissions trading scheme (ETS) using a cap and trade market mechanism. As an accord intended to govern the operations of 27 sovereign nations, each country had to enact laws codifying the applicability of the ETS structure within its borders.

It covers at least 11,000 individual emission sources across the EU. The ETS is being implemented in three phases.

Phase 1, operating from 2005 to 2007, was characterized as a learning phase, and included such features as

• The level of the emissions cap was determined largely by each nation independently;
• It included only power plants with a capacity greater than 20 MW, and other industrial facilities; these represented 42% of emissions; and
• Allocations of emission allowances relied primarily on recent historical records; they were offered at no cost.

In Phase 2 (2008-2012), features that expanded on those of Phase 1 included:

• The level of the emissions cap conformed to the limits of the Kyoto Protocol; and
• Limits on emissions from air travel were to begin in 2012.

Phase 3 (2013-2020) departs from the earlier phases in important ways:

• National emissions caps were to be replaced by a single EU-wide cap; they decrease by 1.74% per year starting in 2010 with the objective of delivering 21% reduction referenced to 2005 by 2020;
• 90% of the allowances will be sold by auction rather than being distributed free of cost.

The performance of the ETS is shown below in the graphic.  Emissions allowances in a cap-and-trade regime were already in use in the EU prior to 2005. In Phase 1 it turns out that for a variety of reasons the auction market in these initial years established early prices as high as almost EUR30 (about US$39.20 at that time) per tonne of CO₂ equivalents (blue and lavender lines; tonne, a metric ton), which then fell to EUR0/tonne toward the end of Phase 1 (orange line; see the graphic).

 

CO₂ price evolution in the EU from 2003 to 2009.  Each period’s price performance is color coded as shown.  The pale aqua line represents futures trading for (the lower number of) allowances to be granted beginning at the start of Phase 2.  The EU-wide number of allowances for Phase 2 was 11.8% lower than for Phase 1.  Once Phase 2 began in 2008, the actual allowance price and the futures trading for 2009 allowances followed essentially identical paths.

Source: Estimations of carbon price in Europe, Nicole Dellero (2008)  http://ec.europa.eu/energy/nuclear/forum/opportunities/doc/competitiveness/2008-10-24/areva--co2prices.pdf.

 

The fall of the allowance price to EUR0/tonne in 2007 has been attributed both to a glut of allowances and to the impending economic slowdown preceding the world financial crisis of the coming years.  Of course, with allowances having no penalty value, emission sources were free to continue “business-as-usual”, rather than to curtail them.  On the other hand, when allowances had a significant price, businesses were able to pass along corresponding price increases to customers, which resulted in windfall profits.

The ETS had to cancel its most recent auction in March 2013 because bids received were “significantly” below the actual market rate.  In 2013, the start of Phase 3, about 40% of newly issued carbon emission allowances are being sold at auction for the first time.  The rest are still distributed at no charge.  The price had fallen by 5.6% to EUR3.73 (US$4.86) a metric ton, and reached a low on Jan. 31, 2013 of EUR3.42. 

Longer term the ETS price for emission allowances has fallen drastically, by 90%, in the last five years as demand for energy has fallen because of recessionary conditions among EU countries.  This has led to an oversupply of unused allowances.  The ETS is reevaluating its allocation of allowances, in an attempt to rebalance the trading system and maintain a price on emissions.

The state of California enacted its Global Warming Solutions Act in 2006, establishing mitigation goals through 2020.  The governor at the time, Arnold Schwarzenegger, extended the Act by executive order declaring further stringent mitigation objectives through 2050.  These actions are significant, because California constitutes about 1/6 of the U. S. economy in view of its large size and population.  The Act is also significant because in the U. S. it is the only economy-wide mitigation plan.  Inititally it covers most fixed point sources of emission, including electric generation plants and industrial facilities, beginning now (2012-3).  It will extend to refining and sale of transportation fuels (i.e., distributed sources) in 2015.  The mechanisms for undertaking its mitigation goals include a cap and trade system as well as continuing and expanding California’s historic, successful energy efficiency programs.  State officials and advisors are undertaking to learn lessons from the experience of the European Union’s ETS, seeking to avoid its mistakes.

The state established a rigorous survey of emissions from every potential covered installation in order to allocate emission allowances.  In its first auctions California sold 23.1 million allowances at US$10.09 each, in Nov. 2012, and another 12.9 million allowances at US$13.62 each at the second auction in Feb. 2013.  This works out to revenue from the first two auctions of US$409 million.

 

Analysis

Two major mechanisms have been devised to abate the emission of CO₂, a major greenhouse gas, (aside from the important contribution of increasing the efficiency of energy usage).  One, a cap and trade regime, operates primarily by capping the supply of energy.  (Of course the auction price imposed on allowances has the effect of raising the price of the energy purchased by the consumer, so cap and trade may also have elements of lowering energy demand as well.)  The second, a carbon fee applied in proportion to the amount of CO₂ emitted when the fossil fuel is burned, directly limits demand by raising the price paid for energy.

A cap and trade regime has many disadvantages in comparison to a carbon fee.  Some of these are apparent when considering the case of the European Union.  The factors, many of which are interrelated, include a) a need to account accurately for baseline emissions from each identified source prior to placing the regime in operation; b) a continued need for monitoring emissions from each source as the regime operates; c) a need for a  mechanism to allot allowances both at the outset and in subsequent periods of operation; d) a mechanism or rule for distributing allowances, including determining whether to grant or sell them; e) monitoring use of energy offsets by those installations unable to comply with emissions limits; and f) creating and maintaining the new administrative and bureaucratic offices needed to operate the regime.  It is seen from this incomplete list that a cap and trade regime presents many challenges, requires an extensive bureaucratic structure, and includes many opportunities for mistakes to be made that defeat the objective of constraining emissions.

In contrast, a carbon fee is extraordinarily simple in its operating features and is easy to implement.  A tax rate is established at the outset, covering most or all sources of CO₂ emissions.  In order to achieve its objectives, it would be optimal to start with an insignificant tax rate, and then have the rate increase annually to a level at which it would have a meaningful effect in reducing energy demand.  The example cited in the gasoline fee graphic above provides ample evidence that a carbon fee is easy to apply, has a broad if not universal reach, and achieves its objective according to its magnitude.  It is clear that the simplicity and effectiveness of a carbon fee offers major advantages over use of a cap and trade regime.

Many commentators have urged use of a carbon fee to mitigate emissions.  One of the most consistent over time has been Tom Friedman, columnist for the New York Times, most recently in this article.   His writing and that of others have considered the many uses to which the revenues from pricing carbon could be applied.  This post will not address that discussion; most alternatives are worthy ones.

 
The time to begin abating humanity’s emissions of CO₂, a major greenhouse gas, is now.  The longer we wait, the more firmly we cement our dependence on fossil fuels, and the more CO₂ accumulates in the atmosphere, exacerbating global warming and its damaging effects on human life and welfare.  The simplest, most direct, and highly effective mechanism for reducing dependence on fossil fuels and mitigate emissions of GHGs is to apply a carbon fee.
 

© 2013 Henry Auer