Enact a Carbon Tax, Not a Cap-and-Trade System

Summary.  The worldwide need to abate emissions of greenhouse gases is becoming more important with every passing year.  Nevertheless, the U. S. has never enacted federal legislation that would limit its emissions.   

This post describes a proposal for a cap-and-trade market mechanism to lower greenhouse gas emissions in the U. S., presented in a recent op-ed article.  Then cap-and-trade is compared with a direct tax or fee on carbon fuels. 

It is concluded that a carbon tax or fee is far more advantageous than a cap-and-trade mechanism, for its effectiveness, efficiency and freedom from the need to create a new bureaucracy to oversee its operation.  The revenues generated can be applied in a variety of ways that would be politically acceptable.  Adoption of a carbon tax or fee in the U. S. is strongly recommended. 

Introduction.  The nations of the world are currently on a path of emitting greenhouse gases (GHGs) that risks putting humanity in great climatic peril by the end of this century.  A principal GHG is carbon dioxide (CO₂) emitted when we burn fossil fuels for energy.  Annual rates of emission while doing “business as usual” (which assumes no meaningful reductions) or only modest rate reductions lead to unacceptably high levels of total accumulated atmospheric GHGs.  It is this accumulated total (not the annual emissions rate) that determines the extent of global warming that we experience.  Thus, although it may sound virtuous to reduce annual emission rates, the new GHGs that are still emitted continue to accumulate to ever higher levels.  Only global emission rates approaching zero suffice to stabilize the global atmospheric GHG burden, leading to stabilization of global average temperature at some value higher than we have today.

The threat that GHGs posed to the world’s climate was already recognized in the 1990’s, and led to the United Nations-sponsored Kyoto Protocol that limits emissions among developed countries of the world. (Please find a Summary of Historical Developments in an earlier post.)  The U. S. never ratified the Kyoto Protocol, and has failed to pass federal legislation to limit GHG emissions on at least two more recent occasions (see the Summary).

Federal policy to lower GHG emissions can rely on market-driven mechanisms, among others.  One such mechanism, a direct fee imposed on fossil fuels based on the amount of CO₂ emitted per unit of energy obtained, has been supported by many prominent commentators and experts.  Among these, most recently, are four Administrators of the U. S. Environmental Protection Agency (EPA) appointed by Republican (i.e. the more conservative of the two American political parties) presidents (see the previous post). 

A second market approach is the cap-and-trade system.  Here we discuss a recent op-ed article calling for creation of a federal cap-and-trade mechanism.

Proposal to enact a federal cap-and-trade regime.  The New York Times published an op-ed article by Dirk Forrister (President and CEO of the International Emissions Trading Association) and Paul Bledsoe (Senior Fellow, Climate & Energy Program at the German Marshall Fund of the United States) promoting a national cap-and-trade program for the U. S.  “Cap-and-trade” refers to imposing an upper limit (the “cap”) to the amount of GHGs, especially CO₂, that a physical facility can emit in a year, and trading of emission allowances between efficient facilities left with excess allowances and inefficient facilities needing extra allowances.  Caps are to be lowered year by year to enforce increased efficiency and lower overall emissions.  The authors extol this market mechanism as being “widely recognized as a cheaper way to lower emissions. [Because President Obama has had to use a regulatory mechanism instead, c]onsumers will pay a higher price for electricity as a consequence.”

The authors cite China’s pilot cap-and-trade market being set up in the city of Shenzhen as an example.  It will cover over 800 individual emission sources, both industrial facilities and municipal buildings, that are responsible for 40% of Shenzhen’s emissions.  The authors state that six more pilot projects are planned in China in the coming year.  They state that currently 20% of GHG emissions around the world occur in carbon pricing systems (they do not indicate whether only cap-and-trade mechanisms are used). 

The op-ed dismisses enactment of a direct carbon tax by surmising, without supporting evidence, that “the tax would probably be small and would not guarantee the reduction in emissions needed.”  The example presented further below rebuts this contention.  Nevertheless, Forrister and Bledsoe correctly state that revenues obtained either from a tax or from a market mechanism could be rebated to taxpayers or used to offset other taxes; still other uses for this new revenue have been proposed by other analysts.  They provide a useful summary of the rancorous political environment in the U. S. Congress that has prevented past attempts to enact cap-and-trade legislation from succeeding. 

Analysis

We need to lower GHG emissions.  The need to abate GHG emissions becomes more apparent with each passing day.  Man-made increases in GHG concentrations in our planet’s atmosphere are directly responsible for increased long-term global average temperature.  Higher temperature contributes to the severity and frequency of extreme climate and weather events that are harmful to human society, inflicting major costs that, in most countries, are borne by the taxpaying public.  Forrister and Bledsoe state “[a]s the costs of adaptation rise… inaction will become an untenable political position.”

A carbon fee or tax.  The previous post presents the case offered by four Republican former EPA administrators for a fee imposed directly on fossil fuels.  (A carbon fee or tax can be considered primarily a way of reducing demand for fossil fuels.)  Here the alternative, a cap-and-trade market which operates by limiting the amount of emissions, and therefore of the fuel use that generates them, is proposed.  (Cap-and-trade may be considered to operate primarily by limiting the supply of fuel.)  A direct fee or tax on fossil fuels is far more efficient and effective in limiting GHG emissions than is cap-and-trade. 

A carbon tax is legislated at the outset and remains in effect indefinitely.  (Only politically motivated tinkering in later years would lead to changes in the size of the tax.)  Importantly, a carbon tax can be imposed on all fossil fuels at the point of extraction from the earth.  For this reason a carbon tax easily covers the entire fossil fuel-based energy economy, including fuel for transportation.  Typically it would start at a low, relatively painless level, and grow in size year by year until it reaches a significant amount.  The added cost of fuel serves as an economic deterrent to its use.  The fee motivates consumers to adopt energy-efficiency and to use renewable energy.

A carbon tax is simple to administer.  It has led, for example, to striking increases in efficiency and decreases in fuel use when it is applied as a tax on gasoline fuel for motor vehicles. The graphic below

Source: 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 decreases as the size of the gas tax increases.  The U. S. has the lowest gas tax correlated with the highest amount of fuel used per capita. In Great Britain, on the other hand, the gas tax is about US$3.95 per U. S. gallon and very low fuel use per capita (but it is seen from the graphic that a similar increase in efficiency can be obtained for as low as about US$2.20 per U. S. gallon).

A cap-and-trade market, on the other hand, requires establishment of cumbersome new bureaucracies to operate.  It further needs to create a new trading market, usually including an auction facility, to buy and sell emission allowances.  Another bureaucracy is needed to work with “offsets”, the buying or selling of emission allowances based on emission credits beyond the actual jurisdiction of the region or nation involved.  Like any commodity market, this one is susceptible to abuse and manipulation by third party traders seeking profits but who are not directly connected with the energy economy.

Consider the example of Shenzhen, cited in the op-ed of Forrister and Bledsoe.  For each of the more than 800 facilities covered, officials must evaluate, and then verify, the GHGs emitted annually in order to be able to issue the correct number of emission allowances.  (Note that there is an incentive for a facility to overstate emissions in order to earn more allowances.)   Officials must account for allowances returned at the end of the year, and must verify that the current emission level for each facility agrees with the number of returned allowances.  Then in each succeeding year the allowances for each facility are reduced, and the cycle of measuring and verifying emissions, and matching those results with allowances, must be repeated.  Third party speculators, who are neither energy officials nor facility representatives, can enter the market for allowances and trade them in search of profit (or garnering losses) without regard for the underlying energy policy, potentially leading to windfalls or market crashes.

In addition, it may be difficult to work out a way to issue allowances for transportation fuel, since vehicles are not fixed emission sources, and are far more numerous than fixed facilities.

The European Union’s cap-and-trade market.  An example of a cap-and-trade regime which failed is found with the Emissions Trading System (ETS) of the European Union (EU).  The ETS was set up as the EU entered under the Kyoto Protocol in 2005.  It covers at least 11,000 individual emission sources across the EU.  At the outset, allowances were determined by each EU nation independently.  Allowances were granted, in certain cases, in excess of need or previous national experience.  The auction market in the initial years established early prices as high as almost €30 per tonne of CO₂ equivalents (tonne, a metric ton) in the middle of 2006, which then fell, for a variety of reasons including the onset of the recession, to about €0/tonne one year later.  As the allocation mechanism improved prices recovered, but by 2012 they were again low, less than €4/tonne, because recessionary conditions across the EU led to a surplus of available allowances.  The EU Parliament voted in April 2013 not to lower the number of allowances, thus essentially generating a “potential death blow” to the ETS.  The Parliament relented a few months later.  This example shows how cap-and-trade is susceptible to political interference, preventing attainment of its objectives. 

(Update Aug. 22, 2013) California’s cap-and-trade program also exemplifies the bureaucratic and operational difficulties identified above.  In its fourth quarterly auction of allowances, the price for the largest emitters was US$12.22 per metric ton of CO₂-equivalent, about 12.7% lower than the previous sale.  An impression of the complex bureaucracy that administers the program may be seen in the state’s Quarterly Auction 4 Summary Results Report.  It refers to setting auction pricing and verifying eligibility of participants in the auction. 

“ARB staff and the Market Monitor carefully evaluated the bids, and determined that the auction process and procedures complied with the requirements of the Cap-and-Trade Regulation….

‘The Market Monitor found that the auction was cleared consistent with the auction clearing rules…[and] confirmed the clearing price and clearing quantities….’”

This document provides further details of the auction that reflect the intensive administrative effort needed to conduct it. 

California’s Cap-and-Trade system covers 359 individual entities whose emissions are higher than the cutoff of 25,000 metric tons per year.  (Link here and then click on the link “Updated List of Covered Entities”.)  Emissions and allowances for each must be monitored and verified.

Conclusion 

It is highly recommended that the U. S. enact a national tax on the carbon in fossil fuels, beginning at a low level and increasing annually.  Its operation is highly effective and very efficient.  It is easily extended to include the entire fossil fuel economy in its operation.  It readily constrains the use fossil fuels by reducing demand on the part of consumers.

Cap-and-trade is shown here to be cumbersome, requiring an extensive bureaucracy operating throughout the lifetime of such a program.  The ETS of the EU has been ineffective.  Cap-and-trade is susceptible of abuse and likely would not cover the transportation segment of the energy economy.

With either mechanism, the revenues obtained can be rebated to taxpayers, or can be used to offset other taxes.  Other possible uses include reducing the national debt or supporting research, development and deployment of innovative renewable energy technologies.  Allocating the funds in ways such as these should ease the political barriers to enactment in the U. S.

© 2013 Henry Auer