Carbon taxes + cap and trade = Tackling climate change like an economist

 
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September 13, 2019

To paraphrase toothpaste advertising, it might be said that 9 out of 10 economists agree: putting a price on carbon dioxide emissions can help bring those emissions down. Using economics to curb climate change is an idea that’s been kicking around for a while.

“The central question for economists, climatologists and other scientists remains: How costly are the projected changes in — or uncertainties about — the climate likely to be, and, therefore, to what level of control should we aspire?” Yale University economist and 2018 Nobel laureate William Nordhaus wrote in 1976.

Forty-some-odd years later, government and academic analyses have provided a solid sense of the costs of climate change. But how the price of carbon is set, and who sets it, are hardly settled.

How carbon taxes and cap-and-trade work

Carbon taxes and cap-and-trade are the two big ideas U.S. economists have come up with to address climate change. Carbon taxes put an initial financial burden on entities that pollute. Governments set the price of pollution while markets determine the amount of pollution — companies can pollute and pay the tax or reduce emissions to avoid the tax. There are carbon taxes in other countries but not in the U.S. In practice, the tax burden might be passed along to consumers. If a refinery that produces heating oil pays a tax for emitting carbon, customers might end up paying higher home heating oil prices. To some economists, this is not a bug but a feature: higher prices would lower demand for carbon-intensive fuels.

Cap-and-trade policy puts a cap on overall amounts of pollution. Governments set the amount of allowable pollution, markets set the price. The idea is the emissions cap is split as credits across companies that pollute. Companies that pollute under the cap can sell credits to entities that pollute more. Part of the appeal is that as the cap lowers over time, so does the number of credits, incentivizing companies to pollute less.

So far, the U.S. has gone with cap-and-trade strategies over carbon taxes. The strategies go by different names, but in practice they may not be that dissimilar — the devil, as always, is in the details.

“Although there is a lot of discussion about carbon taxes versus cap-and-trade, depending on how a carbon tax is designed, it can become very close to cap-and-trade,” says Harvard University economist Robert Stavins. “It’s really a continuous spectrum of carbon pricing — from one extreme of a pure carbon tax to a pure cap-and-trade system with all these hybrid approaches in the middle. That’s why I think it’s the design of the system that is most important.”

Welcome to Econ 101

Stavins assesses the state of the practice in a recent National Bureau of Economic Research working paper. He writes that economists have reached consensus that pricing systems such as carbon taxes and cap-and-trade will be key to reducing carbon dioxide emissions: “There is widespread agreement among economists — and a diverse set of other policy analysts — that at least in the long run, an economywide carbon pricing system will be an essential element of any national policy that can achieve meaningful reductions of [carbon dioxide] emissions cost-effectively in the United States.”

There are other economic levers that can be pushed or pulled — subsidies for clean fuel and energy-efficient cars, for example, or technology standards on machines that burn fossil fuels. But economists generally agree that carbon taxes and cap-and-trade offer the best bang for the buck.

“We know that if you raise the prices of something, people consume less of it,” says Tufts University economist Gilbert Metcalf. “It’s an Economics 101 principle that the demand curve slopes down. Raise the price of gasoline, people buy less of it. Raise it enough and they stop buying Hummers and start buying Priuses. So the economics is pretty clear, either cap-and-trade or a carbon tax can really blunt emissions.”

From national to regional cap-and-trade

The U.S. Environmental Protection Agency’s Acid Rain Program in 1995 became the first national cap-and-trade effort. It seeks to reduce airborne sulfur dioxide and nitrogen oxides coming from power plants. Acid rain happens when those pollutants get into the atmosphere, then fall to the ground via moisture like rain or snow, contaminating waterways and crops. Acid deposits have decreased 30% across the Midwest and Northeast and the program saves 20,000 to 50,000 lives each year, according to the EPA.

Another national cap-and-trade program was the NOx Budget Trading Program, which operated during the 2000s and sought to reduce nitrogen oxides from power plants during the summer. The program prevented nearly 2,000 summertime deaths each year in participating states, most of them along the east coast, according to a 2017 analysis in the American Economic Review. But an economywide cap-and-trade program bought the farm in 2010, in part because opponents rebranded it “cap-and-tax,” making the idea politically unpalatable. No national cap-and-trade program has come close to passing Congress in the decade since.

“In Washington circles, a lot of people think carbon taxes are going to be much more politically feasible,” Stavins says. “We have a number of carbon tax proposals, some within the Congress and some from outside the government, and a lot of people think those will be more successful than cap-and-trade. My view is, if it was possible to demonize cap-and-trade as a tax, it is highly likely that it will be possible to demonize a carbon tax as a tax.”

States have since taken up the cap-and-trade baton. The Regional Greenhouse Gas Initiative covers nine New England and Mid-Atlantic states and set its first carbon cap for the power sector in 2009. Greenhouse gases have fallen 40% in those states, and they’re aiming for another 30% reduction by 2030. The initiative has raised $2.7 billion, which has gone back into renewable energy and to help low-income people pay their energy bills.

Power plants in participating states generate about 112,000 megawatts less each month than states that don’t participate, and they emit 286 fewer tons of sulfur dioxide and 131 fewer tons of nitrogen oxides per month, according to a recent paper in Energy Economics. However, that analysis finds the initiative had a causal effect only on reductions of sulfur dioxide emissions, not nitrogen oxides. This could be because power plants emit much more sulfur dioxide than nitrogen oxides — more data makes it easier to pinpoint causation, explains one of the authors, University of Massachusetts Amherst economist Nathan Chan.

The authors looked at daily data on megawatts produced from power plants in the continental U.S. — 300,000 observations in total — from 2002 to 2016. The initiative has so far achieved its main goal of reducing power plant emissions in participating states, according to the paper. Facilities in participating states saw 20% greater carbon reductions, on average, than facilities in states that don’t participate.

Participating states also reduced overall electricity generation, in particular from coal plants. Some environmental benefits were offset by increased natural gas energy production in neighboring states, like Pennsylvania and Ohio. This concept is called leakage, and it works like this: the cost of carbon credits can lead an energy producer in a cap-and-trade state to raise prices. A competitor just over the state border might sell energy for cheaper, or an energy producer might move out of a cap-and-trade state. Because air pollution doesn’t respect state boundaries, environmental benefits can take a hit if customers buy carbon-intensive energy from plants that don’t have to abide by emissions caps. As far as the Regional Greenhouse Gas Initiative is concerned, that offset appears to be less severe than previously estimated.

“Leakage effects aren’t as pronounced as people might have thought,” Chan says. “There were simulations before that suggested leakage might be as much as 100% so every reduction in carbon in the region would be completely offset. We’re showing that’s not as much of an issue.”

East coast climate change strides aside, it’s the west coast, where the world’s fifth largest economy hugs the Pacific Ocean, that can claim the longest running statewide cap-and-trade program in the U.S.

California, here we come

California’s cap-and-trade program began in 2006 and the legislature extended it in 2017. It has an emissions cap affecting 80% of greenhouse gases coming from about 450 of the state’s biggest polluters. The way the program works is a little inside baseball, but a big part of it is that companies buy something called allowances at state auction. Allowances let companies emit pollutants, and companies can also buy pollution credits from entities that reduce greenhouse gases or store carbon. California takes revenue from those auctions and reinvests the money into climate-friendly programs.

The program “has demonstrated the feasibility and effectiveness of an economy-wide approach, compared with sectoral systems,” write economists Richard Schmalensee of the Massachusetts Institute of Technology and Stavins of Harvard in the Oxford Review of Economic Policy. California reports it is on track to beat its initial target of reducing greenhouse gas emissions to 1990 levels by 2020, and is now aiming for emissions levels 40% under 1990 levels by 2030. Schmalensee and Stavins note in their paper that cap-and-trade alone is not enough to address climate change:

“While there has been a significant amount of experience over the past 30 years with the use of cap-and-trade instruments for environmental protection in the United States and Europe, market-based instruments have not replaced nor come close to replacing conventional approaches,” like governments setting uniform, economywide emissions limits.

Some experts also caution that the People’s Republic of California, as the state is sometimes jokingly called, is markedly dissimilar from most states. California has a strong, mostly popular, single-party majority in its legislature, so it’s an easier political lift to experiment with market-based emissions reduction programs. Its utilities are largely on board with addressing climate change, even through regulation. So the state doesn’t rely much on coal to produce energy, while many other states do.

“Because California is a unique case in several respects, it is unlikely that other states in the U.S. will be able to adopt similar systems,” Guri Bang, research director at the Center for International Climate Research in Oslo, and her co-authors write in a 2017 article in Global Environmental Politics.

Then there is the free-rider problem, which extends well beyond California. There is, right now, no prospect of an enforceable, international cap-and-trade system that could put a meaningful dent in global carbon emissions. There are too many hurdles to mention, but one of them is that countries would probably want higher emissions caps for themselves, but lower emissions caps for the rest of the world, as the late Harvard economist Martin Weitzman explained in a June 2019 article in Environmental and Resource Economics. In other words, countries want to reap the benefits of carbon reduction without paying the price.

“Overcoming the free-rider problem in carbon emissions is central to a successful comprehensive international climate-change agreement,” Weitzman writes.

Carbon taxes: who pays more?

In the U.S. there is no federal, or state-level — or any-level — carbon tax. Still, a national carbon tax is popular among some economists. About 3,500 economists from across the political spectrum, including 27 Nobel laureates, are in favor of a carbon tax plan that would give dividends directly to Americans.

A carbon tax dividend is what some economists might call a second-best design, according to Stavins. But sometimes the policy that’s second-best to economists is first-best to lawmakers.

“The first-best design of a carbon tax from an economic perspective is revenue neutral, that takes that revenue to cut distortionary taxes on labor and investment,” Stavins says. “But there’s very little interest in doing that despite the fact that academic economists love the idea. Policy proposals now are to send checks to each and every family in the country. That’s actually going to be a more costly policy, but it’s probably vastly more politically feasible.”

Discussions about political feasibility also sometimes revolve around whether a national carbon tax would be regressive or progressive. A regressive tax puts a higher financial burden on lower-income households while a progressive tax puts more burden on higher-income households. From a purely dollars-and-cents perspective, a carbon tax would be regressive. For example, lower-income households spend relatively more of their income on vehicle fuel. If gasoline refineries have to pay a carbon tax, the price of fuel may go up. That price hike hits lower-income households harder.

Here’s how Robert Bryce, senior fellow at the Manhattan Institute think tank, which advocates for free-market policies, laid out the regressivity argument earlier this year in the National Review:

The regressive effects are well known. Even if, as many proponents suggest, the proceeds of the tax were paid out to consumers on a quarterly basis rather than being used to fund the government, having to wait months to recover the extra money they’ve spent could cause financial stress for poor and working-class families.

A 2012 study by scholars from the Brookings Institution and American Enterprise Institute found that the carbon-tax burden “would comprise 3.5 percent of the income of the poorest decile of households and only 0.6 percent of the income of the highest decile.”

The authors of that Brookings paper continue: “Results suggest that if policymakers direct about 11 percent of the tax revenue towards the poorest two deciles, for example through greater spending on social safety net programs than would otherwise occur, then on average those households would be no worse off after the carbon tax than they were before.”

Metcalf, the Tufts economist, makes a few other arguments in favor of carbon taxes being progressive in a June 2019 paper in Energy Policy. One point he makes is that a carbon tax on energy producers, like natural gas power plants, is going to lead to either lower profits for companies or lower wages for workers. Data suggest the financial burden would fall on companies, not workers, because of simple labor economics: “If you cut wages too much, you won’t get the workers you need,” he says.

Another point has to do with safety net transfer programs, like housing assistance or food stamps. The amount of money people get from such programs is tied to inflation. As the overall price of goods goes up, so do government payments. If a carbon tax were to raise the price of vehicle fuel across the country, those transfer programs targeted to help lower-income Americans would pay out more.

There’s also that question of what policymakers in the U.S. would do with carbon tax revenues.

“When people say, ‘Oh, a carbon tax is expensive because it’s going to raise the price of gasoline or electricity,’ I think what often gets ignored is that — wait a minute — that revenue is going to come back to people in one way or another,” Metcalf says. “And you really need to look at the balance. You can’t look at one side of the ledger without looking at the other side.”

A 2016 paper in Energy Policy analyzed real-world carbon tax and cap-and-trade programs and found that policymakers earmark 70% of revenues from cap-and-trade to climate-friendly efforts, while 72% of revenues from carbon tax systems — there are several in European and other countries — are refunded to people or put into government general funds.

“One thing we’ve been very focused on as a discipline is efficiency — can we reduce pollution at the lowest cost possible to society?” says Chan, the UMass Amherst economist. “That’s a noble goal, but one thing economists are starting to think more about is political economy. Citizens have been very worried about distributional, regressive concerns. The more journalists can do to help us communicate to the public, the better off we’ll be.”

Economic fallout from climate change will settle on the poor

Regardless of the economic levers that do or don’t get pulled, climate change right now is providing ample fuel to power economic inequality.

“Available evidence indicates that this relationship is characterized by a vicious cycle, whereby initial inequality causes the disadvantaged groups to suffer disproportionately from the adverse effects of climate change, resulting in greater subsequent inequality,” write economic affairs officers S. Nazrul Islam and John Winkel in a 2017 United Nations working paper.

The congressionally mandated Fourth National Climate Assessment from the U.S. Global Change Research Program doesn’t assign likelihoods to its scenarios projecting rates of global warming. Yet even under the most generous scenario, where the amount of atmospheric carbon remains relatively low by 2100, the average global temperature could increase as much as — but will likely stay below — 3.6 degrees Fahrenheit. Under the worst-case scenario, where fossil fuel emissions continue to increase, the global temperature could be nearly 10 degrees Fahrenheit higher, on average, in 2100 than the 1986-to-2005 average. Hot spots around the globe have already breached the best-case temperature increase, a recent Washington Post investigation finds.

Climate change could cost the U.S. economy many billions of dollars. Some academics have argued that there is already a kind of carbon tax — in the sense that some parts of the U.S. are experiencing substantial economic losses from climate change, like from more severe storms that lead to billions of dollars in property damage. One landmark 2017 paper in Science projects that for every 1.8 degree Fahrenheit average temperature increase in the U.S., gross domestic product will fall by 1.2% — an amount equal to about $233 billion at today’s GDP of $19.4 trillion. Poorer Americans would be disproportionately impacted. By the end of this century, the poorest third of counties in the U.S. are likely to see between 2% and 20% less income “under business-as-usual emissions,” according to the paper.

The California cap-and-trade program may also be distributing benefits unequally. Companies that emit greenhouse gases there tend to be located in areas where more people live in poverty, but the program hasn’t led to environmental benefits in those neighborhoods, according to a recent analysis in PLOS Medicine. Greenhouse gas emissions in neighborhoods near polluters actually increased from 2013 to 2015, compared with 2011 to 2012, the authors find. They peg overall greenhouse gas reductions to the state importing less electricity from coal-fired plants. Emissions reductions also vary widely by industry, the authors find. Seventy percent of certain power plants reduced emissions over the period studied, while 75% of cement plants increased emissions. A glut of allowances on the market may keep local, lower-income California communities from enjoying the environmental benefits of cap-and-trade.

“There was a larger aggregate decrease in local [greenhouse gas] emissions in 2015 compared to prior years, suggesting that greater reductions may be achieved going forward as the cap is lowered further,” write San Francisco State University assistant professor Lara Cushing and her co-authors. “However, banking of excess allowances from early years of the program and the substantial use of offset credits suggest that there may continue to be little reduction in in-state emissions.”

Environmental lawyer Alice Kaswan at the University of San Francisco School of Law similarly concludes that California’s cap-and-trade program has provided minimal benefits to lower-income communities near power plants, in a recent article in Natural Resources & Environment:

The data suggest that, although the state has reduced [greenhouse gas] emissions overall, there have been fewer reductions in the industrial sector and, consequently, fewer reductions (and co-pollutant reductions) in communities near industrial sources.

The result is not surprising. Because numerous state programs are designed to drive down emissions in the transportation and electricity sectors, those sectors are unlikely to have strong demand for emissions allowances or offsets. That means that ample, and inexpensive, allowances are available for industry, potentially leading industry to purchase allowances to maintain or, to the extent consistent with existing permits, increase emissions.

By the dawn of the next century, the things the U.S. produces might look much different from the things the nation produces today. Unexpected industries might dominate the economic mix. The future, in short, can be difficult to predict. But there’s one element of the research that appears almost certain to come to pass: the economic consequences of climate change will be felt unequally.

“It is unlikely that future research will overturn the fundamental finding that it is the poor who will suffer most from climate change and reducing poverty should be a key priority for policies aimed at alleviating the impact of climate change,” writes University of Sussex economics professor Richard Tol in a 2018 article in the Review of Environmental Economics and Policy.

 

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Citation: William D. Nordhaus. “Economic Growth and Climate: The Carbon Dioxide Problem,” Cowles Foundation for Research in Economics at Yale University, October 1976, Discussion Paper No. 435.

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Olivier Deschênes, Michael Greenstone and Joseph S. Shapiro. “Defensive Investments and the Demand for Air Quality: Evidence from the NOx Budget Program,” American Economic Review, October 2017, doi:10.1257/aer.20131002.

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