Air Pollution Control Equipment Services, Emissions

Putting a Price on Carbon

By Phil Davies

In considering economywide mandatory caps on greenhouse emissions, U.S. policymakers are following in the footsteps of the European Union (EU), which administers allowance trading under the Kyoto Protocol, an international agreement to address climate change. In addition, more than a dozen states have announced plans to participate in regional cap-and-trade programs for greenhouse emissions.

Oddly, very few people on Capitol Hill were talking about carbon taxes. In a departure from past legislative efforts to curb greenhouse emissions, some bills included provisions that mimic a tax, allowing some flexibility in emission limits.

If greenhouse emissions need to be decreased to address global warming (a scientific debate), economic theory suggests that prices rather than quantities are the policy tool of choice. And the most direct way for policymakers to affect price is to impose a tax.

“The scientists tell us that world temperatures are rising because humans are emitting carbon into the atmosphere,” writes N. Gregory Mankiw, a Harvard University professor and former adviser to Bush, in a September article in the New York Times. “Basic economics tells us that when you tax something, you normally get less of it. So if we want to reduce global emissions of carbon, we need a global carbon tax.”

If government decides that the threat of climate change is grave enough to justify intervention in energy markets, clear price signals are the most efficient way to motivate businesses and consumers to reduce their greenhouse emissions. Applying economic theory to current scientific knowledge about climate change, economists have demonstrated over the past decade that price controls minimize the risks of misjudging the sizable and uncertain costs of reducing greenhouse emissions.

“Fixing” energy markets
The obverse of Mankiw’s observation about taxes is that when something is cheap, you normally get more of it. Arguably, coal, oil and other fossil fuels that provide the bulk of the world’s energy are consistently underpriced because no one pays directly for the consequences of burning them. Cumulative environmental damage from the release of billions of tons annually of CO2, methane and other greenhouse gases can be considered a “negative externality”—an environmental cost not included in the fuels’ market price.

When such externalities cause market failure, governments may choose to step in, using their regulatory authority to “fix” markets for the good of the overall economy and society. Government intervention may be particularly appropriate when market distortion poses a threat to a public good such as a healthful environment. Market-based approaches to environmental regulation use the invisible hand of self-interest to push markets toward a new equilibrium that inflicts less harm on the natural world. Of course, the hand isn’t entirely invisible: The government sets the standard, and that’s true for both quantity controls like cap-and-trade systems and price controls like carbon taxes. In essence, both policies raise the cost of pollution to reflect the full cost it imposes on ecosystems and the public welfare.

A cap-and-trade system works like a hydraulic press, squeezing out ever-greater emission reductions from covered economic sectors such as power production or manufacturing. To stay under a gradually declining cap, firms are forced to invest in new technologies and conservation measures that reduce their emissions—or, if abatement proves too expensive, to buy allowances from other companies that can cut their emissions more cheaply. Firms that can efficiently reduce their output of pollutants stand to make a profit in the allowance market; those that can’t pass along their higher costs of production to consumers, who pay more for everything from electricity to éclairs. Competitive pressures stimulate further investment in production methods that pollute and cost less. Cap-and-trade programs have proved successful in eliminating lead from gasoline and sharply reducing industrial emissions of sulfur dioxide that cause acid rain.

In economic theory, taxes are the classic antidote to negative externalities. In the early 1900s, British economist Arthur Pigou proposed corrective taxes to exact a toll on activities deemed injurious to the public welfare. A direct hit on the pocketbook discourages those activities and raises revenue that can be used to repair the damage they cause. In the United States, environmental pollutants haven’t been taxed in this way, but Pigovian taxes have been levied on other public “bads” such as tobacco and alcohol.

Separated at birth?
Taxes are the purest form of environmental price control, but not the only one available to government. As lawmakers have discovered, it’s possible to incorporate a price mechanism into a cap-and-trade system. An emission cap with a “safety valve,” for example, lets emitters exceed the cap if the allowance price rises above a certain level. Companies pay a “trigger price” per unit of emissions, and that price would rise over time. Banking and borrowing, the price control featured in the Warner-Lieberman bill, allows firms to save emission credits if they expect allowance prices to rise or borrow against future allotments if they expect prices to fall.

At first blush, quantity- and price-based approaches to regulating pollution appear to be fraternal twins separated at birth; both strategies leverage prices to rebalance the environmental ledger. Political debate over the merits of the respective systems has usually focused on the mechanics of implementation—how to distribute initial allowances, where to set the trigger price—not on the basic economic incentives at the heart of market-driven regulation.

Nevertheless, economists heavily favor price mechanisms as a potential solution to global warming. “[M]ore emphasis should be placed on including price-type features in climate change policy rather than relying solely on quantity approaches such as cap-and-trade,” Nordhaus writes in a paper published last summer.

The strong preference among economists for price mechanisms—and carbon taxes in particular—stems primarily from two characteristics of global warming that set it apart from most other environmental problems: the centuries-long persistence of CO2 in the atmosphere and pervasive uncertainty about the costs of reining in greenhouse emissions.

Uncertainty on the loose
If lawmakers knew exactly what the overall costs and benefits of achieving a certain emission target were, a cap-and-trade approach would work as well as a tax or another form of price control. Cut greenhouse emissions to 1990 levels by 2030? No problem. Just set the cap or emission price to the level at which the expected benefits (avoided damages from droughts, rising seas and so on) equal their costs; then stand back and let the market work. Predictable costs would spur businesses and consumers to reduce emissions until the costs of further reductions exceeded the benefits.

However, nothing about global warming is definitive. Estimates of the future damages that could be avoided by curbing greenhouse emissions today are fraught with uncertainty about the pace of warming and how rising temperatures will affect agriculture, property, human health and other aspects of life in various parts of the world.

The costs of reducing emissions are also imprecise, “and the farther you go forward in time, the more uncertainty there is,” said Billy Pizer, a fellow with the environmental think tank Resources for the Future, in a telephone interview. Charting population trends, economic growth, energy prices and other factors affecting emission levels years from now—and therefore how deeply emissions must be cut to slow warming—is akin to reading tea leaves. The evolution of technologies such as fuel cells, energy-efficient lighting and carbon sequestration may dramatically cut the cost of cutting greenhouse emissions—or may not.

The key advantage of using price rather than quantity as an instrument for limiting greenhouse emissions is that price mechanisms bring a measure of certainty to the cost of complying with emission mandates. It’s better to establish a fixed price on emissions and let emission levels rise and fall rather than set a hard cap and let prices fluctuate.

Why? First, predictable and transparent pricing helps producers of greenhouse gases decide how much to invest in mitigation. In cap-and-trade systems, allowance prices can swing wildly in response to changes in abatement costs and the supply of permits; prices have fluctuated markedly in both the EU emission trading market and the U.S. Acid Rain Program. Price volatility breeds uncertainty in boardrooms, discouraging commitments to invest in new equipment and energy conservation.

In contrast, carbon taxes and safety-valve trigger prices are fixed or rise at a predictable rate over several years—a much surer bet for CEOs and investors. “There’s a value to getting people off the dime with a price signal that is clearly defined and transparent,” Pizer said. “Generally, you’re going to get more investment for the same expectation.”

There’s another reason why, given deep uncertainty about the costs of emission reductions, price controls are preferable to cap-and-trade systems. The flexibility of price controls minimizes the consequences of overestimating or underestimating the costs of meeting an emission target. Carbon taxes and other price mechanisms ensure that society derives the most benefit from reduced carbon emissions for the least cost—assuming that the world is not destined to slide off some climatic cliff.

Physics meets economics
The efficiency of price controls is rooted in the fact that CO2 is a “stock” pollutant—the gas lingers in the atmosphere for a century or more before dissipating. In a seminal 1974 paper, Martin Weitzman, formerly of the Massachusetts Institute of Technology-now at Harvard, shows that when abatement costs are not precisely known and incremental benefits from reductions are small, relatively fixed prices lead to increased social welfare.

On a warming earth, the incremental benefits of each additional ton of CO2 kept out of the atmosphere by emission cuts are indeed small. The huge volume of CO2 vented into the air by human activity since the industrial revolution is like water in a lake; scooping out one bucket of water lowers the lake’s level an infinitesimal amount. Incremental abatement costs, on the other hand, are sensitive to changes in the flow of emissions; as a rule, each additional ton of CO2 cut from the emission stream costs firms a little more to achieve.

The upshot of this marked difference in the trajectory of costs and benefits is that increasingly strict limits on greenhouse emissions have a minimal effect on global warming in the short term. But the impact of tighter emission controls on costs shouldered by companies under emission mandates is immediate and potentially large, although difficult to gauge. Because of uncertainties about abatement costs, the actual, sectorwide cost of meeting a particular emission target could be higher or lower than expected, and vary seasonally or annually.

Unlike quotas, price controls allow companies to step up or scale back their emission-reduction efforts in response to changing abatement costs—without appreciably influencing the near-term course of global warming. “The physics of the problem suggests a preference for prices,” Pizer said.

For price and quantity controls with equivalent emission targets, this flexibility results in greater economic gains from price mechanisms. In a 1999 study, Pizer compared the outcomes of the two policies, using a computer model of the global economy and climate. He found that price-based mechanisms generated expected net benefits (benefits minus costs) five times higher than the most efficient quota system.

The Congressional Budget Office (CBO) has published a series of papers explaining why price controls yield higher net benefits than equivalent quantity controls. The price advantage—most evident in a carbon tax—boils down to how companies react under the respective systems to abatement costs that are somewhat higher or lower than expected.

Under a cap-and-trade system, firms facing higher-than-anticipated costs—perhaps because of an exceptionally cold winter or escalating prices for low-carbon fuels—would still have to make increasingly expensive emission cuts in order to get under the cap. If actual costs were lower than expected, firms would cut their emissions to the cap level, but no further.

But a carbon tax allows firms to either throttle back or redouble their emission-reduction efforts, depending on whether it’s cheaper to keep cutting emissions or to pay the tax. The bottom line: Under a carbon tax, companies spend less over the long haul on abatement yet achieve greater emission reductions.

The price is right
There are also fiscal advantages to price controls, specifically carbon taxes. A tax on fossil fuels would generate significant revenue, compensating for higher prices induced by the tax. Government could use this revenue to fund technological research, mitigate the harmful effects of global warming and jump-start emission reductions in developing countries. Alternatively, carbon tax revenues could offset existing taxes, leaving the total tax burden unchanged and possibly benefiting the economy. Taxes on labor, products and services distort prices and incentives, impeding economic growth.

Offsetting the economic impact of a cap-and-trade system isn’t as straightforward. The government could auction off emission permits to raise revenue, but the history of the Acid Rain Program—in which all allowances were distributed at no cost—suggests that the bulk of CO2 permits would likely be handed out for free. In a hybrid program with a safety valve, the sale of government allowances to companies over the emission cap would produce revenue. But the amount would depend on the tightness of the cap and the trigger price.

Price controls may be fiscally prudent as well as efficient, but implementing them is problematic since it requires estimating an emission price. What price today would maximize welfare by making the costs of each additional ton of emissions withheld from the atmosphere equal to the benefits? The emission price must be in the ballpark—roughly commensurate with the expected marginal benefits of emission cuts. If it isn’t, neither price controls nor quantity caps will help the world meet the challenge of global warming.

Uncertainty, again
Here uncertainty raises its head again, confounding attempts to price the benefits of reducing greenhouse emissions and, therefore, the costs that firms and households must bear in order to achieve those benefits. The global impact of climate change makes it difficult to balance the interests of different countries—temperate versus tropical, industrialized versus developing. The long-term effect of higher CO2 levels means that policymakers must consider the welfare of both current and future generations.

A recent iteration of a model developed by Nordhaus pegs the optimal carbon tax at $29 per metric ton. The tax would rise at a rate of 2 percent to 3 percent annually to reflect increasing damages from global warming, reaching $90 per metric ton by 2050 and $200 per metric ton by the end of the century (in 2005 dollars). In other models, estimates of the optimal carbon price range from $18 to over $350 per metric ton—stark evidence of the broad scope of uncertainty.

To avoid a tussle over carbon prices, Congress seems more likely to enact a cap-and-trade system than a tax on fossil fuels. Both environmental and business interests have made known their preference for quantity controls. But it’s still possible that lawmakers might incorporate some type of price mechanism—a safety valve, perhaps, or a bank-and-borrow program.

If greenhouse gases must be regulated, price mechanisms are the way to do it. They send a direct, unambiguous message to producers and consumers of fossil fuels: the right to vent carbon into the air comes at a price. And in a regulatory arena steeped in uncertainty, price mechanisms help ensure that society derives the most benefit from every dollar spent.

Phil Davies is Senior Writer for the Federal Reserve Bank of Minneapolis.