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Economic Inquiry Op-Ed: Assessing the Merits of a Carbon Tax

“The reason we should do a carbon tax is because it’s the right thing to do. It’s economics 101, elementary stuff.”

–  Elon Musk

With the Clean Power Plan in the process of being repealed, and the US Supreme Court rejecting any further court challenges to that decision as of October 2018, Federal legislation or regulations to curb carbon emissions would appear to be in hiatus in the early days of 2019.

Yet, that did not prevent a bipartisan group of more than 40 signatories, including Nobel laureates, former economic advisers to past presidents and former Federal Reserve chairs, from issuing a joint statement sponsored by The Climate Leadership Council formally endorsing a federal carbon tax at the beginning of 2019.  The endorsement argues that a carbon tax would correct a “well-known market failure” and direct “the invisible hand of the marketplace to steer economic actors” to make low-carbon decisions and motivate investment in alternative energy sources.  In the meantime, individual states are backfilling Federal inaction with their own solutions that range from long-term contracts for renewable resources, subsidies, and investment in new technologies.

In light of these disparate solutions, it is prudent to revisit why a carbon tax could offer the most efficient solution to meeting carbon reduction goals.

“A Well-known Market Failure”

At the core of the need to price carbon is the recognition that the environment is a common good that can be used as an input to production for no charge.  Therefore, the cost of carbon emissions are not reflected in the cost of energy or decisions to consume energy.  This economic externality lowers the actual price of energy, causing more to be consumed than is socially optimal. The objective of a carbon tax is to place a price on carbon-emitting resources to remedy this market failure.

“Revenue Neutral”

There are many different ways to establish a price for carbon.  For example, a cap-and-trade program would establish the quantity of carbon emissions that are allowed and let carbon credits trade among market participants to establish the market-clearing price.  The Climate Leadership Council offers a simpler alternative – establish a carbon tax applied to carbon emission sources and then rebate revenues collected through the tax to end-users through carbon dividends so that the program is revenue neutral.

Although the proverbial devil is in the details, the concepts of a tax and tax rebate are well-established and government organizations already are in place to implement.  By reimbursing carbon emissions payments back to the American people, the size of government arguably would be held in check and wealth transfers would be minimized.

“The Most Cost-Effective Lever”

The joint statement claims that the proposed carbon price with refund is the most cost-effective solution to carbon emissions. Compare this approach to the ones being adopted by California, New York, Connecticut and Massachusetts which are pursuing 80 percent or greater carbon emissions reductions from 1990 levels within the next thirty years. Those states already have experienced around a 30-percent reduction due to lower market prices for natural gas versus higher carbon content coal and oil.  Yet, these states have deviated from an exclusively market-based solution tied to carbon trading programs such as the Regional Greenhouse Gas Initiative.

Policy programs in these states include a hodge-podge of market interventions such as long-term power purchase agreements, renewable portfolio standards with centralized procurement of renewable energy credits, and zero emission credits for nuclear plants.  Embedded in each of these contractual approaches is a price for carbon and, yet, the choice of technology is pre-ordained and locked in for 10 to 20 years, creating political winners and losers.

In contrast, a carbon tax offers a market price alternative that allows for the most cost-effective solutions to win while sending a price signal for innovation and development of the next generation of carbon-free technologies.  Although the intent of the leading state legislators on carbon reduction programs is laudatory, it would be more beneficial to simply set the price and let the market decide how to tackle carbon reductions.

“National Action”

Although the call for national action may fall upon deaf ears, individual states should heed the message in the joint statement.  A carbon tax offers a transparent price signal to investors and consumers, unlike many other approaches that pick winners and losers.  At the same time, challenges to national regulations embodied by the Clean Power Plan illustrate the hazards of a national approach given the unique situation of each state and potential for wealth transfers.  That said, the joint statement is timely. Individual states intent on pursuing carbon reduction programs should consider the merits of a simple, transparent pricing mechanism for internalizing the costs of environmental externalities associated with carbon and letting the market decide the most cost-effective solution.

About the author: Tanya Bodell regularly writes “Economic Inquiry” for the Electrc Light & Power Executive Digest. She is the Executive Director of Energyzt, a global collaboration of energy experts who create value for investors in energy through actionable insights. Visit www.energyzt.com. She can be reached at: [email protected] or 617-416-0651.