The Future of U.S. Carbon-Pricing Policy

In 2007, I was asked by the leaders of the Brookings Institution’s Hamilton Project to write a paper describing a national emissions trading system to reduce U.S. carbon dioxide (CO2) emissions to help address the threat of global climate change.  I responded that I would prefer to write broadly about carbon-pricing instruments, including what I considered to be the symmetric instruments of a carbon tax and a carbon trading program.  But the Hamilton Project leaders said no, they would find someone else to write about carbon taxes (which turned out to be Gib Metcalf), and they wanted me to “make the strongest case possible for” what is today called a cap-and-trade system.  I did my best, and in the process I came to be identified – and to some degree may have become – an advocate for CO2 cap-and-trade.  For better or for worse, during the Obama administration transition, the design recommendations in my Hamilton Project paper became one of the starting points for efforts to structure the administration’s proposed CO2 cap-and-trade system that became part of the failed Waxman-Markey legislation, H.R. 2454, the American Clean Energy and Security Act of 2009.

More than a decade later, I have written a new paper in which I seek to approach this question as I wished to in the first place, treating both instruments in a balanced manner, examining their merits and challenges, without necessarily favoring one or the other.  On May 16, 2019, I presented this new paper at the National Bureau of Economic Research’s first annual Environmental and Energy Policy and the Economy Conference, held at the National Press Club in Washington, D.C.  My topic was, “The Future of U.S. Carbon-Pricing Policy.”  (It will be forthcoming in Environmental and Energy Policy and the Economy, volume 1, edited by Matthew Kotchen, James Stock, and Catherine Wolfram, published by the University of Chicago Press.)  In today’s blog essay, I provide a very brief summary of the paper, based upon the presentation I made at the NBER conference.  I hope you will find this of sufficient interest to download and read the complete paper.

Premises, Questions, and Conclusions

I began this research with two major premises:  first, that economists and most other policy analysts agree that carbon-pricing will likely be a necessary (although not sufficient) part of any meaningful, long term U.S. climate change policy, because of:  (1) feasibility – the necessity of affecting millions, indeed hundreds of millions, of decentralized decisions; (2) cost-effectiveness, given the tremendous heterogeneity of marginal abatement costs; and (3) the importance of providing incentives for carbon-friendly technological change.  My second premise was that there is much less agreement among economists (and other policy analysts) regarding the choice of specific carbon-pricing policy instrument – carbon tax or cap-and-trade.

This prompts two questions:  (1) how do the two major approaches to carbon pricing compare on relevant dimensions, including but not limited to efficiency, cost-effectiveness, and distributional equity?  (2) Which approach is more likely to be adopted in the future in the United States?

Having carried out an exhaustive examination, two major conclusions stand out (among others).  First, that the specific designs of carbon taxes and cap-and-trade are more consequential than the choice between the two instruments.  And second, that political feasibility affects the normative merits of the two instruments, and vice versa.

Similarities & Symmetries

Of fourteen separate issues I examine, some appear at first to be key differences (in theory), but many of these differences fade on closer inspection, and depend on specifics of design.

First of all, carbon taxes and commensurate cap-and-trade turn out to be perfectly equivalent in regard to:   (a) incentives for emission reduction (both can be upstream on the carbon content of fossil fuels); (b) aggregate abatement costs (both can be cost-effective, both provide the same incentives for technological change, and both can utilize offsets to further lower aggregate abatement costs); and (c) effects on competitiveness (both can lessen these impacts via appropriate border adjustment mechanisms).

Next, the two instruments are nearly equivalent in regard to possibilities for raising revenue (cap-and-trade can utilize auctions, but given the structure of Congressional committees, revenue recycling may be easier with taxes).

And these instruments are similar in regard to:  (a) costs to regulated firms (cap-and-trade systems can freely allocate allowances, and taxes can provide inframarginal exemptions below a specified level of emissions); and (b) distributional impacts (the two instruments can be designed to be roughly equivalent in this regard).

Differences & Distinctions

Beginning with the least significant differences, there are relatively minor distinctions in terms of transaction costs (decreasing marginal transaction costs in cap-and-trade systems – such as with volume discounts on brokers’ fees – can violate the independence property, whereby the equilibrium allocation of allowances and hence aggregate costs are ordinarily independent of the initial allocation).

There are more meaningful, but still subtle differences with regard to:  (a) performance in the presence of uncertainty (for this, I urge you to read at least this section of the complete paper, because new research suggests that the implications of the classic Weitzman rule in the presence of a stock externality are moderated – if not reversed – due to the persistent effects of technology shocks, which foster positive correlation between marginal benefits and marginal costs); and (b) linkage with other jurisdictions (it is easier with cap-and-trade systems, but tax systems can also be linked).

That said, there are significant differences between the instruments in terms of:  (a) carbon-price volatility (a problem only with cap-and-trade systems, but a problem that can be mitigated with price collars and banking of allowances); (b) interactions with complementary policies (a significant issue with cap-and-trade systems, which is much less severe with carbon taxes, because the “waterbed effect” is eliminated); (c) market manipulation (there is a need for regulatory oversight in cap-and-trade systems, but tax evasion is a parallel issue in tax systems, although presumably less severe in the U.S. context); and (d) complexity and administrative requirements (cap-and-trade is certainly more complex and has greater administrative requirements, but one might ask whether a simple tax will remain “simple” as it works its way through the Congress).

Hybrid Policy Instruments and a Policy Continuum

Many of the remaining differences can diminish further with implementation.  Indeed, hybrid policies which mix features of tax and cap-and-trade blur distinctions.  For example, auctioning of allowances and the use of price collars bring cap-and-trade closer to a tax system; and quantity formula employed to adjust a tax, and the use of tax revenues to mitigate emissions bring a tax closer to cap-and-trade.  The result is that the dichotomous choice between a carbon tax and cap-and-trade can become a choice of design elements along a policy continuum, and the design of these instruments can be more consequential than the choice between the two.

Which is More Likely to be Adopted – Taxes or Trading?  Positive Political Theory

Framing this question in terms of the metaphor of a political market, it is helpful to think about political demand and political supply of policy instruments.  In terms of the demand from interest groups, first, regulated industry may oppose an ordinary tax approach, as it typically leads to greater costs than the simplest cap-and-trade (or than a performance standard, for that matter), because private industry is paying not only for compliance costs, but also for the tax on residual emissions.  Second, regulated industry may favor cap-and-trade, because it conveys scarcity rents to firms, and can provide entry barriers for potential new entrants, which can make the rents sustainable.

Environmental advocacy groups favor cap-and-trade, due to the emissions certainty it provides, but also because presumably they have a preference for policies that help obscure costs, and cap-and-trade does a better job of sweeping discussion of costs under the rug than does a tax.  However, in the era since cap-and-trade was demonized as “cap-and-tax,” this difference may be much less than it was!

Turning to the supply side (within the legislature), the revenue from either a tax or auctioning of allowances can be attractive to government.  And because of the independence property of cap-and-trade, legislators can allocate allowances to build political support without increasing the costs or reducing the effectiveness of the policy.  Of course, this important political advantage becomes an economic disadvantage if it invites particularly harmful rent-seeking behavior.  Finally, environmental policy makers tend to think in terms of pollution quantities, not prices.

Experience with Carbon Pricing:  Emissions Coverage & Price in Implemented Initiatives

            There are some fifty carbon-pricing systems in operation worldwide, with equal numbers of carbon taxes and carbon cap-and-trade systems.  A quick comparison of these policies reveals two striking realities.  First, the highest carbon prices (the height of the bars in the figure below) are for carbon taxes (in norther Europe).  Second, the scope of coverage (the width of each bar in the figure) of cap-and-trade systems greatly exceeds that of carbon taxes.  Putting the two features (severity and scope) together, a reasonable measure of the relative importance of the policies is given by multiplying the carbon price (tax level or market price of allowances) by the tons of coverage, that is, the respective areas in the figure.  On this basis, it appears that political revealed preference has been weighted toward cap-and-trade (at least up until now).

Carbon Price & Emissions Coverage of Implemented Carbon-Pricing Initiatives

Which Has Worked Better – Experiences with Trading and Taxes

Based upon more than thirty years of experience with cap-and-trade systems, including but not limited to CO2 programs, lessons regarding the design and efficacy of these systems can be drawn.  In brief, there is empirical evidence for the following:  cap-and-trade has proven to be environmentally effective and economically cost-effective; downstream, sectoral programs have been common, but economy-wide upstream systems are feasible; transaction costs have been low to trivial; a robust market requires a cap below business-as-usual; banking has been exceptionally important, representing a large share of the gains from trade; price collars are very beneficial; free allocation of allowances fosters political support, with a likely transition to greater auctioning over time; competitiveness impacts can be mitigated with an output-based updating allocation; “complementary policies” are common, but in some cases can have perverse consequences, including no additional emissions reduction, an increase in aggregate costs, and suppressed allowance prices.

Turning to experiences with carbon taxes, two applications stand out.  First, there are the northern European carbon tax systems, initiated in the 1990s in Norway, Sweden, Denmark, and Finland.  Typically these were elements of broader energy and excise tax reform initiatives, and some are at the highest levels of any carbon-pricing regimes worldwide.  However, fiscal cushioning has been common for industries expressing concerns.  That said, these taxes have raised significant revenues to finance spending or to lower other tax rates, but unfortunately, there is little empirical evidence of their emissions impacts.

More striking is British Columbia’s carbon tax, initiated in 2008, which comes closest to that recommended by economists.  Currently, it is an upstream tax of $27/ton of CO2, but with important exemptions in place for key industries.  Importantly, 100% of tax revenue was originally refunded through general tax rate cuts, but over time, there has been more focus on tax cuts for specific sectors and locations.  Although there is some debate in the literature, it appears to have been effective in reducing emissions.

Empirical Evidence for Positive Assessment

Given that the normative differences between the two instruments are minimal, a key question becomes which instrument is more politically feasible, and which is more likely — in practice — to be well designed.  Based on experiences with cap-and-trade and carbon taxes, the relative masses in the figure above suggest that political revealed preference has favored the former.  Furthermore, after years of deliberation, China has chosen trading for its national program (although it appears to be a set of sectoral tradable performance standards, not a true, mass-based cap-and-trade system).  In addition, the new “Transportation and Climate Initiative” in the northeast United States was first proposed in terms of fuel taxes but is gravitating toward cap-and-trade.  Also, New Jersey is preparing to rejoin the Regional Greenhouse Gas Initiative, and Oregon is poised to enact an economy-wide CO2 cap-and-trade system this year.  On the other hand, Washington State has twice defeated a carbon tax.

But past may not be prologue.  The demonization of the Waxman-Markey trading system as “cap-and-tax” may have reduced the political advantage of cap-and-trade (that it can hide the costs).  And there is clearly increasing interest in a national carbon tax in the policy world, including several bills in Congress and the prominent Climate Leadership Council proposal.  On the other hand, the “Green New Deal” is silent about carbon-pricing of any kind.

It is worthwhile focusing on the political economy of the British Columbia carbon tax.  Its successful enactment has been attributed to “the confluence of political conditions ripe for carbon taxation”:  untapped hydroelectric potential; a strongly environmentalist electorate (as in the case of California’s move to cap-and-trade with Assembly Bill 32); a right-center government with trust from the business community (as with the George H.W. Bush administration’s SO2 allowance trading system in the Clean Air Act amendments of 1990); and a premier with institutional capacity to pursue personal policy preferences.  There has been increasing public support over time, due to the perception of emissions reductions without severe economic impacts, but political pressures have caused the evolution of the system from using revenues exclusively to cut distortionary taxes to greater use of tax cuts to favor specific sectors and regions.

Clearly, political pressures can drive up social costs with either type of carbon-pricing instrument.  On the one hand, politics may disfavor the auctioning of allowances in cap-and-trade systems, while, on the other hand, politics may disfavor cost-effective cuts of distortionary taxes in tax systems.

Does Either Carbon-Pricing Instrument Dominate in Normative or Positive Terms?

When carbon taxes and cap-and-trade are designed to be truly comparable, their characteristics and outcomes are similar, and in some cases fully equivalent (normatively), in terms of their:  emission reductions, abatement costs, revenue raising, costs to regulated firms, distributional impacts, and competitiveness effects.  But on some other dimensions, there can be real differences in performance.  The tax approach is favored by administrative requirements, interactions with complementary policies, and effects on carbon-price volatility; whereas cap-and-trade is favored by linkage with policies in other jurisdictions, and possibly by anticipated performance in the presence of uncertainty.  In the positive political economy domain, the evidence is also decidedly mixed.  Hence, there is not a strong case for the blanket superiority of either instrument.  Differences in design simply dominate differences between the instruments themselves.

Can Carbon-Pricing be Made More Politically Acceptable?

The track record of 50 carbon-pricing policies cited above should be contrasted with the 176 countries with renewable energy policies or energy efficiency standards, as well as another 110 national and sub-national jurisdictions with feed-in tariffs.  Hence, carbon pricing has not in general been the favored approach to climate change policy.  Why is this the case?  Survey and other evidence indicates that public perceptions – some of which are inaccurate – are primary factors behind aversion to carbon taxes:  “personal costs too great; policy is regressive; could damage economy; will not discourage carbon-intensive behavior; and government just want the revenues.”  So, one way to improve public acceptance could be through better information, that is, education.

But another way forward could be through judicious policy design, which may well depart from first-best design, including:  phasing in taxes/caps over time (which was effective in California and British Columbia); earmarking revenues from taxes/auctions to finance additional climate mitigation, in contrast with optimizing the system via cuts in distortionary taxes; and/or using revenues for fairness purposes, such as with lump-sum rebates or rebates targeted to low-income and other particularly burdened constituencies (a carbon tax with “carbon dividends” or a cap-and-trade system in the form of “cap-and-dividend”).

Has the Defeat of National CO2 Cap-and-Trade Initiatives Provided Openings for Carbon Tax Proposals?

Political polarization has decimated the key source of Congressional support for environmental/energy action, the political middle.  And the successful political battle against the Obama administration’s CO2 cap-and-trade legislation featured the effective demonization of that instrument as “cap-and-tax.”  Does the consequent reputational loss for cap-and-trade provide a meaningful opening for the other carbon-pricing instrument – a carbon tax?

It would seem that large budgetary deficits ought to increase the attraction of new sources of revenue, but existing carbon tax proposals have largely been revenue-neutral.  That said, it is surely true that there has been increased attention to carbon taxes from the “policy community,” with support coming not just from Democrats, but also from prominent Republican academic economists and former Republican high government officials.  But – finally – what about in the real political world of those currently holding elective office in the federal government?

It is presumably good news for carbon tax proposals that they are not “cap-and-trade.”  Perhaps that helps with the political messaging.  But if conservative opposition could tarnish cap-and-trade as “cap-and-tax,” surely it will not be difficult to label a tax as a tax!  And in addition to such opposition from the political right, it is – as of now – questionable whether the new left will want a carbon tax to be part of its “Green New Deal.”

Hence, in the short term, national carbon pricing of either type will likely continue to face an uphill battle.  Therefore, in addition to considering second-best carbon-pricing design (as I recommended above), economists can work productively to catch up with political realities by considering better designs of second-best non-pricing instruments, such as clean energy standards.

But, at some point the politics will change, and it is important to be ready, which is why – for the longer term – ongoing research on carbon-pricing is very much warranted, particularly if it can be carried out in the context of real-world politics, and focus on policies that are likely at some point to prove feasible.