Ecology and Economics

Willem Buiter Weighs in, Favors Carbon Tax

It is nice to see that Willem Buiter shares my skepticism about Cap and Trade Carbon schemes relative to Carbon Taxes. It is nice because his London School of Economics credentials eclipse mine, and those are just the beginning of why he is held in high esteem in both financial and economics circles. After showing why Cap & Trade and Carbon Taxes are equivalent in theory under restrictive assumptions regarding uncertainty and/or market efficiency. Buiter explains in Today's Financial Times why he favors a simple Carbon Tax over Cap & Trade. Go read it! Here's a snip:

Cap & Trade is a tax on carbon emissions - fortunately! Willem Buiter, Ft.com, June 12, 2008: … An argument in favour of carbon taxes over cap & trade is that cap & trade requires an efficient secondary market. As we know from recent experience, financial market efficiency cannot be taken for granted. While the instrument that is traded in the secondary market under cap & trade is relatively simple, compared to Residential Mortgage-Backed Securities based on US subprime mortgages, cap & trade does have this additional link in the chain, and is therefore vulnerable to all the familiar financial market pathologies, from market manipulation to illiquidity.

The economic equivalence of carbon taxes and cap & trade is exact only in a world without uncertainty, or in a world with uncertainty but with complete contingent claims markets for risk trading. In the real world, where there is uncertainty and markets are incomplete ….

Why then do politicians and outfits like BP prefer cap & trade to a carbon tax? The politicians prefer it because the cap & trade scheme, while economically equivalent to a tax, will not count as a tax in the traditional record-keeping manuals. It does not add to the official 'tax burden' the opposition likes to bash you around the head with. You can present cap & trade in a way that hides/obscures the fact that for it to work, that is, for it to reduce emissions, it must be equivalent to a tax by increasing the marginal cost of emitting CO2E; however, it does not look like a tax and will not show up in conventional tax burden calculations. Lack of transparency means absence of accountability. That is why non-transparent arrangements are universally valued by politicians.

A second reason is that with cap & trade, you can distribute the shadow tax revenue associated with the cap & trade scheme (that is the amount of revenue you would be able to obtain for the permits in a transparent, competitive auction) in a non-transparent manner. Give-aways through explicit grants or subsidies are not as easy. There are parliamentary committees scrutinizing revenues and outlays; there may be institutions like the UK National Audit Office that can ask bothersome questions.

Life is easier with the initial allocation of permits. You can, for instance, hand out the permits free of charge to your friends (including the heavy historical polluters). This is also the reason, I believe, that the heavy emitters, including BP, favour cap & trade over taxes. They believe that the initial allocation of free permits will favour them. There is this crazy notion that past heavy polluters should not be hit too hard by schemes to reduce CO2E emissions, and that they should therefore be given gratis allowances of permits that are related to their recent past emissions record. I can see no efficiency reason in favour of this, and many a fairness argument against it, but the argument carries weight in the unreal real world.

When the problems associated with running an efficient secondary market for CO2E emissions permits and the political economy of the non-transparent initial allocation of the CO2E emissions permits are taken into account, I believe that, on balance, explicit carbon taxes are better than cap & trade.

Gas Prices Not 'Outrageous'

On mainstream news this morning I heard our Utah Governor declare US gas prices "outrageous". Memorial Day national news coverage labeled them "sky high." Wrong! Gas prices only seem outrageous to we Americans who George W. Bush correctly noted are "addicted to oil".

Europeans, by contrast, have lived with high gas prices for years, using proceeds to fund social programs, re-build infrastructure, etc. In addition, as noted in a May 21 Senate-side Congressional hearing Exploring the Skyrocketing Price of Oil (3 hrs), Europeans used gas tax differentials to correctly steer transportation systems toward diesel and away from gasoline, which proves ever-more important now that clean diesel is available. And to steer transportation system toward mass transit and away from single-vehicle transportation. Meanwhile we Americans sat around watching TV and partying until world market forces pushed prices upward, allowing most of the recent 'surplus' to be captured as record profits, record CEO compensation, etc. by what I'll call the Petrochemical Industrial Complex. Finally, Europeans are now beginning to look toward a future free of dependence on petrochemicals and their commingled carbon-loading propensities.

Even though we Americans are just now beginning to face the reality of high gas prices, the prices themselves are not the problem. In fact "sky high" prices are finally getting us to pay attention, however feebly, to alternative sources of energy that are compatible with global climate systems and human survival. As noted in the Congressional hearing, planet Earth is not in jeopardy, rather it is we humans (along with myriad other species) who are at risk. The Earth has worked its way through five Great Extinctions in the past and arguable done remarkably well. But it is in no way clear that we humans will survive the Sixth Great Extinction. Tragically, we humans may be contributing to our collective demise by clamoring for lower gas prices.

This is not to say that all is well in petrochemical industrial complex, medical industrial complex, financial industrial complex, military industrial complex America. But that is a story for another post (or several hundred posts). In the meantime 3 hours are well-spent viewing the hearing. If you want a sneak peak, go to 2:15 in the videocast and watch Senator Charles Schumer (D-NY) in action, followed by others as the hearing winds up.

US Congressional Budget Office Favors Carbon Tax

At a Nov. 16 Congressional Budget Office "Director's Conference on Climate Change", CBO Director Peter Orszag argued in favor of a carbon tax relative to an at-least-for-now inferior alternative of a cap-and-trade policy [Issues in Climate Change, Statement of CBO Director - PDF]. Here is a snip:

… Any effort to limit CO2 emissions would have two principal effects: It would produce long-term economic benefits by avoiding some future climate-related damage, and it would impose immediate economic costs by reducing the use of fossil fuels. Employing incentive-based policies to reduce emissions would help minimize the cost of reducing emissions by any given amount because they would use the power of markets to identify the least expensive sources of emission reductions. Thus, they can better accommodate technological advances, differences between industries or companies in their ability to make low-cost emission reductions, and changes in market conditions.

Two alternative incentive-based approaches for reducing CO2 emissions are to tax them or to establish a cap-and-trade system for them. Either a tax or a cap would be most efficient (that is, would best balance expected benefits and costs) if it was designed to gradually become more stringent over time—meaning the tax would gradually rise or the cap would become tighter. Such an approach would best reflect the present value of avoided future damage (the benefit of reducing a ton of emissions), which would take on greater weight as larger potential damage became closer in time. Further, such an approach would allow a smooth transition to a less carbon-intensive economy, allowing firms and households time to gradually replace capital equipment with alternatives that are more efficient, use less carbon intensive fossil fuels (such as natural gas rather than coal) or use renewable energy sources (such as wind or solar).

Efficiency Advantages of a Tax on CO2 Emissions
Although both types of incentive-based approaches are significantly more efficient than command-and-control policies, studies typically find that over the next several decades, a well-designed and appropriately set tax would yield higher net benefits than a corresponding cap-and-trade approach. A tax creates relative certainty about the cost of emission reductions each year, because firms will undertake such reductions until the cost of decreasing emissions by another ton just equals the tax on an additional ton of emissions. A cap-and-trade program, by contrast, creates relative certainty about the total quantity of emission reductions each year, because the cap limits total annual emissions. In terms of the impact on the climate, however, it does not matter greatly whether a given cut in emissions occurs in one year or the next.

From that perspective, a tax has an important advantage: It allows more emission reductions to take place in years when they are relatively cheap. Various factors can affect the cost of emission reductions from year to year, including the weather, the level of economic activity, and the availability of new low-carbon technologies (such as improvements in wind-power technology). By shifting emission reduction efforts into years when they are relatively less expensive, a tax can yield a given quantity of emission reductions at a lower cost than can a cap-and-trade program with specified annual emission levels. In addition, by avoiding the potential volatility of allowance prices that might result from a rigid annual cap, a tax could be less disruptive for affected companies. Provided that the tax was set at a level that reflected the expected benefit of reducing an additional ton of CO2 emissions, the tax would provide a motivation for firms and households to reduce emissions up to the point at which the cost of doing so was equal to the resulting expected benefits.

The relative advantages of a tax and a cap-and-trade program could change over time as new information became available. For example, because a cap creates relative certainty about the level of emissions, it could become more efficient than a tax if scientists determined that additional emissions were likely to trigger a sharp increase in damage, or if new technologies offered the opportunity to make extremely large cuts in emissions at a low and fairly constant cost. Analysts who have tried to define more precisely the conditions under which a cap would be more efficient than a tax have found those conditions to be quite narrow and not likely to be relevant in the near term. Specifically, scientists would need to have fairly precise knowledge about the level of an emissions threshold—beyond which additional emissions would trigger a sharp increase in total global damage—and such a threshold would have to be sufficiently close that policymakers would want to make very large cuts in emissions each year to avoid crossing it. In the absence of those conditions, a tax offers a more efficient approach for reaching a multiyear emission-reduction target.

Although a tax is generally a more efficient policy, the efficiency of a cap-and-trade approach can be enhanced by various design features. In addition, some participants in the policy discussion believe that analytical comparisons of a tax and a cap-and-trade system ignore the idea that policymakers may be more inclined to set a tight cap than a correspondingly high tax. … [footnotes omitted]

HT: Greg Mankiw

Tom Friedman Jumps on the Gas Tax Bandwagon

In the NY Times, Tom Friedman wonders aloud why politicans are so afraid of the "T-word" when it comes to what he considers very good rationales for imposing a gas tax sooner rather than later — with sooner being sometime, say, prior to 9/11/01.

Greg Mankiw: Several Billion plus One Favor Carbon Taxes

For more than a year, Greg Mankiw has formally/strongly advocated for Carbon Taxes. Mankiw also keeps tabs on who else supports such. Lately he adds, by reference, several billion new members to his Pigou Club:

Several Billion Join the Pigou Club, Greg Mankiw, Nov 5: The BBC World Service [PDF] reports that a majority of people in most countries favor higher energy taxes if the tax revenue is either rebated by lowering other taxes or used to finance energy-related government programs….

Another Member, Greg Mankiw, Nov 2: New York Mayor Michael Bloomberg joins the Pigou Club.

Christian Science Monitor Endorses Carbon Tax

Yet-another vote for carbon taxes over cap-and-trade:

A tax on carbon to cool the planet, Christian Science Monitor, Oct 26: Forcing higher prices for fossil fuels would be simple, fair, and effective. Why do politicians fear to do it?

Conservative and liberal economists like it. James Connaughton, President Bush's top environmental adviser, backs it. Al Gore says he's always preached it. So why isn't a carbon tax on the table in Congress as it weighs measures to curb climate change? A three-letter reason: T-A-X.

From the start of Capitol Hill's debate on global warming, the notion of taxing all uses of oil, coal, and natural gas has made lawmakers look for less direct ways to wean the nation off fossil fuels and onto alternative energies. They'd rather set caps on greenhouse-gas emissions (with allowances to trade emission permits) and tighten up regulations, such as fuel- efficiency standards.

Indeed, caps may put the US on a knowable track to, say, an 80 percent reduction in carbon emissions by 2050. But as the previous Monitor's View pointed out, the flaws in cap-and-trade plans as experienced in other nations – their complexity and vulnerability to fraud and special-interest lobbyists – would reduce the intended effect. They also take a long time to set up and get working right. …

[P]olls indicate strong opposition to higher taxes on gasoline or electricity. But wait: What if the carbon-tax revenues were returned to most taxpayers, canceling out the effect on pocketbooks but retaining the market incentives?

Under one plan, every worker would receive a tax rebate of about $560, cutting the tax bill by 18 percent for those earning $20,000, or by 4 percent for those earning $90,000. The burden on consumers would shrink, but the US would achieve greater conservation and a shift to energy alternatives. And the tax could be fine-tuned to meet rising targets for reducing carbon dioxide.

With Europe's cap-and-trade system faltering, the US should be a leader in using a carbon tax, even if big polluters such as China don't follow. As a last resort, the US could tax goods from countries that fail to cut their carbon emissions.

A carbon tax is not the whole solution. Regulations will still be needed, such as stiffer fuel-economy standards for cars and trucks. And the US should fund research into alternative fuels, too. All it takes is the political will to act.

Dingell Drafts Carbon Tax Legislation

The Carbon Tax Center endorses Congressman John Dingell's Carbon Tax Legislation, set to be introduced later this year. Dingell is chairman of the US House of Representatives Committee on Energy and Commerce. The Carbon Tax Center says of the proposal, "we think the bill is terrific." Here's more from CTC:

… The current version would phase in, each year for five years, a charge of $10 per ton of carbon content of coal, oil and natural gas; plus an additional 10 cents/gallon for gasoline and jet fuel (kerosene). By the end of the five-year period the charges would reach $50/ton of carbon plus 50 cents/gallon of gasoline and jet fuel. These equate to 63 cents a gallon of gas and 90 cents for one hundred kilowatt-hours assuming the nationwide average fuel mix. …

We examined a 20-year ramp-up — starting Dingell's "10/10" tax in 2008 and continuing through 2027 to a level of $200 per ton of carbon plus $2/gallon on gasoline and jet fuel. Here's where the U.S. would be in the representative year 2025:

• Carbon dioxide emissions would be down by 1.55 billion metric tons from projected levels, a 20% drop — a decrease equivalent to current emissions from England, France and Italy combined.
• Petroleum consumption would be 4.5 million barrels a day less than otherwise, an 18% decrease from projected usage, and more than 10% greater than Iran's current production.

Moreover, these reductions could be supplemented by savings from other targeted policies and programs to reduce use of petroleum, natural gas and coal-fired electricity. (Indeed, a companion section of Dingell's bill will call for phasing out the federal tax deduction on mortgage interest on very large homes, thus ending a subsidy through which middle and working class families subsidize gargantuan sprawl homes for the wealthy.) No other single policy measure — not broader CAFÉ standards, not a national Renewable Energy Standard, not a massive biofuels push, and certainly not a new generation of subsidized nuclear power plants — can produce nearly the carbon and petroleum savings promised by the Dingell hybrid carbon tax, provided it extends beyond the initial five-year period.

The brilliant touch in the Dingell bill is the supplemental tax on gasoline and aviation fuel. …

Maybe this will take some heat off Dingell, who some environmentalists have criticized as not "on board" on environmental issues. Or maybe not.

I'll echo The Carbon Tax Center's concluding comment: Let Dingell and others know how you feel on this issue.

… We urge you to read Dingell's Web statement and post a comment on his site and at other sites that cover climate, energy, oil, national security, and politics. Having a legislator of Dingell's stature even float a carbon-tax trial balloon is a very important and positive development — possibly a breakthrough. There's a lot riding on it. Be heard.

See Also:

Newsweek, Web-Exclusive Interview, 'This is Going to Hurt', Sept. 27: A defender of the auto industry proposes a carbon tax that will cause everyone pain. Is the country ready for shared sacrifice to combat global warming? …

Daily Kos, Dingell: A dingbat proposal re Global Warming?, A. Siegel, Sept. 26

Econospeak, Economists v. Politicians, Michael Perelman, Sept. 26: … [T]he Wall Street Journal has chimed in reporting that economists as a whole agree that carbon taxes are the way to limit global warming, yet politicians are just as adamant in supporting the cap and trade. Nobody wants to get blamed for raising taxes. Rep. John Dingell (Dem, GM; i.e. General Motors) is still supposed to introduce a carbon just to prove how unpopular such a tax might be. …

NY Times, What is John Dingell Really Up to?, David Leonhardt, Sept. 5

Auctioning Off Carbon Permits: Better than Carbon Tax?

Over at the promising new blog Econospeak, Peter Dorman argues that auctioning off permits for rationing carbon is a better strategy than either a carbon tax or the much-maligned 'cap and trade' system. I'm not yet convinced, still leaning toward a tax. But at least Dorman has it out there for discussion. Here is Dorman:

Tax Carbon?: The New York Times has a story today about John Dingell's change of heart on climate policy. … [A] carbon tax "is the climate solution that economists and environmentalists have long dreamed of" [says NY Times David Leonhardt] and that the only alternative is cap-and-trade, giving away emission permits to longstanding polluters. The third approach, and by far the best, is setting up a permit system and auctioning off each one of them.

There are two reasons why permits rule. (1) There is great uncertainty about the future relationship between carbon prices and pollution levels (long run elasticity of demand for fossil fuels). Taxes place the burden of this uncertainty on the environment (the amount of pollution); saleable permits place it on costs faced by energy users (fossil fuel prices). (2) Politically, if we go the tax route, we end up in a discussion about taxes. … If we center the policy on permits the debate is over how much greenhouse gas emissions we are willing to tolerate. That's the discourse we need.

Folks, this is a very important issue at a very important time. In the next year the contours of the national debate over climate change policy will be set. Huge ecological consequences — and gobs of cash — are on the line. It is essential to start off in the right direction. I'd like to see enough clarity and truculence in the activist community that journalists are forced to take notice

Background, from Leonhardt's article:

… Devised correctly, a cap-and-trade system could certainly work. But there are enormous complexities. As Gregory Mankiw, the Republican economist, has pointed out, companies that use the most energy today are likely to be given the largest number of permits, essentially rewarding them for their prior pollution. Some companies may even deliberately use more energy in the next few years, to assure themselves additional permits. Given all the issues, a cap-and-trade system could end up being "ineffective or even counterproductive," Lawrence Summers, who was a Treasury secretary under Bill Clinton, has warned.

A solution that relies at least partly on a carbon tax would be simpler, and the revenue it generates would go to the government, rather than to companies. The government could then turn around and cut, say, payroll taxes to cushion the blow of more expensive gasoline and home heating. …

Fundamental Theorem of Carbon Taxation

Greg Mankiw serves up what he calls the Fundamental Theorem of Carbon Taxation:

… Economists recognize that a cap-and-trade system is equivalent to a tax on carbon emissions with the tax revenue rebated to existing carbon emitters, such as energy companies. That is,

Cap-and-trade = Carbon tax + Corporate welfare. …

Yet one more nail in the coffin for rationalizations for "cap and trade" and one more endorsement for setting up "carbon tax" schemes. Or is it? Differing opinions?