Austerity is dead — the victim of its 2010-2012 failure in the Eurozone. At last week’s G-8 summit at Camp David, leaders called for growth, not austerity. Even German Chancellor Angela Merkel, the iron lady of austerity, conceded that the crisis in Greece would require stimulus. A week earlier, IMF Director Christine Lagarde called for growth-oriented policies. And on May 6, the French elected socialist Francois Hollande, rejecting the austerity policies of his predecessor, Nicolas Sarkozy.

So what will austerity’s demise do to the case for a U.S. carbon tax, given that new taxes, or tax hikes in any form, are one of the two pillars of austerity? (The other, of course, is governmental spending cuts.) The answer to that question depends on the alternatives and the uses of the carbon tax revenues, but the key points are these: first, a carbon tax is almost certain to be better for economic growth than draconian spending cuts or higher taxes on incomes or wages; second, if its revenues are used to reduce other taxes or are spent in ways that spur employment, the net effect of a carbon tax can be stimulative.

Ironically, while there is now, finally, broad consensus that austerity in Europe has stunted its economic growth, the fragile U.S. recovery faces a ticking time bomb of automatic austerity, set to go off on January 1. Unless Congress acts, the deficit ceiling legislation enacted in 2011 will “sequester” $1.2 trillion of automatic across-the-board cuts on military and domestic spending. At exactly the same time, the Bush tax cuts are set to expire, which will raise the effective federal tax rate from about 16% of GDP to the Clinton-era 20% level. Last but not least, the payroll tax holiday is set to expire on Jan. 1 as well.

The alternatives to letting those time bombs explode are (i) repeal the “sequester” and extend the Bush tax cuts and the payroll tax holiday (leading to even larger deficits), or (ii) increase revenue by broadening the tax base. In 2010, two bipartisan deficit commissions, “Simpson-Bowles” (officially the National Commission on Fiscal Responsibility and Reform) and Rivlin-Domenici, recommended sweeping tax and entitlement reform. Rivlin-Domenici went further, urging broadening of the tax base by imposing a European style Value Added Tax. A VAT, of course, is a regressive sales tax (levied on virtually all consumer purchases) that can suck up revenue like almost nothing else. But it is so broadly based that it offers little environmental benefit. Other revenue options include worthy but politically-loaded proposals like repealing or limiting the home mortgage deduction.

Where does this leave a carbon tax? In our view, a tax on carbon emissions that starts low or even at zero, with a built-in ramp up over time (as recommended by former Fed Vice-Chair Alan Blinder), is an attractive alternative to pretty much everything on the standard menu — a VAT, higher income taxes or draconian spending cuts. A gradually-rising carbon tax would also yield gradually increasing revenues, helping to close the deficit while working better (at lower cost and more broadly) than any other policy to reduce global warming pollution. One particularly stimulative way to use carbon tax revenue would be to fund and expand the payroll tax holiday, a stimulus measure enacted in 2010 that increased employee paychecks by up to $2,000, but which is set to expire at the end of this year.

Economic analysts of virtually every stripe agree that unparalleled uncertainty about the strength of the recovery is helping to hold back investment and growth. Beyond the general lack of confidence, the energy sector faces additional regulatory and price uncertainty. A clear, upward price trajectory on carbon pollution would give entrepreneurs and investors in efficiency and renewables something to bank on. Without that predictable price signal, renewables will continue to face the prospect of “feast or famine” depending on Congressionally-enacted subsidies or the even more volatile price instability of cap-and-trade systems. And if a carbon tax helps avert an automatic “sequester” triggering draconian cuts in social programs, the result will be enormously better for low and moderate-income households that depend on the safety net.

The fact is that none of the options for avoiding a “fiscal cliff” on Jan. 1, 2013 are pretty. In that context, the dependably-growing revenue stream along with the vast climate benefits of a predictably-rising carbon tax make it a potential winner.

Photo: Flickr — Passarello Luna

“Game Over for the Climate,” Dr. James Hansen’s powerful op-ed in yesterday’s New York Times, adds a compelling new argument to the case for ditching the Keystone XL pipeline:

We should impose a gradually rising carbon fee, collected from fossil fuel companies … [T]he reduction in oil use resulting from the carbon price would be nearly six times as great as the oil supply from the proposed pipeline from Canada, rendering the pipeline superfluous, according to economic models driven by a slowly rising carbon price. (Emphasis added.)

Please be assured that Dr. Hansen’s “nearly six times” assertion is oil vs. oil, so that the substantial reductions in coal use are additional. His figure drew on modeling by the Carbon Tax Center, as I detail below.

The pipeline

The Keystone XL pipeline is primarily intended to carry crude oil refined from Alberta tar sands to various refineries in the U.S. Some crude would enter in Montana and Oklahoma as well, according to Wikipedia. Given the pipeline’s multiple entry and exit points, there may not be a definitive figure for the incremental tar sand crude it will deliver. Dr. Hansen’s figure is 830,000 barrels a day. Friends of the Earth, which is helping spearhead resistance to the pipeline, says “The Keystone XL pipeline would carry 900,000 barrels of dirty tar sands oil into the United States daily,” or 8-9% more than Hansen’s figure.

The carbon fee

As the graphic suggests, our modeling indicates that the oil savings in goods movement alone propelled by a carbon tax would be comparable to the oil delivered to this country by Keystone XL. And that’s just in the tax’s tenth year; the savings would grow further as the tax continued to ramp up, in contrast to Keystone’s maxed-out and eventually declining oil supply. Savings in each of the two top oil-consuming categories ― personal ground travel (mostly autos and light trucks, of course, but also recreational toys such as off-road vehicles and powerboats) ― and the catch-all “Other” (petroleum used in heating, construction, industry, agriculture, and oil refining itself) would be roughly double Keystone’s supply. All told, U.S. consumption of petroleum products in the tenth year of a carbon tax would be nearly 5 million barrels per day less than the business-as-usual projection, a reduction of 24%.

These savings assume the carbon tax devised by Rep. John B. Larson (D-CT) in 2009 and embodied in legislation he introduced in the House. That’s the carbon tax (or “fee,” to use the term Dr. Hansen prefers) that Jim assumed in his op-ed. It kicks off with a first-year level of $15/ton of carbon dioxide and rises at $10-$15/ton per year (we assume $12.50 in our modeling), reaching $127.50/ton of CO2 in its tenth year.

To be sure, Rep. Larson’s carbon tax proposal is an “aggressive” one. A carbon tax that gradually but steadily — unlike the violent gasoline price swings delivered by “the market” — raised prices of gasoline and other petroleum products by 10-12 cents a gallon each year would cut deeply into petroleum usage by driving consumers and businesses to make different (and more efficient) choices on both the demand and supply sides. And the tax would simultaneously reduce coal-burning for electricity generation — the source of one-third of all U.S. CO2 emissions from fossil fuel combustion until very recently — even more, because alternatives and low-cost opportunities for efficiency in that sector are even more abundant.

Here are some of the multitude of ways in which a predictably and steadily rising price for petroleum products would engender reductions in their provision and use:

• Purchasing and preferential use of more-efficient vehicles by individuals, businesses, fleets
• Spurring innovation to manufacture more-efficient cars, trucks, aircraft, etc., by optimizing vehicle shapes, materials, engine designs, controls, components, etc.
• Substitution of proximity for distance in location decisions by families, businesses, institutions
• Acceleration of recent trends away from suburbs and exurbs and toward urban centers
• Prioritization of local sourcing over trans-national or global supply chains
• Reductions in use of recreational motorized vehicles
• Increased provision and use of “active transportation” (cycling and walking) and public transit, with corresponding decreases in driving
• Logistical innovations in the trucking industry to increase load factors and miles per gallon
• Greater car-sharing via price incentives and real-time apps that pair drivers and riders
• Greater efficiencies in the food sector, including more-efficient irrigation and agricultural vehicles and/or their displacement by less energy-intensive farming methods
• Upgrading and maintaining building envelopes and heating systems in oil-fired homes, offices and factories
• Substitution of biofuels, electricity, natural gas, and/or hydrogen for petroleum products

While no econometric model can precisely predict the uptake of each of these measures, economists have combed empirical evidence for decades to infer sector-wide price-elasticities. (“Elasticity” is simply a measure of how much economic actors respond to price changes.) In our modeling of gasoline usage, we assume a 0.4 long-run price elasticity and a decarbonization rate of 1% for each $10/ton attached to CO2 emissions. For the various petroleum products that make up the “Other” category, we assume a slightly greater price-elasticity, 0.5, and the same decarbonization rate as for gasoline. (See further discussion on the Carbon Tax Center’s Web site, here.) The model also builds in lags to reflect lead times needed to adapt to the rising prices (note that legislating a steady ramp-up of the carbon tax would help compress the lags, since carbon-critical decisions could be made with an eye toward future prices rather than just last month’s).

Readers with an analytical bent may want to download the Carbon Tax Center’s carbon tax spreadsheet model. (Note that the link can also be found near the top of our home page, in the second-bulleted paragraph in the light yellow block of text.) With the model in hand, you may alter the carbon tax’s starting amount and the increase rate in the Summary page of the model, if you wish. On the Graph_CO2 page, the model plots emissions reductions compared to “business as usual,” giving an easily understood representation of the extent to which CO2 emissions would decline over time in response to the chosen carbon tax and rate of increase.

The section on “Annual Oil Requirements” begins at Row 173 of the Summary page. The tenth-year savings are shown in Column Y, corresponding to 2021, which would have been the tenth year of the Larson carbon tax, had it been enacted in 2010 or 2011 with startup in 2012.

The model, while skeletal in some ways, is intended to allow analysts and advocates to gauge the approximate impacts of different carbon-price designs on emissions, revenue, petroleum and other key parameters. We’re proud that Dr. Hansen relied on it in his Times op-ed, and we’re glad he continues to point to the enormous benefits of a steadily-rising carbon fee.

A carbon tax offers a unique and powerful combination of fiscal, economic-efficiency and environmental benefits, argued Adele Morris, the Brookings Institution’s Policy Director for Climate and Energy Economics, at an Oct. 18 forum convened by the Brookings Institution, the Urban Institute and the Tax Policy Center. Morris acknowledged the political obstacles. One of course is the failure of anti-tax politicians to distinguish beneficial “Pigouvian” taxes on pollution from conventional taxes that burden and discourage productive activity. But another has been “tepid” support for a carbon tax from the environmental community.

We heard that as a challenge: Why has the environmental community (with a few notable exceptions) parked itself on the sidelines of this crucial policy debate?

Adele shared her presentation text, which we reproduce below:

Time to ’86 the Tax Code? Prospects for Tax Reform After 25 Years

AN URBAN INSTITUTE – BROOKINGS INSTITUTION – TAX POLICY CENTER EVENT 10/18/11

The potential role for a carbon tax in a broader tax reform package is timely and economically important. This paper addresses two aspects of the issue: the economics and the politics. It makes good economic sense to embed a carbon tax in a broader tax reform package. If you’re going to “go big” on deficit reduction, it makes sense to include a carbon tax, and likewise if you’re going to do serious climate policy, it makes sense to raise revenue for deficit reduction or to offset other taxes. Despite the strong economic case, the political challenges to a carbon tax are many, and they aren’t just from anti-tax Republicans who don’t believe in the science of climate change. Some of the headwind to a carbon tax derives from tepid enthusiasm from Democrats and the environmental community.

Embedding a Carbon Tax in Broader Tax Reform

First and foremost, the reason to do a carbon tax is to reduce the risks posed by climate change. If you don’t believe the science that indicates that humans are responsible for rising temperatures then naturally there is nothing else compelling beyond this point. But if we stipulate the risks of climate change, then a policy that prices those damages (as best as we can estimate them) into fossil fuels is an economic no-brainer.

Adele Morris, Climate & Energy Policy Director, Brookings Institution

The kind of carbon tax policy I support is the canonical carbon tax recommended by many economists. It would fall on the carbon content of fossil fuels broadly across the economy. It would start modestly, at something like $15 to $25 per ton of CO₂, and ramp up at a modest real rate over inflation, something like 4 percent per year. It would allow tax credits for carbon in fuels that are not subsequently emitted, for example because it is sequestered underground or embodied in a product, such as plastics.

While it’s true that tax reform is hard enough without larding it up with a grab bag of other policy priorities, especially something as contentious as climate policy, there are several good economic reasons to combine these two efforts. First, a carbon tax can raise significant revenue. Depending on the tax rate, it can raise more or less revenue, but estimates suggest that a price on carbon about $33 per ton of CO₂ in 2020 would raise about $180 billion per year. A tax of about the size I described earlier would start out at revenue of about $100 billion per year, and it would rise from there. However, the revenue profile isn’t as steep as you might think because people respond exactly as you want them to — by emitting less carbon. That means that although the tax rate goes up, the revenue tapers off and eventually falls over the long run as the falling emissions dominate the higher tax rate. So a carbon tax is a medium- to long-run revenue instrument, but as emissions fall to low levels in the very long run the tax eventually raises little revenue, which is exactly what you want if the goal is to stabilize greenhouse gas concentrations in the atmosphere.

A second reason to embed a carbon tax in broader tax reform is that a carbon tax can be regressive. If you don’t make the carbon tax part of a progressive tax reform, then you have to fix the regressivity within the climate policy or not fix it at all. If you address the regressivity within the carbon tax system, you can end up with less efficient climate policy – for example with rebates to households to offset higher energy bills. This blunts the incentive to conserve energy, which means you have to have a higher carbon price to get the same environmental benefits, which is obviously more costly.

Third, a carbon tax used for deficit reduction could possibly avoid some of the protracted rent-seeking we saw over the cap-and-trade bill, where relatively little of the debate over cap-and-trade was over the cap — most of the squabble was over who got the free allowances. Everyone who thought they were about to lose their share of the pie had incentive to block the measure and get another bite at the pie. Maybe if all the carbon tax revenue goes to deficit reduction or to fund the reduction of other taxes, then there’d be less to squabble over and we could make some progress.

Fourth, a carbon tax policy that doesn’t apply the revenue for deficit reduction or to offset other distortionary taxes would be a lot more costly to the economy than one that does. The economic literature is clear on this. If you just give away allowances or carbon tax revenue, you’re not getting the economic benefit of reducing distortions from the existing tax system which in turn makes the climate policy a lot more costly than it could be.

A final reason to embed the carbon tax into other tax reform is that it might make it harder to unwind later. There’s always going to be a constituency to repeal the carbon tax, and it will get louder as the tax and retail energy prices go up. If there’s a countervailing constituency that is the clear beneficiary of the other taxes reduced, then we have a counterweight. That’s what they did in British Columbia, which is a model we should consider.

More on the Politics

AEI’s Kevin Hassett recently observed that one reason we not have discussed climate policy this long without actually putting a price on carbon is that economists haven’t done a good job convincing Republicans that Pigouvian taxes are okay, meaning that taxing something you want less of is good economic policy. I agree with his assessment.

I also think economists haven’t done a good job convincing the environmental community that Pigouvian taxes are good environmental policy. After decades of opposition, the good performance of the Acid Rain program led environmentalists to support the idea of cap-and-trade to control air pollutants. And we saw their strong support of the cap-and-trade legislation as it moved through the House but died in the Senate in 2010. However, even as the environmental community embraced cap-and-trade, which put a specific limit on emissions, they didn’t entirely trust it to do the job. Recall that only one title of the monster bill was cap-and-trade. The environmental community embraced, and still does, a wide variety of ancillary policies, some of which would have been redundant to the cap. These include appliance standards, fuel economy standards, renewable energy mandates and subsidies, and a host of other measures that would have shifted around where emissions reductions occurred and raised costs, but not necessarily decreased emissions below the cap.

So if there was lingering distrust of cap-and-trade, there’s probably even less confidence in a carbon tax to do the job. Very few NGOs supported a carbon tax over cap-and-trade, mostly because they viewed the cap-and-trade as more certain environmentally. Perhaps downward sloping demand is just not that convincing, and now, when we’re in the context of discussing a carbon tax instead of cap-and-trade, the unease over letting go of the ancillary policy apparatus is likely to be higher.

The political reality is that Democrats will likely have to give up something to get a carbon tax. It might include proposed or existing clean air act regulations that could become redundant with a carbon tax, spending on clean energy or green jobs initiatives, or transfers to what Republicans view as sketchy UN bureaucracies for climate finance in developing countries. (I would note that the politics of those ancillary policies aren’t just about concern about the environmental effectiveness of a carbon tax; there are important Democratic constituencies for these clean energy measures, such as renewable energy firms and labor unions.) But be that as it may, I think the way forward, if Democrats are serious about putting a price on carbon, is for leaders to put together a carbon tax proposal and to sell it in part by describing what they would be willing to give up to get it.

It might have to wait until we’ve tried everything else, and it hasn’t worked. We can pursue appliance standards and renewable subsidies and the like. Then when we’re not meeting our environmental goals, we’ll converge on the economic equivalent of concluding the earth revolves around the sun and put a price on carbon.

It’s not cap vs. tax anymore; it’s what kind of tax? That’s the take-home from a symposium, Fiscal Reform and Climate Protection: Considering a U.S. Carbon Tax, held earlier this week at Resources for the Future and co-sponsored by the Peterson Institute for International Economics.

American Enterprise Institute economist Kevin Hassett opened the day by pointing out that economists hadn’t convinced enough Republican lawmakers of the benefits of replacing taxes on productive activity with a tax on CO2 pollution. Hassett noted that damage from fossil fuels’ conventional pollution is large enough to justify a carbon tax even without considering global warming. But he hewed closer to Republican orthodoxy when he cautioned that it would be “folly” for environmentalists and Democrats to try to “prove their machismo” by “holding out for a $65/ton CO2 tax” to combat global warming. Hassett expressed relief that “corrupt” cap-and-trade “is finally behind us.”

RFF’s Ian Parry highlighted the intriguing potential for a CO2 tax to reduce emissions while increasing economic output — provided the revenue is used to cut distortionary taxes that otherwise drag down economic activity — a phenomenon that economists call a “double dividend.” As articulated in their paper, Moving U.S. Climate Policy Forward: Are Carbon Taxes the Only Good Alternative? Parry and his RFF colleague Roberton Williams advocate using carbon tax revenue to cut taxes on payroll and on savings or to lighten future tax burdens. Parry said he estimates that a $33/ton CO2 tax dedicated entirely to deficit reduction could close 25% of the U.S. budget gap.

Bob Simon, Staff Director of the Senate Energy and Natural Resources Committee (ENR), remarked that once one passes the “fork in the road” between “cap” and “tax,” the road signs look the same. Both policies must address revenue, regional disparities and impacts on energy-intensive trade-exposed industries. Simon suggested that broad multi-sector policies like caps and carbon taxes are more politically fraught than sector-specific policies like the Clean Electricity Standard for utilities that ENR voted up two years ago.

Joe Aldy, former White House special assistant on climate, pointed out that a $20/ton CO2 tax could raise $100 billion a year. Aldy, now teaching economics at Harvard, expressed hope that the advantages of a carbon tax will make it more attractive to deficit cutters than other options such as a value-added tax, a cut in mortgage deductions, or curtailing benefits.

Trevor Hauser, an energy specialist at the Peterson Institute for International Economics, presented new modeling results indicating that regional variations in carbon tax incidence may be as little as 3%. Moreover, the emergence of shale gas as a resource option in coal-dependent states may soften opposition there, he suggested, improving legislative prospects for a carbon tax. Hauser stressed both the climate and fiscal benefits of a carbon tax; he showed a Chamber of Commerce memo rating a carbon tax as the most cost-effective climate policy, but he noted that their position may have changed.

Post Script: On the very next day, the Brookings Institution convened a complementary meeting, Time to ’86 the Tax Code? Prospects for Tax Reform After 25 Years. Brookings’ Director for Climate and Energy Economics Adele Morris urged those concerned about climate to push for inclusion of a carbon tax in fiscal and tax reform. In contrast to a value-added tax, Morris pointed out that carbon taxes offer unique additional advantages – they reduce CO2 emissions at the lowest cost and improve the efficiency of the economy.

Photo: Flickr — afagan

The Carbon Tax Center lost a dear friend and generous supporter last week, and the world lost a unique soul, with the passing of Seymour Schwartz — builder, environmentalist, philanthropist, and humanist.

Sy was 88, a World War II vet, father of three, with nine grandchildren. In an obit in last Sunday Times, Sy’s family described him as “visionary real estate developer, environmental champion, and, later, founder of the Common Sense Fund,” a non-profit that promotes practical, creative action on the environment and in the arts.

The Carbon Tax Center has been a fortunate beneficiary of Sy’s vision since our founding in 2007. The support of the Common Sense Fund was integral to the success of our three major public fora to date: the Congressional carbon-tax briefings we convened in 2008 (U.S. House) and 2009 (Senate) and our “Pricing Carbon” Wesleyan Conference last November. Sy’s mixture of optimistic idealism and hard-won realism was a mirror image to ours, and we hope CTC served his beliefs well.

The Common Sense Fund’s Web site says this about Sy:

Over a long career as a real estate developer in Connecticut, Sy was a visionary builder, using conservation zoning before it was popular, understanding how to work with challenging topography, and exploring and implementing alternative energy sources long before the mass realization of global warming.

It was Sy’s ardor for renewable energy that led to our meeting, in the winter of 2005, when Sy was 81. He had seen a video clip of me inveighing against the well-heeled opponents of the Cape Wind project in Nantucket Sound, and he rang me up, suspecting I might be a kindred soul. Little did he know! We quickly bonded over our disdain for self-professed environmentalists who support renewable energy so long as it’s not built nearby. Before long, we realized that our connection ran deeper and included devotion to nature, predilection for straight talk, and love of classical music.

Sy’s life story could fill a book. Yet somehow, his family captured his essence in these 40 words:

Sy had an independent and creative mind; he could make you rethink your position on settled questions. He was a lover of Bach, a walker, and an advocate for the common man. He understood that he was a fortunate man.

Sy relished the beauty in the world while retaining a wry appreciation of life’s absurdities and contradictions. He marveled at modern medical technology, but despaired over its costs and inequities. He was in awe of China’s progress in eradicating chronic poverty, but appalled at its ecological heedlessness. He feared that the world couldn’t stop climate change without building more reactors, but had no qualms in declaring that Fukushima would set back nuclear power for decades. He recognized the need for both congestion pricing and carbon taxes, but was keenly aware of the enormous political difficulty of enacting them.

Sy lived simply and considerately, and he wore old age with grace. He had a little bit of Gandhi in him, though none of the self-righteousness, and some of Mozart’s lightness too. He was sentimental but not soft, cantankerous yet sweet. He had a keen intelligence, a restless mind, and a great heart.

The U.S. Department of Energy’s official estimate of the “Social Cost of Carbon” (SCC) is $21/ton of CO2, which amounts t0 $0.21/gallon of gasoline.  That’s the weighting factor (set by DOE rule) used to decide how much importance to give to the future damage from global warming in a panoply of decisions both inside and outside government.  The SCC can be viewed as an estimate of the “true” cost of fossil fuels — the cost of doing nothing about global warming.  In economic theory it’s the “optimal” Pigouvian carbon price or tax — it would tell us how much effort to make to reduce our CO2 emissions to minimize economic harm from global warming.  But if the SCC estimate is too small, we won’t do enough to avert disaster; if it’s too large we’ll over-react.  Setting the SCC is a bit like deciding how much to spend on fire insurance– except that in this instance, we know that if we do nothing, there’s a “fire” coming, we just don’t have a good handle on how bad it will be or when it will get really bad.  According to “Revising the Social Cost of Carbon,” by economists Frank Ackerman and Elizabeth Stanton (E3 Network), the government’s SCC estimate is far too low because of three crucial assumptions:

1) Climate Sensitivity. How warm will Earth’s climate get if we double CO2 levels from the historic 270 ppm to 540 ppm?  The working consensus among climate scientists is that CS is about 3 degrees Celsius (5 degrees Fahrenheit).  But four years ago, the IPCC concluded that there’s at least a 5% chance that CS is 7 degrees C.  For a sense of that magnitude, the difference between our climate and that of the last ice age (when North America was covered by glaciers) was about 8 degrees C.  Recent data and weather events suggest that CS will need to be revised upward– scientists have  almost certainly overlooked some important feedback mechanisms that will make the Earth get hotter as CO2 levels rise.

2) Severity of Damage from global warming. How much harm will a given amount of warming cause and how soon? Ackerman and Stanton critique the DOE estimates which are based in part on work by economist William Nordhaus which assumes that half of world economic activity would continue even when Earth’s temperature had risen 19 degrees C.  In contrast, economist Martin Weitzman estimates that 6 degrees C would wipe out half of world economic activity.  Credible estimates suggest that a 12 degrees C rise would result in large parts of the world experiencing temperatures at least once a year too high for humans to survive, suggesting that Nordhaus’ (and DOE’s) estimate is far too low.

3) Discount Rate. Discounting reduces the importance of the future by making it seem farther off.  A high discount rate represents an assumption that future well-being is less important than a low discount rate which weighs the future more heavily in our present-day decisions.  If we assume that the future will be prosperous, maybe it’s not so bad to lose half of whatever we value in life to the ravages of global warming.  But if the future looks like a long stretch of hard times, losing half might really be painful, especially if we lose half of our food production.  DOE uses a discount rate of 3%; Ackerman and Stanton point to the Stern review which used 1.5%.  In some ways, the discount rate is a value judgment, somewhat like the question of how much to save for your child’s education when she’s only 2 years old.  But like the decision to start saving early, the discount rate affects results later very strongly, especially when the potential for larger future damages is also factored in.

Ackerman and Stanton argue that low damage assumptions and over-discounting mean that the official $21 figure is far too low.  Using a range of more realistic assumptions, they calculate SCC values ranging from $56 to $893.  But they point out that when the SCC — essentially the present value of the future damage if we do nothing about climate — becomes large enough, standard cost-benefit analysis stops making sense.   In that situation, any effective action we can take will cost less than the discounted present value of the damage.  Translated into pricing policy, that means that if a carbon tax is meant to internalize the social cost of carbon, it needs to aim high.  There may be little advantage in setting the carbon tax very high initially, but it needs to rise and be expected to rise briskly enough to induce as much reduction in CO2 emissions as fast as our economy can deliver.

In short, the message of “Revising the Social Cost of Carbon” sounds like parental advice:  Start modestly, don’t delay, and aim high.   Ironically, it’s Generation Hot who will need to deliver that message to its elders.

Last Wednesday, the Brookings Institution hosted “America’s Energy Future: New Solutions to Fuel Economic Growth and Prosperity.” The first panel, “New Policies for a Cleaner Economy,” featured heavy-hitters: John Deutch (MIT “Institute” professor, former CIA Director…), Joseph Aldy (former Obama assistant on climate & energy), as well as Brookings Senior Fellows Ted Gayer and Michael Greenstone, who moderated.

Greenstone opened by noting how closely-linked energy consumption is to our well-being, but strongly cautioned about very serious un-priced side effects, especially from fossil fuels. Gayer recommended reforming government cost-benefit analysis to focus more on those un-priced externalities, especially since consumer benefits, he noted, are already efficiently priced into markets. Deutch advocated creation of a national energy technology research corporation to harness private sector investment free of a Department of Energy that “is mostly about bombs.” Aldy proposed a technology-neutral “National Clean Electricity Standard” to tax carbon-intense electricity generation and credit low- and zero-carbon electricity,  while providing federal revenue.

Greenstone asked the panel if their proposals wouldn’t be better replaced by a “grand bargain” to provide more of what we like: income, and less of what we dislike: carbon pollution. “[T]he giant prize standing in front of us is the realization that one could raise revenue instead of raising income taxes… through a carbon tax or some kind of carbon charge.” Aldy enthusiastically agreed, claiming “evidence of bipartisan support” and pointing out that he and Brookings economist Adele Morris proposed a carbon tax to the Obama deficit commission.

Deutch chimed in, “I couldn’t agree more with a proposal to do a comprehensive greenhouse gas tax. It depends, of course, on how it’s designed… and how you allocate the revenue. So if you put onto a tax proposal like you say a revenue proposal, then you have at least some chance of selling it.” Deutch urged return of some revenue to taxpayers as “walking around money.” “We’ve got to get the legislation passed,” he concluded.

(co-authored with Charles Komanoff)

From a climate standpoint, natural gas appears to have two huge advantages over coal. First, gas combustion releases 40% less carbon dioxide per Btu produced than does coal. Second, gas-fired power plants using “combined cycle technology” require 40% fewer Btu’s to produce each kilowatt-hour than coal-fired plants. Chain those advantages, and you find that new gas-fired power plants can produce 2.7 – 2.8 times as much electricity as a typical coal-fired generator while emitting the same CO2. No wonder gas is touted as a “bridge fuel” to renewables from coal, which accounts for 45% of U.S. electricity generation and a third of U.S. carbon dioxide emissions.

Of late, however, scrutiny of “fugitive” emissions from gas extraction and transmission is calling into question the assumption that gas is more benign for Earth’s climate than coal. The new wrinkle isn’t CO2 but methane itself, a potent greenhouse gas in its own right which can escape into the atmosphere at almost every step of the natural gas “fuel cycle.”

Natural gas (or simply “gas”) is 99% methane (CH4). Viewed over a 100-year time horizon (as the 2008 IPCC Fourth Assessment report did), methane’s greenhouse potency — its heat-trapping capacity, per pound of gas in the atmosphere — is roughly 25 times that of CO2. And if a 20-year timeframe is used, the greenhouse potency of a pound of methane becomes 72 times that of a pound of carbon dioxide. (The difference between the ratios arises because methane in the atmosphere breaks down about ten times as fast as CO2 — roughly a decade on average vs. a century for CO2.)

What’s bringing the issue of fugitive methane emissions to a boil is “hydrofracking” (or “fracking”). A highly invasive drilling process that releases gas by subjecting underground shale rock to hydraulic fracturing, fracking is being touted as a global-energy game changer. (“How Shale Gas Is Going To Rock The World” was the title of a May 2010 Wall Street Journal “special report.”)  But fracking is also an emerging source of massive air, soil and water pollution in states such as Pennsylvania that are the epicenter of the fracking boom.

In a recently-published peer-reviewed article, Prof. Robert Howarth and colleagues at Cornell University calculated methane releases from fracking and combined them with EPA data on gas pipeline leak rates to estimate methane losses across the gas fuel cycle. Their findings are sobering.  For every 100 cubic feet (the standard volume measurement) of natural gas “gathered” at the well and transferred to the transmission system:

• 0.6 – 3.2 cubic feet are released to the atmosphere in the frack drilling process, and
• 1.4 – 3.6 cubic feet of gas leaks into the atmosphere from the distribution system.

(EPA is expected to revise these estimates upward in view of more complete reporting showing greater leak rates, according to Howarth.)

Howarth et al. caution that their figures are based on very limited data, and are calling for further study. Nevertheless, their preliminary conclusion is that due to fugitive emissions in both the fracking process and gas pipelines, frack gas is causing as much global warming and climate change, per unit of energy output, as is coal. While that result is calculated for a 20-year timeframe, which understates the overall impact of carbon dioxide and, therefore, of coal, even over a 100-year timeframe fugitive emissions appear to take a huge bite out of any climate advantages that might otherwise be ascribed to natural gas.

It’s important to note that the Howarth analysis doesn’t take into account the second of the two “40% advantages” that we noted at the beginning of this post — the one reflecting the greater electric-generation efficiency of combined cycle gas turbines over conventional coal-fired steam turbines. This omission is significant in light of the fact that this efficiency edge has made combined cycle technology the overwhelming choice for recently-completed and proposed new gas-fired power plants. But regardless of the exact quantitative comparison between coal and frack gas, Howarth et al. are focusing much-needed attention on what now appears to have been the even starker omission (by most analysts) of substantial fugitive methane emissions in the natural gas fuel cycle.

Furthermore, as a frack gas drilling boom sweeps over the Marcellus Shale region of southwestern New York and huge swaths of Pennsylvania and West Virginia, residents are learning the hard way that fracking leaves vast amounts of dangerous chemicals in groundwater while also dumping polluted water, some of it radioactive, into rivers and streams. Congress is barely beginning to consider measures to close loopholes that exempt fracking from the Safe Drinking Water Act and the Clean Air Act, and these defensive initiatives are far behind the “NAT GAS” bill pushed by billionaire hydrocarbon mogul T. Boone Pickens to jumpstart a huge market for natural gas vehicles by subsidizing conversion of fleet vehicles and heavy trucks to gas.

Is there a way to legislate a clampdown on fugitive emissions of methane? Regulation requiring capture of gas, especially during the flow-back phase of gas drilling, should certainly be considered. But economic incentives are also worth a close look. Several carbon tax proposals would tax other greenhouse gases, including methane because, after CO2, it’s the top greenhouse gas driving Earth’s climate into instability. If, as Howarth and his colleagues have documented, fugitive methane emissions are a serious threat to Earth’s climate, could a tax on those methane emissions at their CO2-equivalent price correct the apparent market failure that leaves drillers willing to vent valuable and very climate-damaging methane?

We think so. Because methane is (at least) 25 times as potent a greenhouse gas as CO2, let’s consider a fugitive methane tax of 25 times the carbon tax rate, to reflect that potency. We calculate that a tax of $25 per ton of CO2 — to pick a modest, but not insignificant level — would imply a tax on fugitive gas of $13 per thousand cubic feet.* Since natural gas currently sells in wholesale markets for around $4 per thousand cubic feet (down from as much as $12 before the onset of the financial crisis), this tax would more than quadruple the incentive to capture methane provided by its current market price. That would appear to be a lot of leverage to capture fugitive methane, even from a fee pegged to a relatively modest carbon tax.

Howarth et al. report a huge range of fugitive methane emissions over the life of different frack wells — from a low of 140,000 cu ft to a high of 6,800,000.  At $13 / 1000 cu ft, the tax on those fugitive emissions would range from only around $60,000 per well to as much as several million dollars. (This enormous range is partly an artifact of the limited data available to Howarth.) While the low end is just peanuts to frack drillers, the high end is a significant fraction of the $2 to $10 million or more cost to drill a well (see p 25 of linked document).  It seems reasonable to expect that this tax, along with the market price of gas and the expectation of a rising CO2 (and equivalent fugitive gas) charge, would encourage deployment of equipment to capture, compress and store gas, at least at larger wells.

As both Howarth et al. and a recent report by the Post Carbon Institute point out, gas pipelines generally aren’t built and connected until wells are completed. Thus, well drillers who aren’t typically in the business of selling gas (and may not even own the rights to it) may not have ready access to gas pipelines and markets. This “split incentive,” along with the rush to establish and maintain drilling rights before leases expire, may help explain the reckless, wasteful discharge of climate-damaging methane into the atmosphere from frack wells. But gas can be compressed and transported by truck, so we’d expect that the price incentives of a rising greenhouse gas tax on fugitive methane would push well drillers to find ways to capture more of their emissions. Similarly, a substantial price signal should induce pipeline companies to repair and monitor leaking distribution systems. In this way, more of the lifecycle combustion advantages of natural gas as a true transition fuel could be realized.

As for fracking’s often-horrific “other” emissions: tough and comprehensive regulations are sorely needed. Congress should start with the “FRAC Act” H.R. 1084/S. 587 introduced by Rep. DeGette (D-CO) and Sen. Casey (D-PA), which would eliminate fracking’s exemption from the Safe Drinking Water Act; and the “BREATHE Act,” H.R. 1204 by Rep. Polis (D-CO.), which would bring fracking under the Clean Air Act.

* Authors’ calculation:

A $25/ton CO2 tax x 25x GHG potential  = $625/ton CH4.

$625/2000 lb x 44 lb/1000 cu ft  x  1000 cu ft/ 1.02 MM Btu = $13.5 /MM Btu

Flickr Photo:  Frack Well in Dimock, PA.  Brandi Lynn.

Guest Post By Michelle Chan, Economic Policy Project Director, Friends of the Earth

It’s been a bad month for carbon trading. The European Union Emissions Trading System (ETS), the world’s largest carbon market, barely crept back into operation after a four-week closure. Around the same time, California’s proposed cap and trade system went on hold after a Superior Court judge ruled that the rules creating a cap-and-trade system were adopted without proper analysis of alternatives. Adding insult to injury, Pike Research released a study which found that in a survey of 1000 Americans and their reactions to a variety of climate-related issues, offsets and cap-and-trade elicited the highest rates of “strongly unfavorable” or “somewhat unfavorable” impressions.

Some have blamed cap-and-trade’s woes on anti-climate propaganda and retrograde politicians.  Actually, the fault is in cap-and-trade itself; while the concept may appear elegant in an Econ 101 textbook, it is spectacularly unsuited for its supposed purpose of capping and reducing carbon emissions.

To see why, look no further than the troubles besetting the ETS. Only six of the thirty European carbon registries have been permitted to re-open after the EU halted trading in the wake of the theft of millions of euros worth of allowances from national registries. This scandal occurred on the heels of several others. In November, Swiss cement maker Holcim reported that 1.6 million euro of allowances were stolen from its account; only a fraction of them have been tracked down and returned. Last year, Europol reported that fraudulent carbon traders had shortchanged several national governments to the tune of 5 billion euro. In fact, Europol estimated that for a time 90% of trading volume on the Paris-based BlueNext carbon exchange was tied to fraudulent activities.

These are not a new market’s “growing pains”; rather, these scandals were (and are still) all too predictable. Today’s scandals involve opportunists exploiting immature trading structures, systems and rules. Tomorrow’s scandals are likely to involve more sophisticated gaming around complex and unwieldy trading programs, with offsets posing the most risk for fraud and corruption. And as the global carbon market expands further and Wall Street gets fully involved, it will surely suffer from the distorting impacts of unnecessary speculation and excessive financialization.

The root of the problem is that carbon trading entrenches the interests of those who profit from the selling and trading of credits and allowances, at the expense of actually reducing emissions. This dynamic inevitably exacerbates conflicts of interest and heightens corruption risks. It also intensifies regulatory capture — the process by which regulators end up advancing interests of the sector they are supposed to oversee, rather than protecting the public interest.

One poster child for regulatory capture in carbon markets is Christiana Figueres, who is both executive secretary of the UN Framework Convention on Climate Change and an advisor at C-Quest Capital, an offset developer. The larger problem is the revolving door between regulators and industry, a classic way in which corporations wield influence over regulators; and the outsized resources of corporate lobbyists. Already, associations such as the International Emissions Trading Association (whose members were among those charged by the UK police for conspiracy to commit tax fraud) have lobbied against stricter derivatives regulations and have blasted UN officials for not approving offsets fast enough.

While mainstream green groups appear largely unconcerned about the pitfalls of carbon trading, the environmental justice community is finely attuned to the downsides. The Superior Court judge ruling in California, which for the time being has stopped the California Air Resources Board from implementing California’s proposed carbon trading system, was the result of a suit brought not by Big Oil  but by environmental justice organizations which oppose carbon trading because of its likely localized health impacts. For example, under a carbon trading system, a refinery in Wilmington, CA, near Long Beach, could keep emitting carbon along with the associated toxic co-pollutants by purchasing carbon permits or offsets, instead of cleaning up its operations. “Fenceline” communities, which are almost always lower-income communities of color, already suffer from cumulative environmental health hazards, and carbon trading could exacerbate pollution hotspots as companies delay upgrading their dirtiest operations.

Indeed, the “efficient markets” theory behind cap-and-trade, and carbon taxes for that matter, posits that pricing carbon will help allocate financial resources in ways that most efficiently reduce carbon — meaning the cheapest emissions cuts will be made first.  But if carbon pricing isn’t accompanied by stringent regulation of local emissions (which after 40 years aren’t well-implemented in practice – just ask the folks in Wilmington), it leaves fenceline communities suffering the brunt of continually spewing toxic pollutants.

While advocates may differ over whether pricing carbon should be the centerpiece of greenhouse gas reduction policies, it has an important role to play in complementing other foundational strategies such as performance standards, regulations, urban planning and public infrastructure investments like mass transit. And when it comes to carbon pricing, carbon fees or taxes, rather than cap-and-trade, are the vastly superior option. One look at the malfeasance that has plagued carbon trading in Europe, the gaming and excessive speculation of derivatives traders, or the lack of environmental integrity in the offsets markets, and it’s easy to understand why so many people – from Nobel Laureate Joseph Stiglitz, to fenceline communities, to ordinary Americans — are skeptical of cap-and-trade.

The drawbacks of the cap-and-trade approach for pricing and reducing carbon emissions are legion. They include complexity, volatility, lack of price predictability, vulnerability to financial speculation, and impossibility of harmonizing across borders.  Now there’s another, courtesy of a 2010 report by an economist at the World Bank: Institution of a cap-based emissions program by oil-importing countries works to increase oil exporters’ market power, revenue and profits; whereas a carbon tax would have the opposite effect.

That’s the conclusion we draw from Jon Strand’s “Taxes and Caps as Climate Policy Instruments with Domestic and Imported Fuels.” As Dr. Strand, who chairs the economics department at the University of Oslo and has served as a senior economist at the World Bank since 2008, wrote:

[A] c-a-t [cap-and-trade] solution … leaves [oil importing countries] more vulnerable to adverse strategic manipulation of fuel prices by monopolistic exporters.[ [Conversely,] a tax is more efficient than a cap at extracting rent from fuel (oil) exporters. [Abstract and p. 32]

For his paper, Strand modeled a simple situation: Region A consumes two classes of fuels: imported oil and domestically-produced energy. Region B (interpreted as OPEC, plus Russia) exports fuel (oil) to Region A. Each region seeks to maximize revenue in response to the strategy of the other region. Strand concluded that the consuming region would be strategically weaker vis-à-vis the producing region under a carbon emissions cap than under an equivalent carbon tax.

Here’s why: Micro-economic theory teaches that a monopolist sets an optimum price to maximize revenue. Set the price too high, and sales volume falls, more than offsetting the increased revenue generated by a higher price. Set the price too low, and increased sales don’t overcome the lost revenue. Now picture a carbon emissions cap legislated by the importer, Region A. Because the cap constrains sales volume, the monopolist exporter can shift its (optimal) price upward without cutting sales volume. In contrast, were the importer to implement a carbon tax, this would reduce the exporter’s optimal (revenue-maximizing), price because the higher, tax-including price would reduce sales.

As Strand puts it, under cap-and-trade,

[T]he exporter strategically adjusts its tax [or export price] so as to extract maximum rent from the importer, at the given (exogenous) cap, leading to a zero equilibrium value for tradeable emissions quotas in the importer region.

Strand’s analysis points to a fundamental issue that cap-and-trade promoters tend to play down. A cap is an indirect way to set a price by limiting supply. But if someone upstream — the fuel exporter or its government — raises the price (or tax), the allowance price will fall. In the extreme, the exporter could raise the price enough to achieve the emissions reductions mandated by a cap and drive the allowance price down to zero. In other words, the importing nation’s cap enables the fuel exporter to reap a windfall by raising prices without sacrificing sales because falling allowance prices under the cap will tend to “absorb” the exporter’s price increase. In contrast, with a fixed (or gradually-rising) carbon tax, the exporter will be pressed to reduce prices to compensate for the tax in order to maintain sales volume at the revenue-maximizing point.

Strand isn’t the first economist to suggest this advantage of a carbon tax. In 2009, economists at the University of Ontario concluded that in addition to reducing CO2 pollution and providing revenue with which to reduce other taxes, carbon taxes offer a third important benefit: transferring revenue from OPEC to oil-importing countries, reducing OPEC’s monopoly power. Similarly, in an earlier (2002) paper, “Can Carbon Tax Eat Opec’s Rents?,” economists from MIT and the Helsinki School of Economics concluded that a “carbon tax can be used to reduce the producer price of fossil fuels and thereby to shift resource rents from the resource-exporting countries.”

The European Union’s cap-and-trade experience during the current steep recession offers insight into caps’ perverse interaction with “exogenous” (outside) forces. The recession curbed economic activity, and at the same time oil prices rose. In response, energy demand fell, driving down the price of CO2 allowances needed to burn fossil fuels. The EU’s emissions have declined during recent years, not because the cap is doing much to constrain emissions, but because those exogenous factors have reduced demand. Indeed, in the “uncapped” U.S., the trend of falling emissions very closely matches the downward emissions trend in the EU. In effect, a slow economy cut demand, and higher exporter oil prices captured “rent” from under the cap, holding allowance prices down and making it less effective at “putting a price on CO2” that would induce long term investment in alternative energy.

As we learned last week from a diplomatic cable written by U.S. Secretary of State Hillary Clinton, released by Wikileaks, “[D]onors in Saudi Arabia constitute the most significant source of funding to Sunni terrorist groups worldwide.” (NYT, Dec. 5.) Saudi Arabia, of course, is the world’s largest petroleum exporter and the second largest crude oil producer (after Russia). The Saudi economy is utterly dependent on oil and petroleum-related industries, including petrochemicals and petroleum refining, with oil export revenues accounting for 90 percent of total Saudi state revenues and more than 40 percent of the country’s GDP.

It thus may not be much of a stretch to ask if a U.S. carbon cap (especially when added to an EU cap) could wind up helping funnel money to Islamic fundamentalists with terrorist inclinations. Obviously, Strand’s analysis oversimplifies the situation — oil exporters are not a strict monopoly, they do compete somewhat, and energy technology or consumption patterns could change the dynamic. But it’s worth noting that economic analysis suggests that a carbon tax would tend to work against the interests of the oil cartel, while cap-and-trade would tend to reinforce the cartel’s price-setting leverage.

Photos: Flickr–foreclosurepro, digitaltrends.

P.S. This Just In:

Ecuador Asks OPEC to Support Oil Tax on Importers (Bloomberg, 12/11/10).

“With the first global tax on carbon emissions OPEC would achieve the most efficient and just way to do what Kyoto has failed to: make carbon emitters internalize the effects of their actions and pay for the pollution they create,” Ecuador’s President Rafael Correa said.