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As brutal drought and punishing heat waves remind voters how deeply climate affects our lives, Washington State Democrat Jim McDermott today stepped up to the climate plate. Rep. McDermott, a 12-term House member who sits on the powerful tax-writing Ways & Means Committee, introduced the “Managed Carbon Price Act of 2012.” His carbon tax bill would substantially reduce emissions of carbon dioxide and other greenhouse gases by predictably raising their costs relative to energy efficiency, renewables and innovation.

The Carbon Tax Center estimates that by imposing a steadily rising “upstream” tax on polluters emitting the six principal greenhouse gases driving global warming, McDermott’s bill would reduce U.S. greenhouse gas emissions by a whopping 30% within a decade. His elegant bill, just 21 pages of legislative text, would start modestly with a price of $12.50 per ton of CO2, but would then ramp up the cost of carbon pollution to $125 per ton of CO2 over a decade. (The actual price would fall within a tight, predictable price range. Non-CO2 greenhouse gases would be taxed at their CO2-equivalent rates.) CTC estimates that within a decade, McDermott’s price path would reduce greenhouse gas emissions almost twice as much as the most optimistic projections for prospective EPA regulations or the targets in the Waxman-Markey bill passed by the House in 2009 but dropped in the Senate the following year.

Consistent with World Trade Organization rules, McDermott’s bill would exempt U.S. exports of energy-intensive goods while imposing an equivalent pollution tax on imports. The bill would thus protect U.S. domestic energy-intensive trade-exposed industries from unfair competition while offering an irresistible (and growing) “carrot” for our trading partners to enact their own carbon taxes in order to capture a rising stream of carbon tax revenue that would otherwise flow to the U.S. Treasury.

The McDermott bill also obviates the need for emissions trading by requiring polluters to purchase permits as needed. It returns 75% of revenue directly to households through a monthly “dividend” for each adult (with a half share for each dependent). This provision eliminates regressive income effects on low- and middle-income households while preserving a clear price signal across the entire economy so that everyone is rewarded for efficiency, innovation and investment in renewable energy. The remaining 25% of the bill’s revenue would be dedicated to deficit reduction, a feature that is sure to be salient as Congress confronts the looming “fiscal cliff” next January.

CTC estimates that the revenue stream available for deficit reduction in the tenth year after enactment would be roughly $100 billion, even accounting for the 30% reduction in emissions.

Photo: Flickr — WSDOT

Co-authored with Sieren Ernst, Environmental Markets Advisory.

“The Case For A Carbon Tax” (Island Press, 2011, 233 pp) brings to mind Hans Christian Andersen’s “ugly duckling” story. The word “tax” screams “cost” to most people, and so the beauty of a carbon pollution tax isn’t apparent on first glance. Prof. Hsu reveals the beauty as he shows why a gradually-rising carbon tax is the least costly and most effective policy for curbing the pollution driving global warming, and how enacting such a tax can usher in a new era of clean energy and efficiency.

Trained in engineering, law and economics, Shi-Ling Hsu, a law professor who is moving from the University of British Columbia to Florida State University, deftly marshals a multi-disciplinary “case” for a carbon tax. He opens by describing and comparing the four main climate policy tools: subsidies, regulations, cap-and-trade, and carbon taxes. Then he briskly articulates ten arguments for a carbon tax, emphasizing economic efficiency and the advantages of basing a coordinated international system on a simple, transparent tax.

Hsu is especially strong in rebuttal, answering the arguments against carbon taxes, including the oft-repeated assertion that a carbon tax is politically impossible. He dissects psychological “hang-ups” that have kept the public and elected officials from embracing carbon taxes. Hsu points to British Columbia’s enactment and implementation of North America’s first carbon pollution tax, arguing that it is broadly supported because its revenue is used to reduce taxes for individuals and businesses. As Hsu and Yoram Bauman wrote this week in their New York Times op-ed, “The Most Sensible Tax of All“:

On Sunday, the best climate policy in the world got even better: British Columbia’s carbon tax — a tax on the carbon content of all fossil fuels burned in the province — increased from $25 to $30 per metric ton of carbon dioxide, making it more expensive to pollute. This was good news not only for the environment but for nearly everyone who pays taxes in British Columbia, because the carbon tax is used to reduce taxes for individuals and businesses. Thanks to this tax swap, British Columbia has lowered its corporate income tax rate to 10 percent from 12 percent, a rate that is among the lowest in the Group of 8 wealthy nations. Personal income taxes for people earning less than $119,000 per year are now the lowest in Canada, and there are targeted rebates for low-income and rural households.

Hsu crisply articulates the theory of Pigouvian taxes — the idea of taxing pollution rather than productive activity. But he sidesteps the thorny question of how high to set a carbon tax and how rapidly to increase it. And he does not mention the potential efficiency advantages of using carbon tax revenues to reduce other taxes such as taxes on work and thereby use climate policy to improve overall economic well-being. (Economists call that a “double dividend.”) He notes that while British Columbia’s carbon tax is revenue-neutral, the regressive effects of carbon taxes can be addressed by a wide variety of other mechanisms, leaving substantial revenue for cash-strapped governments, as recent reports and a new book by the International Monetary Fund have stressed.

Hsu delves into the limitations of EPA regulations, which he shows cannot create the broad incentives for innovation and planning needed to drive carbon eminssions way down:

A [carbon] tax, by imposing a cost on every single ton of pollutant, constantly engages the polluter with the task of reducing her pollution tax bill. By contrast, a command and control scheme that mandates a one shot, irrevocable installation of pollution control equipment allows for the polluter to stop thinking about pollution reduction. Why, if compliance is achieved, should the polluter look for other ways to reduce?

There are further problems, too: EPA can too easily be persuaded or intimidated by industry into granting exemptions and relaxing standards. Hsu also glosses over the enormous effort that would be required to write and enforce permits for each of the thousands of point sources of CO2. One has to wonder where and how the already-stretched EPA (and state environmental agencies) would find funding for such a massive undertaking.

Hsu neatly unveils the hidden high cost of taxpayer-funded subsidies of renewables and supposed low-carbon fuels. Subsidies, along with regulations and cap-and-trade with offsets, are attractive to the public and Congress despite serious limitations on their effectiveness, because their costs are largely hidden. Not only is Congress notoriously ineffective at picking technology winners, but subsidies create “lock-in” to incumbent technologies and businesses, foreclosing opportunities to spur innovation. In contrast, as Hsu shows, a carbon pollution tax’s laser focus on CO2 pollution creates incentives for all low-carbon alternatives, leaving specific technology decisions to engineers rather than politicians.

Cap-and-trade with offsets seems to be Hsu’s choice for second-best policy; it allows flexibility and could result in a “price on carbon” pollution, albeit one that is indirect and subject to price volatility. Happily, Hsu debunks the notion of “emissions certainty” that was used to sell cap-and-trade, by pointing out that for a “stock” pollutant such as CO2 that persists in the atmosphere for a century, the objective must be cumulative rather than annual reductions. Even year-to-year “emissions certainty” is vitiated in the European Emissions Trading System by provisions allowing borrowing and banking of allowances as well as by voluminous offsets. Carbon prices there have remained so low that recent analyses have concluded that industrial facilities will have little incentive to reduce their emissions through at least 2020.

Hsu points out the hidden costs that cap-and-trade would impose on consumers, profiting the financial sector and purveyors of offsets. His most egregious example: Chinese refrigerant manufacturers who garnered far more revenue from offsets awarded for destroying their greenhouse gas byproducts than from the sale of their underlying products. As documented by UN and GAO reports, the carbon market paid about 100 times more for the installation of emissions reducing equipment (an HCFC 23 incinerator) than the price of the equipment. The Chinese refrigerant manufacturer and the investors in the offset project reaped those windfalls, contradicting claims about the efficiency of cap-and-trade.

As Hsu illustrates, evaluating and verifying offset projects is staggeringly difficult. Applications for hundreds of different project types are submitted to a single U.N. panel with little capacity to evaluate “additionality” — to determine whether projects would have occurred in the absence of offset funding. Stanford University law professor and offset expert Michael Wara estimates that 30-50% of offset projects in the U.N. systems should not have been awarded credit, a fraction so large as to overwhelm any claim of “emissions certainty” under a cap with offsets.

Hsu concludes that linking cap-and-trade internationally would offer constant opportunities for mischief and arbitrage. In contrast, under a tax every country would have an incentive to scrupulously monitor emissions in order to collect the revenue. Moreover, the transparency of a carbon tax offers potential for international linkage via World Trade Organization sanctioned Border Tax Adjustments. WTO rules were built around a consumption tax — the European Union’s Value Added Tax; Hsu suggests that a carbon tax should similarly be supportable under WTO rules. But he seems to understate the capacity of Border Tax Adjustments to protect domestic energy-intensive industry while offering a growing monetary incentive to trading partners to enact their own carbon taxes.

Finally, Hsu’s discussion of the psychology of carbon taxes adds a dimension that we haven’t seen elsewhere. As behavioral economists like Daniel Kahneman have shown, we humans tend to underestimate the benefits of avoiding future harms while overestimating the cost to avoid them. And when a harm isn’t clearly identified with a specific person or persons, we have difficulty feeling concern. One child trapped in a well evokes national interest and empathy, but because we can’t see or name the millions who might drown or starve because of climate instability, we refuse to bear the near-term price of avoiding catastrophe. And we are easily misled into thinking that policies whose price is hidden, such as subsidies, regulations or cap-and-trade with offsets, are preferable to a carbon tax. Hsu proposes that polls disclose the cost of all policy alternatives in order to fairly gauge public opinion.

Hsu’s book offers a readable and authoritative, comprehensive and concise “case” for the most broadly effective, least-bureaucratic and least-costly approach to the climate crisis: a gradually-rising carbon pollution tax. We highly recommend “The Case For A Carbon Tax” to both general audiences and to those steeped in climate policy who may be seeking further insight on the nuances.

Photo: Flickr — jbparker

On Tuesday, a unanimous three-judge panel of the DC Circuit Court of Appeals declined to block the U.S. Environmental Protection Agency’s process of regulating greenhouse gases under the Clean Air Act. The 81-page decision upheld EPA’s 2009 endangerment finding that “anthropogenically induced climate change threatens both public health and public welfare,” and concluded that having made that finding, EPA is “unequivocally” compelled by the Supreme Court’s decision in Massachusetts v. EPA (2007) to regulate greenhouse gases as pollutants under the Clean Air Act.

The panel also held that the parties challenging EPA’s action were not harmed by (and thus had no legal “standing” to challenge) the Agency’s decision, via the “tailoring rule,” to regulate only the largest sources of greenhouse gases. The court thus swept away the last remaining obstacle to broad regulation of the largest category of greenhouse gas polluters, existing stationary sources.

The ruling came the day after a report in Bloomberg News that owners are selling off, at deep discounts, coal-fired power plants that have been under EPA mandates to install emission controls on “conventional” (non-climate) pollutants such as sulfur dioxide and mercury. The fire sale occurs as cheap natural gas has been displacing coal as the main fuel for electricity generation in many parts of the U.S. Calculations by the Carbon Tax Center’s Charles Komanoff show a 14% drop in coal-powered electricity last year vs. the 2007 peak, with nearly half of the decline filled by gas (with the rest from increased wind and hydro-electricity). Behind the coal-to-gas trend, which is accelerating thus far in 2012, are 10-year low natural gas prices stemming from the controversial fracking boom.

The spectacle noted in the Bloomberg article of billions of dollars left “stranded” in uncompetitive coal-fired power plants points to a serious limitation in using the regulatory process to constrain emissions of greenhouse gases. If regulation, rather than carbon pollution taxes, is to drive the 80% or greater reduction in emissions that scientists say is needed in the next several decades, then emissions standards for coal plants will need to be tightened again and again, rendering many of those investments obsolete long before the end of their assumed economic life.

Indeed, “stranded capital” looms as a huge problem in any inflexible regulatory system to cut down on sources of greenhouse gases that have long lives. Adding costly capital equipment to those dinosaurs is likely to waste utility ratepayers’ money while driving up the financial stakes of owners who have invested in retrofits that may never get to pay for themselves. Because stabilizing the climate will be a long-term and very capital-intensive process, the cost of inefficiencies built into regulations will be enormous and cumulative.

In contrast to this regulatory lock-in, a predictable, gradually-increasing carbon pollution tax would reward long-term investment and innovation in the lowest-carbon technologies while reducing demand. Even too much investment in gas-fired power plants might be ill-advised under a briskly-rising carbon price.

As things now stand, the renewables industries must make regular pilgrimages to Congress to continue their life-support “production tax credits.” A long-term, rising carbon tax would make long-term investments in renewables safer while spurring innovation (and obviating the need for those pilgrimages). And a rising carbon tax will also signal when to efficiently retire old, coal fired power plants — dirtiest first.

Economist and former Undersecretary of Commerce Robert Shapiro was asked about climate policy at a recent National Journal panel. Shapiro said that as EPA moves ahead with greenhouse gas regulations in the next year, he hopes complaints from industry will spur Congress to replace those cumbersome regulations with a more effective, broad-based carbon pollution tax.

That prospect gives a new dimension to yesterday’s DC Circuit decision to uphold EPA regulations. The decision is indeed a victory — not because EPA regulation of existing stationary sources can be effective long-term climate policy, but because the threat of their cost could help prod Congress to take the most efficient (and least bureaucratic) step to reduce carbon emissions: enact a substantial, gradually-rising carbon pollution tax.

Photo: Flickr — arbyreed

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Shortly after posting this commentary on June 27, I received e-mail comments from three well-known analysts of climate policy ― two resource and environmental economists and an attorney who has analyzed ways to regulate greenhouse gases under the Clean Air Act. We share some of that exchange below. ― James Handley, June 30.

Commenter 1: James – a nice piece, lots of important issues here. But I think you are mis-stating the stranded costs problem, and overstating the merits of a carbon tax.

You have compared myopic regulation – this year’s regulation can be treated as permanent until, oops, we have to change it again – with a long-term, gradually and predictably rising carbon tax. One could equally well have long-term, gradually and predictably tightening regulations, or a myopic carbon tax (it will never go above $21/ton until, oops, etc.).

James Handley: True; there are no guarantees that a carbon tax would keep rising. But a revenue stream (especially if committed to an important purpose in advance) seems to offer additional incentives to stay on course.

C-1: Stranded costs result from making long-term investments under the myopic approach to taxes OR regulation, not from regulation per se. A “read my lips – no carbon tax increase above today’s level” tax policy could induce large investments in incremental technologies, which would then be stranded when taxes were raised. (Or would lead to overwhelming political pressure not to raise the tax, in practice.)

JH: I agree.

C-1: A long-term schedule of predictably tightening future regulations would have the same salutary effect as a long-term schedule of predictably rising carbon taxes (and would be almost equally difficult to achieve, in realistic political terms).

JH : Yes, Joe Aldy [former Obama White House climate economist, now at Harvard Kennedy School] suggests a carbon intensity standard declining on a pre-announced schedule.

Richardson & Burtraw (Resources for the Future) have expressed doubt about whether the Clean Air Act offers such flexibility or allows more flexible options like utility-wide carbon intensity standards. (See Greenhouse Gas Regulation under the Clean Air Act: Structure, Effects, and Implications of a Knowable Pathway.) EPA said in a Notice of Proposed Rulemaking that it is not mandating fuel switching and does not contemplate it as a compliance option — which I think also means they’re contemplating rules that can be met without switching to renewables. So the “knowable pathway” probably comes down to plant-specific technology standards. And those are hard to ratchet down, especially predictably and smoothly. In practice, EPA tends to look at the technology available and set standards that can be met.

And technology mandates for coal power plants, especially existing ones, can only go so far. Retrofitted plants would be a lot more energy intensive. The thermodynamic minimum energy penalty (independent of process) for capturing and sequestering CO2 is roughly 1/3 of the energy output of a power plant. (I’ve read of research to use the vast waste heat from power plants to do the work of capturing, but nobody’s done it.)

So I don’t expect EPA technology mandates to offer anything like the flexibility and predictability of a tax. Nor do they offer revenue, create broad incentives to reduce energy demand or offer monetary incentives for innovation.

C-1: I think a carbon tax along the lines you propose would be great. But so would a well-planned, progressively tightening system of command-and-control regulation. The real advantages of a carbon tax, in terms of administrative simplicity, are important for many purposes, but it isn’t right for every situation and it shouldn’t be oversold.

JH: Having worked to prosecute polluters for 14 years at EPA, I have doubts about the Agency’s ability to effectively enforce declining technology-based emissions standards. I feel more confident that IRS can collect a carbon pollution tax.

Commenter 2: Excellent dialogue that inspires many thoughts, and two comments.

Despite many virtues, I am not convinced a carbon tax is administratively simpler. It could/should be, but won’t necessarily be simpler. Various exemptions and especially border tax adjustments or rebating revenues to energy intensive trade exposed industries could get complicated.

JH: Compared to the voluminous EPA Clean Air Act regs?

We like the Border Tax Adjustment (BTA) in Rep Stark’s bill, the Save Our Climate Act. It’s short, not complicated. And BTA’s strike me as vastly superior to rebates of carbon taxes to the Energy Intensive Trade-Exposed Industries. Rebates would enshrine dirty, inefficient practices and sacrifice revenue; BTA’s would protect domestic industry while offering a rising bounty for trading partners to enact their own carbon taxes.

I’m surprised by all the worry about World Trade Organization rules. WTO’s trade-harmonization provisions were written to accommodate a consumption tax — the EU’s VAT. Why wouldn’t a simple, non-discriminatory carbon tax be similarly consistent with WTO? I wonder if the EU is blundering by asserting that its aviation tax is an environmental measure. That’s a harder standard in WTO. Taxing authority is clear. (As Chief Justice Roberts just said about the constitutionality of the health care mandate.)

C-2: I think a BTA will become more complicated when offended parties claim things like their renewable support programs or smooth roadway surfaces or color of roofing shingles contribute to mitigation efforts, and hence must be considered as part of a border tax adjustment calculation that is tied specifically to a carbon tax.

JH: Yikes. Metcalf & Weisbach proposed setting BTA’s using a default carbon intensity for five energy intensive commodities (steel, aluminum, chemicals, paper, cement) derived from average U.S. production practices. (See [Design of a Carbon Tax, Harvard Env’tl L. Rev, 2009, p. 540, et seq.) Carbon content for each imported (or exported) good would be calculated by summing the “carbon content” of those five.  An importer (or exporter) asserting that their goods’ carbon content is lower (or their competitors’ is higher) would have the burden of proof. (Is that when they’d point out their white roof, smooth road, etc?)

C-2: My other comment is that although EPA cannot raise revenue for the national government, I understand it could raise revenues for state governments. That is, a plausible scenario is that states administer implementation plans under the Clean Air Act that raise revenues through taxes or auctioned allowances. There are a lot of possible obstacles to that happening, especially political, but no single legal obstacle…so I understand. A real conservative might like that state’s rights aspect of CAA regulation.

 JH: That’s interesting. States enacting carbon taxes as their State Implementation Plans to meet their Clean Air Act requirements. Does that assume EPA chooses to set a National Ambient Air Quality Standard for CO2? In various Federal Register notices they’ve shown no stomach for NAAQs, despite Bill Snape’s (Center for Biological Diversity) efforts.

And 50 separate State Implementation Plans? What about the law of one price? All kinds of arbitrage and distortions there? And wouldn’t the international trade harmonization problems come up then, too?

C-2: 50 SIPs, not. For instance, the northeast states will try to submit a coordinated SIP around a strengthened RGGI [Regional Greenhouse Gas Initiative], with one price in that region. Given the flexibility of it, Pennsylvania might opt in, compared to less flexible options.

In sum, I would walk to Chicago to get a carbon tax in place, but I am increasingly dubious of the Faustian bargain some have suggested of sacrificing the Clean Air Act in exchange. I really agree with [C-1] about the virtues of the CAA. Let the CAA go slack or lag behind if the tax is doing the work. But I would be glad it is there as a backup. Nonetheless, I will walk with you to Chicago.

JH: I imagine we’d have a good time. Maybe Jim Hansen and Bill McKibben would join us.

C-2: I’ll carry a copy of the CAA as ballast in my backpack.

JH: It’s ~ 300 pages [the Clean Air Act statute]. But I meant the implementing regulations (in the Code of Federal Regulations) ~ 10x. I knew EPA lawyers who enforced just one part of the CAA regs (e.g. mobile source rules) for decades.

I much appreciate this discussion, your solidarity “walk to Chicago”… CAA as a backup to a carbon tax might be point where some bargaining could happen. It might also help address the concern about a carbon tax not rising or not rising fast enough.

Commenter 3: I agree 99% with [C-2]. However, the 1% is that it’s not so easy to let the CAA “go slack”. It grants a lot of discretion to EPA about how to act but not over whether to do so. Mass v. EPA and the recent DC circuit ruling illustrate that EPA can be compelled to start the regulatory process, and that it is hard to stop it w/o legislation. I understand that summary elides over a political shift in the middle. I also agree strongly with the result in both cases (though I think the tailoring rule should go down if a plaintiff with standing can be found).

The CAA isn’t written as a menu option. It’s a powerful statute that’s hard to stop. Usually that’s a good thing. But not always, especially when you have a better tool in place. The best solution would be a carbon price with a CAA tweaked to serve specifically as a backstop tool. But that’s a big political ask.

JH: I take your word on the difficulty of letting CAA go slack… yes, a fall-back would be terrific. Would industry prefer a carbon tax (because of flexibility and lower cost) even with EPA as a fall-back?