Economists widely advocate establishing a price on carbon as a central means of reducing greenhouse gas emissions and the risks of global climatic disruption and ocean acidification. To be sure, a price on carbon is necessarily one part of a broader climate policy portfolio that includes diplomatic engagement, research, investments in adapting to a changing climate, assistance for vulnerable populations, and other aspects of the challenge.

But because market forces can be powerful and efficient agents for change, a policy to price carbon is arguably an indispensable part of the solution. Here we focus on one way to price carbon: through a tax or fee.

When it comes to developing an actual policy, a host of devilish details arise. Any carbon levy legislation would have to address a number of key design decisions—and serious tradeoffs arise across nearly all of them. How, for example, would the policy balance giving certainty to firms that make long-term investments, but still allow for updates as information, technology, and outcomes evolve?

What follows are eleven essential design questions to consider when designing a carbon charge. Each question has several potential answers with their own considerations, pro and con (recognizing that one person’s pro can be another person’s con). To inform your own thoughts on how a price on carbon should work, imagine you are a policymaker and think through how you would address each of the following questions. The goal here is to elucidate at a high level the options for carbon pricing policy design, not to build the case for a carbon price itself or quantify the benefits or costs of specific approaches. The hyperlinks will take you to further reading, but are not necessarily endorsements.

Click on a question below to jump to its discussion:

1. What is the name of the carbon pricing policy?

2. What greenhouse gas (GHG) sources and gases does the policy cover?

3. What’s the initial price and how does it change over time?

4. Who pays the carbon charge?

5. Who collects the revenue?

6. What happens to the revenue?

7. Does it change other Federal climate and energy policies, and if so how?

8. Does it constrain state-level policies?

9. Does it allow offsets (alternatives to paying a fee)?

10. Does it give credits or rebates for certain activities?

11. Does it include measures to reduce effects on U.S. competitiveness and emissions leakage?

1. What is the name of the carbon pricing policy?

Here we’re talking about a policy that economists typically call a carbon tax. This is shorthand; the tax is based on tons of carbon dioxide (CO2) and might cover non-CO2 greenhouse gases (such as methane, nitrous oxide, and certain industrial gases) as well, for example at a rate weighted by the global warming potential of each gas relative to CO2. A cap-and-trade or hybrid program can also impose a price on carbon emissions, but here we are focusing on the design of policy that sets a carbon price rather than an emissions quantity, recognizing that the various approaches can be designed to be similar in practice.

“Tax” is the term economists apply to most revenue instruments. Because imposing a new tax is potentially politically fraught, some people advocate calling a carbon pricing policy something besides a tax, such as a fee, levy, charge (PDF), or adder. Some would advocate referring not to carbon, but to climate pollution or some other term for greenhouse gas emissions. The best label is a judgement call; a variety of terms will appear here, but they all refer to the same thing.

A few points about using “tax” as a descriptor:

• Most existing state and federal fuel charges (e.g., on transportation fuels and coal) are called excise taxes, i.e. taxes like cigarette and alcohol taxes that apply on goods based on their volume or quantities, not their price.
• “Tax” is the legal term that applies to most collections by the U.S. Treasury’s Internal Revenue Service (IRS). The IRS also collects “user fees” for services it provides, such as making special determinations like whether a specific employer’s retirement plan meets IRS requirements.

Pros and cons of referring to the policy as a tax:

• A term other than tax may improve the appeal of the policy and make it easier for policymakers to vote for it.
• However, using a term other than tax could prompt charges of trying to hide the fact that the policy is functionally equivalent to a tax.
• Calling the policy a “tax” may be more attractive if it is part of a tax shift or swap, meaning at least some of the revenue is used to reduce other taxes.

Finally, the terms “penalty” and “fine” have unique considerations. For one thing, they carry the inaccurate connotation of emitters being in violation of the rules; when the IRS imposes penalties, it’s because someone underpaid their taxes. Also, fines and penalties are not typically deductible against business income.

2. What greenhouse gas (GHG) sources and gases does it cover?

Every tax needs a base to which it applies. Most obvious would be carbon dioxide. CO2 is known to contribute to climatic disruption and ocean acidification: it accounts for around 81 percent of all U.S. GHG emissions from human activities (PDF); 76 percent of total U.S. GHG emissions are CO2 from fossil fuel combustion. Since not all fossil fuels have the same carbon intensity, a levy on their carbon (either the carbon content before combustion or the carbon dioxide in their combustion gases) would raise the relative price of fossil fuels in proportion to their propensity to disrupt the climate. For example, natural gas has about half the carbon per unit of energy than coal. Renewables and nuclear power don’t emit carbon, so those energy sources would not be taxed. Some sources of non-fossil CO2 (for example from cement production) and some non-CO2 gases (such as landfill and coal bed methane emissions) may be feasible to tax. Including small sources expands the administrative burden, so it may be worth establishing some emissions threshold below which emissions are not subject to the charge.

All else equal, the more greenhouse gases and sources that are subject to the price, the greater the emissions reductions it will produce. Broad coverage also equalizes marginal incentives for abatement (the cost of that last ton of emissions reduced) across the economy. This ensures that investment in emissions abatement goes to the least-cost strategies and can lower the overall cost of achieving any particular emissions goal. It also incentivizes technology development across a wide range of emissions-reducing applications. However, for any given carbon price, broader coverage raises the scope of the macroeconomic impacts of the tax.

Policymakers could limit the pricing policy to certain sectors. For example, if a regulatory approach such as the Clean Power Plan covers the electricity sector, then policymakers could control emissions in other sectors with a fee. Likewise, if policymakers want a supplement or replacement for the tax on gasoline, they could impose a carbon tax only on diesel fuel and gasoline. This approach would produce less abatement and revenue than a GHG levy with broader coverage. It would also result in inefficient disparities in abatement incentives across sectors and may neglect opportunities for cost-effective environmental benefits.

Managing carbon fluxes from terrestrial ecosystems, such as agricultural soils and industrial forests, will be important to stabilizing GHG concentrations. Some of these carbon stock changes could be included under a carbon pricing policy, but doing so would involve policy design issues unique to these sectors, like figuring out how and whether to give credit for carbon stored in forests that may burn down later. In some cases, it may be better to use policy options other than carbon pricing for these sectors.

3. What’s the initial price and how does it change over time?

The starting rate and trajectory of the price are integral to the outcomes of the policy. All else equal, research shows that higher carbon prices will produce greater economic burdens but higher emissions abatement than lower carbon prices.

Not all sectors will respond at the same speed. For example, abatement is likely to come more slowly in the transport sector than the electricity sector, owing to the greater availability of low-cost, low-carbon technologies for power generation than for transport.

A carbon price that stays constant will reduce emissions for a time, but eventually emissions will probably start going up again owing to economic growth. Emissions will be still lower than they would have been without the policy, but they won’t necessarily keep going down. Accordingly, most economists would advocate a carbon price trajectory that goes up over time at a pace that encourages continued abatement even as the economy grows.

There’s a limit to how high the price can go and still encourage additional abatement. Carbon prices that are controversially high (however that is interpreted) can raise the risk that Congress will amend or repeal the policy. If investors believe the future price might be reduced, expected carbon prices could fall significantly below the statutory price and investors would pursue less abatement than they would if they thought the statutory price path would remain intact.

Options for setting a carbon price path and their pros and cons:

1. Congress could set a carbon fee equal to the present value of the environmental and social damages produced by each additional ton of CO2 emissions (or the equivalent in other GHGs), a value called the social cost of carbon (SCC).

• In theory, setting the tax path at the SCC would equate marginal damages to marginal costs and ensure that the abatement costs are justified by the benefits.
• The White House has adopted an estimate of the SCC for federal agencies (PDF) to use in analyzing the costs and benefits of regulations and other policies that affect GHG emissions. The SCC grows gradually over time in real terms. Congress could use this set of values to set the trajectory of the tax.
• In practice, using the SCC may have drawbacks. That’s because the estimated SCC is really a range of values that depend heavily on the discount rate, the appropriate value of which is much disputed. The SCC also involves large uncertainties and depends on judgements like whether to count just benefits to the United States or global benefits. It is also subject to sharp revision as new analyses become available. Also, the SCC adopted by the White House, however analytically developed, is ultimately controlled by the Executive branch. Congress may wish to control more directly the carbon price trajectory.

2. Another option is to establish a formula for the tax rate that evolves over time, for example with a specified initial value and change each year, such as a percent increase over inflation or an increase of $X per year.

• This would have the advantage of providing clear information for businesses and households that make long-term capital decisions and investments in new technology. It would also be relatively easy to administer, parties could reliably project their tax liabilities, and budget authorities could straightforwardly score the pending revenue.
• Without other policy measures or adjustments, this approach would not guarantee a particular emissions outcome. This could complicate ensuring compliance with an international pledge that is framed in emissions levels in a particular year.
• A formula like this would not take into account important developments, such as new evidence on the SCC, evolving climate pledges by the United States or other countries, macroeconomic conditions, and other outcomes that are important to stakeholders. This suggests some kind of periodic review and/or revision of the price trajectory would be warranted—more on that below.
• If the escalation is not capped at some point, the carbon price may become politically unsustainable or exceed estimates of the benefits of abatement.

3. An ambitious start and/or rapid increase would reduce emissions more quickly and spur technology development and deployment more sharply by increasing the returns to low carbon investments.

• It would also raise more revenue in the short run, which could help jump start whatever goals the revenue is meant to pursue. An ambitious start or rapid increase could also ensure that the environmental performance of the policy quickly surpasses the regulatory alternative.
• An ambitious start would create a bigger jump in fossil energy prices, which may galvanize opposition to the policy even as it motivates change. It would rapidly make some existing capital (like power plants or industrial facilities) uneconomic.

4. A modest start and gradual increase would allow businesses and households time to adjust their activities and lower their tax burdens.

• A gradual start and ramp up would impose lower abatement costs and help some companies preserve their international competitiveness. It would allow U.S. diplomats time to coordinate carbon pricing policies with other countries before the prices become more ambitious.
• It would also provide modest near-term climate benefits, particularly in sectors like transportation in which low-carbon alternatives are currently relatively costly.
• This approach may also make it harder to achieve deep decarbonization targets by mid-century. For example, a low carbon price may not prevent the irreversible decommissioning of higher-cost nuclear power that may be important for longer-term deeper decarbonization.
• A gradual price increase raises the probability that investors deploy lower—but not zero—carbon technologies like natural gas at greater scale. This could achieve modest climate goals cost effectively but may turn out to be uneconomic if climate policy becomes more stringent later.
• Even a modest carbon fee that rises slowly can raise enough revenue to lower other taxes, the deficit, or accomplish other fiscal goals. For example, according to CBO (see option 35 on page 176), a greenhouse gas tax that starts at $25/ton CO2-equivalent could raise over $1 trillion in the first 10 years.

5. Tying the carbon price to other tax changes (or vice versa) could help ensure the tax shift is revenue neutral, meaning that the policy package does not increase or decrease overall revenues to the federal government.

• This can be attractive to stakeholders who wish to ensure that the policy does not grow government.
• Ensuring exact revenue neutrality each year may lead to fluctuations in the carbon price or rates on other taxes that complicate the administration of the program and raise uncertainty for private sector investment decisions. The approach in British Columbia suggests that some such linkages are feasible.

Especially over the long run, it’s hard to predict how emissions levels and other outcomes will respond to any particular carbon price trajectory, even one in which the real price on carbon increases predictably each year. Thus it may make sense to build in a regular review of relevant information and plan for orderly updates to the carbon price trajectory (or other policies) depending on how things turn out. Any process for updating the carbon price path would introduce uncertainty for investors. Some would end up making abatement choices or undertaking R&D projects that turn out to be ill-suited to the revised policy. Thus, the updating question involves balancing the benefits of taking into account new information in policy-setting and the costs of any uncertainty introduced into investment incentives. This is probably one of the most difficult issues in the design of a carbon price policy.

Considerations regarding the process of revising the carbon price path

Some stakeholders focus on ensuring that emissions outcomes move towards a particular annual or cumulative goal. For example, what happens if the carbon tax isn’t producing emissions levels consistent with achieving the United States’ international commitments? Is there some process by which the tax path is increased, or is there some other policy approach that kicks in? Some stakeholders may be especially concerned about this question if the carbon pricing legislation repeals, suspends, or otherwise reduces EPA’s authority to regulate GHGs via the Clean Air Act (see question #7). They want to be sure that down the road that the tradeoff was a good deal for the climate. Certainly, if the president and Congress agree, they can legislatively change the carbon pricing policy at any time. But this is likely a heavy political lift and provides little reassurance to those most worried about emissions outcomes.

Congress could delegate the updating of the tax to the Executive Branch or a third party, such as an expert panel, with guidelines on the objectives they should pursue. However, Congress generally eschews delegating tax rates, and in some cases certain legal issues arise if Congress delegates significant matters. A number of other approaches, short of delegation, could inform or prompt changes in the carbon price path, including expert reviews, fast track authority, and automatic carbon price updates. It makes sense to conduct reviews of the carbon price every few years, for example to coincide with 5-year rounds of commitments under the UN Framework Convention on Climate Change (UNFCCC). Alternatively, the policy could trigger reviews in specific circumstances, such as hitting or not hitting certain emissions outcomes.

Policymakers could set a quantitative relationship between the carbon tax rate and the emissions outcomes, for example to raise the tax or its growth rate if emissions are higher than expected. This would encourage more certain emissions outcomes and boost support for the policy amongst some stakeholders. However, it might complicate the Congressional negotiations around a carbon price bill because not only would legislators have to agree on a tax path, they’d have to agree on the update process and any potential emissions targets or triggers that are embedded in it. Making updates infrequent and setting new tax values years in advance may simplify the administration of the policy and give more certainty to investors. If prospective increases are large, emitters might hasten their activities to take advantage of lower near-term tax rates. Using cumulative emissions rather than annual emissions would make adjustments less volatile.

Another approach could link emissions outcomes to amendments to other policies, such as regulatory authority (see question #7) or how the revenue is used (question #6). For example, if emissions are higher than expected, so are revenues. Policymakers could target the extra revenue towards further emissions abatement, such as a reverse auction for emissions reductions, incentive payments for soil or forest carbon sequestration, or international funds, such as the Green Climate Fund.

In theory, an updating process could also result in a lower fee trajectory, for example if the process allows taking into account factors such as: economic outcomes are worse than expected; new technologies can decarbonize the economy at unexpectedly low cost, so a big tax isn’t necessary; or new scientific evidence suggests climate change is less damaging than previously thought. A policy design that can raise OR lower carbon prices introduces another dimension of uncertainty for investors. This could dampen investments in lower carbon technologies that would only find a market at higher carbon prices.

4. Who pays the carbon charge?

Any carbon pricing policy has to identify a particular set of actors who would be responsible for paying the charge. For example, the charge could apply to producers, processors, or distributors of fossil fuels, or it could apply to those who actually burn the fuels, such as power plants and industrial facilities – or even individuals when they put gasoline in their cars. We call this the point of taxation. In general, the economic outcomes don’t depend on which entities pay the levy to the government. Taxed firms will pass costs along to suppliers, consumers, and workers to the extent they can through prices and wages.

Pros and cons of different points of taxation:

• Each fuel has a different chain of supply, so there are different points at which the government could impose the carbon charge. Applying the charge at the chokepoint of each fuel’s distribution system would minimize the number of taxpayers and maximize the coverage of the policy. However, it may then be appropriate to give credits to downstream firms in cases where the carbon doesn’t end up in the atmosphere (see question #10). A chokepoint approach would not work as well if certain downstream sectors are exempt from the tax. For natural gas and petroleum, the chokepoint of the distribution system may closer to midstream (at processing and refining facilities) than upstream at wellheads. The Congressional Research Service estimates (PDF) that the levy could apply to fewer than 2,300 entities and yet cover 80 percent of U.S. domestic GHG emissions.
• An upstream charge imposes the price at the start of the fossil energy distribution system, such as at the coal mine mouth, natural gas wellheads, oil wells, and international borders. The carbon content of coal per ton produced can vary a lot across different coal deposits, as may the carbon content of oil. Thus, a well-targeted upstream approach would need to keep track of the differences and apply the appropriate fee.
• To fully cover GHG emissions in the fossil fuel supply chain, emissions in the fuel production process, for example natural gas flaring and venting should be taxed as well.
• A mid- to downstream approach would price fossil carbon at power plants and other large industrial facilities. This could build on EPA’s GHG reporting system for large stationary sources. It could also allow emissions to be measured by continuous emissions monitoring (CEM) equipment that these facilities use to comply with existing pollution regulations. However, in some co-firing facilities, the CEM approach might make it hard to distinguish CO2 emissions from fossil fuels and those that derive from biomass (which may not be subject to the carbon charge) in the fuel supply.
• A fully downstream approach, such as carbon-based surcharges on household natural gas bills, would make the price signal more obvious to consumers– what economists call saliency. This could be more environmentally effective if it makes people pay more attention to (and reduce) their energy consumption, but regular reminders of the tax might also engender more opposition. The value of tax salience at the household level may be limited because many of the most significant emissions reduction strategies are further upstream, such as in the fuel choice for electricity generation. Downstream approaches could involve vastly more taxpayers and may exclude relatively small emitters.

5. Who collects the revenue?

The legislation must give authority to collect the tax or fee to a specific federal agency. The most likely candidates would be the U.S. Treasury and the Environmental Protection Agency (EPA).

The U.S. Treasury currently collects several federal fuel-related excise taxes, including a tax on most coal produced in the United States (PDF) that funds the Black Lung Disability Trust Fund. The agency has deep expertise in collecting and managing large flows of funds. It would be the logical collection authority for any policy labeled a tax, although Treasury could do the job even if the label is something other than tax.

The EPA collects emissions data from large emitters and enforces limits on those emissions. For example, EPA could collect GHG fees from the sources the agency already regulates (see question #4). Even a modest carbon charge would produce far more revenue than EPA has ever handled, and giving EPA what amounts to taxing authority (even if the policy is labeled a fee) would be opposed by some stakeholders.

6. What happens to the revenue?

One of the biggest challenges of designing a carbon charge is working out what to do with the revenue. This question has big implications for its political appeal, distributional outcomes, and overall net benefits of the policy. (Some ways to price carbon, like a cap-and-trade program that gives away free allowances or a hybrid program, wouldn’t involve the government collecting revenue, but they would involve resource allocations with similar underlying implications.)

Assuming we are in the mode of designing a tax-like policy, policymakers can pursue at least three alternative policy goals (PDF) with the considerable revenue from the tax:

1. Offset the new burdens that a carbon price places on consumers, producers, communities, and the broader economy
   
2. Support further efforts to reduce greenhouse gas emissions or build resilience to climatic disruption
   
3. Fund priorities unrelated to climate
   

Each of these approaches has strengths and weakness, and important tradeoffs across different goals arise. One of the most important aspects of this question (although it’s not easy to predict) is how the use of revenue affects the potential for a legislative deal and, after that, the political durability of the program. Climatic disruption and ocean acidification are challenges that will span generations, so the long-term persistence of the carbon price is critical. Many emissions-reducing investments involve large expenditures on long-lived capital, such as power plants and industrial facilities. A carbon pricing policy that businesses and individuals believe will endure will be more environmentally successful and more economically efficient than one that

      

 

 

Recently, the Climate and Energy Economics Project at Brookings hosted two former governors along with environmental policy experts to discuss the Clean Power Plan, its importance, the challenges it faces, and how the United States can be a role model for decarbonization. Former Governors Bill Ritter (D-CO) and Christie Todd Whitman (R-NJ) discussed the drastic impact of the environment on national security, how states can continue work on implementation plans despite the uncertainty created by the Supreme Court, and the U.S.’s commitments to the international community. The conversation was moderated by Economic Studies Senior Fellow Adele Morris.

Governor Whitman framed clean energy as a health issue for the country. She noted that 93,000 people died from dirty air in the United States in 2013 and lamented that this problem does not get enough attention from the American public or politicians. Watch:

In his opening remarks, Governor Ritter discussed individual state actions to decarbonize and explained what the current Supreme Court decision means for the movement. Watch:

Governor Whitman, while lauding the international community’s actions to preserve the environment, explained how positive actions taken by the U.S. are undermined by its failure to live up to commitments it has made to the international community. She argued that the U.S.’s failure to sign the Kyoto Protocol or meet its decarbonization promises is equivalent to “flipping the bird” to countries that care about energy emissions. Watch:

Governor Ritter expressed disappointment in Congress’s lack of decisive action on decarbonization and other climate measures. He praised the Clean Power Plan as the “crown jewel of Obama’s Climate Action Plan” and commended the recent and coming actions on energy policy made by the international community. Watch:

This event also included a panel discussion with experts on environmental policy and politics who discussed data issues, political sustainability, and the role of state and local governments in energy policy and the implementation of the Clean Power Plan. This panel included Greg R. White, executive director of the National Association of Regulatory Utility Commissioners; Jonas Monast, director of the Climate and Energy Program at Duke University; Josh Linn of Resources for the Future, and Brookings Fellow Philip A. Wallach.

Get the full event video here.

Brennan Hoban contributed to this piece

      

 

 

On February 22, Economic Studies at Brookings hosted an event to discuss theses issues. Presenters and panelists took questions from the audience.

      

 

 

Over the last decade, China has adopted measures to lower the energy and carbon intensity of its economy, partly in response to worsening local air pollution from energy generation. At the 21st Conference of the Parties (COP) to the United Nations Framework on Climate Change (UNFCCC), held in Paris in late 2015, China committed to furthering its efforts by affirming its previously announced goal to cause its emissions to peak around 2030 and to increase the share of non-fossil fuels in its primary energy consumption to around 20 percent by the same year. 

China’s intended nationally-determined contribution (INDC) to the Paris accord also puts forward two new goals for 2030: reducing China’s CO2 emissions per unit of GDP (known as its carbon intensity) by 60 to 65 percent relative to 2005 levels, and increasing the volume of its forest carbon stock by around 4.5 billion cubic meters from 2005 levels.

In a new paper titled China’s carbon future: A model-based analysis, Warwick J. McKibbin, Adele C. Morris, Peter J. Wilcoxen, and Weifeng Liu model the policies China could adopt to achieve its energy-related INDC commitments with an eye to understanding how the policies could affect both the Chinese and global economies. 

The model

In the analysis, the authors use an updated version of the G-Cubed model, a global intertemporal computable general equilibrium (CGE) model, to explore the possible effects of emissions control policies on the Chinese macroeconomy, individual industrial sectors in China, and other outcomes, such as trade flows, currency values, emissions levels, and economic activity. 

The major innovation in the version of the G-Cubed model used in this paper is a significant disaggregation of electricity generation technologies with a focus on non-fossil fuel technologies.

Findings 

The results of the authors’ analysis show that illustrative policies to achieve China’s commitment to cause its emissions to peak in 2030 imply a substantial departure from baseline emissions, even after accounting for large baseline reductions in China’s emissions intensity. 

In the scenarios, Chinese emissions are 6 percent lower than baseline in 2020, 26 percent lower in 2040 and 33 percent lower by 2050. The reductions come at a cost; in 2030 in the policy scenarios, China’s real GDP would be about 1.5 percent lower than baseline, and real wages would grow less rapidly than they otherwise would have. At the same time, the target appears quite credible: the changes to peak emissions in 2030 are manageable for a country that will be growing rapidly in the coming decades and do not involve disruptions that would be likely to cause the commitment to be abandoned.

The authors also find that China’s policies to control emissions have little effect on emissions elsewhere; there is almost no shift in emissions from China to its trade partners. There are, however, small reductions in real GDP in other countries as China’s economy grows more slowly than under the baseline. Those changes are most important for Eastern Europe and the Former Soviet Union and OPEC, and are very small for Europe and the United States. Thus the authors find that countries that import energy-intensive goods from China would bear little of the burden of Chinese emissions control efforts.

You can download the full paper here.

      

 

 

Reuters/Stephane Mahe – Laurent Fabius, Ban Ki-moon and Christiana Figueres hold apples marked with the logo of the World Climate Change Conference 2015 during a meeting at Le Bourget, near Paris, France, December 7, 2015

Climate change is an enormously complicated problem, perhaps the most complicated ever tackled by international negotiations. At its core, it is about the way societies fuel their economic activity. For most of the modern period, economic growth and energy growth have moved in lockstep. Only in the last two years have we seen even the beginnings of a decoupling of energy growth from greenhouse gas emissions. And, at present, in most countries the forms of energy that power economic growth are those with the highest concentrations of carbon—oil and coal. Natural gas is an important bridge technology, or at least it can be if fugitive methane is controlled (and it probably can be). Ultimately, of course, carbon-free energy is the answer—but a widespread shift from plentiful, low cost forms of energy (principally oil and coal and now gas) to mostly-still-expensive renewables and nuclear has yet to materialize.

Climate change and the great power dynamics

Seen through that lens, criticisms of the UNFCCC for having failed so far to craft a legally binding global climate deal are absurd. Is it really conceivable that an inclusive, diplomatic body engaging the foreign and environmental policy ministries of 193 countries, and working broadly by consensus, is the right body to chart the pathway toward a hugely complicated economic transition? A transition, moreover, that matters most in a handful of countries. We talk about climate change as a global problem—and obviously, the consequences of climate change are global. But it only takes three economies—the United States, China and India—to get to more than 40% of all global greenhouse gas emissions. Add the European Union and you reach 75% of global greenhouse gas output.[1] Climate change may be the ultimate global issue in its consequences, but the driving dynamics are those of great powers.  

We need the U.N. to be the umbrella under which real negotiations happen, not the venue of those negotiations themselves.

And the great or major power dynamics here are complicated enough. Climate change is not actually a “we are all in one boat” problem. Yes, many countries will suffer if the world gets dramatically hotter—but not all countries, and not equally. We know an increasing amount about who will lose (India, North Africa, the American Midwest) and who will win (the UK, parts of northern Europe) in a slightly hotter world. A shift toward unpredictable weather and rising seas is uncharted and worrying territory, but a future loss of agricultural productivity (the first and most likely economic consequence of a hotter world) is a distant worry for an Indian farmer currently toiling well below the poverty line and with no access to modern power. India and the United States, increasingly aligned on strategic issues, are in opposite worlds when it comes to climate change mitigation.

Weaknesses of the UNFCC negotiation process

The UNFCCC process to date has had one major advantage: it carries the perceived legitimacy that comes from the slow, grinding, and frustrating but genuinely inclusive process that characterizes contemporary global negotiations. For setting up a broad policy framework and a set of global goals, inclusion is the right way to go. For getting action, not so much.

The UNFCCC process, for all its legitimacy, has two deep weaknesses that will have to be left behind if we’re going to start crafting genuine economic and energy policy that puts us on a path toward limiting global temperature rises to between 1.5° and 4° Celsius.[2]

First, it’s too inclusive. That’s not a politically correct sentiment in multilateral circles, but it’s a reality. Historically, the UNFCCC has worked on what’s known as the “hard consensus” rule, which has meant achieving unanimity to craft an agreement. This led to the absurd consequence of a deal brokered by President Obama in Copenhagen, brokered with China, India, Brazil, and South Africa, and that garnered support from the EU and many other countries—a deal, in short, that captured well over 90 percent of global carbon emissions—being blocked by those titans of economic power, Bolivia and Venezuela. That’s not a democratic system, as its champions would claim; that’s the tyranny of the (tiny) minority.

Recently, in an important deal crafted under Mexican leadership in 2013-14, the UNFCCC has moved away from hard consensus toward more typical consensus rules—which at the UN normally mean that the vast majority of countries have to agree, and every important country has to agree, but small, irrelevant players can’t block progress. That’s a step in the right direction, but a small step. Even with softer consensus rules, the weight of UN climate negotiations is still tilted heavily toward small, developing states. They have every moral right to a seat at the table and a voice in global climate negotiations. But the hard, costly mitigation measures must be taken by the world’s top economies. When it comes down to brass tacks, an inclusive concern with the legitimate interests of the 160 countries that collectively make up less than 10 percent of global emissions is a distraction.  

The second problem with the UN negotiations is that some policymakers with the most powerful levers to effect change, particularly finance ministers, are largely absent from the mitigation negotiations. In almost all major markets, energy policy comes out of a complex—and often combative—interaction between regulatory agencies, economic agencies, sub-federal regulators, and the private sector, and the those who prevail in those debates aren’t necessarily responsible for climate negotiations. In particular, to the extent that climate commitments can compromise domestic economic growth or trade competitiveness, environment ministries may not be the real agenda-setting authorities. A key way to align mitigation commitments and the real authority to meet them is to involve the most powerful ministers more directly in climate talks.

Reuters/Stephane Mahe – Laurent Fabius, Ban Ki-moon and Christiana Figueres during the World Climate Change Conference 2015 at Le Bourget, near Paris, France, December 5, 2015

Faced with these challenges, the UN has taken two smart approaches. One is a focus on goals over concrete policy agreements, and another is to forge networks for public-private dialogue on those goals. That’s a reasonable scope of efforts for the goal-setting stage of these negotiations, and the men and women who’ve worked endless hours to get us a deal at Paris deserve far more recognition and honor than they are likely to get. Now that we have a deal at Paris, they should take a bow and then a back seat.   

The UNFCCC vs. the G-20 vs. the MEF

That doesn’t mean that the UNFCCC should close up shop; rather, its normative and goal-setting and legal work has to be actively supplemented by more specific economic and energy policy discussions among the major economies in a body like the G-20 or the Major Economies Forum (MEF). The MEF and the G-20 each have their strengths and weakness on energy policy. The MEF has more energy policy in its DNA—it was established by the Bush administration with the more honest name of the Major Emitters Forum, precisely as a tool to discuss energy and climate policy. At birth, though, it was viewed by the major emerging powers (correctly) as an effort by the administration to undermine the UN and treated accordingly with distrust by countries like China.

The G-20 has the opposite strengths and weakness: the major emerging economies were ”present at creation” of the G-20 and view it favorably, but the G-20 has repeatedly shied away from tackling climate problems—even when it’s dealing with an issue like global infrastructure spending, which dominates the current G-20 agenda and is hugely consequential for shaping emissions trajectories. (Build a trillion-dollar infrastructure for oil and automobiles and that’s what we’re going to be using for the foreseeable future; build it for gas and rail and we’re on a different carbon pathway). The G-20 was supposed to tackle energy subsidies but has done so only rhetorically. Still, such decisions were made by men and can be undone by men and women. The G-20 (perhaps minus unhelpful Saudi Arabia) could create a working group on energy and climate policy that would do much to bridge under-communicating worlds of climate negotiations and real world energy/economic policy.

The men and women who would negotiate policy in a body like this are likely, given the domestic ministries they will come from, to have a better understanding of the economic implications of their commitments, and thus to craft more feasible and effective agreements. Of course, while macroeconomic and sector-specific outcomes matter, the private sector should not have a veto over climate policy; commercial interests are often misaligned with ambitious climate policy, and accountable officials should make decisions focused on the public interest. At least the natural gas revolution—by creating a profit stream for energy majors in a fuel that’s less carbon intensive than coal—has given some fossil producers a potentially productive role in the debate, the occasional energy dinosaur and most hard core climate activists notwithstanding. Among the more moderate actors on both sides we see the outlines of what Brookings President Strobe Talbott has called as “pragmatic caucus” around which genuine solutions could be built. 

Balancing inclusion with efficiency

But if energy and climate policy shift to a major economies body like the G-20 or an equivalent, won’t the small countries and the developing world cry foul? They will, and they have good cause—they need a solution to climate change because they’ll be first in suffering the consequences of rising global temperatures, and they deserve a seat at the table as those solutions are crafted. So how to marry the legitimacy of inclusion with the efficacy of small group settings for the domestic policy actors of the small handful of countries that will have to do the heavy lifting?

And the great or major power dynamics here are complicated enough. Climate change is not actually a “we are all in one boat” problem. Yes, many countries will suffer if the world gets dramatically hotter—but not all countries, and not equally.

One option—which one of us first explored in a book with Carlos Pascual and Stephen Stedman—is to iterate the negotiations. In the U.S., legislation starts with an individual member of Congress or a small team; goes to a series of committees; then to the floor; and possibly back and forth between committees and the floor for refinement. In the international arena, we could think of this happening in reverse. To sustain a sense of international legitimacy, we would treat the Paris agreement as setting overarching emissions objectives for the next few years. The deal would then go to a variety of smaller “committees”—like the MEF or a G-20 Working Group on Energy—for far more detailed discussion of how countries will implement their commitments. The annual Conference of the Parties meetings can evolve into a vehicle for those smaller “committees” to report back to the global whole about progress. Smaller countries and developing states could voice their concerns and make their own (necessarily modest) contributions. The real mitigation action would lie with the major economies, and their talks would foster policy tools that allow cooperation and comparison, such GHG pricing measures. These talks would not be imposing a great powers’ solution on the world; they’d be acting within the mandate agreed at the COP.

The road ahead on climate change

Climate change is undoubtedly the hardest economic and social problem of our time. Inclusive diplomatic negotiations and some creativity on the part of the UN—all critically boosted, it should be stressed, by vital U.S.-China joint announcements in November 2014 and September 2015—will, by the time of Paris, conclude the first phase by crafting a global policy agreement. That will send an important message to those who’ve denied that climate change is a real problem, or sought to obstruct progress: get out of the way.

Reuters/Jacky Naegelen – Children of AVAAZ NGO activist group hold letters reading “farewell fossil fuels” as they demontrate at the entrance of the venue for the World Climate Change Conference 2015 in Le Bourget, near Paris, France, December 11, 2015

But Paris should also be a turning point away from the unproductive business of making broad declarative goals that are largely divorced from the economics of achieving them. Paris shouldn’t be a milestone, but rather a launching pad for a new phase of productive, practical conversations about the economic policies that can most cost effectively shift the global energy mix.

      

 

 

Since the release of the final rule, much attention has been given to how states can trade emissions allowances across borders to reach goals jointly, allowing more abatement where costs are lowest. The requirements for these complicated schemes occupy hundreds of pages of the rule, while EPA devotes only one sentence (in the preamble) to the potentially equally cost-minimizing carbon tax approach. The agency clearly prefers cap-and-trade over other options, as evidenced by the detail in the rule and EPA’s accompanying proposed federal plan for states who do not submit an acceptable (or any) implementation plan.

However, another factor accounts for EPA’s apparent short shrift for a tax approach: the concept is remarkably simple to understand—one-sentence simple—and just as easy to administer. By gradually increasing the cost of emitting greenhouse gases from coal- and natural gas-fired power plants by charging a per-ton fee for the CO₂ emissions the plants already monitor, states could both reduce electricity demand from fossil fuel sources and level the playing field for zero-emissions alternatives like wind and solar. States already know how to implement such a tax; every state already taxes fuels such as gasoline, diesel, and natural gas. A state would just need to show, by modeling (the kind EPA already does), that its proposed carbon tax trajectory will hit its Clean Power Plan target and be prepared to adjust it or take other actions if emissions are off course.

This simplicity can provide real economic and environmental benefits. British Columbia, the first government in North America to implement a straight-up carbon tax, reduced its emissions 7.1 times faster than analysts expected, in part because the transparent and predictable price signal allowed business and consumers to invest efficiently and with foresight. A new paper from the Brookings Institution shows that a carbon tax has a slight efficiency edge over tradable performance standards. And, unlike trading schemes, a carbon tax won’t transfer ratepayer dollars from one state to utilities in other states.

The benefits of a carbon tax, state or federal, will depend heavily on how the revenue is used. States could use the revenue any way they wish, including giving dividends to households or swapping out other taxes. Studies show that the most cost-effective policy would lower (or prevent increasing) other taxes that discourage working, investing, and saving. States could also use revenue to protect low-income households from energy cost increases, assist coal workers in the energy transition, fund climate adaptation, repair infrastructure, reduce budget shortfalls, or pursue other goals.

Importantly, states that adopt a carbon tax can demonstrate the policy’s viability and inform both federal and international efforts. The Clean Power Plan, assuming it survives the inevitable litigation, addresses just one sector in one country through 2030. To stabilize concentrations of greenhouse gases in the atmosphere, stronger and more coherent and transformative legislation, carefully leveraged to achieve ambitious action abroad, will be essential, and economists agree that pricing carbon is a core strategy.

Already there are campaigns underway to put a price tag on climate pollution in Massachusetts, New York, Oregon, Rhode Island, Washington, and Vermont; the approach would be even better-suited to states like Illinois, who need to make significant greenhouse gas reductions and have unfunded liabilities. State innovations have led to some of the biggest federal policy changes in our nation. By allowing states to pursue fees on carbon, the Clean Power Plan opens the door for states to lead once again.

      

 

 

Both reports are based on a global economic model. The results in these reports should be treated very cautiously because of the enormous uncertainty involved. The outcomes for the consequences of any particular emission target depend on many factors such as the particular model used, the future projections of the world economy which would occur without the imposition of a carbon target and the nature of the policies that are actually used to reach any given emissions targets. The usefulness of applying a well-documented and transparent model to evaluate policies is that the assumptions are clear and the key sensitivities in the analysis can be explored to get a better idea of the range of possible costs for a given target. It is easy to argue that a policy would devastate an economy or would be costless, but a model based exercise forces the analyst to be explicit in the assumptions that are required to generate these alternative worlds. Models can easily be criticized but the alternative is worse, a good deal more flexible and very popular with extreme proponents in any debate.

The first report explored the impact on the global economy if all major countries (except Australia) achieved the targets they have pledged, either with the policies they proposed or with a reasonably efficient policy in lieu of an actual policy announcement. Many countries have pledged energy efficiency improvements which in many cases appears to be a “free lunch”. Someone has to pay for improvement in energy efficiency and this was explicitly taken into account in the modeling. The focus of the report was what impact this would have on the global and Australian economies and key sectors by 2030.

It is no surprise that fossil fuel industries in Australia were most affected with coal bearing the largest costs. Coal exports by 2030 are estimate to be about 7.8% lower than otherwise and coal production in Australia 8.3% lower (although still higher than 2015 levels). Exports of non-fossil fuels sectors are projected to rise, as a weaker Australian dollar would make these other sectors more competitive in global markets. Overall Australian GDP would be roughly 0.16% lower than otherwise by 2030 – or if the absence of an Australian policy response increased the risk in the energy sector, this loss might be doubled.

The second study considered four alternative emission targets for Australia: reductions of 13%, 26%, 35% and 45% relative to 2005 emissions. Also considered were the costs of alternative energy options in electricity generation and the impact of access to international credits.

In considering the impact on overall GDP, there are at least three different ways of measuring these impacts. Commentators have chosen whichever measure suits their argument. You can compare the level of GDP lost in 2030 relative to what would have been without the Paris commitments. GDP is 0.6% lower than it would otherwise be in 2030. This translates into a GDP loss in 2030 of around $20 billion. You can also calculate the sum of GDP lost each year until 2030 to get a cumulative GDP loss by 2030 which is close to $200 billion. If you calculate the impact on the average growth rate from 2015 to 2030 then the rate of economic growth is roughly 0.01% lower. All of these figures mean the same thing when scaled by the appropriate metric. Whether this is a large or a small cost is in the eyes of the reader.

Another lesson from the analysis is that if international permits are available and if they are as cheap as they are today (the assumption of the modeling) then this cost might be reduced by 50%. If the cost of international permits where higher than the cost of reducing carbon domestically then none would be used and the economic costs would be unchanged by this option. If technology costs are cheaper than expected then this figure might also be reduced but if they are higher then this cost would rise. There is a wide range of uncertainty on the economic costs just as there is a wide range of uncertainty over the impact of carbon emissions on temperatures.

In summary, the report finds that Australia’s target of 26% to 28% below 2005 emissions, when compared to other countries in terms of economic costs, is at the high end of the commitments made by all countries for Paris. The extent of effort is better measured by the economic costs than the size of the target. The size of the global target is important for climate change but an equal allocation across countries is not a measure of effort. It is a political measure used for political purposes.

In aggregate, it is reasonable to argue that the Paris commitments by all countries are not sufficient to meet the reductions estimated by many climate scientists that are needed to avoid two degrees of warming. However to argue that Australia is not making a large contribution to the overall effort for Paris is incorrect. Only focusing on the emissions target is playing politics. Until the economic costs relative to the environmental benefits are at the core of the global response, there will not be an effective global agreement.

Editor’s Note: This op-ed originally appeared in The Australian Financial Review

      

 

 

We choose these two approaches because they resemble two key options facing policymakers: continue implementing a performance standard approach under the Clean Air Act or adopt an excise tax on the carbon content of fossil fuels instead. Our goal is to highlight the important high-level differences in these basic approaches, abstracting from the details of specific policy proposals. We explore a wide variety of the illustrative policies’ economic outcomes including: changes in capital stocks and electricity production across eight types of generators, changes in end-user electricity prices, changes in gross domestic product (GDP), overall welfare impacts on the household sector and, finally, one outcome represented in the G-Cubed model and few others: short to medium-run changes in aggregate employment.

We find that a national tradable performance standard (TPS) of the ambition reflected in EPA’s draft Clean Power Plan (CPP) could achieve a significant reduction in future economy-wide emissions relative to business as usual, and would stabilize emissions from electricity generation through 2030 with only a very small reduction in GDP. A carbon tax on fuel purchased by the electric sector would have a similarly small effect on GDP but would be slightly more efficient.

While both policies would have similar and relatively modest effects on the economy as a whole, they have markedly different effects on the electricity generation sector. For an equivalent effect on electric sector emissions, a TPS produces a significantly larger shift to non-fossil generation as a result of the large credit payments it induces between the fossil and non-fossil generating sectors. However, a carbon tax, which shifts some revenue to households through the tax system, produces a slightly better economy-wide outcome as measured by equivalent variation. Both policies cause a variety of reallocations of investment and employment between the clean energy sectors and the rest of the economy.

Finally, it is important to note that many of our key results are robust to wide variations in the assumed elasticity of substitution between different generation technologies. Effects on electricity prices, overall GDP, employment and welfare are modest and change little in response to changes in the elasticity. However, some results are more sensitive: as it becomes easier to substitute between energy generation technologies (particularly between fossil and non-fossil technologies), the price of a TPS credit falls, as does the size of the carbon tax, and the many of the outcomes under the two policies tend to converge. On the other hand, as it becomes more difficult to substitute generation technologies, the differences between the TPS and the carbon tax become larger, as does the efficiency advantage of the carbon tax.

1. See McKibbin and Wilcoxen (2013).  The version in this paper is 124e.

      

 

 

As follow-up to my most recent testimony, I was asked to submit written comments on my view of the American Energy Efficiency Act (S.1063) sponsored by Senator Al Franken (D-MN). Although the bill’s title refers to “energy efficiency,” and the first line states that the goal is “to establish a Federal energy efficiency resource standard for electricity and natural gas suppliers,” the bill does not actually address efficiency. Energy efficiency standards typically set limits on the ratio of energy output (e.g., BTUs) to energy input (e.g., watts). In contrast, the Franken bill establishes a supplier-specific cap on electricity and natural gas delivery rather than addressing efficiency directly.

Caps on energy or energy efficiency are less cost-effective than a price on pollution because they afford less flexibility. For example, in the case of air conditioners, energy-efficiency standards do not give purchasers any incentive to reduce the number or size of air conditioners that might be purchased or how much each of them will be run; only the energy-efficiency of a particular-sized model is regulated. 

The Franken bill mandates that each retail electricity supplier reduce the amount of electricity it produces or supplies relative to the three years before compliance begins, starting with a 1 percent reduction in 2017 and increasing to a 20 percent reduction in 2030. Each natural gas supplier must reduce the amount of natural gas not going to electricity by 0.50 percent in 2017, increasing to a 13 percent reduction in 2030.  (Natural gas going towards electricity is covered by the electricity cap.)

These are quotas on electricity and natural gas that apply individually to each supplier, which means there is no flexibility for different electricity or natural gas levels across suppliers. Across-supplier flexibility would lower costs (while maintaining the same overall cap) because sources could search for the lowest cost actions across the entire regulated sector.

The bill highlights the problem with targeting electricity or natural gas (or any other energy source) rather than targeting pollution directly. The problem with energy use is that we use too much of it because the costs to the environment are not included in the pricing. The optimal response is to charge a price for polluting (whether with a tax or through cap-and-trade), which would raise the price of each energy source in proportion to its pollution cost. Targeting electricity or natural gas (or energy efficiency for appliances or mileage standards for cars or any number of other things) rather than pollution misses the mark. Indeed, in the case of electricity it isn’t certain that a quota would reduce greenhouse gases, the main pollutant of concern. For one, the required reductions in electricity might be achieved by cutting back on clean forms of energy, such as wind and solar power. And by establishing facility-specific quotas rather than a broad cap-and-trade or tax for pollution, total emissions could increase with the emergence of new (albeit regulated) facilities. It is also conceivable that the optimal way to reduce greenhouse gases is to shift our transportation sector towards electric vehicles, which would mean we want more electricity rather than less in order to cost-effectively reduce greenhouse gas emissions. This quota plan is yet another example of how we are pursuing poorly targeted and inefficient regulations instead of the economically sound approach of pricing pollution.

      

 

 

On May 18, Vitor Gaspar, director of the IMF’s Fiscal Affairs Department, presented the key findings of the study. First, energy subsidies are dramatically higher than previously estimated, and projected to remain high despite the sharp decline in international energy prices. Second, the vast majority of energy subsidies reflect domestic externalities, so countries should move ahead with energy subsidy reform unilaterally in their own interests. Third, the potential fiscal, environmental and welfare impacts of energy subsidy reform are substantial. A panel discussion followed and included a question and answer session with the audience.

Download presentation slides.

 Follow the discussion @BrookingsEcon or #EnergySubsidies.