Now Is the Time to Implement a Carbon Tax

Editor’s Note: This is the first of two posts on market-based approaches to reducing carbon emissions. Today’s focuses on a carbon tax; tomorrow’s on real-time pricing of electricity.

There is a broad consensus among economists that we will not be able to mitigate climate change efficiently and effectively unless we place a price on carbon. Placing a price on carbon of $40 per ton or more would discourage use of carbon-based fuels. That, in turn, would reduce significantly the quantity of carbon dioxide, the most important greenhouse gas (GHG), that is emitted into the atmosphere.

Placing a price on carbon creates powerful incentives of two types. First, it encourages consumers to devise and implement methods of reducing their use of products and services that account for large emissions of GHGs. Second, it encourages tens of thousands of companies to increase significantly their research and development efforts along every margin that has the potential to reduce GHG emissions. An army of firms will have a powerful economic incentive to find and to implement new methods of using carbon-free or low carbon sources of energy to replace the high carbon fuels that dominate the vehicle and power generation sectors of the economy today. The most important incentive effect will be to encourage innovative firms and individuals to discover and to implement new, more efficient methods of satisfying human needs that will reduce emissions of GHGs by reducing energy consumption. I cannot predict what combination of energy sources and efficiency-enhancing methods and equipment will emerge from this market-driven rush to reduce emissions of GHGs, but I can predict that it will yield a rich and cost-effective mix.

There are two ways of pricing carbon—a carbon tax and a cap and trade system. I strongly prefer a carbon tax. Yale Professor William Nordhaus has explained in detail why a carbon tax has economic effects that make it superior to a cap and trade system. The European Union adopted a cap and trade system about a decade ago. It has produced disappointing results. The price of carbon yielded by the EU cap and trade program has varied significantly, thereby reducing the incentive to invest in the research and development efforts that can reduce emissions of GHGs. For lengthy periods, the EU cap and trade system has produced a carbon price as low as $6 per ton—a price that is far too low to have any significant incentive effects.

There are four reasons to think that now is the right time to persuade our political leaders to adopt a carbon tax.

First, the evidence of the existence and adverse effects of anthropomorphic climate change is mounting rapidly. As that evidence increases, a higher proportion of the public will see climate change as a serious threat that requires a serious response. The government’s new emphasis on describing and explaining the many painful and costly measures that will be required to adapt to the major changes in climate that will occur if we do not mitigate climate change should help to sway public opinion. CPR’s Member Scholars recently had the privilege of hearing a description of some of those adaptation measures from the EPA official who is responsible for the new government program to educate the public about the high costs of adaptation. That presentation was so well crafted that it is has the potential to persuade even the most committed climate-change denier to reconsider his position.

Second, on May 12, 2015, Yale University announced its decision to adopt and to apply to itself a $40 per ton carbon tax. The chair of the committee that recommended the adoption of the carbon charge explained the university’s decision by referring to the effects of a carbon tax on incentives. “The benefit of a carbon charge at Yale is that it would be an incentive for everyone to work to reduce greenhouse gas emissions on campus,” according to a summary of his remarks on the Yale website. He went on to say that a revenue-neutral carbon “tax” is not really a tax, because units of the university would receive either a charge or a rebate, depending on whether their emissions exceeded or ran below a base level .” Since “the sum of the base is the sum of the emissions,”  he said, total charges and rebates around the university would likely cancel each other out. I hope that the words of the Yale Provost when he announced the program prove to be prophetic: “We believe that this proposal can serve as a model for other institutions, expanding Yale’s role as a pioneer in researching, teaching, and designing innovative solutions to climate change.”

Third, on May 21 and 22, 2015, 2,000 major companies met in Paris to discuss climate change. They concluded their meeting by urging governments around the world to implement measures “that can tap the innovation of industry and the capital of banks to focus on climate change solutions” by adopting a “sufficiently high carbon price.” The CEO of the company that is one of the largest suppliers of electricity in Europe and the second largest supplier of solar energy in the world described the effects of placing a sufficiently high price on carbon on his company’s behavior:  a carbon price would “accelerate” implementation of his company’s “three prong strategy .  .  .  of ending routine gas flaring and shifting from coal to natural gas, alongside a focus on lower emissions through energy efficiency innovation.”           

 Fourth, on June 18, 2014, EPA proposed the most ambitious and most controversial climate change rule that any environmental protection agency has ever proposed. The Clean Power Plan for Existing Power Plants would require existing electric generators—the largest source of GHG emission—to reduce their emissions by 30 percent. EPA expects to issue that rule during the summer of 2015. I support the EPA’s bold initiative, but many responsible firms and individuals with expertise on the operation of the complicated U.S. electricity grid have expressed serious concerns that even small mistakes in implementing the program could have devastating unintended adverse consequences on the performance of the grid. The debate over the proposed Clean Power Plan provides an excellent opportunity for the supporters and opponents to join together to support an alternative that would be equally effective without the risks posed by the EPA Plan—a carbon tax of at least $40 per ton.

Tomorrow’s post will examine real-time pricing of electricity as a complement to a carbon tax.