With a new administration months away, and a frenetically urgent sense that something big is about to happen, it is likely that bold new energy proposals will be heard in the halls of the capitol this coming year. Any improvement on the status quo should be lauded, and because of this it is easy to sweep the flaws under the rug in the rush to redecorate. We must be careful and deliberate in choosing the best way to reduce our carbon output, both environmentally and economically. To date, there have been two widely recognized and debated systemic approaches to fighting global warming. The 'cap-and-trade' system, and the carbon tax. I think we will see some variation or combination of these proposals come out of Washington in the Obama administration, and it is of critical importance that we make the right choice. Tax increases are considered legislative suicide on the hill, especially in our current economic circumstances, but when both systems are scrutinized, the carbon tax is the most comprehensive and effective way to reduce C02 emissions across all sectors of the economy. Consider the following paper I wrote for a political science class last semester dealing with cap and trade vs carbon taxes. A tax is the only comprehensive and effective solution to create a real power shift in how America and the world gets its energy. Tell your representatives you will support their vote for a carbon tax if a bill makes it to the floor- they will need all the encouragement they can get!

A re-shaping of the fundamental values inherent in our consumer culture is necessary to transform our society from one of waste and excess to a sustainable global community. The beginning of this value transformation is changing the way the global market deals with greenhouse gas emissions, especially in the energy and transportation markets. These markets today do not take into account the negative externalities associated with production, one of which is the greenhouse gases (including CO2) released into the atmosphere with the burning of fossil fuels. The modern market and its prices, therefore, do not reflect the true cost of production, because these externalities have a dramatically increasing cost for society in the form of global warming. Without finding a way to effectively incorporate these heavy costs into the market, our consumption will continue to be inefficient and remain part of the problem instead of a road to a solution in the climate crisis. 

     
There is little debate anymore that humans are warming the planet by releasing a slew of greenhouse gases. Although there is no exact scientific model, most agree that without a serious reduction in CO2 emissions the human race will face devastating consequences in the not-so-distant future. There have been many proposed actions to combat global warming from both intergovernmental and state agents, and virtually all of them include some variation of the two primary schemes for regulating CO2 emissions from energy sources: a cap-and-trade system and/or a carbon tax. Despite the vast economic differences in these two policies, their ultimate objective is largely the same: to put a price on carbon, thereby limiting emissions and spurring development of alternative energies. Policymakers around the world agree that setting a price for carbon is the key to transitioning the world market to a sustainable model, but the debate over cap-and-trade vs. carbon tax is as complex as the proposals themselves. Both approaches have their pros and cons, and a careful analysis of both is necessary to determine which is the best option for our energy future. In comparing these two policy proposals, I will argue that a carbon tax is the most effective and practical way to reduce emissions, and though a cap-and-trade system may be a more politically feasible first step, its limitations will prevent it from providing the real reductions in carbon emissions we need to secure the future of our planet for all mankind.

In order to understand the effectiveness of either proposal, a careful examination of the components of each is necessary. Under a cap-and-trade system, a maximum total limit (cap) on emissions is mandated, and the regulating body then issues permits for the right to pollute. In the case of CO2 emissions, permits may be issued on a per-unit basis of 1 ton of carbon dioxide. Permits may be held by anyone, but they are typically granted to major polluters, such as power companies and utilities in energy-intensive industries. The permits are either auctioned off or given freely to polluters, and the permits are then traded. The trading occurs when one polluter facing low reduction costs can meet its target emissions reductions and sell its excess permits to a polluter facing higher costs for reducing its emissions. Through this trading process, the permits will attain a value based on the supply and demand influences of the free market, making the price of a ton of carbon reflective of the energy market’s demands at any given time. This price and emissions flexibility allows the market to reduce emissions in the most cost-effective manner; companies facing high costs can offset these by buying additional permits, while cleaner companies can profit by trading permits. This makes a cap-and-trade system a more appealing solution for the business world, and it has been advocated by many businesses and CEOs, most notably the U.S. Climate Action Partnership, which includes 33 major U.S. corporations, including the top ten companies of the fortune 500 list and many major polluters like Duke energy and Exxon Mobil. Their “A Call to Action” plan, submitted to the president, calls a cap-and-trade program “essential”. (USCAP A Call to Action pdf online). Corporate CEOs are being joined by other prominent figures like state governors in support of the cap-and-trade system.

Some states are already undertaking a cap-and-trade for greenhouse gases in the absence of decisive federal action. The Regional Greenhouse Gas Initiative, or RGGI, is comprised of ten states in the Northeast and Mid-Atlantic regions (every state in both regions is involved except Pennsylvania) who have agreed to cap emissions at 2009 levels and reduce them 10% by 2019 (www.rggi.org). Many governors involved in this program are also calling for a 100% auction of pollution permits, a decision that would require companies to pay for the right to pollute instead of being given permits for free. State-led initiatives like RGGI (affectionately nicknamed ‘Reggie’ by some) are putting pressure on the Federal government to act quickly. As varied plans to cap greenhouse gases spring up across the nation, economists like Ian W.H. Parry and William A. Pitzer of Resources for the Future point out, this “patchwork approach” will become “cumbersome for business” operating nationally (“Combating Global Warming” p. 19).

Despite a lack of national legislation, the Feds are not completely inert on this issue. There have been many proposals for a cap-and-trade system from the House of Representatives and the Senate; there are currently eight different proposals that all include some form of cap-and-trade program. These bills are sponsored by a slew of prominent politicians from both parties, including Barbara Boxer, John McCain, Joe Lieberman, John Kerry and Arlen Specter. (UCS online chart). Advocates argue that the cap-and-trade system is the most economically sound approach to fighting global warming because of the flexibility it gives to businesses in emissions reductions, and its effectiveness is enhanced by the clear limits it sets on greenhouse gases through an emissions cap, a feature the tax approach lacks.

Some proposals for a cap-and-trade system include a feature known as a ‘safety valve’, where the government issues additional permits if permit price spikes as a result of high demand. This feature is controversial, however, as many argue that a safety valve would undermine the effectiveness of a firm cap on emissions by allowing polluters to pollute above the cap if the market becomes stressed. Some point out that this also opens up the potential for polluters to use even more energy to force the government to issue additional permits. The safety valve is beneficial from an economic point of view, however, since it provides some safety net for runaway permit prices that could otherwise have damaging economic effects by creating a shortage in energy supply and cause prices for consumers to skyrocket. This scenario is not common, however, and the safety valve feature creates the potential for increasing the basic problem instead of solving it. Our excess energy consumption is what is driving pollution from the energy industry, and the ultimate goal of the cap-and-trade system creates is to promote a more sustainable pattern of consumption that works to conserve energy. Limiting supply and raising prices is the most economically effective way to achieve this effect.

An additional price-control mechanism that has been proposed for the cap-and-trade system is known as borrowing, where companies facing high immediate costs can ‘borrow’ additional permits from other companies or the government in exchange for making more drastic reductions in the future to compensate. This has obvious complications, however, since it allows short-term goals of emissions reductions to fall to the wayside in favor of keeping producers economically comfortable, and does little to ensure that emissions targets will be met in the future.

Another crucial and highly debated detail of the cap-and-trade system is the decision to auction permits to polluters or give them freely. Many prominent groups, including the Union of Concerned Scientists, argue that a 100% permit auction is a key component of an effective cap-and-trade system because it creates a pool of money that goes to the government (as opposed to remaining in the private sector as profits from trades) that can then be used to subsidize alternative energy industries or offset increased consumer energy costs through tax breaks for low-income households (ucsusa.org). But once the government collects the revenues, the issue of where to spend them becomes controversial. There are many economists and legislators who are worried that alternative industries who receive the benefits of these revenues through subsidies may not prove worthy of their investments, and the government will waste a great deal of money that could have otherwise been spent on improvements within the well-established private industry sector. This is not the only issue that comes into play in the permit auction debate. Polluting companies can logically be expected to pressure the government to provide the permits for free, not only to save themselves a great expense but also on behalf of savings for their consumers. Any increased expense the companies face in reducing their emissions will be passed on to consumers in the form of higher energy prices. The already powerful energy industry lobby has the argument for protecting consumers and the economy on its side. The idea of free permits is also a big selling point for advocates of cap-and-trade policies because it provides a form of ‘compensation’ to the energy industry for the economic burdens re-vamping the industry will inevitably create, and anyone familiar with effective lawmaking knows it is all about compromise and compensation.

Within this debate also emerges the issue of how to distribute the permits among polluters. If the permits are given away for free, how do you determine who gets them? Programs in the past, such as the cap-and-trade system implemented to fight SO2 emissions associated with acid rain, granted permits to polluters based on their emissions history, the most permits going to those with the highest emissions. This has drawn criticism from many in recent debates, since it essentially awards heavy polluters with the most permits, and some fear that companies will initially increase their emissions in order to be granted a larger share of the permits from the government. The issue of political favoritism also comes into play here; with a commodity as valuable as emissions permits on the line, larger companies may pull all the political strings at their disposal in order to be granted a greater number of permits, opening the permit market to a vast potential for corruption. This corruption is not limited to the political aspect of permit allocations. Permit trading can be vastly profitable for companies that can reduce their emissions, and without tight monitoring and corporate transparency, companies can make a lot of cash without making large reductions in their emissions. As Yale economist William D. Nordhaus puts it “there are very poor intrinsic incentives for honesty in a cap-and-trade system. The purchasing unit gets a permit whether or not any true reductions take place by the selling unit”, and this applies vice versa for the selling unit’s profits as well (Life After Kyoto: Alternative Approaches to Global Warming Policy p. 19).

The traditional cap-and-trade model is most easily applied to heavy polluting industries like electricity and chemical production, where polluting facilities are easy to identify and regulate, and a relatively small number of companies control these facilities. But in order to be effective in capping all CO2 emissions, the cap-and-trade model would have to be extended to include a broader range of economic sectors, including housing and transportation. In order to be truly effective, the cap-and-trade program would have to be re-worked to include a much wider range of economic sectors than the traditional model includes. To date, no politically viable and effective cap-and-trade system has been devised to address all economic sectors. If a comprehensive plan were developed, applying it would impose far greater administrative costs, since the government would be responsible for regulating a much more complicated system with the addition of multifaceted industries like transportation or housing, which are much harder to regulate than an industry like electricity, concentrated in a relatively small number of plants.
           

Although most Americans are not familiar with the economic subtleties of a cap-and-trade system, many polls suggest that a majority of Americans approve of measures that would create the kind of industry regulation that a cap-and-trade would impose. In a recent Gallup Poll, 75% of those surveyed said they thought the government should “restrict emissions from cars and industrial facilities such as power plants and factories” to reduce global warming. In a Newsweek poll, 57% of those surveyed responded that “lowering the amount of greenhouse gases that power plants are allowed to release into the air” should be “required by law”, and 62% responded the same in a joint poll conducted by ABC News/Washington Post/Stanford University. Americans are also aware of the source of greenhouse gases; according to the same joint poll, 54% agreed that global warming is caused by “industry and cars” (pollingreport.com).  These statistics suggest fairly high popular support for initiatives aimed at reducing and regulating greenhouse gases from industry, especially the energy and transportation sectors. The cap-and-trade system is an initiative aimed at doing just that, so it has the advantage of likely public support were it to become law.
           

The second major policy option takes a very different tact. The basic structure of a carbon tax would levy a fixed tax on fossil fuels based on the amount of CO2 released when a unit of that fuel is combusted. This means that carbon-intensive fuels like coal, which are relatively cheap now, would become more expensive because the high amounts of carbon they release when burned (or carbon released in their production, as in the case of biofuels, known as ‘closet carbon’) would be factored into their cost by the tax. Gasoline and other oil-based petroleum products would also become more expensive to burn, although not as much as coal, and fuels with lower CO2 outputs like natural gas or solar would become more price competitive. Determining the value of this tax per ton of carbon is obviously the key issue when considering a carbon tax, and at this point (in the absence of any serious administrative debate on implementing such a tax) there is only speculation as to what this price should be. According to Resources for the Future, an economist’s view of what the tax should be would reflect the cost of the damage the negative externalities from GHG gases would impose. Since the impact of these damages is greater as more and more gases are emitted into the atmosphere, the value of the tax should slowly increase over time as the cumulative effect of burning fuel dramatically increases the potential impact of these externalities. This cost is obviously very complex and tremendously difficult to calculate, but “most mainstream economic assessments value the damages from today’s emissions at around $5-$15 per ton” (rff.org). This is a rough estimate, and many argue that more factors influence the cost and it can reasonably be considered much greater if “ecological effects, the well being of future generations, or the risk of abrupt climate change” are taken into account (rff.org). According to an article in the New York Times, “the general consensus in the energy business is…a charge that could start at $10 per metric ton or more”. Taking this price range into consideration, it is useful to compare the costs of energy sources under a hypothetical tax to see the changes in the economics of energy. When coal burns, it produces 1.9 pounds of CO2 per kilowatt-hour. Natural gas produces about .84 pounds of CO2/Kwh. Without any price on CO2, a kilowatt-hour produced from coal costs about 5.7 cents. “At $10 a ton, the impact is minimal. But at $50 a ton… the cost of a kilowatt hour from coal goes from about 5.7 cents to 10 cents”. Cleaner technologies like wind and solar power are very expensive (a photovoltaic Kwh can range from 25-30 cents) and therefore are not economically viable when compared with coal, but with a double digit carbon tax in the range of $25-$50 per ton, these cleaner alternatives have “a much larger chance of being relevant”(NYT Nov. 7 2007). When price competitive, alternative fuels have the potential for even further reductions in cost as the market demand shifts to increase production, leading to further development in technology and decreased per-unit production costs through economies of scale (increase in production leads to a decrease in long-run production costs).
           

The most cost effective way to tax carbon is to implement the tax as far ‘upstream’ as possible- meaning as close to the source of the fuel as one can get. This means fuels would be taxed at their point of distribution into the market- as it leaves the mine for coal and natural gas, as it comes off the tanker or from the wellhead for oil, and as its pumped from the refinery for ethanol. This would greatly reduce the administrative costs in administering such a tax, since the carbon content of every fuel is known and the volume of fuel in the market is easily calculated by monitoring the source directly. This would also create an even distribution of the tax cost throughout the market. Suppliers would simply increase the cost of their raw product to offset the cost of the tax to those further down the supply chain and ultimately to consumers. This upstream approach to levying a carbon tax makes it much more effective than a cap-and-trade system at reducing greenhouse gas emissions across all sectors of the economy, because a tax of the fuel at its source applies the tax to all sectors of the economy that use fossil fuels. The tax approach has a much broader scope than a traditional cap-and-trade program, which in its most politically viable form only applies to industries like electricity and chemical production.
           

One of the greatest advantages of a carbon tax is the fixed price it gives to carbon emissions across all economic sectors and markets. Fossil fuels are taxed based on their carbon content, which is known, and therefore the price of a ton of carbon does not fluctuate or change unless by administrative adjustment. This is crucial for investors and economists, since knowing the price of carbon in the long run is a key factor in determining the investment potential of any given technology or area of the market. Having a fixed price on carbon gives certainty to the price competitiveness of various fuels, greatly increasing investor confidence and allowing economists to make market predictions with greater certainty. This feature is absent from the cap-and-trade scenario, where price volatility is commonplace. For example, the European Union’s Trading Scheme has seen dramatic fluctuations in the price of carbon permits. Regulators made the mistake of granting polluters too many permits over time, and “prices have collapsed from about $38/ton in 2004 to [a recent average] of $1.40” (SFGate.com) The well-known Yale economist William D. Nordhaus sums up the problem of price volatility in the cap-and-trade market very well in economic terms “Carbon prices are likely to be extremely volatile because of the complete inelasticity of supply of permits in the quantity case along with the presumption of quite inelastic demand for permits in the short run” (p. 15). He goes on to point out the extreme volatility of cap-and-trade markets in the past, using the example of the SO2 permit market in the US, which he claims are “more volatile than oil prices or stock-market prices”(p.15).
           

Like the cap-and-trade approach, one of the biggest debates with the issue of a carbon tax is what to do with the revenues the legislation would generate. A major advantage of the carbon tax on this front is that its revenues would be going entirely to the government under all circumstances, and since there is no market for private gain created by a tax, the issues of corruption and incentives for dishonesty that exist under the cap and trade approach are all but eliminated (save a new form of tax evasion, of course). The ability of special interests like energy companies or oil producers to manipulate a tax system in their favor is dramatically low compared to a cap-and-trade scenario. But what should the government do with the revenues once they are collected? A popular theory on this point involves the implementation of a ‘tax shift’ by using the revenues from the carbon tax to offset another form of taxation, like the federal income tax or housing taxes and mortgage rates. This is widely suggested by carbon tax advocates for several reasons. First, it makes the tax more palatable for everyone by offsetting the hardships of increased gas and energy prices by reducing the burden of the income tax or some other tax. This would effectively make the carbon tax ‘revenue neutral’ for the government, meaning that the government would not profit by the tax, but instead all the money generated would be poured directly back into the economy and the bank accounts of consumers by paying them back part of their income tax. Tax dollars could also be pumped into alternative fuel industries or technology development in the form of subsidies and grants, leading to further development of cheaper low-carbon fuels, which may lower the burden of the carbon tax over time by increasing availability of low-carbon technology. The tax could also be used to provide greater assistance to low-income families who would be hit hardest by the increase in fuel and energy prices (under both cap-and-trade and tax scenarios), either by helping them to become more energy-efficient or by alleviating a greater portion of their tax burdens. Al Gore, in his Nobel Prize acceptance speech, called for a carbon tax that returns the revenues to the people: “And most important of all, we need to put a price on carbon — with a CO2 tax that is then rebated back to the people, progressively, according to the laws of each nation, in ways that shift the burden of taxation from employment to pollution. This is by far the most effective and simplest way to accelerate solutions to this crisis”(Al Gore, Dec. 2007).
           

One of the greatest critiques of the carbon tax is just that- it’s a tax. Taxes are vastly unpopular in the government and with the public. They are virtually impossible to approach on Capitol Hill, especially among republicans, and many legislators see them as political suicide. The tax also lacks the key feature of compensation that a cap-and-trade system (with free permit allocation) has in its favor to gain industry support. This makes the tax even more unlikely to be politically viable, as the lobbying power of industry in the government is strong. The public visibility and simplicity of taxes, while arguably a benefit for their implementation from an administrative point of view, actually plays against them in the eye of the public. The complexity of a cap and trade program partially obscures the cost to the public from view, but with a tax the price hikes are clear and this contributes to their unpopularity. In a poll from June 2007, 58% of those surveyed said they would oppose a federal tax increase on gasoline to fight global warming. In the joint poll cited earlier, 79% responded they would oppose a tax on electricity “so people would use less of it”, and 67% responded they would oppose a gas tax with the same aim (pollingreport.com). To some extent, people are right to believe that a tax on gasoline is not in itself going to make people consume less- demand for gas and electricity are fairly inelastic, meaning their demand is not dramatically altered by change in price, but a tax would cause a shift in the market as a whole, thereby influencing consumer behavior. These polls clearly show the strong public opposition to direct taxation, yet ironically enough, other polls show a majority of people supported regulations on power plants similar to a cap-and-trade program. The higher prices would be passed on to them from the power companies, raising the price much like a tax would, but people are more averse to the price increase if it is applied to them directly by the government.
           

Despite the unpopularity of taxes, many prominent figures have recently come out in support of a carbon tax, from both political parties and various professions. Most notable among them is former vice president Al Gore, who stated a carbon tax was “most important of all” in his Nobel Prize acceptance speech, and the IPCC (International Panel on Climate Change), who received the prize along with Gore, has also spoken out in favor of a tax. Prominent economists like Greg Mankiw, former chief economic advisor to the Bush administration, and Yale economist William D. Nordhaus, have also voiced support for the tax. Some unlikely supporters have also popped up in our current government- John Dingell has actually put forth the only carbon tax proposal to date (although some are skeptical about its legitimacy), and in an article he wrote for the Washington post, he lists some other supporters as diverse as they are improbable- from Gary Becker (arch-conservative and CEO of the US’s largest auto dealer chain) to Alan Greenspan and Greenpeace (washingtonpost.com). New York mayor Michael Bloomberg has also spoken out in favor of the tax (NYT Nov. 2 2007) Activist groups like the Carbon Tax Center have become more vocal recently in garnering support for the tax, and support is indeed growing. In a Nov. 2nd 2007 New York Times article, an economist remarked “The irony is that there is a broad consensus in favor of a carbon tax everywhere but on Capitol Hill, where the “T” word is anathema” (NYT 2nd Nov. 2007). With this growing and influential group of support, the carbon tax has a rising chance of overcoming the tax stigma and emerging as the most sensible option for fighting global warming. Even the American public may not be an impossible sell on the tax issue- a poll from Pollingreport.com found that 42% of people thought that the costs of effectively reducing global warming would be “high but worth it”, and only 17% responded that the cost would be “too high”.
           

The greatest limitation of a carbon tax is its political improbability in the short run, but growing support from many sectors indicates this may not be the case forever. A ‘green tax shift’ may be a feasible political reality as early as the next presidential term. The cap-and-trade approach, although more politically practical, and from an industry standpoint less economically disruptive, will not provide the reductions in GHG’s we need in order to eschew the worst effects of global warming in the future. It is not as far-reaching as a tax, limited largely to industry, and expanding its capabilities to provide a firm cap on all forms of emissions would require a re-thinking of the cap-and-trade approach, requiring complex, time consuming and expensive government oversight and administrative cost to be effective. The potential for manipulation by ‘special interests’ like the powerful energy and oil industries and permit profiteering also dramatically undermines cap-and-trade’s effectiveness as a concrete, long-term solution to emissions reduction, especially with industry-pleasing features like free permit allocations and a ‘safety valve’ already present in current proposals. The fixed price a tax would put on carbon could be applied as a stable, international ‘gold standard’, providing a much greater level of investor confidence and economic predictability in the increasingly sensitive and volatile energy market; a powerful and positive tool to creating a stable and sustainable energy future for our growing, energy-hungry world. The opposite scenario has been observed in several cap-and-trade programs, with dramatic price volatility a common feature. When applied to carbon, this could lead to economic upheaval further down the road when global emissions become an increasingly sensitive economic issue for the world market. The short term improbability of a carbon tax and the traditional unpopularity of taxes in American politics is an economic reflection of the core problems in our fundamental consumer values- Americans are unwilling to make sacrifices to their decadent consumer lifestyle in order to create real change. But faced with the increasingly devastating threat that global warming poses, many are starting to change their tune. A recognition that we need to change the way we live, at least until we can live sustainably, is emerging in popular culture. The will to create this change will determine when proposals for real change like the carbon tax shift will reach a tipping point of support in our country and the world. With a close consideration of the facts and proposals at hand, this will can be created in the minds of rational Americans, and to quote one of my favorite Gore-isms, “Political will is a renewable resource”.