Why a Carbon Tax Is Better Than Obama’s Cap and Trade

This weekend, former Treasury secretary Hank Paulson weighed in at the New York Times abouyt the need for more urgent action on the climate front, and described how various indicators of how quickly climate change is taking place, such as the speed of Arctic and Antarctic ice melt, are moving much faster than models had predicted.

Paulson, who has long been an ardent conservationist (and in contrast to his alpha Wall Street male standing, lives modestly), made a forceful pitch for carbon taxes. The irony of this proposal is that we have a Republican showing what a right-winger Obama really is. Without mentioning the recent Administration carbon scheme directly, Paulson’s article make the case for more forceful and effective intervention than cap and trade, a central part of the Administration’s proposed “pay to pollute” program.

…viewing climate change in terms of risk assessment and risk management makes clear to me that taking a cautiously conservative stance — that is, waiting for more information before acting — is actually taking a very radical risk. We’ll never know enough to resolve all of the uncertainties. But we know enough to recognize that we must act now.
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I’m a businessman, not a climatologist. But I’ve spent a considerable amount of time with climate scientists and economists who have devoted their careers to this issue. There is virtually no debate among them that the planet is warming and that the burning of fossil fuels is largely responsible….

We need to craft national policy that uses market forces to provide incentives for the technological advances required to address climate change. As I’ve said, we can do this by placing a tax on carbon dioxide emissions. Many respected economists, of all ideological persuasions, support this approach. We can debate the appropriate pricing and policy design and how to use the money generated. But a price on carbon would change the behavior of both individuals and businesses. At the same time, all fossil fuel — and renewable energy — subsidies should be phased out. Renewable energy can outcompete dirty fuels once pollution costs are accounted for…

A tax on carbon emissions will unleash a wave of innovation to develop technologies, lower the costs of clean energy and create jobs as we and other nations develop new energy products and infrastructure. This would strengthen national security by reducing the world’s dependence on governments like Russia and Iran.

I wish Paulson had made his case years ago. The more popular solution heretofore has been cap and trade, which Gaius Publius described in a recent “explainer” post:

According to the League of Women Voters, this is what a carbon tax looks like (my emphasis and some reparagraphing throughout):


As typically envisioned, a carbon tax would be imposed on fossil fuel suppliers at a rate that reflects the amount of carbon that will be emitted when the fuel is burned. The tax would beincluded in the price of the coal, oil and natural gas supplied to wholesale users and ultimately passed on to consumers in the price of electricity, gasoline and other energy-intensive products. Coal, which generates the greatest amount of carbon per unit of energy (BTU), would be taxed at a higher rate per BTU than oil or natural gas.

By raising the price of carbon-based energy, the tax would create incentives to reduce energy use, stimulate demand for more energy-efficient products, and promote a shift to cleaner fuels and renewable energy.

Note that last — “promote a shift to cleaner fuels [methane] and renewable energy [wind, solar, etc.].” You could do either or both, depending on how you designed the tax. For example, methane gets a “bye” when it comes to leakage under the current EPA “Clean Power Plan” (see here for details). It’s almost as if the EPA had written a Methane Plan.

But a carbon tax doesn’t have to give a pass to methane. If the tax accounted for rates of methane leakage — methane itself, before burning, is a much more powerful greenhouse gas than CO2 — it would price (and punish) methane fairly for all of its carbon emissions effects. After all, methane is a greenhouse hydrocarbon before burning (CH4), and it produces CO2 after burning. It leaks from all kinds of places — fracking fields, transmission lines, energy plants, liquid natural gas (LNG) facilities, etc.

If a carbon tax took all of that into account, it could eliminate as much carbon emissions from all sources as it wished to, instead of just favoring one source of emissions over another, as the current plan seems to do.

Now what may not seem obvious is that under a cap and trade regime, emissions are supposedly capped and various participants get to trade allowances, and in some schemes, offsets. That leads to bad side effects. First, Wall Street was eager to get into the cap and trade market when Europe launched a cap and trade program. As in other markets, the traders benefitted from price volatility. But uncertainty is anathema to investors. Unpredictable prices for carbon discourages investment in new, cleaner energy technologies and energy-saving programs. The Financial Times, in an editorial in 2007, describe how We need a clear and predictable price for carbon:

The way forward is a framework that compensates developing countries for the costs they bear, but also encourages the most efficient possible use of energy resources. The buying of rights to emit by high-income countries from developing countries is one way to achieve this result. A common tax regime, with accompanying cross- border transfers, would be another.

The crucial requirements, however, are three: a clear and predictable price for carbon emissions across the world; much increased investment in research and development in renewables, nuclear power and carbon capture and storage; and arrangements for transfer of best technology across the globe.

This is a huge, long-term and global challenge that involves difficult questions of justice both within and across generations. Humanity’s ability to address it is a test of its capacity to manage the consequences of its own actions. So far it has failed. It can afford to do so no longer.

Second, cap and trade rewards past bad conduct. As Greg Mankiw, another Republican who prefers carbon taxes,argued in 2007:

I am less fond of cap-and-trade programs than Pigovian taxes because they, in essence, give the revenue from a Pigovian tax lump-sum to a regulated entity. Why should an electric utility, for example, be given a valuable resource simply because it has for years polluted the environment? That does not strike me as equitable. A new firm entering the market should not have to pay for something that an incumbent gets for free. And the fact that the incumbent has for years been taking a valuable resource from the rest of society is no reason to think it deserves a free ride in the future. On equity grounds, one could just as easily argue that the incumbents should compensate society for their past misdeeds.

Cap-and-trade systems are also relatively inefficient, for two reasons. First, they encourage utilities to pollute more before the cap-and-trade system is put into effect in order to “earn” pollution rights. Second, they waste the opportunity to use the Pigovian tax revenue to reduce distortionary taxes on labor and capital…. One exception: If the pollution rights are auctioned off rather than handed out, then cap-and-trade systems are almost identical to Pigovian taxes, including all the desirable efficiency properties.

Third, the experience with past carbon trading schemes has found them to be rife with fraud.

So while it is good to see some movement on the climate front in the US, the Obama plan is no solution, due to its failure to include methane emissions (which means it is a huge sop to the fracking industry) and its reliance on the flawed device of cap and trade for enforcement. Carbon taxes are a far sounder route, but Hank Paulson’s call for them is about seven years overdue.

This piece is cross-posted from Naked Capitalism with permission.