A Conservative Carbon Tax


jerry taylor is the president of the Niskanen Center, a libertarian think tank in Washington.

Illustrations by Mark Anderson

Published January 19, 2017


While opposition to government initiatives to slow climate change has long been orthodoxy for the Republican Party – and Donald Trump – that position is becoming increasingly untenable. The case for climate action is now so strong that one would be hard-pressed to find a serious academic economist who opposes using market forces to manage the damage done by greenhouse gas emissions.

trends image 10

Meanwhile, the low-cost opportunities for substituting renewables for fossil fuels have undermined the argument that the transition away from coal, oil and gas would make it difficult to maintain healthy growth. And by no coincidence, the political price of climate denial has recently gone from inconsequential to significant. Indeed, I would argue that, while the initial inclination for the Trump administration will be to roll back the clock, the stage is set for Republicans to embrace carbon pricing down the road.

When in Doubt...

The debate among genuine experts in climate science is now limited to the timing of the warming and the magnitude of the impact. Climate policymaking has thus morphed into a high-stakes risk-management exercise in crafting the optimal response when the consequences of warming might be modest or might be catastrophic.

In this exercise, there is nothing "conservative" about ignoring risks at the catastrophic end of the distribution of possible outcomes, just as there is nothing conservative about putting all one's money into a single stock in an era of economic volatility. Quite the contrary: when low-probability, high-impact threats arise in non-environmental policy contexts, conservatives are inclined to become extremely averse to bearing risk. In the days after 9/11, for instance, Vice President Dick Cheney famously said, "If there is a one percent chance that Pakistani scientists are helping Al Qaeda build or develop a nuclear weapon, we have to treat it as a certainty in terms of our response."

If conservatives believe that "the precautionary principle" is worth embracing in non-environmental contexts, why don't they believe that it is worth embracing in the environmental arena? The warming scenarios at one extreme of the distribution of possible outcomes, after all, might well render the planet uninhabitable.

trends image 7

The Cost and Benefits of Climate Action

Conservatives have typically come at the problem from another perspective. They've rejected the precautionary approach to climate change primarily because they believe that the potential damage is uncertain while the cost of precautionary action is both certain and very high. That argument, however, no longer stands up to close examination. Although the costs associated with curbing greenhouse gas emissions are not trivial – more on that later – the irresolvable uncertainties about both the future costs and future benefits of climate action render dispositive cost-benefit analyses impossible.

While there are plenty of studies estimating the impact of climate change on the global economy, only a few have zeroed in on forecasts for the United States economy. The most thorough of these comes from the Rhodium Group (a private consulting firm), which concluded that U.S. losses would most likely total between 1 and 3 percent of GDP annually by the end of the century. This is a conservative estimate, because it does not consider the impact of climate change on a host of significant factors – everything from agricultural productivity to the control of disease vectors as rising temperature and altered rainfall patterns open pathways for a greater variety of insects. Nor does it take account of a raft of low-probability, high-impact scenarios in which temperature-related tipping points could be crossed.

On the cost side of the equation, the most comprehensive contemporary analysis of jettisoning most uses of fossil fuels (known in the lingo as "deep decarbonization") comes from a joint undertaking by Energy & Environmental Economics (E3), Lawrence Berkeley National Laboratory and the Pacific Northwest National Laboratory. Their modeling found that an 80 percent reduction from 1990 levels of U.S. greenhouse gas emissions by 2050 (the target consistent with a global commitment to hold warming to 2 degrees Celsius above preindustrial levels) would probably cost about 0.8 percent of GDP annually, with a 50 percent probability range of costs from a gain of 0.2 percent of GDP to a loss of 1.8 percent of GDP.

While 0.8 percent of GDP is not small change (around $135 billion), it's probably less than the cost of inaction. But remember, these comparisons of high-probability costs and benefits largely miss the point. Provided similar efforts to slow climate change are made worldwide, deep decarbonization would serve as a hedge against the truly catastrophic risks – the ones associated with, say, the sudden collapse of the Antarctic ice sheet, which might raise sea levels by three feet, or the rapid release of massive quantities of greenhouse gases from melting permafrost.

Conservatives are often aghast at the prospect of spending billions or even trillions to prevent possible horrors that might turn out to be merely manageable dislocations. But they have embraced tremendously costly risk-hedging initiatives in the past. The Bush-Cheney administration spent $4 to 6 trillion on wars in Iraq and Afghanistan to address the risks of Islamic terrorism – surely a lesser threat than the serious drought, more violent weather and widespread coastal flooding that may follow global warming.

According to the study by E3 and the two national labs, annual decarbonization costs would run about $100 billion per year, rising to about $400 billion per year by 2050. That estimate, by the way, is also in the central range of an independent analysis from Geoffrey Heal, an economist at the Columbia Business School.

The impact on consumer energy costs would likely be modest. Average electricity rates in the E3/national labs analysis would increase from 17 cents per kilowatt-hour (the reference case, which represents business-as-usual) to about 18 cents per kilowatt-hour. Average household spending on energy would rise only about $35 per month. Though spending on energy would be higher in absolute terms, energy costs would constitute 6.4 percent of U.S. GDP, compared to 7.1 percent in 2015.

These are still big numbers, which could be seen as ammunition for climate skeptics who would rather wait and see. But as we've noted above, even a low probability of a catastrophic outcome makes the case for action stronger, not weaker. In a recent survey of economists who publish in leading peer-reviewed journals that cover the economics of climate change, 93 percent agreed that, despite these uncertainties, an aggressive policy response to global warming is warranted.

Skepticism about Low-Carbon Energy

Many conservatives find the E3/national labs study and others of the same ilk to be implausible on their face because low-carbon energy will be far too expensive relative to coal, oil, and natural gas. Moreover, renewable energy, they often note, is too unreliable for a modern economy that must keep the gears moving when the wind isn't blowing and the sun isn't shining. Finally, the scale and scope of the transition, they say, is unrealistic in the relatively short period contemplated in the E3/national labs scenario.

While those criticisms were probably on the mark before the turn of the millennium, advances in low-carbon energy technology have radically transformed the energy sector. Just since 2008, the total cost of land-based wind energy in the United States (absent federal production-tax credits) has fallen by 41 percent, distributed solar power generation (such as rooftop panels) by 54 percent and utility-scale solar generation by 64 percent. Meanwhile, production costs for electric-car batteries have dropped by 73 percent.

Markets understand this, even if conservatives don't. Solar and wind energy constituted 66 percent of all new electricity generation capacity installed last year in the United States. Today, as many jobs are tied to wind energy as coal mining, while solar construction and maintenance employs three times the number in the coal business.

In 2022 (with no federal production-tax credits), the U.S. Energy Information Administration estimates that advanced combined cycle gas-fired turbines (the cheapest source of new fossil fuel electricity) will produce power at $55.80 per megawatt-hour, onshore wind-power facilities at $58.50 per megawatt-hour and utility-scale solar at $74.20 per megawatt-hour. By 2040, the Energy Information Administration projects that wind will be cheaper than gas turbine power and that utility-scale solar won't be far behind.

Fossil fuels may also be displaced in transportation. Bloomberg New Energy Finance estimates that by 2022, declines in the production cost of lithium-ion batteries will make the total cost of owning an electric vehicle lower than the cost of owning an equivalent vehicle powered by gasoline or diesel. Of course, the electricity must come from somewhere. But there is no reason that "somewhere" can't be renewables.

So much for low-carbon energy being too expensive. But is it reliable, and can it be delivered over long distances? Recent academic analyses suggest that the answer is yes – but with some caveats. Unless utility-scale storage technology becomes cost-effective, we would need to shift from regionally divided electricity networks to an integrated national system built upon high-voltage, direct-current transmission – an expensive, though doable, option. But many energy forecasters remain optimistic that cost-effective storage technology is on the horizon.

An obvious means of addressing the intermittency issues surrounding wind and solar – though, to be sure one that faces considerable political opposition – is investment in nuclear power. Although the Energy Information Administration forecasts that nuclear energy will be far more expensive than wind and solar power in the future (with a levelized costs of $93 per megawatt in 2040), the E3/national labs study finds that including nuclear energy in the portfolio of low-carbon sources would actually reduce net costs. That's because the higher generating costs of nuclear would be more than offset by savings on infrastructure otherwise needed to reduce the uncertainty about hour-to-hour availability of solar and wind.

trends image 8

If not a Carbon Tax, What?

Once one accepts that hedging against climate risk makes overwhelming sense, putting a price on carbon (and related greenhouse gases) through market mechanisms seems a no-brainer. Among other virtues, carbon pricing is attractive to the corporate community, because it leaves the decision about when, where and how to reduce emissions to market actors rather than to regulators. And it should be attractive to consumers because market-based pollution abatement has a long track record of cost-efficacy.

The four alternatives to carbon pricing (beyond direct regulation) are subsidizing the production or consumption of low-carbon energy, or both; mandating low-carbon energy production; subsidizing or mandating energy efficiency investments, or doing both; and subsidizing energy R&D. While they may have a place in a climate-management portfolio, none of those approaches should tempt us to turn away from carbon pricing.

Subsidizing low-carbon energy production is not cost-effective compared to carbon pricing. A 2012 study by the Pew Charitable Trusts calculates that federal spending and tax programs designed to reduce greenhouse gas emissions only reduced total U.S. emissions by 1.4 percent in 2009. A 2013 study from the National Research Council found that, extended forward, existing federal production- and investment-tax credits for renewable energy would reduce greenhouse gas emissions from the power sector by only 0.3 percent over the next two decades – and at a cost of $250 per ton.

That seems counterintuitive because production and investment tax credits do significantly increase renewable energy generation at the expense of coal and natural gas. However, they also lower the competitive market price of power and thereby serve to boost electricity use. This reduces investments in energy efficiency and sacrifices emissions reduction that might otherwise have been achieved at competitive cost.

Subsidizing low-carbon energy consumption (for instance, by subsidizing hybrid and all-electric vehicles) runs into most of the problems associated with subsidizing low-carbon energy production. On top of that, the benefits heavily favor the affluent. Economists Severin Borenstein and Lucas Davis at the University of California (Berkeley) found that fully 90 percent of the credits claimed for electric vehicles went to the top income quintile.

Running through the list, state regulations dictating the percentage of electricity that must be generated from renewable energy – a.k.a. mandates – are inefficient; so are mandated energy-efficiency requirements.

Some observers, echoing Microsoft's founder, Bill Gates, take an entirely different tack. They argue that existing low-carbon energy technologies are simply too expensive to displace fossil fuels, whether encouraged by mandates, subsidies or taxes. Accordingly, they embrace large new R&D programs designed to produce the necessary energy miracles required for deep decarbonization without tears.

But the historical evidence doesn't square with this implied pessimism about market-based incentives as the mother of invention. Past increases in energy prices have induced significant innovation, and there's every reason to believe that a carbon tax would do the same now. There is a consensus in the economics literature, moreover, that public R&D produces less innovation on its own than would an efficient carbon pricing program. That's because carbon pricing would immediately change price signals. An R&D-only policy would produce no changes in market behavior until breakthroughs were achieved – if they were achieved.

Even then, technology breakthroughs are not self-executing. Price signals – in this case, delivered by carbon taxes – are needed to spur rapid deployment. As the economist Richard Newell of Duke University notes, "R&D without market demand for the results is like pushing on a rope, and would ultimately have little impact."

Past increases in energy prices have induced significant innovation, and there's every reason to believe that a carbon tax would do the same now.
Remember Cap-and-Trade?

Carbon pricing does not necessarily need to be based on taxes. Prices reflecting the private and public costs of fossil fuel generation could also be produced with cap-and-trade programs. This would entail putting a cap on the total permissible volume of greenhouse gas emissions. The government would then sell or give away (or both) a corresponding volume of tonnage permits that emitters would need to legally add carbon to the atmosphere. Initial government auctions for the permits or secondary markets for them would establish the economy-wide carbon price that would act like a carbon tax.

Cap-and-trade and carbon taxes both aim to use prices to internalize the external costs of emissions. There is, however, one big difference. A carbon tax establishes certainty with regards to price, but leaves emissions volume up to the market; cap-and-trade creates certainty with regards to emission volumes, but leaves price to the market.

Many environmentalists prefer the volume certainty afforded by cap-and-trade. For their part, energy producers and fuel consumers prefer the price certainty afforded by carbon taxes. Either, though, can be modified to create the certainties offered by the other. Carbon taxes can have escalation or de-escalation clauses that kick in if specific emission targets are not met or, alternatively, exceeded. Cap-and-trade programs can generate volume certainty by having the government add or subtract permits if the market price for the permits exceeds or falls below a predetermined range.

One advantage of cap-and-trade is familiarity. Approximately 25 percent of Americans already live in jurisdictions in which carbon emissions are priced via cap-and-trade programs. The case for a carbon tax rather than cap-and-trade, however, is fairly strong.

First, the administrative burdens associated with monitoring and taxing greenhouse gas emissions are quite modest – contact with the government would be limited to a few hundred large "upstream" fuel sellers and industrial emitters. By contrast, the administrative burdens associated with creating and policing the market for emissions permits, which would constitute the largest commodity market in the world, would be no walk in the park.

A carbon tax, moreover, would almost certainly spur more innovation than cap-and-trade. That's because the future schedule of carbon taxes would be fixed by law. Successful technological innovations in a cap-and-trade world, however, would reduce demand for emissions credits and would consequently lower carbon prices. This in turn would reduce incentives to invest in more innovation.

The political case for a carbon tax over cap-and-trade is likewise strong. First, cap-and-trade programs in the real world tend to be weak tea, while ambitious policy goals seem to go hand-in-hand with carbon taxation.

I think I know why. Some 70 percent of the global revenues generated from government auctions of cap-and-trade permits have been dedicated to subsidies for low-carbon energy, while roughly the same percentage of revenues from carbon taxes have been rebated to the public or effectively substituted for other taxes in paying for regular government expenses.

Any form of carbon pricing, after all, represents pain to energy consumers. If that pain is not offset with some visible payoff to the public, tolerance for carbon pricing will likely remain low. While it is unclear why revenues tend to be distributed differently under these two policy plans, I suspect that cap-and-trade initiatives are more prone to corporate rent-seeking and favoritism. That drives revenues toward well-organized interest groups and away from the general public.

Second, no form of carbon pricing could be imposed without significant support from Congressional Republicans. And (in spite of an initial endorsement by the then-Speaker of the House, Newt Gingrich), cap-and-trade is seen as a "liberal" policy vehicle because it has been embraced by the European Union along with a host of blue states, from California to Massachusetts. Carbon taxes, on the other hand, are championed (or at least preferred) by most multinational oil and gas companies and have been loudly promoted by free-market economists in other contexts as the policy approach of choice to internalize the costs of pollution.

What a Carbon Tax might look Like

A tax rate capable of producing the deep decarbonization needed to limit warming to 2 degrees Celsius would be steep. According to simulations by the Stanford Energy Modeling Forum, we would likely need a $65 per ton tax in 2020, rising to $296 per ton in 2045.

Consider, for starters, the impact of a $45 per ton carbon tax that increased at a rate of 2 percent a year above inflation. The simulations suggest that this tax would yield a 40 percent reduction below 2005 levels in U.S. greenhouse gas emissions by 2030. That's a far greater reduction than would likely be secured by the Clean Power Plan. Even so, the tax would reduce disposable household income by less than one percent if the revenues were rebated in some form unrelated to the beneficiaries' energy use.

The total cost to the economy – that is, the reduction in goods and services otherwise available – would be less than 0.2 percent of GDP, and that's before we even consider the benefits from reducing the side effect of paring public exposure to the conventional pollution produced by fossil fuels. Netting out those health benefits would likely mean that the tax would be costless in economic terms – and that's before considering the bulk of the benefits, which would come from hedging against major climate risk. Net employment impacts (though not necessarily regional and sectoral impacts) would be negligible.

The most contentious issue (after the threshold issue of getting Republicans to agree to a new tax) would be the allocation of the revenue. If the revenues were used primarily to cut capital gains and dividend tax rates, income earners in the bottom four-fifths would probably experience modest losses in household purchasing power while the top fifth would experience a slight increase in net income. However, if revenues were rebated evenly across the income spectrum, the net impact would be progressive. That is, lower-income households would receive more in rebates than they paid in higher energy prices because they buy less energy.

The most likely scenario, however, is that carbon tax revenues would be distributed by political rather than economic criteria, with an eye toward recruiting legislative support for the tax. And given the revenues at issue – more than $2 trillion over 10 years from our hypothetical $45 per ton carbon tax – there would be plenty to go around. Politically expedient uses would include compensating the coal sector and coal regions for the dislocation associated with rapid switching to other fuels; help for coastal areas in adapting to rising sea levels; and subsidies for energy R&D, renewable fuels and conservation.

trends image 9

The Political Case for a Republican Pivot

Given that the Republican wall against government action on climate change has been rock solid, on first glace the carbon tax looks like a nonstarter. But political tectonic plates are shifting beneath that wall, rendering it unstable. The shift is primarily a consequence of three recent developments.

First, the federal regulatory train has, after nearly three decades, finally left the political station. That train was put into motion by the 2007 Supreme Court decision in Massachusetts vs. EPA, which compelled the EPA to regulate greenhouse gas emissions under the aegis of the Clean Air Act as long as those gases are found to endanger human health or the environment. Reversing that agency determination would be nearly impossible unless a Supreme Court that's been beefed up with conservative appointees chose to reverse itself. Rewriting the clean air act to render Massachusetts v. EPA moot would be extremely difficult politically, as would passing legislation that required Congressional approval for future regulations. Consequently, even climate skeptics are becoming interested in policy interventions that offer a market-oriented alternative to direct regulation.

Second, while denial continues to play well with the GOP base, and climate change hardly came up during the campaign, surveys tell a different story about the country as a whole. Only one in 10 Americans say that climate change is not happening and only 18 percent of Republicans agree that climate change should be ignored by government. Although the issue was long a low priority for most voters, most recent surveys suggest it was more important than race relations, gay marriage, taxes or abortion. Moreover, millennials consider climate change a core issue and support more-aggressive policy action than any other age group does. Thus, while climate denialism has had little impact on the GOP thus far, that is unlikely to continue indefinitely.

Third, the declining cost and growing market penetration of low-carbon energy, coupled with increasing belief in Silicon Valley and on Wall Street that green energy is the wave of the future, is rapidly reversing the public's concern that a renewable-energy economy is an expensive, unrealizable pipe dream. This opens political space for a potentially powerful morally charged campaign against fossil fuels that could prove devastating to the GOP.

Current activism against fossil fuels, ranging from opposition to the Keystone Pipeline to state investigations of whether oil companies have been covering up their knowledge about climate risk, has come from the left. But as middle-income Americans who voted for Trump realize they won't be inconvenienced much by driving Chevy Volts instead of Chevy Cruzes, the door will open to moral arguments against carbon emissions, much the way the sharp decline in tobacco addiction in the late 1980s opened the door to morally driven arguments against smoking.

A Republican pivot away from climate change denial, however, would not necessarily mean a Republican pivot toward carbon taxation. Arguably, it would be politically easier for the party to embrace suboptimal climate strategies (such as subsidies for favored low-carbon energy sources and R&D) that impose fewer visible costs on consumers.

It's worth remembering, of course, that this conversion might well be opposed by many Republican donors from the fossil fuel industry because the potential costs of deep decarbonization would be huge for them. If we wish to keep warming from exceeding 2 degrees Celsius, then one-third of total global oil reserves, half of global natural gas reserves, and over four-fifths of global coal reserves must remain in the ground. The value of the assets that policymakers would be taking away from the fossil fuels industry could run in the trillions.

Nonetheless, the political case for Republicans to embrace carbon taxation is fairly robust. It would give them a way to climb down from denial without acceding to the Democrats' vision of more government regulation.

A selective embrace of more familiar low-carbon energy sources (like natural gas, nuclear power and hydropower) might be a more comfortable shift for the Republican base. But to go this way, Republicans would be swimming upstream: most Americans want to embrace the new technologies, not delay them. Only 9 percent of Americans oppose more solar energy, and only 15 percent oppose more wind energy.

Moreover, a carbon tax initiative need not be a declaration of war against the fossil fuels industry. Carbon taxation is actually supported in principle by most major oil and gas companies – at least as an alternative to more intrusive direct regulation that targets Big Oil. This alliance would help insulate Republican leaders from charges from the conservative base that it is selling out free enterprise.

It Could Happen Here

No one knows what the optimal policy toward greenhouse gas abatement should be because there's still a great deal of uncertainty about the timing and impact of global warming. And what goes for the world as a whole goes double for a single country that faces the added imponderable of how other countries will act.

But we do know for certain that the plausible risks associated with climate change are real and alarming. Moreover, we know that hedging against very-high-damage scenarios is economically rational even if the probability of catastrophe is modest. And we can be pretty sure that a carbon tax would deliver more abatement for the buck than the alternatives.

Harnessing price signals to solve economic and environmental problems is a signature tenet of modern conservativism. It's time – well, way past time – for the GOP to get on board.

main topic: Climate Change
related topics: Regulation, Tax Policy