Monday, December 7, 2009

Carbon Taxes vs Cap and Trade, and a third alternative.

I’ve been thinking a lot about this issue. Carbon taxes and cap-and-trade both have unique good and bad features, but they also share one critical weakness that may sink the whole enterprise. I’ll go over those here.


Carbon taxes have the inherent advantage that they are very simple. There will be few transaction costs involved with reducing carbon emissions. You also have the wonderful factor that everyone has an incentive to look to replace emitting technologies, and while the government may not be very good at determining which industries have ready substitutes in waiting, the industries themselves certainly do. So it will create the “maximal” level of shift over… it doesn’t put a ceiling on the amount of emissions we cut, and it gets every industry thinking about how to reduce emissions, not just the ones the government thinks can do it easily / the government doesn’t get money from.


There’s also a government issue – it’s a lot harder for the government to move the goalposts. With cap and trade, the government can allow more emissions during a recession, but reestablishing a lower cap will be very politically difficult. Tax rates may (I emphasize may) be harder to shift around, slightly.


The disadvantage, however, is that there are some industries that are harder than others to reduce emissions in, and the tax will cause a lot of hardship there, and possibly disincentivize production or expansion in highly innovative, important, but carbon-intensive industries (portions of manufacturing or chemicals, for example). Cap and trade, in its best form with a government with perfect information, lets the government allocate carbon credits based on ease of substitution. An industry where there is no substitute for carbon emissions (perhaps some sort of fertilizers or other chemicals) would not suffer, whereas an industry with easy substitutes (switching types of energy or production processes, or building more efficient buildings, etc) would switch. This is highly unrealistic, but it’s a model. The other problem is that emissions reductions are hard to measure ahead of time with a carbon tax, whereas cap and trade lets us set a cap and thus gain credibility in trying to force China/India/Middle East/Europe/everywhere else to match us.


The problem with BOTH of these approaches is that they don’t address imports. If I’m an American manufacturer, and I see America making it more expensive to manufacture, I shift production offshore and export to America. That becomes much harder to tax or cap because you have to establish how much every good consumed in the US produces instead of just every form of energy used in the US to manufacture, and assess it at ports, and catch smugglers, etc.


The easiest solution, of course, is to Pigouvian tax consumption goods that emit a LOT of carbon. Instead of taxing production, you tax consumption, which addresses the imports/exports issue. Tax the hell out of bottled water, incandescent lightbulbs, gasoline, residential utilities, whatever else has a ready substitute and produces a lot of carbon. Black markets need to be avoided but at least that’s easier. It’s just doubtful that’s enough to stem the tide.


So we look bigger at consumption goods that can shift over time. Emissions by sector in 2004 were as follows: Electric Power (39%), Transportation (33%), Industrial (17%), Residential (6%) and Commercial (4%). So why not a specialized sector by sector attack instead of a blanket policy?


Industrial and Electric power need to be grouped together, because you can’t reduce electricity consumption quickly without reducing industrial output. So a slowly stepped up carbon tax on electric and heating utilities may be the best approach – it can’t be sudden, because utilities need time to develop alternatives. It has to be the utility so that it’s a consumption, not a production, tax. You may even want to exempt manufacturers from this tax and just levy it on retail stores and homes. This would entail an immobile rate ceiling (no rate increases), and also entail penalties to utilities (including mandatory equity issuance to pay the government) for not reducing emissions fast enough, because the nature of rate regulation is such that some of these utilities have monopolies and thus have some market power (state congresses can’t let utilities go out of business, so the utilities can go to the brink and force congresses to let them raise rates – it’s the same moral hazard issue people are so worried about with the bank bailouts). This would have to be managed very carefully – the idea is to tax consumption of electric power by people, not by companies that employ people. Because of the escalating tax, one would expect that utilities would not add significant incremental fossil fuel plants. Incremental power would come from more efficient sources, and as we work out kinks in green energy and the tax gets high enough, you could start seeing fossil fuel plants get phased out.

Transportation can be dealt with as a gasoline tax and efficiency mandates (MPG, etc) for cars/buses/trains/planes and the military. This gas tax can escalate faster and faster so that as people replace their durables, they buy efficient ones. Short term, durables don’t get replaced, but intermediate term, they do. (Meanwhile, Warren Buffett makes another fortune on his BNI purchase, as railroads stand to benefit more than anyone else from a gas tax).


Construction and agriculture (not listed) are a massive proportion of the remainder. Construction could be handled with changes in building codes, as well as the electric power solution up above. Cash for caulkers may actually be helpful, and requiring every building to meet some insulation standard (tested every X years – like Radon, I think, or at least like Radon should be) would do a lot in the construction arena.

Agriculture is the hardest to find a simple solution, because unlike electric power, there isn’t a potential solution even remotely on the horizon. A meat tax would hit consumption somewhat, but meat consumption may not be that elastic, and subsidy of methane reactors (from animal excrement and decaying plant matter) would help with a more efficient way to address CO2 from waste, but that’s expensive and not necessarily an efficient use of cash. All of these aren’t very palatable options as you may not hit carbon emissions much and you don’t want to send every farmer out of business.


You can also tax things that consume a lot of water (water treatment is very carbon inefficient, and water is going to be key to green energy), or update residential code to limit things like grass backyards or pools in areas with water shortages.


The general idea is that big taxes or bans on inefficient components of these industries may be enough – you don’t have to tax all carbon, because there are a very small number of replaceable sources that account for a lot of US emissions. That also reduces the offshoring-manufacturing issue, because you could target consumption with all of these. Consumers get walloped a little bit, but they’re getting walloped by any carbon-reduction solution (and healthcare, and trade-deficit…). This wallops them less, because it eliminates a lot fewer jobs.


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