Carbon Taxes and Cap and Trade – State Policy Options

Carbon Taxes and Cap and Trade – State Policy Options ( Depositphotos_©-ruigsantos )

The Debate Over a Carbon Taxes, Cap and Trade, or Doing Nothing Matters to Environmentalists, but also State Budgets

State governments have a lot of power to go beyond Federal requirements in setting environmental standards. Taxing power is also extensive, and legislators and state budget officers are always looking for new ways to generate revenue. Although climate change remains a highly politically polarized issue, it is becoming less so. According to Gallup, today 59% of Americans believe we should prioritize protecting the environment over developing energy supplies, such as coal, oil, and gas. This is an eighteen-point increase since 2011, when only 41% of Americans thought we should prioritize the environment over energy supply. Carbon taxes and cap and trade programs are commonly proposed policies that work towards this goal.

Scientists overwhelmingly agree that limiting our carbon output can help mitigate the effects of climate change. Carbon production is also a component of every state economy, albeit some larger than others. States looking for revenue sources to shore up fiscal positions may be attracted to ways to generate revenue that also have other positive effects on society. What is the best way for a state to cut carbon output? Regulations can be highly effective if well crafted and targeted, but add costs to both business and regulatory agencies. A 2015 survey of economists with expertise in climate effects found that 75% think a market-based approach is the most economically efficient way to cut carbon output.  These market approaches still would add costs to carbon producers, although likely less so than regulations, and be far cheaper, perhaps even lucrative, for state governments. What are the trade-offs economically and politically to each approach?

Cap and trade for energy producers and large industrial facilities, and carbon taxes for everyone else, may be a proper approach for state governments

The State of Play

Currently, no state in the union implements a carbon tax. Washington State was the latest state to successfully get a carbon tax on the ballot, but its measure I-732 was defeated 59% to 41% by popular referendum in November 2016. Governor Jay Inslee has continued to push for a carbon tax despite this recent setback. There are three different regional cap and trade agreements among U.S. states.

Regional Greenhouse Gas Initiative – The first market-based mandating a reduction in greenhouse gas emissions, RGGI is a cooperative effort among the states of Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, and Vermont. The program moved from planning to implementation in 2014, and is actively reducing emissions from the power industry through 2020.

Western Climate Initiative, Inc. – WCI originally formed as a grouping of U.S. states and Canadian provinces to set up a sub-national, regional emissions reduction program. Initially, the organization included California, New Mexico, Oregon, Washington, and Arizona, with Utah and Montana joining later. Today, California is the only participating state, along with the Canadian provinces British Columbia, Manitoba, Ontario, and Quebec.

Midwest Greenhouse Gas Reduction Accord – The MGGRA was originally formed in 2007 among six Midwestern states, Illinois, Iowa, Kansas, Michigan, Minnesota and the Canadian province of Manitoba. It’s design was to also set up a regional cap and trade system. While the MGGRA is still technically active, no concrete actions are taken or adhered to at this time.

As of 2017, the nine states of the RGGI and California are the only states involved in regional cap and trade programs. The RGGI has been considered a success.  Analysis shows that as of 2015, the expected reductions in CO2 emissions by 2020, relative to a 2005 baseline, is more than 45 percent. Additionally, the program has generated net economic benefits of $1.3 billion to participating states just in the second-phase period of 2012-2014, mostly through the use of auction proceeds towards energy efficiency, renewable energy, and customer bill reductions.

Cap and Trade

Cap and trade programs see the government set a ‘cap’ on the total amount of CO2 emissions that can be generated by any and all producers (usually limited to energy producers, as opposed to trucking companies, individuals, etc.) within their jurisdiction. Emissions are broken up into permits that are typically either sold initially at auction, or distributed to current producers based on current emission levels. Permits are then swapped, bought, and sold between producers. The government has no further intervention other than to monitor emissions, and any producer that exceeds its allotted permits is penalized. Producers who find it worthwhile can lower production, or invest in energy efficient infrastructure, and sell their extra permits on an exchange. Other producers can choose to simply buy permits available, if that is more economical to them than reducing emissions.

Carbon Tax

Carbon taxes are quite simply a per-unit tax on each unit, often in tonnes, of carbon produced. The logic is twofold. First, if you price the tax high enough, it will become unprofitable to produce more emissions. It would be cheaper to reduce production or invest in energy efficient infrastructure than pay the tax. Second, the government can use the revenues to make their own investments to protect the environment or reimburse citizens who are impacted by climate change.

Pros and Cons

A cap and trade system is generally seen, all else being equal, as more effective at limiting emissions. This is naturally because the government sets the overall limit. It also allows the market to set the price of permits, and the price of energy in general. This is a more efficient cost-setting mechanism than the government having to periodically reset the carbon tax level, which may fluctuate with energy costs and technology changes.Carbon Tax Cap and Trade Chart

However, a cap and trade system is much more costly for the government to administer than a simple emissions tax, especially in the initial development. Carbon taxes are also more economically efficient, as they make it easier for firms to determine what course of action to take. They set greater cost stability. Firms can just plug in the per-unit cost of the tax to figure out whether to decrease production, invest in emissions-reducing technology, or pay the tax. However, a carbon tax offers less assurance that emissions will be reduced to the level desired.

Charles Frank, a Senior Fellow at the Brookings Institution, points out that a cap and trade system is unrealistic for small producers like trucking companies, small businesses, and individual households. Each transaction has a cost, and to involve all of society in the market would force too many transactions of too many types of buyers and sellers. It is better for most of the public to simply pay carbon taxes. However, many large producers, like energy companies, may prefer the flexibility of a cap and trade system. This mix, cap and trade for energy producers and large industrial facilities, and carbon taxes for everyone else, may be a proper approach for state governments.

The Yale School of Forestry and Environmental Studies brought together eight experts in economics, political science, environmental studies, risk analysis, and asked them to pick between a cap or a tax. They were split 4-4. The main criticisms of each policy being that the theoretical simplicity of a carbon tax will disappear once it goes through the legislative process, and the theoretical certainty of a cap and trade policy to reduce emissions goes away in practice, because special interests are more able to game the system.

State policy makers should also review this excellent paper from Brookings on state-level carbon taxes. The paper compares carbon taxes to other alternatives from both the emission-lowering perspective and the revenue-generating perspective, which is useful for states with varying priorities. In addition, it focuses on the following:

  • The tax treatment of carbon embodied in fuels, electricity, and goods that are imported or exported from the state;
  • Tradeoffs arising across addressing the disproportionate burdens on low-income households and using the revenue in ways that promote economic growth;
  • How states can harmonize policies to avoid distortions in investment and trade; and
  • How a carbon tax can feature in state implementation plans for the Clean Power Plan and EPA rules under the Clean Air Act.

There is no definitive answer as to whether a carbon tax, a cape and trade program, or other regulatory alternatives are optimal. One thing that all experts seem to agree on is that doing something is better than not acting to combat the problems of climate change. There are plenty of alternatives for policy makers to choose from, to construct a smart energy policy that works for them.

by Jeffrey L Garceau

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