The Case for Carbon Pricing

An overwhelming majority of economists and many policy experts believe that a carbon fee or tax must be a core component of climate policy if we are to create incentives for innovation and new investment in lower-carbon technologies—and thus accelerate the transition to clean energy.  Pricing carbon can be the most effective and least expensive way to confront the climate challenge, while producing substantial new revenue to protect families against higher prices and grow the economy.

Transforming an economy that has flourished for more than a century mainly on fossil fuels will require powerful market signals. But it is also generally acknowledged that “pricing” alone will not be sufficient to hit climate targets. A medley of other measures, including standards and other requirements, will also be important - - particularly in addressing emissions from transportation, agriculture, and buildings.

By putting a price on carbon, we put the market to work and at the same time generate substantial new “carbon revenue”, some or all of which can be rebated as dividends to families. Alternatively, a substantial amount of carbon revenue could be used to invest in infrastructure and new low-carbon energy and vehicles, research and development, additional assistance to low-income families or fossil fuel workers most impacted by the price regime, or other national priorities.

Significant analytical work, modeling and economic analysis has been done over the past few years on the likely impacts of various carbon pricing regimes in the United States. This rich inventory of data includes estimates of emissions reductions in diverse sectors of the economy at different prices or tax rates, details on how to impose and adjust pricing over time, the impact on energy and other prices, distributional impacts on families and regions, and competitive pressures on carbon-intensive industries.

The most extensive recent modeling exercise based on 11 separate models indicates that a carbon fee of $25/metric ton (MT) of CO2, escalating at 1% per year over inflation, will result in a 17-38% reduction in carbon emissions below 2005 levels 10 years after enactment. A tax of $50/ton, escalating at 5%/year above inflation, is estimated to produce a 26-47% reduction in emissions over 10 years.  [Barron, et al., "Policy Insights from Stanford Energy Modeling Forum exercise 32 (EMF 32) Study on US Carbon Tax Scenarios," Climate Change Economics, Vol. 9, No.1 (2018), pp. 9-10.]

Either of these scenarios would enable the United States to meet the target we committed to in the Paris Climate Accord of a 26-28% reduction in emissions from 2005 levels by 2025.

A carbon fee in this range would also produce substantial new revenue. According to calculations by the U.S. Treasury and the Congressional Budget Office, a $25/MT carbon fee increasing at a real 2% per year would produce about $1 trillion over 10 years; a fee starting at $49/MT with a similar annual rate of increase would produce $2.2 trillion over 10 years.

The simplest, most transparent, and easiest-to-administer carbon fee would be imposed on coal, oil and gas when they enter the economy. This “upstream” fee would be based on the CO2 emissions anticipated when the fossil fuel is burned. The federal government already measures and taxes coal and oil for other purposes at the mine mouth and refinery gate. (There are fewer than 120 refineries in the United States.) Natural gas is already measured at various upstream ports, so imposition of a fee would be simple. The system would have fewer than 2500 taxpayers, but increased prices would be felt throughout the economy, creating a pervasive disincentive to purchase or invest in high-carbon products and processes, and an incentive to choose less-expensive lower-carbon alternatives.

A well-designed cap-and-trade regime like the one passed by the House in 2009 could also theoretically put a price on carbon emissions. But the implementation of such systems in the European Union, California and Northeast US states has revealed flaws. These systems are very complicated, reduction targets were not ambitious enough, and many of the tradeable permits were given away free to industry, leading to widespread price instability and very low carbon permit prices. Thus the anticipated market incentives for low-carbon investment failed to materialize. These systems are trying to cure the problems, but it remains unclear whether they can achieve the underlying pricing objective: a consistent, predictable and gradually-increasing carbon price over the foreseeable investment future.

Increasingly, carbon pricing has been embraced by countries, companies and experts (some of whom are listed here under “Supportive Voices”). More than 20 countries, including Canada, have implemented carbon taxes. In 2015 the CEOs of the largest European oil companies wrote to the United Nations urging a single European or global price on carbon. So did the heads of the International Monetary Fund and the World Bank, as well as the International Chamber of Commerce. Numerous bills proposing an economy-wide carbon tax have been introduced in the U.S. Senate and House by both Democrats and Republicans.

Carbon pricing can be a bipartisan strategy in the United States and win the support of a substantial portion of the business community. Well-known former Republican cabinet members, together with major oil companies and other corporations ranging from Ford and GM to Pepsico and Metlife, have embraced a proposal for a $49 fee that would increase annually, with 100% of revenue refunded as “dividends” to all families. In May 2019, the CEOs of 13 major companies publicly endorsed a set of six principles urging enactment of climate legislation, including this one: “An economy-wide price on carbon is the best way to use the power of the market to achieve carbon reduction goals, in a simple, coherent and efficient manner.”

Carbon pricing has popular support. 67% of registered voters support requiring fossil fuel companies to pay a tax on the carbon pollution they produce, with the proceeds used to reduce other taxes (Yale Program on Climate Change Communication, December 2020).

Three compelling arguments in favor of a simple upstream carbon fuel fee (where a substantial amount of the revenue is redistributed in a carbon dividend to low- and middle-income families) is attracting conservative and business support. First, an increasing carbon fee whose level and rate of increase can be adjusted over time to guarantee that emissions reductions targets are met or exceeded could  substitute for a substantial amount of new, potentially-onerous and complicated regulations that would otherwise be required - - and avoiding new regulation is a key objective of both conservatives and business interests. Second, even a small portion of the substantial revenue produced can hold most American families whole against slightly increased fuel prices and still allow huge investment in national priority programs. If all the revenue were distributed to families, the vast majority of them would have a significant income boost. Finally, economic modeling indicates that a properly-designed carbon fee program will help grow the economy.

Adoption of an economy-wide carbon pricing program in the United States, though essential, will not be sufficient to avert the long-term risks of climate change. Analysis and economic modeling show that while a moderate climate fee moves the power system rapidly toward total de-carbonization, reducing emissions in the transportation and building sectors will require standards and incentives. Designing a pricing program that is not only effective in reducing emissions but also economical and equitable, protecting those most adversely affected, will also be key to ensuring the program’s durability in future years.

Moreover, with a decreasing percentage of the world’s emissions, how the United States exercises its foreign policy and leadership in the global climate arena to encourage other countries to adopt strong climate policies - - and how successfully the United States can develop and promulgate the low-carbon technologies that countries like China and India will need - - will be as important as what we do domestically.  A strong program with pricing at its core that demonstrates a commitment to serious emissions reductions and to accelerated development of low-carbon technologies will be critical to that global leadership effort.