Editor's Note: The Progressive Policy Institute has long been a leading advocate of market-based policies to limit greenhouse-gas emissions. PPI has advanced a "cap-and-trade" approach, which would set a cap on total emissions; allocate this cap as emission permits to private-sector emission sources; and allow these firms to buy and sell permits. Through the cap-and-trade market, an implicit price on carbon dioxide (CO2) provides polluters an economic incentive to reduce their emissions. A similar market-based policy would directly price pollution by setting a fee or tax on CO2 emissions.
Cap-and-trade and emission fees typically differ along two dimensions. A fee provides certainty over the cost of reducing a ton of CO2, while the alternative provides certainty over the total amount of emissions allowed under the cap. A fee can generate substantial government revenue, while traditional cap-and-trade approaches may forego revenues by giving away some or all of the emission permits.
In the spirit of encouraging an open debate and a greater understanding of all policy options, the cap-and-trade aficionados of PPI present the following summary of an emission fee policy, by Joe Aldy, a fellow at the research organization Resources for the Future in Washington, D.C.
Any serious effort to address anthropogenic climate change will require giving the private sector a financial incentive to reduce emissions. Firms and consumers currently pay nothing to emit carbon dioxide (CO2) and other greenhouse gases. If we want to reduce the harmful effects of such gases on our environment, this free ride for pollution must come to an end.
The two most cost-effective approaches to change incentives and reduce emissions are: (1) ration CO2 emissions through a so-called "cap-and-trade" system; or (2) set a fee on CO2 emissions. Either approach would raise the cost of emitting CO2 and spur investments in more climate-friendly fuels and energy efficiency. These policies, however, are not interchangeable; each has its own advantages and drawbacks, and these merit careful consideration.
Because the emission fee strategy has received markedly less public attention so far than the cap-and-trade approach, this paper focuses on explaining emission fees -- how they would work, how they differ from cap-and-trade, and the potential advantages and disadvantages of such a system for the environment and the economy.
Under an emission fee system, energy producers pay the federal government a certain amount based on the CO2 content of the fossil fuels they bring to the U.S. market. For example, refineries and importers of petroleum products would pay a fee based on the carbon content of their gasoline, diesel fuel, or heating oil. Coal-mine operators would pay an emission fee reflecting the carbon content of the tons extracted at the minemouth. Natural-gas companies would pay a fee reflecting the carbon content of the gas they bring to surface at the wellhead or import via pipelines or liquefied natural gas (LNG) terminals.
These fees would be administratively simple and straightforward to implement. The fees could incorporate existing methods for fuel-supply monitoring and reporting to the Department of Energy. Given the molecular properties of fossil fuels, monitoring the physical quantities of these fuels yields a precise estimate of the carbon-dioxide emissions that would occur during their combustion. Focusing "upstream" in the energy system allows the fee to cover more than 98 percent of all U.S. CO2 emissions through a relatively small number of firms (about 2,500). An emission fee would be similar in form to excise taxes that many fuel suppliers already pay, so it would be easy for firms to understand and account for in their operations.
A crediting system for sequestration could complement the emission fee system. A firm that captures and stores CO2 through geological sequestration, thereby preventing carbon dioxide from entering the atmosphere, could generate CO2 credits and sell these to firms that would otherwise have to pay emission fees. Similar approaches could be undertaken to promote biological sequestration in forestry and agriculture.
As fuel suppliers face the emission fee, they will increase the cost of the fuels they sell. This will effectively pass the emission fee down through the energy system, creating incentives for fuel-switching and investments in more energy-efficient technologies that reduce CO2 emissions.
To illustrate, consider emission fees of $15 per ton of CO2 ($2005) in 2015, with fees that increase over time to $20/ton in 2020 and $50/ton in 2030. Recent analyses show that such a fee structure would reduce CO2 emissions by five percent by 2015, nine percent by 2020, and 29 percent by 2030.
An emission fee could generate hundreds of billions of dollars annually. An emission fee of $15/ton in 2015 would raise approximately $95 billion in that year alone. The revenues from an emission fee can be returned to the economy by reducing existing taxes on income, labor, and capital. Recent research suggests that an emission fee up to about $15/ton could actually make the economy grow faster if the revenues are used to reduce marginal rates on income. Such a revenue-neutral program would stimulate more investment in capital and labor as the taxes on these productive elements of the economy are reduced.
The revenues could also be targeted to specific needs such as shoring up Medicare or Social Security. In addition, some revenues could finance additional research-and-development work on climate-friendly technologies, climate-science research, transition assistance for adversely affected workers, and residential energy assistance for low-income households.
The U.S. can achieve its climate change goals at lower cost through emission fees or cap-and-trade than through any other policy options. Efforts to curtail emissions through fuel economy standards, renewable portfolio standards, biofuel mandates, or appliance standards may be well-meaning, but they impose higher costs on society for a given amount of emissions abatement than an economy-wide emission fee or cap-and-trade program.
Regardless of whether firms pay an emission fee or receive emission permits for free from the government, they will increase the cost of their goods and pass the higher energy costs down to consumers. While it may be clear that a fee would increase the cost of emission-intensive goods, why would a firm that receives free permits increase the prices of its goods?
Here's why: Although a firm would not have to buy a freely-allocated permit from the government, using the permit to cover its emissions prevents the firm from taking advantage of the opportunity to sell the permit to other firms. This foregone revenue is a real cost that firms will account for in pricing their goods. The European Union's Emissions Trading Scheme illustrated this effect: Electricity prices fluctuated with CO2 permit prices even though nearly all permits were given away for free to the private sector.
The costs passed on to each consumer might be noticeable, but need not be onerous. An emission fee of $15/ton or a permit price of $15/ton would increase gasoline prices about 15 cents per gallon and residential electricity prices about ¾ of a cent per kilowatt-hour.
One difference between the two carbon reduction systems is that emission fees provide cost certainty, while cap-and-trade carries risk of price volatility. The EU CO2 market and the U.S. sulfur dioxide trading program have both experienced substantial market turbulence. This volatility can discourage investment and potentially raise long-term costs as firms undertake less climate-friendly R&D in light of uncertain costs.
An emission fee, by contrast, gives firms a clear understanding of what they will have to pay for a ton of carbon dioxide. A hybrid approach, such as a cap-and-trade program with a "safety valve" (in which the government sets an effective maximum on permit prices by promising to sell additional permits at a pre-determined price), would reduce volatility and more closely approximate an emission fee.
Different people may come down on different sides of this price certainty versus emission certainty trade-off. But a certain level of emissions in any one year is not important to the climate; it is the aggregate accumulation of many years of emissions that drives climate change. As we learn more over time about the science of climate change, we will likely realize that any one year's emission goal was, in hindsight, too stringent or too lax.
The overall costs of a climate policy are substantially lessened if revenues are raised and used to reduce existing taxes on income, labor, and capital. Many cap-and-trade proposals would give away a majority of emission permits for free -- a policy that effectively represents a large subsidy to the heaviest polluters. Some utilities in the EU witnessed an increase in their stock prices as they received free emission permits, and their stock prices went up as permit prices rose. A cap-and-trade program could avoid such corporate subsidies if it included a 100 percent auction for permits.
The atmosphere can only accept so much more carbon dioxide before the prospect of major, adverse climate change becomes a reality. Firms and individuals should have to pay for the right to use the atmosphere as storage for their greenhouse-gas emissions. This emission fee can be considered an atmospheric user fee.
One political obstacle to the establishment of an emission fee is the inevitable objection that such a fee constitutes a tax increase. Taxing goods discourages their consumption; for example, taxing labor income discourages workforce participation. This is why there is general dislike for these kinds of taxes -- they discourage good things.
On the other hand, discouraging a bad thing -- such as the pollution that causes global climate change -- actually makes us better off. Moreover, taxing an undesired phenomenon (again, such as CO2 emissions), and using the revenues to reduce taxes on a desired phenomenon (such as increased labor income) can improve economic growth and increase workers' take-home pay. This would not be a tax increase, but a revenue-neutral tax swap that strengthens the economy, not unlike some elements of the 1986 tax reform.
It is also important to recognize that whether we implement an emission fee or a cap-and-trade program, the costs to consumers of using energy and other emission-intensive goods will increase. Those higher costs will reflect the price set by the emission fee or the price of permits in the cap-and-trade market.
We must be mindful not only of the costs and sacrifices that the limitation on greenhouse gases will require, but also of the enormous new opportunities for innovation and the climate-protection benefits we will bequeath to future generations. A carbon emission fee presents an important potential avenue for realizing these opportunities and addressing this urgent environmental challenge.
