TODAY’S STUDY: Why A Carbon Tax

Achieving U.S. Emissions Targets With A Carbon Tax

Noah Kaufman, Eleanor Krause, Kehan Desousa, June 2018 (World Resources Institute)

Highlights

▪ Adding an “emissions target mechanism” to a carbon tax will help to ensure that national emissions targets are achieved. ▪ Such a mechanism would involve a periodic evaluation of whether greenhouse gas (GHG) emissions levels are too high, and, if so, would ensure a policy change is triggered. ▪ The policy change may involve adjustments to carbon tax rates, increasing government spending in ways that reduce emissions, or activating a “back-stop” policy or regulation. ▪ Emissions targets can be achieved most cost-efectively when a carbon tax is supplemented by complementary policies. ▪ Policies that are likely to complement a carbon tax include those that support low carbon innovation, encourage energy savings from customers, target diferent emissions sources, or target diferent policy objectives. ▪ The importance of emissions target mechanisms and additional policies alongside a carbon tax depends on the tax rate and other details of the carbon tax policy

Executive Summary

A national carbon tax would decrease U.S. GHG emissions by providing a fnancial incentive to shift to less carbonintensive behavior. Additional policies and mechanisms alongside a carbon tax can further decrease emissions and improve economic outcomes. This paper, the fourth in a series by World Resources Institute (WRI) on carbon pricing in the United States, provides an overview of how a carbon tax can ft into a broader strategy to achieve national GHG emissions targets by ensuring that emissions targets are achieved with sufcient certainty and by surrounding the tax with complementary policies that enable larger and more cost-efective emissions reductions.

Policymakers can add an emissions target mechanism to a carbon tax to help ensure that emissions targets are met. The response of producers and consumers to a carbon tax cannot be predicted with certainty, so future emissions levels are uncertain. Some advocates of climate change policy are skeptical of carbon taxes due to the possibility that emissions levels under the tax may be higher than expected, jeopardizing national emissions targets. However, in two simple steps, policymakers can design a mechanism that can ease concerns of higher-than-expected emissions under a carbon tax.

The first step is a periodic evaluation of whether GHG emissions levels are too high, which involves setting the timing and benchmarks by which the emissions trajectory is evaluated. Hypothetically, the policy could say that if the total annual emissions covered by the tax are above a benchmark, for example 4 gigatons (GT) of CO2 after fve years, the emissions trajectory is too high. To enable even greater control over emissions outcomes, policymakers can opt for more frequent evaluations, more complex benchmarks than annual emissions covered by the tax, and/or a benchmark that is relatively close to the emissions trajectory expected under the tax. If, instead, the tax is expected to drive emissions well below the benchmark, the mechanism is akin to an insurance policy against an unlikely high emissions outcome.

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The second step is a policy change that is triggered when the evaluation deems emissions levels to be too high. This policy change can come in many forms, which we separate into four categories:

1. Automatic adjustments to carbon tax rates. Greater emissions reductions can be achieved by increasing future carbon tax rates above originally planned levels. Switzerland’s carbon tax does just that, and because 2016 emissions exceeded a benchmark prescribed in the legislation (73 percent of 1990 emissions), the tax rate will increase from $87 to $100 per metric ton in 2018 (Hafstead et al. 2017; World Bank 2017). Alternatively, the adjustments could shift all future tax levels upward by a certain percentage, so that, say, a 4 percent annual increase is raised to a 10 percent increase until emissions have fallen below the benchmark trajectory (Metcalf 2009). Under this approach, regulated entities would need to plan for multiple possible future tax levels, but they would still beneft from a predictable regulatory pathway; improving regulatory certainty can reduce compliance costs and boost innovation (Mordfn 2014).

2. Increasing government spending in ways that reduce emissions. If emissions levels are higher than expected, carbon tax revenues will also be higher than expected. The legislation could direct a government agency to use this “extra” revenue to fund activities that further reduce GHG emissions; for example, the revenue could fund changes in forest and agricultural practices or to capture methane leaks (Murray et al. 2017). Unlike an adjustment in the tax schedule, this policy change would not directly afect regulated entities. Similar to “ofset programs” included in cap-and-trade policies, this approach requires a market for additional mitigation opportunities and strong monitoring and verifcation of emissions reductions, which is a challenge for many emissions sources (Murray et al. 2017). Another challenge could arise if the extra revenue is insufcient to reduce emissions to desired levels; in theory, policymakers could divert additional funding, but those funds would need to be diverted from another intended use or from increased debt, which could create signifcant political challenges.

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3. Activating a “back-stop” policy or regulation. A carbon tax can be paired with an alternative policy that ensures sufcient emissions reductions and is implemented only when the evaluation deems emissions to be too high. While the federal government has broad authority to regulate greenhouse gas emissions, current federal regulations have not achieved emissions reductions that are as large and as certain as a strong carbon tax would achieve, which are prerequisites for a useful “back-stop.” The back-stop policy would therefore likely need to consist of additional policies or regulations passed alongside the carbon tax, such as a national cap-and-trade program or far more stringent versions of current federal climate regulations, which could signifcantly increase the political hurdles of passing legislation.

4. A streamlined process for modifying the carbon tax based on new information. Carbon tax legislation could include a process by which the policy is periodically reviewed and revised based on new information about climate science, the cost of the policy, and/or the actions of other countries. Aldy (2017) provides one detailed proposal, whereby changes to the future carbon tax levels proposed by the U.S. president would receive an expedited “up or down” vote in Congress with no amendments or flibusters, similar to the process for congressional approval of trade agreements. Under Aldy’s proposal, if the president’s recommendation is voted down, the status quo carbon tax levels would remain. This approach provides fexibility to respond to changing circumstances, but also relies on future governments to act in good faith in developing and using new information to improve the policy.

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None of these approaches would entirely eliminate the uncertainty in emissions outcomes, but the objective of the mechanism is to enable countries to credibly make and follow through on emissions pledges, not to achieve precise emissions outcomes.

Additional policies alongside a carbon tax can further reduce emissions in a cost-efective manner. The following are three major categories of policies that can complement a carbon tax as part of broader strategy to achieve a U.S. emissions target:

▪ Policies, regulations, incentives, and infrastructure that support low-carbon innovation. Technological progress occurs naturally in a market economy, and a strong and stable carbon tax is one important way to encourage innovation in low-carbon technologies. But, even with a carbon tax in place, the private sector will underinvest in the research, development, demonstration, and deployment (RDD&D) of emerging low-carbon technologies. Investors prefer short-term payofs and minimal risk, and they make decisions largely based on their own expected fnancial gains, and not the much broader societal benefts that derive from the emergence of new and productive technologies. These barriers can be addressed with government-sponsored RDD&D, incentives for deployment of early-stage technologies, regulations, and infrastructure that encourage the emergence of low-carbon technologies.

The U.S. federal government has been involved in all stages of RDD&D in low-carbon technologies through grants, loans, subsidies, and the work of national laboratories and other government ofces. Still, most experts recommend signifcantly increasing current funding levels for research and development (R&D) of emerging low-carbon technologies (Newell 2015). Governments should be more cautious in supporting more mature technologies to avoid “crowding out” private sector actions, but targeted policies that encourage early-stage deployment (e.g., solar photovoltaic [PV]) and largescale demonstration projects (e.g., carbon capture and storage [CCS]) have and will continue to be essential in enabling emerging low-carbon technologies to compete on a level playing feld with high-carbon alternatives.

▪ Policies that encourage energy savings from consumers. A carbon tax encourages energy savings by increasing the price of energy, but a price signal alone is insufcient to induce consumers to take advantage of all cost-efective opportunities to improve energy efciency. Consumers often lack incentives that reward long-run energy savings, sufcient information about energy efciency opportunities, or the means to invest in new equipment (Gerarden et al. 2017).

Policies can help to overcome these market barriers by providing information, targeted fnancial incentives, or technology standards. A wide range of policies are currently on the books to support energy efciency, including at the federal level (e.g., energy efciency standards for appliances and equipment, and fuel economy standards for vehicles), at the state level (e.g., 20 states have binding mandates requiring utilities to achieve specifed levels of customer energy savings), and at the local level (e.g., cities like Austin, Texas, that mandate home energy audits). Energy efciency policies that enable emissions reductions or other objectives at a relatively low cost are important complements to a carbon price.

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▪ Policies targeting “uncovered” emissions or intending to achieve nonclimate objectives. A large majority of GHG emissions can be covered by a carbon tax with relative ease, including nearly all CO2 emissions from energy use, which make up about 80 percent of U.S. emissions. However, the administrative burdens associated with covering certain categories of GHG emissions (e.g., methane leaks from fossil fuel systems) with a carbon tax may be sufciently large that alternative policies are preferred, particularly in situations where emissions sources are highly dispersed and reductions are difcult to verify. For example, in 2016, the Environmental Protection Agency (EPA) issued performance standards requiring oil and gas producers to reduce methane emissions from new or modifed equipment, using technologies and methods that the government would be able to monitor and enforce (U.S. EPA 2016).

Policies intended to achieve nonclimate objectives and reduce GHG emissions as a “cobeneft” can also complement a carbon tax. For example, regulations of conventional air pollutants like particulate matter often cause signifcant GHG emissions reductions because they discourage an activity (e.g., burning coal for electricity in power plants without emission controls) that produces both types of emissions.

Policies that do not fall into these three categories are less efective complements to a carbon tax if they are likely to involve administrative and regulatory costs without achieving signifcant climate benefts. In particular, policies may be duplicative if they (1) address the same emissions sources and (2) do not have a major rationale aside from reducing GHG emissions (e.g., addressing a separate market barrier). Indeed, if a sufciently strong federal carbon tax is implemented, some policies are likely to be partially or fully duplicative from a GHG-reduction perspective.

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The benefts of mechanisms and policies alongside a carbon tax depend on the details of the tax. If carbon tax levels are relatively low, it is more likely that an emissions target mechanism will be triggered to achieve a given emissions target. Alternatively, stronger complementary policies may be needed because the carbon tax alone is not “pulling its weight.” For example, with a “weak” carbon tax that insufciently encourages private sector investments in clean energy innovation, additional government support for RDD&D— from support for basic research to incentives for deployment of emerging technologies—could help fll this gap.

On the other hand, if carbon tax rates are sufciently high to comfortably achieve emissions targets, a mechanism that kicks in when emissions are too high is unlikely to be triggered. Still, even an emissions target mechanism that is never triggered can be an important component of a national climate change strategy—after all, ensuring that emissions targets are achieved without such a mechanism may require higher carbon taxes or additional complementary policies, both of which could impose additional costs on regulated entities and taxpayers.

Assembling a coalition of lawmakers to pass strong federal climate legislation will require policies that stand up to environmental and economic scrutiny. Even among those inclined to support a carbon tax, some powerful voices (e.g., many in the environmental community) will push for greater emissions certainty and additional policies alongside the tax, while others (e.g., many in industry) will push for greater policy simplicity, regulatory certainty, and fewer duplicative regulations. Designing a policy that earns support from both groups will be a major political challenge. By combining a strong carbon tax with a simple emissions target mechanism and a targeted portfolio of complementary policies that focuses on areas where a carbon tax has limitations, policymakers can design a national climate strategy that achieves ambitious emissions targets cost-efectively, which should earn the support of all groups that wish to reduce the risks of climate change…

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