Wednesday, December 2, 2009

KEEP IT SIMPLE: From Cap-and-Trade to Tax-and-Cut

The California Air Resources Board (CARB) released last week the “Preliminary Draft Regulation for a California Cap-And-Trade Program. Sandwiched right between “ClimateGate” and the Australian rejection of a similar system, the timing of the release could scarcely have been worse… But it’s a very important document nonetheless.

The regulation seeks to drive a reduction in greenhouse gas emissions (GHG) on the order of 2%-3% every year, potentially exceeding the targets which are being mentioned for Copenhagen. But how are going to realize them? A review of the summary text provides a quick reminder of some the challenges which are inherent to any cap-and-trade (or emission trading) scheme:

  • Complexity: As most people know, the determination of carbon footprint is far from obvious, and relies on approximations and assumptions (see for example this). These pale in comparison to the additional elements built into a cap-and-trade system. Such complexity virtually guarantees that the impact on incentives will—at best—take a LONG time to materialize.

  • Costs: The system entails significant costs to administer, monitor, track, and report, as well as the need to create and fund secondary trading platforms for the allowances/credits.

  • Inequity: The system is potentially arbitrary, due to the likely need to allocate allowances and to adjust the allocation over time.

  • Rigidity: A system which is not designed to be responsive to on-going changes in the conditions of Californians

  • Adverse economic impact on growth: An effective levying of a significant tax on corporations, small businesses, and individuals (the draft suggests that some of the government revenues might be redistributed to Californians—to be further discussed).

These challenges should come as no big surprise to anyone even vaguely familiar with such systems. So why should California follow the wrong approach to tackle the GHG targets? I strongly believe that California—true to its track record in many fields—should innovate, rather than replicate, in this area.

So what should we do? Well, let’s go back to basics: If we seek to reduce the amount of carbon which we add to the atmosphere (beyond what is part of the normal carbon cycle), we have three primarily levers:

  1. Shift the mix of energy sources away from fossil fuels (crude, gas, and coal) and to sources which have a no (or low) contribution to the carbon total
  2. Increase the efficiency with which we use energy in our daily life (as long as some of this energy relies on fossil fuels)
  3. Keep incremental CO2 out of the atmosphere, either by limiting deforestation, or via novel technologies for carbon sequestration and storage

It so happens that the first two levers can be addressed by a fairly straightforward economic mechanism: A carbon tax shift or what I’ll call “Tax-and-Cut.” Al Gore described a variant of this approach in his book, "Earth in the Balance;" my suggestion for California is:

  • Tax fossil fuels (crude, gas, and coal) and their products, based on their carbon content. This would raise the costs of using energy and thus would provide a “price umbrella” for introduction of lower/zero-carbon content alternatives (dealing with issue #1 above) and also encourage consumers to adopt higher-efficiency solutions (dealing with issue #2 above).

  • Redistribute the entire carbon tax revenues (ideally on a quarterly basis) to individuals and corporations, in proportion to their income tax payments to California during the preceding 12 months. Some proportion of the revenue should initially be used to increase payments to recipients of unemployment benefits and other State transfer payments.

  • Set the tax level against a benchmark of the modeled societal cost of GHG (e.g., $30 per metric ton of CO2 equivalent), and the price can be set up on a sliding scale over time: for example, 25% of target cost in year 1, 35% in year 2, etc. California will still have the flexibility to adjust carbon tax level based on changes in environmental and economic conditions.

For further discussion of this topic please read Elaine Kamarck (who was Al Gore ‘s domestic policy advisor) or the Carbon Tax Center.

Having addressed items #1 and #2 with a “Tax-and-Cut” scheme, what can we do about #3 (carbon sequestration)? In part, it could be folded into Tax-&-Cut, via a carbon tax on wood products (calculated based on the net lost in sequestration capacity, in a way similar to the method for fossil fuels) and a tax credits for buyers of carbon-sequestration solutions (including RE-forestation). However, it is less obvious how California could use a tax solution as a disincentive for deforestation, given than the majority of it occurs in other nations… Something to think about—but not enough to question the superior simplicity of the Tax-&-Cut approach.

In summary: Setting up a California system for “Tax-and-Cut” which will use pricing and incentives to drive GHG emission reduction will be much simpler and cheaper than the draft “Can-and-Trade” approach, which is based on onerous limits on quantities and complex tracking and reporting.

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