The Six Flaws of Cap/Trade and How to Fix Them

Can and Trade proposals, like the Waxman-Markey discussion draft released last week, generally contain six major flaws. Aw we remedy each of those flaws, we move closer to the "gold standard" -- a revenue-neutral carbon tax.

1) Upstream: Impose the cap (or tax) at the first point of sale. Easiest enforcement, fewest regulated entities, broadest effect. Only advantages to downstream cap or tax is lack of transparency (hide the price). Price signal will be passed down the chain of distribution anyway.

2) 100% Auction. Some cap/trade proposals (Waxman-Markey leaves this unspecified) would give allowances (pollution permits) to utilities and other large polluters in the hope that this would prevent them from passing on costs to consumers. But because those free allowances have value, utilities can be expected to charge market rates for them. This is what happened in the EU when they gave free allowances to utilities. (Like your grandmother leaving you her house. Just because you got it free doesn't mean you rent it for nothing.)

Obama has supported both of the first two fixes -- big improvements over the Lieberman-Warner bill of last year. Recent reports suggest that the Administration is considering concessions on its "100% auction" position.

3) Revenue-Neutral: "Recycle" the proceeds from auctioning carbon permits (or taxes). Rep. Chris VanHollen has a cap and "dividend" bill that would distribute auction revenue equally to households. This eliminates the overall regressive effect of a carbon tax. People who use less than average amounts of fossil fuel would get "dividends" larger than their increased fuel costs. But everyone would feel the price pull to conserve and switch to cleaner energy. NASA climate scientist, Dr. Jim Hansen favors this "dividend" approach because it's very explicit and builds political support for the program. "Tax carbon, pay people" he says.

Another option is to use auction or tax proceeds to reduce payroll taxes. Because payroll taxes are even more regresssive than a carbon tax, the net effect of a carbon tax offset by a reduction in payroll taxes is a progressive tax shift. That is, middle and low income households come out ahead. That's the approach Rep. John Larson's bill uses. Cutting payroll taxes has the added advantage of stimulating employment.

Note that in both instances, the payment isn't linked to carbon use, so the tax encourages everyone to reduce carbon use, but below average carbon users would get more back in either dividend or payroll tax reduction than their increase in fossil fuel costs.

4) No offsets. Offsets are a way for polluters to pay someone else to make reductions. If those reductions come cheaper than making their own reductions, that means we get the same net reductions at lower cost. Offsets can be a way to fund important forestry and agricultural activities that sequester carbon. But Friends of the Earth now opposes all offsets because they are extremely difficult to verify. It's difficult to establish that a project would not have been done without the offset funding. FoE is concerned about the potential for "subprime carbon" offsets infecting the whole market in the same way subprime mortgages infected the world's financial system. Greenpeace criticized Waxman's inclusion of about 1/3 of total allowances as offsets. With access to so many cheap offsets, U.S. firms would have little need or incentive to reduce emissions for decades as cheap offsets siphon off funds needed for investment in carbon reduction infrastructure here.

Even with those four "fixes," there's still a very big problem of price volatility which can discourage needed investment in alternative energy and efficiency upgrades. When investors can't predict their return on investment, they tend to choose other, more predictable investments.

5) Price Floor. Establish a minimum allowance price. If prices go too low, there's no incentive to conserve or invest in alternative energy. That's what's now happening in the EU-- low allowance prices are discouraging green investment. A floor would mean the government would have to buy allowances at that pre-determined minimum price in the event of over-supply. Similar to the way currency is managed. The Fed buys dollars when the exchange rate gets too low. A floor would assure a minimal return on green investment.

6) Price Ceiling. Establish a maximum price to avoid crashing the economy with a price spike, for example if weather or high levels of economic activity drive up carbon permit prices. Government would have to sell additional allowances at that ceiling price. This would eliminate the much touted "emissions certainty" of a cap but would prevent political upheaval in the event of a price spike.

Other ways to manage volatility include banking and borrowing of allowances.

To the extent that the floor and ceiling converge on a single price (high floor, low ceiling) and with the other 4 fixes in place, you have a revenue-neutral carbon tax. In my view, each of those six flaws could prove fatal to a cap/trade system. From what I can tell, the Waxman-Markey proposal carries all six flaws.

Rep. Inglis Engages Climate Skeptics: Tax CO2, Not Work.

Who'd have expected a Republican from South Carolina to emerge as one of the clearest voices for effective climate policy? After a trip to Antarctica where scientists showed him ice cores that record the jump in CO2 levels now warming the Earth, Congressman Bob Inglis (R-SC) is convinced: "The evidence is compelling: Global Warming is a real, human-caused problem."

Inglis addresses skeptics with a science experiment:

“This is an egg... from the grocery store that’s been sitting there in some vinegar. Vinegar, as you remember from high school science, is an acid, and when it encounters the calcium on this egg, the calcium gets dissolved by the acid of the vinegar. This is essentially the problem with carbon dioxide levels rising in the atmosphere and the ocean being a sink for that carbon dioxide.

“...CO2 levels in the atmosphere are causing the ocean to become more acidic, and potentially dissolve the shells of the calcium based plankton. We would open a hole in the bottom of the food chain, and the result would be a very serious impact in human life on this planet.

“Unlike the models which really are very complicated, this is really a very simple chemical equation, and it will happen any time you have calcium coming in contact with an acid. So it’s more certain and something that therefore should cause us to act.

Inglis points out that we can take action without hurting ourselves. Now, we dump CO2 into the air as a free good. If we price it, and use the money to reduce other taxes we can gain in three ways. Less pollution, more jobs and better national security.

He explains, "Start with a tax reduction, that’s something conservatives can warm to, and make it a payroll tax reduction, something liberals are excited about... Reduce the taxes on payroll, and then in equal amount, apply a tax on carbon dioxide, so there’s no additional take to the government. There’s no tax increase there, it’s reducing one tax, and imposing a tax on something different. It’s reducing taxes on something we want more of which is Labor, Industry and income, and imposing a tax on something we want less of, which is carbon dioxide.

“If we do that, and then apply that mixture to imported goods as well as domestically produced goods, so we’re not simply exporting jobs and exporting the problem, what we can do is change the economics, so that incumbent technologies no longer have a free good in the air, and a free pass on the national security implications of that product. If you internalize those externals, attach those external costs to the products - to the fossil fuels - then the competing technology has a chance to win.

“[W]e can do for energy what Microsoft and Apple did for the PC and the internet. We can break through to a future that’s not dependent on fossil fuels, and that uses newer, cleaner, job-creating fuels that also improve the national security of the United States. It really is the triple play of this American century... improve the national security of the United States, create jobs and clean up the air."

See the full report at Congressman Bob Inglis: How to Engage Republicans, even Skeptics, on Carbon Legislation and Inglis' NY Times op-ed with economist Arthur Laffer, An Emissions Plan Conservatives Could Warm To.

Inglis isn't the only one who's getting the idea. The House Ways & Means Committee is catching on, too: see Ways & Means Weighs Bypassing Trading, Going Straight for Carbon Price.