The Basics of Carbon Pricing

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This training explores the basic economic rationale behind why carbon pricing is an effective policy and climate solution. Written by CCL's Global Strategies Director Joseph Robertson.
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What is Carbon Pricing?

Pricing carbon generally refers to a carbon tax or a “cap and trade” system. With a carbon tax, a fee is applied wherever fossil fuels enter the economy. This carbon price flows through the economy, incentivizing businesses and people to switch to clean energy. Fossil fuels such as oil, natural gas, and coal all contain carbon. When burned, they release potent greenhouse gases (GHG) and carbon dioxide (CO2) into the atmosphere. Putting a price on carbon involves placing a fee on these fossil fuels and carbon pollution. The carbon pricing fee is based on the metric tons of carbon dioxide (CO2) the fuel would generate, and it would be assessed at the earliest point of sale into the economy—as close as possible to the well, mine, or port.

A cap and trade works by setting a “cap,” (maximum for total emissions) and then selling and trading permits for the right to pollute up to that cap. It requires bureaucracy to implement and run, and it creates price volatility that is difficult for businesses. A carbon tax is far simpler, with less bureaucracy, lower costs, and more predictability.

Learn more about carbon pricing bills that have been introduced in the 116th and 117th Congress (2019-2021).

Why put a price on carbon?

Anything that moves through our economy has value. Sometimes, value is quantifiable, as with a gallon of milk—which is bought and sold in stores. Sometimes, value is pervasive, and can only be seen through trace relationships, as with rainwater—which cannot be bought or sold. Carbon dioxide molecules are not bought or sold as such, but they are tied to much of what we do in our everyday interaction with the economy.

Carbon-emitting fuels are the main source of energy in the human economy of the world; when we produce energy—heat or electricity—we tend to use fuels that are burned and which then emit carbon-based molecules into the atmosphere. We pay the retail price for access to this energy, but we don’t pay for the underlying chemistry, the distortionary impact of pollution costs, or the destabilization of our climate system—at least not at retail.

Those costs are incurred indirectly; in other words, they are “externalized”, paid for outside of the business model, not priced into the retail product or service, and so remain generally “hidden” from view.

Negative Externalities

Think of externalities as a massive flock of origami birds that you had no way of knowing you were creating when you paid for gasoline:

  • If the origami birds are just pretty paper, then they are either decorative or they are waste which will need to be disposed of or recycled.
  • Now imagine there are billions of tons of them produced every year, and they have no productive value for anyone, not even decorative.
  • If the price of your gasoline didn’t cover their costs, and they are generated when you buy gasoline, who is paying for them? Is there a system in place, or are they just being dumped into rivers and streams?
  • If the origami birds are laced with poison, that’s a much more expensive problem.

The idea of “putting a price on carbon” is simple: we add to the cost of doing business in those resources, because we want to reveal the hidden costs that no one is taking responsibility for, at present. Getting that price right means making the market tell the truth, and that means ordinary people—consumers, small businesses, taxpayers—will recover the market leverage they are supposed to have to determine whether we do something that is too costly or not.

In other words: when markets fail, they create a bubble of inflated value, which can expand only so far before it bursts and the air goes out of it. Corrections can happen spontaneously and chaotically, as when the so-called “housing bubble” burst in 2008—and property values suddenly fell, undermining a property-dependent financial system. Smart carbon pricing is simply a deliberate action to correct the market’s failure, so chaos never comes.

What is at Stake?

“The economy” is the sum total of all human interactions where value is exchanged. Some of that value is measured in dollars and cents; much of it is not. Market failure is not as esoteric as it might sound. It is not limited to the private offices and homes of people working in finance and industry leadership. When markets fail, the ripple effect touches the lives of everyone in that economy.

The ripple effect of carbon-related market failure will determine whether we can expect a future where Main Street economic activity builds value for everyone and offers a better future to young people, as they emerge into the workforce. If we correct the fossil fuel market failure carefully, intelligently, and in a way that motivates low-carbon activity on Main Street, we can build a future of inclusive propserity and a growing middle class. If not, not.

Five Ways to Pay

If we break down the financing of the cost of doing business in carbon-emitting fuels into the most discrete, value-driven categories possible, we get a list of 5 basic options we have for paying the cost of using carbon-emitting fuels. The graphic to the right explains the five ways in brief, but for clarity and added detail, the five ways are:

1. The Status Quo

In our current economic model, most of the costs of finding, extracting, transporting, refining, and burning, carbon-based fuels, is farmed out to the rest of society. The industry makes very large profits, but that is because it is able to depend on direct subsidies, indirect subsidies, and also structural/contextual assistance (prevailing physical infrastructure, prevailing financial infrastructure, and the types of activity our economy is structured to incentivize). No one is directly responsible for paying the cost of major long-term impacts, and so the whole of civilization acts like a giant insurance pool, with all of us paying hidden premiums to make the business model work.

2. Regulation

Straight regulation, what critics call “command and control” is the most obvious way to tackle this problem. It is obvious, because we see negative impact from routine behavior, and so some public authority needs to take action to make sure that activity does not harm others. In the strict regulatory scenario, the response to excess carbon emissions entails “boots on the ground” and “eyes on the problem”—people, with salaries, monitoring the behavior of emitters. This tends to get expensive and can be undercut by underfunding. It is most useful where less intrusive options are not available or do not work.

3. Licensed Emissions Trading

Often called “cap and trade”, a licensed emissions trading scheme—the most popular abbreviation is ETS—sets a “cap”, a maximum, for total emissions, and then sells permits for the right to pollute up to that cap. In order to incentivize a higher price for the permits, the permits can be auctioned. In order to allow new capital to flow to businesses that move away from carbon-emitting energy sources, an ETS allows for the trading of permits.

In some ETS, derivative financial instruments are created, and the value of the permits is abstracted, or disconnected, from the underlying energy business. Some ETS also allow for “offsetting”—an example would be buying an acre of rainforest to conserve it as a “carbon sink”, thus allowing for more pollution than one’s permits would allow.

Cap and trade (or ETS or LET) creates a regulation enforced by the trading of artificial assets—the permits. It can help reduce emissions, but is complex, requires new regulatory mechanisms, both for the cap and the trading market, and is usually narrower in scope than more straightforward carbon tax policies. The scope is narrowed due to the need to issue licensed emissions permits and to regulate both the cap and the trading.

4. The Carbon Tax (“sin tax” version) 

A carbon tax is a “Pigovian tax”, a tax that follows the thinking of the economist Arthur C. Pigou. Pigou explained how using taxes to add to the cost of something that generates negative externalities (hidden costs to the public), it is possible to internalize the costs, so that the market tells the truth and the everyday economic activity of a healthy market could continue to be the driver of economic reality.

A Pigovian tax is inherently conservative, because it eliminates market distortions, builds efficiency and allows enterprise to go to work, instead of requiring regulation to get “bad behavior” under control. The “sin tax” version operates on the assumption that if consumers don’t consume the thing that causes harm, then the harm can be eliminated by putting pressure on suppliers of that thing (think: cigarettes or alcohol).

A steadily rising tax on carbon-emitting fuels will disincentivize investment in those resources and signal the market for investment that it should move in another direction, to capture consumer dollars. One problem with the straight carbon tax is that it is designed to pressure consumers to reduce consumption, which can then constrain overall economic activity, depriving the alternatives of affordable capital.

5. Carbon Fee and Dividend 

Carbon fee and dividend puts a steadily rising fee on carbon-emitting fuels, at the source, where they are first introduced into the economy. 100% of the revenues are then returned directly to households, in a monthly dividend check. This solution directly internalizes the cost to industry, freeing consumers and intermediary businesses of the burden of financing someone else’s business model.

Carbon fee and dividend is the simplest and most direct flavor of what is known as a “revenue-neutral carbon tax“. A revenue-neutral carbon tax returns 100% of the revenues to the people, in some way. Other options use tax rate reductions, annual tax credits, subsidies to homeowners who install solar panels, or some mix of these. The direct monthly (100%) dividend to households is the most economically efficient.

It requires no new spending, no new bureaucracy, no new regulation, and it allows the Main Street economy to keep chugging along and even expand, while sending a direct price signal to investors that the smart path for future investment is moving toward low-carbon energy sources. A clean fee and dividend plan allows even the energy sector to transition investments cost-effectively, so we see economic gain, not harm.

What REMI says

Regional Economic Models, Inc. (REMI), one of the nation’s most trusted economic policy analysis firms, published a study on June 9, 2014, showing that Fee and Dividend will rapidly reduce emissions, grow the economy, accelerate job creation, raise incomes and move more of the economy’s wealth into sectors that hire locally and sustain hiring. That means more resources creating more opportunities for more people.

Specifically, the study found that Fee and Dividend:

  • Adds 2.1 million net new jobs over 10 years, 2.8 million over 20 years;
  • Increases GDP by $70 billion to $85 billion per year, or $1.375 trillion over 20 years;
  • Prevents 13,000 premature deaths per year from particulate pollution;
  • Reverses the downward trend in real disposable personal income (RDPI goes up with F&D, whereas without it, it is in going down);
  • Reverses the downward trend in labor share of income (incoming going to hiring is declining in the baseline, expands with F&D);
  • Cuts carbon dioxide emissions across the entire US economy by 33% from 2005 levels after 10 years, 52% after 20 years;
  • Drives new hiring not only in clean energy sectors, but in retail, health, food services—the kind of activities the Main Street economy is built on.

Fee and Dividend will reduce emissions at the rate we need to stave off catastrophic climate destabilization, but it will also improve our economy, create new wealth and incentivize innovation and the building of our local marketplace. It is the plan anyone who wishes to avoid intrusive government regulation, the burden of excess bureaucracy, uncertain market conditions or a drag on our economy, should support.

It is fiscally conservative, economically efficient, 100% market-driven, and good for the climate and the economy.

The Case For A Carbon Tax

In The Case for a Carbon TaxCitizens’ Climate Lobby Advisory Board member Dr. Shi-Ling Hsu examines the four major approaches to curbing CO2: cap-and-trade; command and control regulation; government subsidies of alternative energy; and carbon taxes. For more information see Dr. Hsu's video.

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