McKinsey Greenhouse Gas Abatement Costs

Exploring a Carbon Price for Colorado

In May of 2013 I gave a talk at Clean Energy Action’s Global Warming Solutions Speaker Series in Boulder, on how we might structure a carbon pricing scheme in Colorado. You can also download a PDF of the slides and watch an edited version of that presentation via YouTube:

The short policy overview:

  • We should begin levying a modest carbon tax, in the range of $5 to $25/ton of CO2e.
  • The tax must be applied to the fossil fuels used in electricity generation (coal and natural gas). Ideally it should also be applied to gasoline, diesel, natural gas used outside the power sector, and fugitive methane emissions from the oil and gas industry, but those are less important for the moment.
  • New electricity generation resources must be allowed to compete economically with the operation of existing carbon-intensive facilities, and fuel costs must not be blindly passed through to consumers without either rigorous regulatory oversight, or utilities sharing fuel price risk.
  • Carbon tax revenues should be spent on emissions mitigation, providing reliable, low-cost financing for energy efficiency measures and a standard-offer contract with modest performance-based returns for new renewable generation.
  • Over time the carbon price should be increased and applied uniformly across all segments of the economy, with the eventual integration of  consumption based emissions footprinting for imported goods.

But wait… I can hear you saying, I thought James Hansen and others  were rallying support for a revenue neutral carbon tax proposal?  Even the arch-conservative American Enterprise Institute was looking into it, weren’t they?

A carbon price alone is not enough to get the job done — there are other pieces of our energy markets that also have to be fixed to get us to carbon zero.

Regardless of whether it’s done via an emissions trading system or a tax/fee, the goal of carbon pricing is to reduce greenhouse gas emissions — presumably by quite a bit, if our aim is to avoid civilization-crippling climate destabilization.  I’m arguing that a revenue neutral carbon tax, by itself, is incapable of delivering substantial emissions reductions.  There are two big reasons for this:

  1. Our energy systems are rife with market failures, which will prevent carbon price signals from reaching the relevant decision makers.
  2. Even if our energy markets were efficient, politically tenable carbon prices result in price signals that are smaller than fuel price increases we have already experienced, and which have had little to no effect on our emissions to date — with the significant exception of coal.

Instead, our proposed fee-and-invest policy:

  1. Circumvents many market failures by directly investing in cost-effective emissions mitigation (energy efficiency and renewable generation).
  2. These investments reduce our overall energy consumption and displace the most carbon-intensive fuels, rendering our economy less sensitive to increases in the carbon price.  This in turn allows the price to be ratcheted up over time, funding additional investments in efficiency and renewable energy, which further de-carbonizes our economy… in a virtuous cycle.

Of course there are other potentially successful policy packages — a revenue neutral carbon tax might work great in combination with a massive overhaul of our energy markets at the local, state, and federal level… but I don’t hear anybody talking about that.  Instead I hear things like NPR’s Planet Money podcast entitled Economists Have a One Page Solution to Climate Change and this 90 minute long panel discussion on revenue-neutral carbon taxes at Wellesley that never once makes mention of a single energy market failure.  Ditto this Op-Ed in the New York Times from last summer which states in classic utopian economist-speak:

[T]he carbon tax would actually give Americans more control over how much they pay in taxes. Households and businesses could reduce their carbon tax payments simply by reducing their use of fossil fuels. Americans would trim their carbon footprints — and their tax burdens — by investing in energy efficiency at home and at work, switching to less-polluting vehicles and pursuing countless other innovations. All of this would be driven not by government mandates but by Adam Smith’s invisible hand.

If only!

[Note: it’s an open question as to whether any market based strategy can deliver the emissions reductions now required to have a 50/50 chance of staying under 2°C of warming, but I’m not wading into that here.  If you want a taste, follow the work of Kevin Anderson (@KevinClimate) and Alice Bows (@AliceBows) from the Tyndall Center for Climate Change Research in the UK.]

Market: #Fail

Nobody even peripherally involved in energy and climate policy should be forgiven for ignorance of energy market failures and distortions.  They are not minor, nibbling-at-the-edges inefficiencies.  They are big enough to sail oil tankers through.  Especially with respect to energy efficiency, Amory Lovins and the Rocky Mountain Institute have been harping on these failures for decades, most recently in their Reinventing Fire initiative.  But you don’t have to be drinking the (admittedly tasty) RMI Kool-Aid™ to count up how many billions of dollars a year are pointlessly spent on energy we didn’t actually need to use. Business consulting giant McKinsey has chimed in as well, producing a series of GHG abatement cost curves for various nations, corporations, and the global economy as a whole. They tend to look something like this:

McKinsey Greenhouse Gas Abatement Costs

Everything below the zero line on that chart is already profitable.  You can quibble with the details of this and any similar analysis (I’m particularly skeptical of the carbon capture and sequestration they’ve got on the right end) but as far as I can tell, everyone who looks at the issue in detail finds a huge array of sensible energy saving measures that already make money — sometimes a lot of money — but which aren’t being implemented.  Why?

In short: markets are imperfect, and people are irrational.

The American Council for an Energy-Efficient Economy (ACEEE) has done a good job of cataloging some of the big failures in a report entitled Overcoming Market Barriers and Using Market Forces to Advance Energy Efficiency.

A few examples:

  • Split Incentives/Principal-Agent Problems:
    For example, if you rent a home or commercial space, you probably pay for the energy it consumes, but you have limited power to influence that energy usage.  You probably don’t control investments in more efficient heating/cooling equipment, lighting, or additional insulation.  By the same token, your landlord doesn’t stand to benefit from making those investments, since any savings would go to you, the tenant.
  • Bad Utility Regulation:
    The relationship between monopoly utilities and their captive customers is a special, and especially egregious, principal-agent problem.  Regulated utilities generally make an approved return on their capital investments — things like the construction cost of a new power plant.  Their business model cares very little about operating expenses like fuel (and *ahem* carbon taxes applied to fuel).  Instead, those costs are passed through to customers who have no choice but to pay.  Utilities also pass risk through to their customers, rather than internalizing it or hedging it away (see Practicing Risk-Aware Electricity Regulation, by former Colorado Public Utility Commission chairman Ron Binz).  This failure to price risk puts low-risk renewable energy and efficiency at a huge disadvantage in competition against fossil fuels, whose prices 30 years hence are very poorly constrained.  Because utilities usually recover their costs on a per kWh basis, they have clear conflict of interest, biasing them against facilitating investments in energy efficiency.  They may begrudgingly comply with their utility commission’s energy efficiency mandate, but with a few rare exceptions, it’s not a core business or a profit center.
  • Imperfect/Asymmetric Information:
    The life-cycle energy costs of buildings, industrial machinery, vehicles, and appliances — in short just about everything that uses much energy — tends not to be taken into account when purchasing decisions are made.  Sometimes this is because the information isn’t easily available, as with buildings.  Sometimes the information is available, as in the case of vehicle fuel economy, but buyers don’t take it into account in a rational way.  Even if the information is available, and you take it into account rationally, on a long-lived asset which you are likely to resell (such as a building), you have to be confident that whoever you sell it to will also take that information into account rationally, or the value of your investment in additional efficiency will not be reflected in the resale price.
  • The Corporate Income Tax Code:
    Business operating expenses (like energy) are completely tax deductible.  Capital costs (like more efficient industrial plant or building equipment) have to be depreciated, sometimes over decades.  This discourages investments in improved efficiency, and subsidizes wasteful energy use.
  • Sunk Costs:
    The US has trillions of dollars locked up in sprawling automobile dependent real estate.  These land-use patterns limit the extent to which transportation energy use can be reduced in the short term, because cities are re-built only on very long timescales.  The electric utility industry has roughly a trillion dollars locked up in existing generation resources, many of which have operational lifetimes and depreciation schedules of 30 years or more.  They are understandably reluctant to walk away from those investments without assurances that they will be compensated for them, and so they fight to be able to continue operating them.
  • Externalized Costs:
    This is the one energy market failure that everybody likes to focus on, and that a revenue-neutral carbon pricing mechanism could conceivably address.  So what is the social cost of carbon?  As of November 2013, the Federal Office of Management and Budget gives estimates ranging from $12 to $128/ton in 2020 (with a central estimate of $37/ton) depending on your choice of discount rate of and the level of confidence you require in the estimate.  In the fall of 2012 the NRDC highlighted work criticizing the choice of discount rates used by the feds, and suggesting a range of $55 to $266 was more appropriate (see Part I and Part II).  Estimates of the real social cost of climate change depend on a lot of assumptions, but they hinge utterly on the choice of discount rate.   Unfortunately when applied to long timescales and uncertain outcomes, our economics breaks down.  The choice of an appropriate discount rate in the context of climate change is almost a religious debate.  A religious debate that Dave Roberts has done a good job of summarizing over at Grist.

Fuel Price Sensitivities

For the sake of argument, let’s assume that we’ve fixed all of the above market failures, with the exception of externalized costs.  Looking at the carbon intensity of some fuels along with their prices can help give us a sense of what the price signals resulting from a price on carbon would look like.

In Colorado each $1/ton of CO2 is:

  • A little less than a penny per gallon, or a ~0.3% price hike with $3/gallon gas.
  • About 5 cents per thousand cubic feet (Mcf) of natural gas. With residential and commercial natural gas rates running about $8.25/Mcf, that’s a 0.66% increase.
  • About a tenth of a cent per kWh of electricity on a coal dominated system like the one we have in Colorado. This is roughly a 0.87% price increase, since we currently pay about $0.09/kWh.

Of course, electricity isn’t really a fuel — there are lots of capital and non-fuel operational costs rolled up into electricity prices. Those other non-fuel costs mean that electricity prices will be significantly less sensitive to a carbon tax than the fuels that go into generating the electricity, namely coal and natural gas. In this context each $1/ton of carbon price means:

  • Still about 5 cents per thousand cubic feet of natural gas, but electricity generators pay much less for their gas than we do: about $5/Mcf today, which makes this a price increase of about 1%.
  • About $0.093/MMBTU of coal, which is about a 5.3% price hike on top of the fuel’s $1.75/MMBTU delivered cost in Colorado (as reported by the US EIA).

So all these sources of energy are not equally sensitive to carbon pricing. This might seem obvious, given that they have different amounts of carbon per unit energy. However, their sensitivity to carbon pricing depends not on their carbon content per unit energy, but rather on their carbon content per unit cost.

Fuel Price Sensitivity and Relative Emissions in Colorado

The bar chart above shows in red the % increase in fuel costs that results from a $1/ton price on CO2 that I listed above.  And then in black we’ve got the total annual emissions from that fuel in Colorado.  Petroleum fuels (far left) and electricity (center) are about tied for being the biggest emitters, with 40 Mt each per year.  The rightmost two bars break down the electricity emissions into those from natural gas (5 Mt/yr) and those from coal (35 Mt/yr).  You’ll notice that coal is the only fuel with a big red bar.  It is vastly more sensitive to carbon pricing than any other fuel.  It’s also a huge source of emissions.

Another simple way to illustrate this sensitivity is to consider how large a carbon price would be required to double the cost of a given fuel:

Carbon Price Required to Double Fuel CostsOn the left in red is liquid transportation fuels, which are by far the least sensitive to a carbon tax — it would take a price of more than $400/ton to double the cost of gasoline.  Natural gas for home or commercial/industrial use is next, at just over $150/ton required to double.  Doubling the cost of electricity overall would take about $110/ton, which is significantly more than for either of the fuels that go into making electricity.  Utility priced natural gas would double in cost with a carbon tax of about $90, while it only takes $20/ton of CO2 to double the cost of coal, which is extremely cheap today, relative to how much carbon it contains.

Electricity is less sensitive to carbon pricing than either of the fuels that go into it because (as I mentioned above) there are lots of non-fuel costs rolled up in our $0.09/kWh retail rate, and they act to dilute the carbon price signal that would be visible to consumers.  However, on the utility’s end, the fuel price signals would be clear — even stark in the case of coal — but so long as utilities can simply pass the fuel (and carbon) costs through to their customers, the clarity of that price signal won’t make much difference, since the customers of monopolies don’t have any choice as to where they get their power from.

Another interesting comparison is to look at how much fuel prices have varied recently — say, over the last decade — and convert the size of that price range to an equivalent carbon price.  Especially in the case of petroleum fuels and coal, whose prices have increased pretty dramatically, this comparison can give us some idea of how sensitive our behavior is to increases in price.  That’s important to understand, since the only way a revenue neutral carbon tax affects behavior is through prices.

Carbon Prices Compared to Fuel Price VolatilitiesGasoline prices have fluctuated wildly in the last decade, from $1.37 to $4.03/gallon.  That $2.66 range is equivalent to a nearly $300/ton CO2 price. Natural gas (both for electricity generation and domestic use) has fluctuated by about $5/Mcf, which is equivalent to a carbon price of just under $90/ton.  Coal’s price has actually increased dramatically, nearly doubling over the last decade, from $0.97 to $1.75/MMBtu (see also CEA’s most recent coal report), but because it’s so sensitive to carbon pricing, that same price increase could have been effected by charging a paltry $9/ton of CO2.

All of this highlights the magic of pricing carbon versus simply taxing energy: it changes the relative attractiveness of different energy sources, which can stimulate a change in the mix of energy, while general energy taxes might be better at inducing overall improvements in energy efficiency.

Using the price sensitivities above, we can explore the impacts of a carbon tax on energy prices, and see how those changes compare to the fluctuations in energy prices that we already experience, and our response to those fluctuations. For the sake of argument, let’s consider a carbon price of $25/ton, which is in line with what British Columbia and many EU nations have adopted.

Gasoline: $25/ton would mean about a $0.22/gallon increase in gas prices. For comparison, that’s the same as the $0.22/gallon Colorado state gas tax, and just a little more than the $0.184/gallon federal gas tax. Over the last 10 years, weekly average gas prices have varied between $1.37 and $4.03/gallon in Colorado, a range of $2.66 — that range in price is equivalent to a $298/ton carbon tax. Despite that enormous price signal, our driving habits and the fuel economy of our vehicles have changed only modestly — VMT per capita has flattened out and started to decline rather than continuing to increase, but there doesn’t appear to be much historical correlation between fuel prices and VMT. Vehicle fuel economy has improved, but only to the extent that has been required by law under CAFE standards — fuel costs apparently haven’t been the driver. This suggests to me that an additional $0.22/gallon from a carbon tax would not have much impact on fuel consumption. This is largely a consequence of our land use patterns — in many parts of Colorado, driving is functionally mandatory, with little in the way of alternatives, even if one wants to drive less.  Maybe people would shift to more efficient vehicles… but if so, it would be a departure from our collective behavior over the last decade.

Natural Gas: Space heating and domestic hot water both rely primarily on natural gas in Colorado. In those applications (as opposed to industry or electricity generation) annual average prices ranged from $5.62/mcf to $10.45/mcf between 2002 and 2012 (a $4.83 range). Last year’s average price was $8.26/mcf. A $25/ton tax on CO2 emissions translates into a $1.35/mcf increase in price, which is about 16% of the current price, and just a bit more than a quarter of the total natural gas price variability we’ve experienced over the last decade. Looking at Colorado natural gas consumption data from the EIA, there’s no clear correlation with price.  There’s a giant caveat here, which is that we’re just starting to understand the impact of fugitive methane from the natural gas supply chain.  If it’s big (and this recent paper from PNAS suggests it is) then the climate impacts of natural gas could be large, and a carbon price applied on a CO2 equivalent basis could raise natural gas prices by a lot, which would probably result in a lot of the supply chain getting cleaned up, which would be good.

Electricity: Based on EIA statistics, Colorado’s electricity supply emits on average about 0.8 tons of CO2 for each MWh generated, and on average across all sectors we pay about $90/MWh ($0.09/kWh). Charging $25/ton of CO2 emitted with our current generation mix would thus result in an increase in price of $20/MWh, or 22%, to about $110/MWh retail, which is still cheaper than the entire Northeast, California, and many other states, but a little higher than the US average of $96.50/MWh. Nationwide, per capita electricity consumption is well correlated with the retail prices. Despite its low electricity prices, Colorado is relatively efficient, using about 10 MWh/person annually, significantly less than the national average of 12MWh. If our response to the increase in electricity prices was consistent with the general price-consumption relationship nationwide, the additional $20/MWh might eventually be expected to take our consumption down to the levels seen in New York, California, New Jersey, and the other most energy efficient states, but it’s not clear how much of the difference in electricity consumption is due to the price elasticity of demand, and how much of it has to do with the most expensive electricity also being in states that have the strongest energy efficiency mandates.  (Correlation ≠ Causation.  See XKCD, below.)

Of course, fossil fueled electricity is really coming from two different sources: natural gas and coal.

Natural Gas for Electricity: Utilities buy natural gas at a steep discount from the retail consumer rates, currently paying around $5/Mcf, but that price has bounced around between $2.50 and $7.50/Mcf (annually averaged) over the last decade. Our hypothetical $25/ton CO2 price would again add $1.35/Mcf, or 27% to the cost of gas for electricity generation, which is significant, but still well within the range of price volatility that gas has experienced in recent years.  The caveat on fugitive methane mentioned above obviously applies here as well.

Coal: Unsurprisingly, coal feels the impact of a carbon tax far more than any other fuel. Coal costs in Colorado are about $1.75/MMBtu, and each MMBtu puts out about 0.093 tons of CO2, so each $1/ton of CO2 increases the cost by about 5.3%. This means that our heretofore modest $25/ton tax more than doubles the price of coal in Colorado, taking it from $1.75 to just over $4/MMBtu!  This is comparable to the most expensive delivered coal prices anywhere in the US. That’s the kind of price you pay if you put Wyoming coal on a train and take it to Georgia.

It’s important to note that currently no matter what effect a carbon price might have on fuels for electricity generation, the costs would just be passed through to rate-payers.  Other than regulatory oversight (which has tended to be lax, using high discount rates on future fuel costs, flat fuel price projections, and virtually no risk pricing) there’s no incentive for utilities to minimize fuel costs in their resource planning.  Furthermore, even if we had good regulatory oversight going forward with new generation, the standing assumption is that if you’ve already built a power plant, it must be cheaper to operate than any possible new source could be, since you’ve already committed to the capital investment for existing plants, while you need to factor in both capital and operating expenses for new facilities.  For a carbon price to affect our existing generation facilities, these assumptions have to change.

So, with the notable exception of coal, the price signals that would result from charging $25/ton of CO2 emissions are much smaller than the price fluctuations that we already deal with, either from state to state or as market prices change over time. I think this is both encouraging and discouraging. It’s encouraging because it means we could probably implement an economy-wide carbon tax without being any more disruptive to the economy than existing market fluctuations, which seems like it ought to make the tax more politically palatable. It’s discouraging because the whole point of a carbon tax is to be disruptive! Not disruptive in the sense of rolling blackouts and mile long lines for gasoline, but rather in the sense of spurring a major re-organization of the economy around low and zero carbon energy sources, and vastly more efficient utilization of that energy.

But I know it works, because… British Columbia! (or Denmark, or Finland, etc.)

Everybody on this side of the Atlantic likes to highlight British Columbia as the poster-child for a revenue-neutral carbon tax.  Their tax started at $10/ton in 2008, and rose $5 each subsequent year to $30/ton in 2012, where it remains today.  The revenues are used to displace both corporate and individual income taxes.  Since the introduction of the tax, this paper reports that BC’s per-capita consumption of petroleum fuels has dropped 17.4% (compared to an increase of 1.5% in the rest of Canada) and greenhouse gas emissions have dropped 10% (compared to 1.1% for the rest of Canada).   Another recent paper takes a more detailed look at the BC carbon tax and concludes that the tax was apparently vastly more salient to consumers, and thus much more powerful than a simple non-tax price increase would have been… because the reduction in emissions was much larger than could be explained by the price increase alone.  Woo hoo!  Success, right?

In the immortal words of XKCD:

Correlation

Both of those papers note the substantial difference in emissions and petroleum consumption between BC and the rest of Canada, and the fact that the emissions seem to have diverged at about the same time that the carbon tax was imposed.  They establish a correlation.  Unfortunately there’s precious little to indicate causation other than their assumptions going into the papers.

BC is actually a lousy place to try and figure out how carbon taxes work for a couple of reasons.  Their electricity is already almost carbon free.  The state-owned utility BC Hydro generates 86% of its power from (you guessed it!) hydroelectric dams.  The remaining 14% is natural gas.  Second, fully half of BC’s population lives in the Metro Vancouver area.  Together these two things mean that overall emissions for BC ought to be fairly sensitive to transportation fuel usage in Metro Vancouver.  Looking at the 2012 Vancouver Transportation Plan Update, it’s clear that there has been a lot of change in Vancouver’s transportation and land use policies over the last decade or two, in line with the city’s own aggressive climate action goals.  One might cynically note that the large investments made in public transit in the lead up to the 2010 Winter Olympics also just happen to coincide with the divergence in per-capita petroleum fuel consumption between BC and the rest of Canada.

None of this is to suggest that BC’s carbon tax didn’t help reduce emissions.  I’m just trying to point out that attribution is really difficult.  Certainly difficult enough that I wouldn’t hold BC up as an obvious unequivocal demonstration that revenue neutral carbon pricing is the way to go.  On the other hand, it does seem to demonstrate that taxing carbon need not tank your economy.  (At least, if you already get all your electricity from hydro, and all your major cities have great public transportation and dense urban land use patterns.)

There’s every theoretical reason to think that carbon pricing will reduce emissions, but the empirical details of how it happens in practice are still poorly understood.  I’m not alone in being skeptical.  NREL’s 2010 review of carbon taxation policies worldwide pointed out:

One of the most rudimentary metrics for measuring carbon tax effectiveness is overall reductions in GHG emissions that can be tracked using GHG emissions inventories at the national or local level. This metric is flawed in that it captures not only the carbon tax effects but also the effects of other carbon mitigation polices and exogenous variables such as the level of economic growth.

In an ideal world, we’d be able to model the effects of the tax in isolation, but without controlled experiments, nobody seems to give these numbers much credence. Governments often model expected effects in advance of policies (for political purposes), but NREL notes that most retrospective evaluations of carbon tax policies haven’t even attempted to do confirm or deny those projections:

Examining the effects of a carbon tax alone on GHG emissions would provide a more precise estimation of policy effectiveness. Many governments model the effects of a carbon tax acting alone during the implementation phase of the tax. […] However, determining the actual impact of a tax in isolation of other factors is often difficult, and most evaluations have not attempted to do so. Because of the lack of common evaluation practices, it is difficult to compare the effects of policies across jurisdictions.

Of course this difficulty in economic attribution isn’t unique to carbon taxes.  In January the OECD published a study on the effects of taxing energy use more broadly (reviewed here by the Washington Post). Their data shows that energy use per unit GDP is somewhat negatively correlated with energy tax rates, but there are big exceptions in that scatter plot. For example, Mexico and Sweden have the same emissions per unit GDP, but Sweden taxes energy at more than 25 times the rate of Mexico. Average overall energy taxes aren’t the same thing as carbon taxes. You can have the same effective tax rate with very different economic makeups. You might also tax different parts of the economy differently, discriminating between different fuels (the EU taxes petroleum much more highly than other fuels) or by market segment (most countries tax industrial and commercial energy use much less than residential, since industry is often willing to re-locate to avoid the taxes).

Again, there’s every reason to think that in an ideal, frictionless world, pricing carbon would have the desired and predicted effect of reducing emissions.  But we don’t live in that ideal world, and we don’t yet fully understand how carbon prices propagate through our complex, imperfect economies.  So what are we to do?  Should we just charge ahead and start cranking up the carbon price because we’re pretty sure it ought to work?

Revenue Source vs. Policy Lever

A revenue neutral carbon tax is what I would call a pure market policy — all of the change it hopes to effect must flow from the price signals it sends to market actors.  The idea of pricing carbon to get economic actors to internalize its social costs is elegant, and attractive given that most of the world has ended up with a strong pro-market ideology, but ideological elegance alone seems a thin justification for relying on such a narrow tool.  (Political expedience is another possible justification, which I’ll get to below.)

Unfortunately as I noted above, there are numerous market failures that prevent us from taking advantage of already sensible energy efficiency opportunities. Additionally, we have a general policy of heavily discounting future costs and giving preference to present day consumption instead. This results in low estimates for the real cost of carbon — often the order of the $25/ton that I used above. The economic impacts of that kind of carbon price are modest (unless we’re talking about coal), which makes them both more politically plausible, and less effective in stimulating the required steep decline in our greenhouse gas emissions.

Under a green dictatorship, we might be able to brute-force our way through the market failures.  If carbon were very expensive, the incentive for demanding good information about building energy use before you sign a lease would be large.  Public outcry over ineffective utility regulation that dumps costs and risks on unwitting, powerless customers might become politically potent.  There would be no business case for continuing to operate existing carbon-intensive capital stock, allowing us to overcome some sunk costs.

Brute-forcing might be possible, but it wouldn’t be economically efficient, and efficiency is supposed to be one of the main selling points of a carbon tax.  Given that we don’t live under the iron fist of El Señor Verde (no matter what Fox News might say about Obama), to me this path also sounds like a political train wreck.

However, using the revenues from a very modest initial carbon tax, we can work around many existing energy market failures and start the work of decarbonizing our economy, focusing especially on the the measures that are already profitable (in the absence of market failures).  Having done that, further increases in the carbon price should become more palatable, allowing us to work up the ladder of necessary investments and fuel substitutions.  That is, rather than using the carbon price as a policy lever initially, we can treat it as a revenue source that funds emissions mitigation.  As our economy becomes less carbon-intensive and the carbon price rises, its role would shift gradually from funding mechanism to policy lever.

This approach has several advantages.

  • It’s much easier to measure the emissions consequences and cost effectiveness of mitigation programs, which lets us keep track of whether what were doing is actually working.
  • When the price elasticity of demand for a given fuel is low (as with liquid transportation fuels), a small carbon tax will have much less impact on emissions than the mitigation measures that the corresponding revenues can fund.
  • When viewed primarily as a funding mechanism, it’s much less important that the carbon tax be applied uniformly across different economic sectors and fuels, which allows more political flexibility in its application.
  • The emissions mitigation that results from funding EE/RE policies directly is much less dependent on addressing the market failures that keep people from taking advantage of existing opportunities.

Yeah, investing directly in efficiency and renewable generation is just a tad “command and control”, but then again, so is our entire regulated electric utility industry.  We should absolutely do the work of fixing the failures and inefficiencies in our energy markets, but we don’t have to wait until that work is done to start mitigating emissions.  As the carbon-intensity of our economy is driven down by direct investments in efficiency and renewables, higher carbon prices become possible without serious economic consequences, and eventually you can start displacing even gasoline and diesel, despite their relative insensitivity.

Another Kind of Neutrality

The “revenue neutrality” that’s usually considered with carbon pricing is seeking to keep overall tax revenues constant, by shifting tax burden from income or payroll taxes to carbon.  With a fee-and-invest carbon policy, we can think about another kind of revenue neutrality, within our energy systems instead of the tax coffers.  If we take carbon revenues and invest them directly in cost-effective mitigation — all that stuff on the left hand side of the McKinsey GHG abatement chart above — then what we’re doing is shifting how we spend money on energy services.  Instead of buying imported commodities like oil, natural gas, and coal, we’re spending on high performance building components like heat recovering ventilation systems, high efficiency heat pumps, LED lighting, and triple glazed windows.  We’re also shifting from paying for materials (mile long trains full of coal) to paying for good design, more skilled construction labor, and flexibility in our consumption patterns.  Instead of building large centralized generation facilities owned by distant shareholders, a big chunk of the new renewable energy facilities we require can be locally owned by the communities they serve, or small to medium businesses, because the economies of scale for renewables are significantly less powerful than they are for thermal generation, and there are system benefits for less centralized generation.

These changes in our energy system would be good for local economies, good for employment, and reduce our exposure to energy price risks going forward.  Oh right, and they’d also reduce traditional air pollution, greenhouse gas emissions, as well as the water intensity of our power supply, which in the semi-arid Western US is a significant concern (highlighted by Western Resource Advocates in their report A Powerful Thirst).

There’s a lot of work to be done here that actually makes money once we work around the market failures.  As we address more challenging sources of emissions, the carbon price would need to rise, and we would eventually exhaust the most profitable mitigation options, so we might end up spending more overall on our energy services in a super-efficient, zero-emissions world, but it doesn’t seem like the foregone conclusion it’s often made out to be.

A few supporting figures…

ACEEE Efficiency Investment Returns and RiskUS Wind Cost Curve

PV_CostCurve

Wind and especially solar PV continue to get cheaper.  We will eventually figure out cost-effective, scalable electricity storage.  And even if the new energy system does cost more when all is said and done, part of that will be because we’ve started honestly accounting for the costs of climate change, and other currently unpriced risks.

The Back of the Envelope

Does this really pencil out?

Say natural gas and coal burned to generate electricity were taxed at $25/ton of CO2 emitted. Together, they emit about 40 million tons of CO2 a year in Colorado, so at current rates of usage, this tax would raise $1 billion. The most cost effective emissions mitigation is still energy efficiency. Seattle City Light just initiated a Pay for Performance energy efficiency program, offering $30/MWh saved. If we take that as the cost of efficiency, then $1 billion could buy 33 TWh worth of energy savings. Conveniently, 33 TWh is roughly the amount of electricity we generate from coal each year in Colorado.  Given these (very naïve) assumptions, we ought to be able to displace all our coal-fired electricity with efficiency alone!

The cheap efficiency opportunities get used up first and you have to go for more costly improvements, and probably that happens well before we’ve cut our electricity usage by a factor of 3. Also, the nature of a carbon tax (and all Pigovian taxes) is that as the tax takes effect, there’s less and less of a tax base — as energy demand declines due to the efficiency improvements, we would have to raise the carbon tax rate to maintain the same level of revenues.

Another example: say instead of choosing to fund efficiency, we decided to build wind farms. Without the production tax credit (PTC) new wind in good sites is coming in at around $60/MWh (the PTC is worth about $22/MWh, so with it, new wind would be more like $38/MWh). Spending the same $1 billion in carbon tax revenues on wind would get us about 17 TWh of wind energy per year, which at a 33% capacity factor is equivalent to nearly 6 GW of installed capacity, capable of displacing roughly half of the 35 TWh of coal fired electricity we use each year.

Both of these examples are obviously naïve, but they suggest that $25/ton is at least the right order of magnitude to consider if we want to replace our existing coal fired generation with a mix of better energy efficiency and renewable power. All I mean by that is, looking at the average carbon price over the lifetime of the policy $5/ton isn’t gonna get it done, and $125/ton isn’t likely to be necessary, though we might start at $5/ton and work our way up to $125/ton as emissions are reduced over the next 30 to 40 years.

Taxing Politics

Another good reason to use carbon tax revenues for mitigation programs rather than to displace other tax revenues, or to create a climate dividend, is that by design — if we are successful — the revenue source will eventually dry up. Paying carbon tax revenues into the general fund or out to the public creates a potentially powerful political constituency that doesn’t want to see the revenues decline.  They might fight to raise the carbon price, but they might also fight to avoid reducing emissions — stranger things have happened. In contrast, the need to spend money on emissions mitigation programs comes to an end along with our emissions, and thus the carbon tax revenues.

Treating a carbon tax primarily as a revenue source rather than a policy mechanism also makes it less important for all sectors of the economy to be taxed at equal rates initially. Different consumers have different demand elasticities. Sweden has the highest carbon tax in the EU at more than $100/ton, but that rate isn’t applied uniformly to everyone — industry pays only $23/ton. We can argue about whether or not that’s fair, but from a utilitarian standpoint, it’s reasonable. If the economic impacts of a carbon tax are great enough that it makes sense for a business to relocate to avoid it, there’s every reason to think that they will do so, in which case their emissions end up being unaffected by the tax — rather than paying into the mitigation fund, they’ll end up spending money on relocation expenses.

Many countries in the EU use their carbon taxes as general revenue sources.  They also pay for emissions mitigation programs out of their general funds.  Denmark dividends 60% of its carbon tax revenues, and uses 40% for mitigation programs. Finland and British Columbia both have revenue neutral carbon taxes that displace other tax revenues in the general government budget. All of these jurisdictions are willing to implement policies and spend general funds in order to reduce emissions. Linking carbon tax revenues to mitigation programs is elegant and convenient, because the available revenues and the required spending generally scale with each other, but it’s not strictly necessary if emissions reductions are a high policy priority generally.  Unfortunately, that’s not yet the case in the US.

So why all the fuss with revenue neutrality?

I suppose there’s some platonic attraction to the concept of a revenue neutral carbon pricing scheme.  It plays well with the neo-liberal fantasy that we live in a efficient, free market utopia.  It lets us lay blame on the externalities — the costs we didn’t know were attached to our energy consumption until recently.  Unfortunately, our energy economy is also broken in more subtle and complicated ways, that are just as pervasive as the uncounted social costs of carbon.  Social costs which are themselves almost entirely determined by our moral judgement about the net present value of the future.

From a utilitarian point of view, the singular attraction of a revenue neutral carbon pricing scheme is political.  The idea is that hiding out there somewhere, there’s right-wing support for climate action… so long as it’s revenue neutral.  There’s rhetorical support for displacing taxes that conservatives are especially averse to — mostly income taxes, and especially corporate income taxes.  So it’s worth looking at whether a revenue neutral tax displacing carbon price would really make much of a difference in the context of our overall tax structure.

Federal Tax Receipts by Source (2010)At the federal level, this proposition is questionable. The US emits about 7 billion of carbon each year, and all federal tax revenues add up to about $2.1 trillion ($2,100 billion). So, hypothetically, if we were to apply a carbon price to all of our emissions (politically unlikely, to say the least), and wanted to use it to displace all of our federal tax revenues… we’d have to charge $300/ton. Nobody’s really suggesting that, but people do talk about using a revenue neutral carbon tax to say, “fix” the federal deficit, which in 2013 was projected to be $650 billion. Again, with a uniform carbon price applied to all 7 billion tons of US emissions, that would mean charging about $90/ton — still a higher price than most policymakers are willing to moot in public. For the $900 billion in personal income taxes or payroll taxes, you’d have to charge $130/ton. For the $200 billion in corporate income taxes, it would be about $30/ton.  So we could effectively displace the corporate income tax, if we really wanted to.  Which would, by the way, make our tax system even more regressive than it already is.  Conservatives seem markedly less enthusiastic about revenue neutral carbon pricing that displaces payroll taxes (which would be progressive) or that directly dividends the revenues on a per-capita basis.  And when I say “less enthusiastic about” what I mean “completely opposed to”.

Especially given the large policy trade-offs that revenue neutrality requires — foregoing the possibility of investing directly in mitigation, and relying entirely on market mechanisms in broken markets — I think that going with a revenue neutral carbon pricing model represents an enormous concession, to be made only as a desperate last resort.  If making this concession resulted in conservative support and durable implementation, maybe it might be worthwhile — at least, if it happened in conjunction with fixes to our electricity regulations, so that a modest carbon price could actually change the economics of coal fired generation.

Unfortunately, the list of caveats that gets attached to even a corporate income tax displacing carbon tax is scary, and includes: gutting the EPA’s power to regulate emissions; discarding energy efficiency standards for vehicles, buildings, and appliances; ending the production and investment tax credits for wind and solar; getting rid of renewable portfolio standards; etc.  On top of that, I’m having a hard time finding much conservative support for a carbon tax of any kind, with any list of caveats.

Anti-tax crusader Grover Norquist suggested last fall that he might, possibly, be able to support a carbon tax swap, but was immediately rebuked by the energy industry, and reversed his position within a day.  The American Enterprise Institute briefly flirted with the idea of a carbon tax, in a series of closed-door discussions that was leaked unflatteringly last summer, leading up to a joint event called Understanding the Economics of Carbon Taxes with the IMF and the Brookings Institute, also last fall.  But watching the panel discussions and excerpts from that event, I find it difficult to find much that qualifies as “support” for a carbon tax.  Just look through AEI’s current posts on climate change policy.  They’re not very far from denying that anthropogenic climate change exists and is a problem.

Maybe Norquist and AEI really were interested in a carbon tax, and this discussion and event were trial balloons.  Maybe they were disappointed by the instant conservative backlash, and that’s what put them off. But to my cynical mind, it seems more likely to be a clever ploy on the part of the right wing to shape our thinking on carbon pricing — if a carbon price is likely to happen eventually despite their objections, then they’d like to make sure that it’s the most innocuous carbon price possible. A small, revenue neutral carbon tax is extremely unlikely to disrupt existing business models and energy consumption patterns, and so can likely be held up as an example of policy failure after its been in place for a while. In the meantime if they can ensure that it’s regressive (displacing income taxes) then it can also reduce the tax burden on corporations and the rich. If they can trick us into discarding our existing regulatory options as part of the “compromise”, so much the better! And if the revenue neutral carbon tax should be successful?  Then they will have potentially deprived the government of an existing revenue stream altogether: another anti-government win.

Really bad carbon pricing has the potential to do more harm than good.  We should be careful we don’t get lured into accepting such a proposal.

The Cost of Regulatory Uncertainty

There’s a trade off between cost and risk, between the potential for economic efficiency and the certainty of a regulatory outcome.  Cap and trade might be the most efficient way to allocate emissions, but the outcome is volatile, partly because political constraints make it difficult to reduce the cap and keep the emissions price high enough to make a difference, and partly because the emissions price is likely to be volatile on its own anyway.  A predictable tax might be less efficient, but its predictability actually reduces the cost of planning around it, because the economics of long-term investments based on the tax rate are known, which reduces the cost of capital applied to making those investments.  A similar analogy exists for feed-in-tariffs, where the return on your investment in renewable generation is essentially fixed, rather than being subject to competition in the prevailing wholesale power markets.  If have high confidence that you’ll make a 6% return, you’ll make the investment, even if you could potentially earn 12% in some other riskier venture… where you might also lose everything.

As with the original electrification of our society and economy a century ago, we need to deploy a lot of capital fairly quickly to make long-term investments in building out a new energy system.  The kind of investments we need to make are different (efficiency, smart transmission/distribution, distributed generation), but the long capital lifetimes and desire for predictable, reliable outcomes over decades is similar.  Interestingly many of the investments we need today can be made in much smaller chunks than the utilities are used to. This means we can offer the same kind of relatively fixed return on capital to individuals, small organizations, cities, and businesses of all sizes, rather than just a few giant holding companies.

Is it absolutely the most economical way to do things?  Maybe not, but it sure looks good enough to me.  What we’re doing here is satisficing — trying to find an acceptably good solution now, because the cost of waiting until we find (and implement) the best possible solution is very high.  The International Energy Agency estimates that each year of delay on climate action costs us about $500 billion.

We could be building a lot of solutions for $500 billion a year.  So let’s get to work.

Further Reading: