Cap and Trade: An Inconvenient Tax

Friday, October 30, 2009
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Although the Obama administration has been fixated on bailouts and stimulus, it has not lost sight of the fact that its campaign promises included a dramatic change in environmental policies. Reacting especially to the Bush administration’s apparent unwillingness to grapple with global warming and energy issues, President Obama has taken the same bold steps on these issues as he has on other issues in the headlines.

Although many environmentalists argue that markets and prosperity are the cause of environmental degradation, our analysis begins with the premise (based on strong evidence) that markets are the source of prosperity and that prosperity and property rights are necessary for environmental quality. If economic growth and international trade are weakened by ill-conceived, risky policies, political support for environmental protection will be reduced, and we may end up with a poorer economy and environment.

Given President Obama’s focus on climate change, we begin by asking whether the administration’s carbon reduction targets are realistic; whether they are likely to have a significant impact on global temperatures in the relevant political time frame; what it will cost to achieve these targets; and what regulatory controls (e.g., trade policies) would be necessary to make them effective. We emphasize political time frame because politicians seldom see beyond the next election cycle, whereas the effects of and solutions to global change require decades.

Without getting into climate science, we stipulate that global temperatures are rising, that some part of the rise is of human origin, and that greenhouse gases already in the atmosphere will cause temperatures to rise, even were the United States to reduce its greenhouse gas emissions immediately. Regardless of the climate model used, most accept that realistic targets for reducing current greenhouse gas emissions will lower temperatures by only small amounts over the course of the century.

Moreover, trying to set meaningful greenhouse gas emission targets is difficult because of the complexities of climate models. As models have been refined to take account of other variables (e.g., ability of oceans to absorb carbon dioxide and the impact of increased cloud cover associated with carbon dioxide), predicted temperature increases have declined. Also, as models have improved it is clear that climate change will vary considerably from region to region. Owing to these complexities, greenhouse gas targets could depend as much on politics as they do on science.

A possible reaction to these concerns about costs, compliance, and results is that the Obama administration’s primary mechanism for reducing carbon emissions—cap-and-trade legislation—will be different. (The proposal for capping and reducing carbon emissions in the United States is patterned after the successful sulfur dioxide permit trading system established under the 1990 Clean Air Act Amendments.) The right to release carbon is to be limited by the overall cap, which is a valuable factor of production. Firms holding emission permits can use them as a basis for carbon releases, bank them for future shortfalls, or sell them to firms that have insufficient permits. In all cases, the permits’ value is related to the tightness of the cap and the scarcity of permits. By auctioning off the permits, the administration argues that it will capture the value for the public.

For recognizing the potential of a greenhouse gas cap-and-trade system to create property rights and thus incentives for reducing emissions, the Obama administration gets high marks. For not recognizing the important differences between applying a cap-and-trade approach to regional sulfur dioxide emissions and applying such a system to global carbon discharges, and for not recognizing the added costs that auctioning the carbon permits will have on the economy, however, it gets low marks. (Those costs are in addition to those described above for greenhouse gas emission controls.)

Most accept that realistic targets for reducing current greenhouse gas emissions will lower temperatures by only small amounts.

One big hurdle to establishing a cap-and-trade system for carbon is allocating the initial emission permits. In general, the Obama administration has followed the lead of the dozens of economists who sent a petition to the House Energy and Commerce Committee on March 3, 2009, calling for auctioning permits, rather than grandfathering them to existing emitters. Economists argued that the revenues raised from auction could be used by the government to reduce distortional income taxes and thereby make the economy more efficient.

If the permits are auctioned, the price paid will become “an inconvenient tax” (as it was called in an article in the February 27, 2009, Wall Street Journal). And, like any other tax, it will be shared by both producers and consumers.

The expected revenue that might be generated from a carbon permit auction gives some sense of how much this tax will be. The administration’s initial estimates of the expected revenue from a carbon permit auction were between $130 billion and $370 billion annually by 2015, totaling $650 billion over the next ten years. By 2019, auction revenues will be the sixth-largest source of revenue for the federal government, perhaps raising as much as $300 billion every year. The Congressional Budget Office (CBO), however, considers these estimates low, putting the sum closer to $900 billion over the next ten years. At a closed meeting on March 17, 2009, administration officials acknowledged that the auction could raise two to three times the $650 billion figure.

Whatever the number, it is a big pill for producers and consumers to swallow. Moreover, the tax will fall disproportionally on lower-income families. The CBO breaks down the burden of achieving a 15 percent reduction in carbon emissions as follows: the bottom fifth of households will see after-tax income fall by 3.3 percent; the three middle fifths will see it fall between 2.7 and 2.9 percent; and the top group will see it fall by 1.7 percent.

Recognizing the potential for this tax regression, the Obama campaign promised to return the windfall to taxpayers. Now that he is president, Obama wants $525 billion to go, through its “making work pay” tax credit, to taxpayers who do not pay income taxes. This amounts to $400 for individuals and $800 for families earning less than $250,000 per year. The president’s budget further proposes to use another $120 billion to fund clean energy technology.

Any realistic political analysis, however, raises questions about the likelihood that the auction revenues will be redistributed to the public. Already the administration is on the defensive and strapped for cash to fund its policy objectives. In March the CBO’s baseline projections of the budget deficit for 2009 and 2010 rose, leading to estimates that it will total $1.7 trillion, or 11.9 percent of GDP, this year (the largest since 1945, when World War II ended). Accordingly, the opportunity to use cap-and-trade auctions as a revenue source becomes overwhelmingly appealing, potentially hijacking the environmental objectives. Further, with windfall tax revenues such as these, political scientists predict that disproportionate amounts of the revenues are likely to go to special-interest groups, with the amount determined largely by lobbying efforts.

Lest you be skeptical that auction revenues will go to uses other than tax refunds, consider what happened to tobacco settlement revenues. In November 1998 a settlement was reached between the major U.S. tobacco producers and forty-six states. In exchange for dropping their lawsuits, states were to receive payments from the tobacco companies projected to be $206 billion over the first twenty-five years. Those payments were to be used to promote public health and implement tobacco-related health measures. To date, $79.2 billion from tobacco settlement money has been received by the states. Between 2000 and 2005, 30 percent of the money went to health-related spending, but the rest went to everything from infrastructure to public debt service; the latter took 5.4 percent of the revenues.

Although a cap-and-trade program is a property rights approach to environmental problems that has been successfully applied to regional fisheries and sulfur dioxide controls, it is not as effective for global carbon emission controls because of uncertainties regarding costs, benefits, and worldwide compliance. Given that we are experiencing global warming and that it might lead to catastrophic events, the question remains: If not cap and trade, then what?

To get at the answer, put the issue in the context of risk analysis. Some policy analysts contend that incurring the huge costs of reducing carbon is like buying insurance. But unlike insurance, which pools risk and pays those insured if and when they have a loss, spending money now to avoid uncertain future costs has no such pooling benefit. Instead of being like fire insurance, it is more like buying a smoke detector. As such, the decision to reduce the likelihood of a catastrophic event depends on the cost of prevention versus the expected cost of the event. Because the smoke detector is cheap relative to a bad fire, almost all homes have them. Based on the cost-benefit evidence of reducing carbon dioxide emissions, however, it appears that, rather than reducing risk, the administration’s policies could increase it, making the United States and the world poorer and, therefore, not only less able to respond to climate change but also more vulnerable to other threats, such as terrorism and general unrest, as the world’s populations suffer constrained opportunities and dashed expectations. We recognize that there are potential costs to climate change, but at this time an aggressive emissions control policy through a cap-and-trade program is apt to be counterproductive economically, politically, and environmentally (i.e., have little impact on global temperatures in the foreseeable future).

Greenhouse gas targets could depend as much on politics as they do on science.

Fortunately, policies are in place that will help us cope with global warming more effectively. For example, state insurance regulators are requiring insurance companies to disclose the added risk that they likely face if the warming occurs. Such disclosure provides better information of the expected cost of global warming and therefore a price signal to reduce that cost, just as higher fire insurance rates do. Encouraging the dissemination of transparent information is something the Obama administration should consider.

Mitigating any global effects of climate change through a cap-and-trade program in the United States is unlikely to have much impact owing to problems of free riding and enforcement in other countries, notably China and India. And it is certain to be costly. On the other hand, if some of the damaging climate effects that the administration predicts are going to occur, we should be preparing for them. But adaptation has received much less attention from an administration focused on cap-and-trade legislation. Yet means of adaptation—through reductions in subsidies for development in flood-prone areas; construction of dams and water storage facilities to address possible drought; and greater emphasis on water markets to better manage scarce water supplies-can be lower-cost, responsible reactions to any perceived climate change.