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Cap and Trade: Right Debate, Wrong Solution

David Gold

         As we have seen in just the past few years, fossil fuel prices can vary dramatically over very short periods of time.  Creating greater certainty regarding steady increases in fossil fuel prices over the coming decade would have an enormous impact on private sector investments in both alternative energy and energy efficiency.  Cap and trade is the right debate to be having because it focuses the discussion on how to change the fundamental economics of fossil-based energy.  But ultimately cap and trade is the wrong solution; superior means exist to achieve the results we need not only for the environment but also for national security and our economy.  A better solution is a strategically targeted “ceiling” tax on carbon combined with a tax dividend.          Cap and trade sounds good on the surface. Seemingly it would allow the market the freedom to choose among implementing technologies that reduce greenhouse gas emissions, paying to use existing technologies that emit greenhouse gases, or paying for offsets from another entity.  But cap and trade is inherently flawed in its complexity and the slow rate at which it can propel change.  The potential for loopholes  and corruption, both through the specifics of how the law is implemented and the trading markets that will be created, are enormous.  If you have read my blog previously, you may be surprised to hear me come out against a seemingly market-based solution like cap and trade.  Many assume that because cap and trade worked for acid rain, it will work for greenhouse gases.  But for markets to work well there needs to be transparency around both price and what actually is being purchased.  As the graphics shown help illustrate, the complexity of greenhouse gases are enormous compared to the simplicity of sulfur emissions from coal plants. The challenges around accurate and transparent accounting of how much carbon is emitted or “re-sequestered” through an offset is fairly daunting.  There have already been significant challenges around carbon offsets with the European cap and trade efforts.  So far in Europe, the impact on greenhouse gas emissions has been much less than desired (for additional reading see the upcoming book by Roger Pielke).   Because of these factors, not only does cap and trade create risk of corruption because of the challenges around defining exactly what has been emitted or how much an offset has recaptured, but its ability to actually achieve the desired reduction in greenhouse gases also falls into question.

         Efforts to implement a cap and trade system that would be truly comprehensive would treat all long-lived greenhouse gases as equal. To make any meaningful difference, the price of carbon must be set high enough to move the meter significantly on the cost of fossil fuels.  Many experts estimate that price to be as much as ten times the current price in Europe.  As a result, if a cap and trade system is actually going to result in a meaningful reduction in greenhouse gas it will have an enormous impact on the economy given the scope of activities that generate greenhouse gases.  In addition, the sheer process of requiring businesses to account for their emissions would lead to significant wasteful administrative costs beyond the cost of the carbon emissions themselves.  Such a requirement would, however, create a great jobs program for accountants, attorneys and even investment bankers who would get paid to navigate the complicated mess that would result.  This reality is why many cap and trade proposals end up being limited to areas of highly concentrated emissions that are easy to track.  This effectively means focusing on power plants, which represent about 39% of the impact-weighted greenhouse gas emissions (of which 85% is from coal-fired plants).  And most proposals generally leave transportation -- which produces about 33% of the impact-weighted U.S. greenhouse gases – largely unaffected.

         “So what?” you say.  Let’s focus on reducing the 39% that is largely from coal-fired plants, right?  From an environmental perspective it does not matter where we reduce emissions – just that they are reduced.  But from an economic and national security standpoint it matters significantly.  The U.S. is home to roughly 25% of the world’s coal and supplies virtually all the coal Americans consume.  Meanwhile, the U.S. imports the majority of petroleum that we consume.  Reducing consumption of coal will not strengthen our national security, and the most immediate effect on our economy will be negative.  Even if one doesn’t believe those are important factors (hard for me to fathom but I know some feel that way), I suspect that everyone would agree that the political ability to implement something that moves the meter is critical.  A policy that appeals to the left and right of the political spectrum holds the best promise.

       Tax and dividend, whereby a tax is placed on carbon and some, if not all, of the proceeds are distributed back to those who paid the tax, is a concept that has begun to receive discussion as a potential alternate solution.  Such a system taxes based on consumption but the dividends are paid out without respect to specific consumption.  So, the motivation to move to alternative fuels or implement energy efficiency remains because the dividend will still be received even if tax payment is reduced.  Yet, the sting of the tax is reduced by receipt of the dividend.  Tax and dividend eliminates many of the problems associated with the complexity and lack of transparency with cap and trade and it largely leverages systems already in place to tax things like gasoline, coal, etc.  However, it still is flawed in that it treats all carbon as being equal.  Again, while all emitted CO2 is equal from an environmental standpoint, it is not from an economic or national security standpoint.  In addition, the greater the scope of the tax, the more interest groups it will upset and the less likely it is that it can ever pass Congress to become law. 

         The better solution, both from an efficacy and political standpoint, than cap and trade or tax and divided is a strategically placed “ceiling” tax on carbon combined with a tax dividend.  Our greatest opportunity lies at the nexus where greenhouse gases are reduced, national security is strengthened and our economy is at least not harmed.  As a result, the first element of the solution should focus on petroleum consumption, which is predominantly consumed in vehicles and the first strategic place for a “ceiling” tax is on CO2 emissions from fossil-based transportation fuels used in automobiles and trucks.  This is effectively a gas tax, except it would apply to gasoline, diesel and any future form of fossil-based fuel sold for ground transportation and would be based on the amount of non-renewable CO2 emitted upon combustion.  In addition, the tax rate would be determined by the difference between the price the retailer/vendor pays for the fuel and a pre-determined fixed maximum charge to the consumer (individuals and businesses alike).  If the ambient price of the fuel commodity increases, the tax that is charged would decrease.  Thus, it creates a “ceiling” on the tax where there is an ambient price at which the tax would no longer be charged.  Implementing the tax in this manner accomplishes several objectives:
  • It creates clarity, certainty and stability around the price that alternatives will need to compete with.
  • It sends a clear political message that this tax is not forever; it has a built-in mechanism to end when the ambient market price catches up with the artificial price created by the tax.
  • It puts a limit on the pain inflicted at the pump.  If fuel prices spike, the tax will diminish and even go to zero if the maximum charge to consumers is exceeded.
Now, what to do with the revenue?  We must ensure that the negative impact on our economy is minimized as much possible.  In addition, we have to be realistic and create something that can fly politically.  As a result, the tax revenue should be sent right back to the consumers who paid it.  For individuals, the amount received could be based on the size of the family to reflect the likely increased transportation needs.  Economically speaking, the dollars received by each family will be much more meaningful to a low-income family.  Yet, the payment is not based on income – something for Democrats and Republicans to celebrate.  For businesses, we must endeavor to avoid making specific businesses non-competitive. If a business has a transportation intensive business, the cost increase could be substantial.  So, distribution to companies could be based on their fuel consumption for transportation over a multi-year period prior to enactment of the tax.  That way, transportation-intensive companies will receive a much larger share than those that use little transportation directly in their business. What about the impact on the oil industry?  No doubt that such a tax would have an impact on oil consumption and therefore production.  It may even be politically required to dividend some of the tax proceeds back to the oil industry.   After all, democracy is the art of the possible.  This would likely mean a smaller oil industry to the extent that the industry doesn’t redirect its efforts to other profitable business efforts (e.g., geothermal, solar, etc.).  However, with a tax on transportation fuels, there would be a clear economic upside to the change.  The clarity provided with respect to future prices of gasoline and diesel would provide significant impetus and support for private sector investments in renewables as well as vehicle energy efficiency.  In addition, such clarity would spur significant economic growth in the automotive industry as consumers become eager to find energy efficient or alternative energy vehicles. One need only look at what happened with the sales of hybrid vehicles when gas prices spiked a few years ago. The auto industry would see a boom as consumers looked to switch to vehicles that consume less fossil fuels. President Obama’s desired goal is a 17% reduction by 2020 from 2005 emission levels.  If the tax is set at a high enough level, studies indicate it would drive significant change in buying decisions and driving behavior of consumers.  A key to the success of the tax is that it creates long-term certainty with consumers regarding the likely price of gasoline and diesel.  A Congressional Budget Office Study found that a 10% long-term increase in fuel prices would result in roughly a 4% reduction in fuel consumption (through a combination of reduced driving as well as purchase of different vehicles).
If the ceiling tax were set based on a target price of $5 per gallon retail price for gasoline, this would create long term visibility into a price increase and would imply we could see a reduction in fuel consumption (and corresponding emissions) of 40%-50% representing a 13%-17% reduction in overall greenhouse gas emissions.  The U.S. consumes more than 6x the gasoline per capital than Europe and one reason is that gasoline costs 2-3x as much at the pump than the U.S.  What the CBO study did not take into account (given the challenge of doing so) is what happens to petroleum consumption when alternative fuel vehicles then become cost-competitive.  I would suggest that the accelerated innovation that would occur in such vehicles once businesses knew they would be competing with a $5/gallon price would drive even greater reductions in greenhouse gas emissions and petroleum consumption well beyond 17% in 10 years. Clearly, such reductions are much less meaningful from an environmental perspective if carbon emissions elsewhere were to increase.  Given that electric vehicles are a probable future for some vehicles, we must address the emissions created by electricity production.  Otherwise, we will simply push CO2 creation from the tailpipe to the smokestack.  But rather than a complex loophole- and scandal-fraught cap and trade system, a strategically placed ceiling tax on CO2 emissions and corresponding dividend should also be used in the utility industry.  The challenge here is that just like cap and trade, in order to have a meaningful impact regarding the business decisions made on utility plants, the price of carbon must be set fairly high.  Because electricity costs impact every person and business in the nation, a carbon tax applied to power plants significant enough to be meaningful would have a broad-based negative impact on the economy.  Everything would become more expensive. Instead of a blanket tax, the ceiling tax on CO2 from electricity production should be much more strategic.  First, the tax placed on existing plants should be fairly modest and intended primarily to generate tax revenue that would be utilized specifically to provide funding to the coal industry for clean coal and sequestration technologies.  That is not only the politically correct move; it is economically smart given our vast coal resources.  A tax of just $2 per million metric tons of carbon would generate roughly $5 billion a year in tax revenue (U.S. utilities generate roughly 2,400 million metric tons per year).  Yet, it would add an average of about one tenth of a cent to the cost of every kilowatt-hour (U.S. total electricity production is roughly 4,100 billion kilowatt hours per year) or roughly a .01% increase in retail price.   Second, the tax on new plants built after a couple-year grace period for those already being constructed, should be set at a much higher level that ramps up over time to a capped amount. An initial tax rate of roughly $30 per metric ton would equate into a cost increase of about 3 cents per kilowatt-hour for the worst offending coal-powered electricity generation.  However, the specific amount of the tax should also vary based on the price of the underlying commodity (e.g., coal or natural gas).  That way, if there were a spike in a commodity price (like with natural gas a few years ago), the tax is automatically reduced or eliminated, thereby eliminating excessive spikes in electricity prices.
To make a carbon tax on utilities achieve the desired goal of driving a change in decisions regarding which type of plants to build, it is critical that utilities are not allowed to work the tax into their rate base - they must eat the tax cost or implement new plants that emit less or no CO2.  In addition, when plants reach a set timeframe after the end of their depreciation period, they would begin to be subject to the higher tax on new plants.  The incentive must be squarely placed on utilities to implement low carbon or no carbon means – all of which they can work into their rate base.  That means implementing renewable, nuclear, sequestration and likely some additional natural gas.  Given that the incremental plants will, by and large, create more expensive electricity than the base coal plants, utilities will have increased incentives to promote energy efficiency and implement the smart grid.   Until technology innovation allows otherwise, most incremental electricity load above the current base will likely cost more to deliver.  Such a tax, if set high enough on new plants, would likely create something akin to a cap on any increases in carbon emissions by utilities. As aging plants are replaced or retrofitted, reductions in emissions would begin.   In 10 years, if the vast majority of new electricity production beyond what was currently being built has been low- or no carbon and if just 15% of aging coal plants are replaced with low or no-carbon emitting alternatives, we would see a reduction from 2005 utility emissions of 3%-6% on top of the at least 13%-17% reductions from action on transportation fuels but without a severe negative impact on the economy.  And the clean coal and sequestration technologies developed from the R&D generated through the taxes would hopefully enable an acceleration in reductions as they are able to be implemented in the following years.

 In making decisions about how to reduce green house gas emissions, as a nation we cannot and should not focus solely on the issue of global warming while ignoring the equally important goals of maintaining our national security and economic strength.  We must implement a system that changes the economics of energy in a way that supports all of these goals.  Not only will cap and trade be unable to achieve these three goals, but without an extremely high price on carbon that likely cripples our economy it won’t even have a significant impact on the single goal of reducing green house gas emissions.  A system that does not focus first on our consumption of petroleum has little chance of strengthening our economy or national security.  In addition, to be successful, we must create greater clarity over long-term fuel price that the alternatives must compete with in order to provide the impetus for private sector investment in energy efficiency and alternative energy.  Cap and trade cannot give this clarity and the government cannot simply buy our way out of this problem.  We must have the innovation, creativity and financial power of the private sector motivated to making the scale of change that is required.  A strategically targeted ceiling tax on carbon with focused use of the dividends could create the log term clarity needed in the market and will motivate the private sector to dramatically increase investment in the type of innovation and change that is the source of ours (and the world’s) prosperity.

David Gold is an entrepreneur and engineer with national public policy experience who heads up cleantech investments for Access Venture Partners (www.accessvp.com).  This article was first published on his blog, www.greengoldblog.com.

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Read your blog. Makes sense. However you are wrong about cap & trade. I live in Belgium. We have all the above you mention : tax + dividend, high ceiling prices on petroleum consumption, cap & trade.

Concerning Tax & Dividend. We pay a tax of 1.5 cents per consumed kWh if it is fossil fuel produced electricity, be it home or corporate consumption. That small tax is then collected by the independent grid corporation (completely deregulated energy markets). The grid corporation then deliver all this money to our government, who supplies a dividend in the form of tax rebates on insulation and solar water heating or other valid energy efficiency upgrade investments, be it home or corporate. Another dividend is supplied in the form of a Feed-in-tariff for renewable energy sourced electricity. This allow corporations or home owners to invest in green electricity power production, since they get a much higher price per kWh for their produced electricity, compared to their competitors using fossil fuels to produce their electricity. This much higher price per kWh feed-in-tariff is the reason why the E.U., a $15 Trillion economy, now is doing hereunder provided investments :

The European Wind Energy Association (EWEA) says 39% of all new capacity installed in 2009 was wind power, followed by gas (26%) and solar photovoltaics (PV) (16%). Europe decommissioned more coal and nuclear capacity than it installed in 2009. Taken together, renewable energy technologies account for 61% of new power generating capacity in 2009.

The EU provides all projects of all renewable energy companies with feed-in tariffs, guaranteed fair prices for all generation. All independent companies get opportunities. The US forces renewable energy companies to bid for projects and prices from utility monopolies that favor themselves, their affiliates and friends during bidding. Most independent companies get no opportunities.

Concerning high ceiling prices on petroleum consumption. You are correct about this system, which has been in place for 40 years in the E.U. I use a 10 years old VW Golf turbo diesel achieving 45mpg in mixed used and 50 mpg on highways. I do not invest in fancy Priuses or other still expensive PHEV, HEV, EV. Why ? because it doesn’t yet makes sense economically, given that they all cost much more than my second hand 10 years old fuel sipping Golf. However, we achieve less than half the US average in petroleum use, simply because I pay the equivalent of $6.8 per gallon right now at the pump. It seems much, but given the fuel efficiency of my old car, I do not pay more than the average US joe Sixpack with his 2 ton truck guzzling a 20 mpg.

Concerning Cap & Trade. The system is indeed very flawed. However, it forced the mothballing of old inefficient power plants and a serious efficiency drive all over the place, in the E.U.. For this reason only, it is worth pursuing :

EU member states have approved European Commission proposals to allocate billions of euros from the EU carbon Emissions Trading Scheme (ETS) to fund renewable energy, including wind, and carbon capture and storage (CCS) projects.

Fossil-fuel emissions of CO2 from unified Germany have declined 20.6% since 1990 to 220 million metric tons of carbon in 2006. The 2006 per capita emission estimate of 2.67 metric tons of carbon is comparable to 1950s levels. Although the largest fraction of emissions (38.7%) is from burning of solid fuels, the use of coal has been in general decline since 1950, at which time 97.3% of the total emissions were from coal burning. Natural gas burning first contributed over 1% in 1968 and is now 22.6% of the total. The year 1991 marked the first year the United Nations published energy statistics for unified Germany.

The law that passed Friday aims to increase the amount of power generated by renewable energy sources, including wind and solar power, to 30 percent of the renewable total by 2020, from 14 percent now.
Germany's share of wind in its total electricity generation is 4.4 percent, third after Denmark and Spain, the Environment Ministry says. Renewable energy makes up about 6 percent of the total primary energy supply.
The amount of energy that will be generated by direct sources of electricity and the excess heat they generate - a process known as co-generation - will be doubled to 25 percent over the same period.
Co-generation is a common and efficient system in Germany and Eastern Europe, allowing excess heat from power stations to be converted into electricity instead of being released into the atmosphere.
The law is the first of two that are part of the government's overall goal to reduce Germany's carbon dioxide emissions by 40 percent by 2020 compared with 1990 levels. That is twice the minimum percentage cut agreed to last year by the European Union's 27 member states.
The second package of environmental laws, to be passed after the summer recess, according to the Bundesrat, will include measures designed to lower electricity consumption, with the focus on private homes. For example, the bill, agreed on last month by the Bundestag, the lower house of Parliament, stipulated that beginning in 2009 all new and renovated buildings will have to meet stricter energy efficiency standards.

Europe, however, is committed to reducing carbon dioxide emissions, and is increasing its use of wind, solar and biomass technologies. Biogas is a small but rapidly expanding part of the continent’s renewable energy portfolio. Sweden, Austria and Denmark are leaders in the development of biogas, but nowhere is the potential of this industry being realized like it is in Germany. The German Biogas Association (GBA) projects that biogas will provide 17 percent of the country’s electricity by 2020, according to GBA Secretary General Claudius da Costa Gomez. German expertise in biogas production could become a marketable commodity. More than 400 companies perform engineering, components manufacturing, construction, and technical and laboratory services for the biogas industry. The GBA estimates that 30 percent of the country’s biogas engineering services could be exported by 2020. At the present time, manufacturers have to work hard just to keep up with the German demand. “Our manufacturers have enough experience (to exploit the export market), but they don’t have enough workers,” Horbelt says. “The demand for biogas plants in Germany is very high, and they aren’t able to build enough plants for the German market before they go to foreign lands.”

A smart grid could reduce electricity use and cut carbon emissions by 12% for US power utilities by 2030

McKinsey explains that these measures, if fully enacted over the next decade, would save a remarkable 1.2 billion tons of CO2 equivalent annually, which is 17% of U.S. CO2 emissions in 2005. In other words, the entire 2020 target in the Waxman-Markey climate bill could be met with energy efficiency at a net savings to U.S. consumers and businesses of $700 billion. Such a program is estimated to reduce end-use energy consumption in 2020 by 9.1 quadrillion BTUs, roughly 23 percent of projected demand. And what is even more stunning about this analysis is that it didn’t even look at the transportation sector, where we know huge savings opportunities are possible

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