Post-Paris: On Pricing Carbon

Alex Mayer

Coal emits around six times more CO2 per dollar than natural gas, and twelve times more than oil. The most effective way to cut carbon emissions is to cut coal, yet it is still a wildly popular source of energy around the world. This is because coal is the least expensive fossil fuel. The price of coal is externalized, meaning people do not pay the full social for it. In fact, carbon is actually priced at zero dollars, despite its dangerous side effects. Nordhaus tackles these issues in his book, The Climate Casino.

Let me back up.

CO2 is a prevalent greenhouse gas that acts as a blanket to warm the earth. Greenhouse gases do not interact with sunlight, also known as visible radiation. So, sunlight is able to pass through greenhouse gases from space on the way to earth. Then, the earth absorbs the visible radiation, and by heating the surface converts the sunlight into infrared radiation, also known as heat. Next, the earth emits said infrared radiation. Here’s where we get into trouble. Greenhouse gases love to absorb infrared radiation and emit it in all different direction. This means that some heat is pushed back down to earth. This heat, in turn raises earth’s temperature even more.

If you’re from a place with long, dreary winters like me, you might, at first, welcome the idea of a warmer climate. However increases in temperature have serious consequences. A 1°C increase in the world’s average temperature is predicted to cause water shortages, coral bleaching, coastal flooding, and amphibian extinction. A 2°C increase is on track to do all of the above, as well as lead to the spread of diseases. It will also put 20-30% of species at high risk of extinction. At 3°C higher, in addition to the above, we expect to see a decrease in food production, sea level rise, and a “substantial burden on health systems.” A change of 5°C is catastrophic, causing mass extinctions, an enormous drop in food productivity, a 30% decrease in coastal wetlands, fatal floods, a change in coastlines, and huge changes in ocean circulation. Each prediction listed above is likely to spur a chain of destructive occurrences.

The scientific community has stated that we should not let the world’s temperature rise above 2°C. However, Nordhaus argues that we should let the earth warm 2.5°C. He comes to this conclusion through his own cost benefit analysis, in which he measures the cost of decreasing carbon emissions against the cost of adaptation to a new climate, arguing that if we spend too much now to reduce carbon emissions, we would put the health and safety of all humans at risk.

Okay, so now that you’re all caught up, the question is… what policies can incentivise the reduction of carbon emissions? Nordhaus has the answer: Climate pricing. He writes, “governments must ensure that people do pay the full costs of their emissions. Everyone, everywhere, and for the indefinite future must face prices that reflect the social costs of their activities.” There are two approaches to setting a price for carbon. You can either calculate the social cost of carbon by evaluating the risks of climate change, or you can base your price off of a temperature ceiling goal. According to a US Governmental approach, the social cost of carbon is $25 per metric ton of CO2. Nordhaus insists that if one were to follow the second approach of pricing carbon and limit the average global temperature increase to 2.5°C, carbon would start at $25 per metric ton of CO2 and increase about 5% annually due to estimated CO2 emission swells in the future.

Pricing carbon would greatly influence the costs of electric power generation. The cost of creating electricity from coal, for example would rocket. Natural gas production would also see a steep increase in cost, though it would be less dramatic. Nuclear power and renewable resources would be the cheapest energy sources.  This would encourage refineries to shift away from emitting carbon in mass and in turn would inspire researchers, inventors, and investors to put time and money into innovating more sustainable and efficient ways to extract and use low carbon energy sources. Furthermore, a carbon price would ensure that carbon rich products and activities would be more expensive for the consumer. This, of course, would encourage people to buy carbon-low materials.

There are two common approaches for pricing carbon: the carbon tax and cap and trade. A carbon tax would have companies, individuals, or the source pay a tax on their emissions. Cap and trade at the national level is a system in which the government allocates or sells carbon emissions permits to corporations. In this approach, all of the country’s businesses, firms, refineries, etc. cannot exceed a total quantity of carbon emissions. However, they are able to trade their carbon permits. Say a business is looking to go green due to public pressure. This company can sell it’s carbon permits to a refinery that wants to release more carbon than it has permits. The intersection of interests between the two companies sets the price for said permits. The corporation, of course would be looking for the highest payer, while the refinery would seek the lowest bid.

Hypothetically, these two approaches have the same effects, but in real life, each carbon pricing scheme has specific benefits and downfalls. Let’s take a closer look. Quickly, you may be wondering who actually pays for CO2 in a carbon tax scheme.  The consumer could pay, as could the refinery or gas station. Economically, it makes no difference. The consumer, will pay the price of carbon no matter what. However if say, the refinery is taxed directly, the consumer may not see the price surge as their own burden. Thus, many advocate for taxing away from the consumer. Nordhaus argues that “a carbon tax would yield $168 billion of revenues in 2020, equal to about 1 percent of GDP. Because the tax rate would soon shoot up, the revenues would also increase substantially over time.”

One benefit of the carbon tax is that taxes are universal. While every country has some sort of tax system, many have limited exposure to cap and trade systems. Thus, the carbon tax may be easier to implement on a larger scale. Furthermore, a carbon tax would not be vulnerable to price volatility. The cap and trade system on the other hand, lends itself to intense fluctuations in cost, which we see when looking at the EU model. An added bonus of the carbon tax is that it can produce money for the government, which can then spend said revenue on environmental initiatives. In a cap and trade system, permits are usually given for free (though there has been some recent resistance to this). This decreases revenue for government, but would keep the American public on board. This is because special interest groups have flooded America with the idea that taxation, especially of corporations, is heinous, anti-capitalistic, and oppositional to free trade.

The carbon tax does have it’s weaknesses, however. In countries like the US, tax plans are difficult to pass and easy to repeal. A changing partisan tide can reverse these environmental initiatives in a heartbeat. Here, cap and trade comes into play. In the US, environmental regulation seem to have staying power. For this reason, cap and trade can be more beneficial in the long run. Also troubling is that a set carbon tax does not in itself curb carbon use. In the cap and trade system, there is a set quantity of carbon releasable. No matter how much money mega-corporations have, they are unable to burn more carbon than they can buy, and they can only buy carbon permits allocated to firms by the government. Here’s a silly analogy to help comprehension:

Say there is a mega-wealthy supervillain who wants to destroy the world by releasing all the carbon he can excavate. Under the carbon tax system, with enough money, he could burn all the carbon in the world. Under the cap and trade system, he could only buy everyone’s permits. This latter plot, would not allow him to destroy the world via climate change because the government would allocate carbon permits based on how much carbon is emittable for a safe world.

Unfortunately, this is oversimplified. Carbon “offsets,” actions that supposedly reduce atmospheric carbon dioxide, are often used to game the cap-and-trade system. When a company offsets carbon pollution, they get an offset permit, which they can sell or trade. Though sensical in theory, offsets are not always carefully monitored and can actually result in extra greenhouse gas emissions. For example, in Indonesia, Sinar Mas Corporation, a palm oil producer, chopped down indigenous forest. In the barren space, the company planted palm oil trees. This, of course, harmed the environment and released carbon emissions. Yet, the corporation still applied for and received offset permits, which they were then able to sell for more profit.

Hypothetically, there is no way of ensuring that a carbon tax or a cap-and-trade can curb carbon emissions enough. Still, it’s all about incentive. Of course, a country could opt to do a carbon tax/cap and trade hybrid. Because each nation has a unique set of political and economic challenges, no one policy will work for every country.

Of course, climate change does not discriminate based on nationality. It will hurt everyone and everything. Therefore, mitigating climate change must be a global effort. This seems rather challenging, as without a unifying treaty or discussion, countries are apt to price carbon in different ways and perhaps at different costs. If the difference in the pricing of carbon is vast, complications will arise at borders over how to translate one country’s carbon pricing to another’s. Nordhaus outlines two ways to harmonize global carbon costs. First, there could be an international cap and trade scheme. Second, all countries could hypothetically agree on a minimum carbon cost instead of an emissions ceiling. In this scenario, countries could legislate higher carbon prices than the agreed upon minimum if they wanted. These ideas are great concepts, but a major question remains: How do we get all countries to stick to their deals without international enforcement authorities and systems?

Nordhaus skeptically advocates for tariffs.Yet, it would be too difficult (and ineffective) to tariff only the carbon rich products. It is near impossible to trace supply chain, and therefore near impossible to know how much carbon is emitted in the production processes of a good. If a Furthermore, many carbon heavy products are used domestically, which renders tariffs irrelevant. It seems more sensical to tariff a specific percentage of all products coming from a noncompliant country. In this way, those countries who shoulder the costs of climate change mitigation get to participate in free trade. Noncompliance countries do not. Ideally, countries would tax carbon at the source to avoid the above mess. Counties that do not, would be tarrifed.

This is a lofty goal, that many will reject ideologically due to the historic struggle against protectionism. Although this simple regulation is radically different from protectionism, the lines could be blurred by a self interested country. The fact that a conservative economist such as Nordhaus even entertains tariffs, much less pushes for them, proves how costly climate change will be if we continue business as usual.