The Basics of a Carbon Fee

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The Basics of a Carbon Fee

A number of key design issues arise in any federal policy to price GHG emissions, including which sources and sectors to cover, what types of entities must comply, how environmentally or economically ambitious the policy should be, and whether and how to modify or suspend other federal and state climate policies (such as EPA’s GHG regulations under the Clean Air Act).

The two GHG pricing options most frequently discussed are cap and trade and a carbon tax or fee. Each has pros and cons, but they have much in common. Given the recent interest in tax reform and infrastructure spending initiatives, we focus here on a carbon fee or that policymakers could include in a broader fiscal policy package. However, the approach we describe could also work with a cap and trade program in which the federal government raises revenue by auctioning emissions permits.

Cap and Trade

In addition to pricing carbon using a fee or tax, policymakers can also use cap and trade. In a cap and trade system, the government sets a limit on the number of tons of pollution allowed in a particular year from a specified set of sources. It allocates the rights to pollute (via emissions permits) and lets regulated parties trade them. Alternatively, the government can raise revenue by auctioning emissions permits rather than allocating them to polluters. Assuming that the emissions limit or cap declines over time, pollution will fall each year by a predictable amount. This approach has worked well in a number of real-world programs, such as the U.S. Environmental Protection Agency’s acid rain program, which reduced sulfur dioxide emissions (mainly from power plants) at a fraction of the expected cost. However, the economic cost of a cap and trade system can be hard to predict, because emissions and the price of emissions permits fluctuate for all sorts of reasons, for example, including changes in economic growth or fossil fuel prices. Thus, the price at which the permits sell at auction or trade on the secondary market will be uncertain, and will likely vary from year to year.

These policies sound quite different, but can be very similar in practice. For example, both approaches create economic incentives to reduce pollution. Both can raise public revenue, if desired, and in practice are usually designed to do so. Moreover, both approaches impose analogous burdens on households and businesses: they increase the cost of carbon-intensive energy and products when companies pass on a portion of the cost of the permits or fees to customers. Policymakers can design cap and trade systems to more closely resemble a carbon fee by narrowing the potential range of the economic cost. They can impose a price floor for auctioned pollution permits or offer more permits to polluters if prices rise too high. Those price floors and ceilings resemble a carbon fee that varies within the defined range. When the range is small the two systems produce very similar economic and environmental outcomes. Likewise, if a carbon fee underperforms environmentally, policymakers can raise it, or if the costs to the economy prove greater than expected policymakers can lower the fee. Such adjustments can be automatic if they are anticipated in the design of the carbon pricing instruments, or they can be left to future lawmakers.

A carbon tax requires polluters to pay for every ton of pollution emitted, usually at a fixed price during any given year, with the tax rate rising in a predictable manner over time. A U.S. carbon fee would be simple to administer, in part because the federal government already imposes excise taxes on some fossil fuels. A fee approach would let regulated parties project their likely liabilities by establishing the per-ton rate in advance. Likewise, investors in low-GHG technologies can anticipate the market advantage of their products relative to the dirtier competition. Yet, while carbon fees offer predictable prices, they do not guarantee specific environmental outcomes, i.e. hitting a particular emissions target in any particular year. Rather, fees guarantee a level of economic cost per unit of pollution, leaving the quantity of pollution to be set by the market in response to the value of the fee.

If a carbon fee policy underperforms environmentally, policymakers can raise it, or if the costs to the economy prove greater than expected, policymakers can lower it. Such adjustments can be automatically incorporated into the fee design, or they can be left to future lawmakers.

A few principles or best practices should apply to any policy design. Namely, the policy should:

Have broad coverage: Under any carbon pricing system, economists generally advocate for the broadest possible coverage of GHGs in the economy (across economic sectors, pollution sources and GHG types), contingent on the feasibility of identifying a responsible party and measuring their emissions. While broader coverage also results in larger macroeconomic impacts (more companies are required to pay for their emissions), it also achieves a given amount of pollution reduction at the lowest possible cost. Broad coverage ensures that the lowest-cost abatement opportunities across the economy are realized first, thus lowering the overall cost of achieving an emissions reduction goal. An economy-wide carbon price signal also incentivizes technology development across a wide range of emissions-reducing applications and sectors. Finally, broader coverage also means that the policy can have a bigger environmental benefit—driving down emissions across a larger number of sectors and companies.

Address competitiveness concerns: Some companies cannot pass along the cost of a carbon price to their customers, most notably companies facing competition from countries without an analogous policy. The set of industries that would face this problem is narrow (cement, pulp and paper, metals, glass and chemicals), but the issue is of keen concern to affected companies, workers and communities. Policymakers can help avoid the unnecessary loss of American jobs in several ways.

The best approach is to leverage the U.S. carbon fee policy diplomatically to encourage major trading partners and competitors to adopt similar measures. An inducement to successful negotiations is to establish a border carbon adjustment that would impose a carbon-based tariff on emissions-intensive goods from countries that have less stringent emissions policies. It could also rebate the carbon fees for emissions-intensive U.S. exports. Another option would be to use some of the revenue to reduce existing federal or state taxes that make U.S. firms less competitive. Finally, as it might take time for these other strategies to take effect, it would be advisable to set the initial carbon price at a modest level and ramp it up gradually and predictably, but not so low as to justify retaining more-costly regulatory burdens.

Offset the burden on low-income households: Although the tax liability would fall on businesses, much of the cost to businesses will be passed down to consumers in the form of higher prices for GHG-intensive energy and goods. Poor households spend relatively more of their income on things whose prices will likely go up, such as electricity and gasoline, making a carbon price especially burdensome for them. Economic research suggests that a small share of the revenue, targeted appropriately to these households can hold them unharmed, and still leave plenty of revenue for other policy objectives.

Generate revenue: A carbon fee that is large enough to significantly reduce emissions will raise substantial revenue. Policymakers can allocate the revenue to uses that foster economic growth (such as reducing other taxes or investing in infrastructure), bolster measures that benefit working households (such as the Earned Income Tax Credit), or meet other priority needs.

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On March 27, 2017

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