June 19, 2017

Q&A: Increasing Emissions Certainty under a Carbon Tax

Nicholas Institute for Environmental Policy Solutions

Some organizations and individuals have expressed interest in a carbon tax as the primary federal policy to reduce greenhouse gas emissions, but such a tax leaves the emissions outcome uncertain. In an issue of the Harvard Environmental Law Review focusing on carbon taxes, three researchers affiliated with Duke University’s Nicholas Institute for Environmental Policy Solutions examine options for increasing emissions certainty. Brian Murray, Billy Pizer, and Christina Reichert discuss how these options could respond to deviations from identified emissions goals as well as identify the challenges and opportunities associated with different approaches.

Various stakeholders have suggested a carbon tax at the federal level as a method to reduce greenhouse gas emissions. How does your article build on this conversation?

Ahead of any vigorous policy discussions about a carbon tax, we see value in a neutral analysis regarding the consequences of various design option—that is, an analysis that doesn’t take sides on whether a carbon tax is in itself good or bad. Recently, the idea of a carbon tax has been tied to concerns, particularly among environmental stakeholders, about whether emissions goals will be achieved. In our Harvard Environmental Law Review article, we explore this previously unstudied concern, discuss and develop possible options to address it, and lay out a research agenda to better inform a choice among the options.

An important context for this discussion is the reciprocal nature of an alternative tax and a tradable permit. A tradable permit program, also referred to as cap-and-trade, requires emissions sources to surrender one permit for each ton of emissions; the government then issues a fixed number of emissions permits—effectively putting a cap on the total volume of emissions. Sources can then trade the permits in advance of their compliance obligation, thereby establishing a price for each emitted ton. So under a tradable permit program, the emissions are certain, but the permit price (and hence compliance cost) is not.

Alternatively, a carbon tax requires emissions sources to make a payment based on their emissions activity. The tax directly sets a price on emissions, typically expressed in dollars per ton of carbon dioxide. Although the emissions outcome can be estimated, we can’t have certainty about what it will be. Our article explores mechanisms that move the needle back toward greater certainty about emissions.

Your article draws parallels to the idea of an allowance price reserve, a feature of some cap-and-trade programs. How is such a reserve relevant to a carbon tax?

Despite the reciprocal nature of taxes and tradable permits policies, there are design features that can lessen their differences. These features can balance emissions and cost uncertainty according to stakeholder tastes and, in turn, structure a possible compromise between cost concerns and environmental interests.

Under a cap-and-trade program, an allowance price reserve is one such feature. This feature, advanced by two of us and another Duke colleague in 2009, allows additional allowances into the market at specified high-price points. This additional allowance supply reduces otherwise high prices and avoids inflicting economic hardship for potential buyers and their customers. This mechanism may allow economic interests to agree to what may be viewed as an economically risky cap because they have the assurance that further steps will be taken should prices become too high.

In the same way that the allowance price reserve can help contain prices under emissions trading, mechanisms are available to help contain emissions under a carbon tax. These mechanisms include (1) changing the tax rate or schedule, (2) using traditional regulatory tools, or (3) using revenue spending. It is possible to combine elements of all three mechanisms and to trigger them automatically or on the basis of a discretionary process. By providing assurance that additional steps will be taken should emissions outcomes diverge from identified goals, these mechanisms might allow environmental stakeholders to agree to a carbon tax that they might otherwise view as environmentally risky.

Describe in more detail what you discovered when you looked closely at policy mechanisms for increasing the emissions certainty of a carbon tax.

Policy makers have several policy mechanisms they could use to guide a carbon tax to reach an emissions reduction goal. These mechanisms include changing the tax rate or schedule, using traditional regulatory tools, spending revenue raised by the tax to directly reduce emissions, or creating hybrid approaches that combine elements of all three. Each mechanism could be designed to trigger automatically, or it could arise through the discretion of Congress or a delegated agency. Each mechanism also brings associated challenges and opportunities, which we define and discuss in the article.

One mechanism is to adjust the tax rate to reflect updated information about emissions performance vis-à-vis an identified emissions goal. If designed to trigger automatically, legislators would decide up front how the tax would change over time and in response to emissions performance relative to established goals. Alternatively, Congress would first establish the emissions performance goals and an initial trajectory for the tax rate over time. Then, either Congress or a delegated agency would review emissions performance and determine the necessary adjustments to achieve the stated performance goals.

Another mechanism is the use of various regulatory tools as a backup to the carbon tax. This approach would initiate one or more regulatory programs if the United States failed to meet its performance goals with the carbon tax. If legislators decide to use such regulatory tools, they could choose from multiple options: use of existing mechanisms under the Clean Air Act, modification of those mechanisms, or creation of an entirely new regulatory mechanism.

In addition to tax rate adjustments and regulatory tools, legislators could use part of the revenue from a carbon tax to fund programs that provide financial support for emissions mitigation within or outside the sectors covered by the carbon tax. This method is similar to offset mechanisms under a cap-and-trade program, particularly if the mitigation achieved through this financial support is designed to exactly negate the emissions that exceed an established emissions goal. However, because the revenue programs would be based on government procurement rather than private sector trading, the government would have the ability to continually scrutinize mitigation projects.

Finally, two or more of the above-described mechanisms could be combined, perhaps better addressing the range of stakeholder concerns arising from unmet emissions goals. For example, legislation could pair a carbon tax rate that adjusted in response to small deviations with regulatory tools to be used only when large and persistent deviations arise.

To operationalize any of these approaches, policy makers would need to carefully define both the emissions goal and the notion of deviations that trigger a response. Our article discusses different approaches to this task and options for both an automatic and a discretionary response.