Blending taxes and cap-and-trade could improve carbon pricing

Although Washington state’s proposed carbon tax failed at the ballot box, carbon pricing remains one of the best policy solutions to mitigate the effects of climate changes as the window to keep global warming below 1.5°C continues to narrow.

The big picture: There are stark trade-offs to both a carbon tax, under which companies pay for each ton they emit, and a cap-and-trade system, which requires them to buy permits for emissions. However, a hybrid model could be the sweet spot between practical politics and effective policy.

Details: Both would reduce carbon emissions, but with distinct disadvantages:

• A carbon tax, often favored by conservatives because it is easier for businesses to plan for, nevertheless carries heavy political risk. Opponents outspent supporters two-to-one in Washington state, reflecting the inherent difficulty of passing new taxes and the added force of lobbying by the fossil fuel industry.
• A cap-and-trade approach, generally preferred by national environmental groups, presents high cost uncertainty for politicians: Too few permits could lead to high prices and economic disruptions. Policymakers typically err on the side of leniency, creating an oversupply of permits at insufficient prices and prompting industry to criticize any adjustments as unfair changes to market rules.

A hybrid approach, on the other hand, could reduce emissions through declining caps while ruling out price extremes via ceilings and floors on permit prices.

• Should permit prices reach the ceiling, the government would bring down prices by auctioning off more permits. Meanwhile, a price floor ensures stable prices even if faster-than-expected emission reductions produce a surplus of permits.
• A price floor of $40 per ton, as proposed by Republicans James Baker and George Shultz, would be a good starting point. (The World Bank recommends a carbon price of $40-$80 per ton by 2020).

While carbon pricing is a powerful tool, it leaves behind substantial cost effective reductions that are unresponsive to pricing carbon. Using the revenue it generates to underwrite the transition to clean energy can address this gap — though policymakers have sometimes taken a “revenue neutral” approach, returning revenue to people or businesses either through tax cuts or a check.

• Canada’s new plan uses this strategy, paying dividends that will offset costs for 70% of households.

Why it matters: Scientists are confident that carbon pricing is an essential, efficient way to slow climate change. Demographic trends favor it as well, with millennials supporting climate action at much higher rates than older generations.

Chris Busch is the director of research at Energy Innovation.