Carbon policy details: Part 3
Posted by Sean Casten on March 28th, 2008
Carbon taxes vs. carbon trading
This is the third post in a series about details we are still getting wrong in the climate policy discussion. See also part one and part two. Or download pdf of full series.
There is no shortage of economic analysis and policy discourse that shows that carbon tax and cap-and-trade methodologies can deliver economically equivalent outcomes. The general consensus — at least today — seems to be that since they’re equivalent, it really comes down to politics, and it’s politically difficult to do anything with the word “tax” in it, so we’ll do cap-and-trade. I like the conclusion, but the rationale is pure bunkum.
To understand why, we need only go back to my simple test of any climate policy proposal: the degree to which it encourages investment in capital that lowers atmospheric greenhouse gas concentrations.
Cap-and-trade and carbon taxes do not pass the test equally.
A carbon tax provides no direct revenue to carbon reducers
Suppose you’re me. You’ve got investors who want you to invest in projects that reduce GHG emissions. They also want to invest their money as rapidly as possible, and to earn as much money as possible from those investments. All of that makes them very keen to figure out how different carbon policies affect their investment thesis.
You now find yourself in a board meeting, trying to explain to them how you will realize financial value from a carbon tax, given your expertise identifying and building projects that reduce GHG emissions. Let’s walk through your conversation:
Q: Will your projects get paid for their beneficial GHG impacts?
A: No. The tax gets charged to emitters. Since my projects don’t emit carbon, I don’t have to pay the tax. But I don’t get any of the revenue.
Q: That still gives you a cost advantage relative to your competition, right?
A: Not precisely. In the long run, the tax could increase the cost of electricity as produced by more carbon-intensive suppliers.
Q: “Long run”? “Could”?
A: Yes. Utility costs don’t immediately translate into higher rates. First they have to go through rate cases, and there is a time lag between when their cost structure goes up, when they file for a new rate case, and when that rate case gets approved.
Q: But you can at least assume it will have a demonstrable impact on the competing price of power, right?
A: Not really. I don’t know how the rate case will apportion rates across different rate classes, so I don’t know whether my customers will be affected in a predictable way by the carbon tax. It is possible that they will simply impose those costs on other rate payers.
There is also a move afoot in the environmental community that would prohibit utilities passing the costs of greenhouse-gas abatement along to their rate payers; in that case, the impact of the tax would be to lower the profit margins of regulated utilities, but it would not have any impact on the competing price of electricity.
Q: But surely you can structure power contracts with your hosts such that they give you some upside from the resulting carbon tax, should it come, right?
A: Maybe, but that’s a hard commercial sell. Would you pay me money today on a gamble about the direction that Congress will take on tax treatment for carried interests to private equity funds? Probably not — and for the same reasons, it’s unlikely that my customers would give me upside on a tax bet.
Q: So what value should we place on carbon reductions for your projects, given this carbon tax?
A: Zero.
This (Socratically) is the crux of the problem with carbon taxes. It is a stick upon the emitter, without any direct carrot for the reducer. And the financial value to the reducer is therefore only realized depending upon the manner in which the emitter’s prices change — but this is far from precise. (Witness all the manufacturers whose profits get squeezed when fuel costs rise because they have no direct way to pass those costs along to consumers.) By contrast, a system that allows emitters and reducers to trade allows for direct financial benefits to those who do the right thing — and a benefit that can be negotiated, built into contracts, and used to affect investment decisions.
Tax policy is a blunt tool
So suppose we could fix all the above. Maybe we do a balancing tax and use tax increases on one side to offset tax reductions on the other side. Does that solve the problem?
Directionally, it’s an improvement. But it is still a poor substitute for a market-based trading system, for the simple reason that tax policy is an indirect tool.
Tax incentives are a great vehicle, if you are a taxpayer. Individuals pay income tax, and mortgage interest tax deductions are a nice perk. But people who invest in energy projects are not taxpayers, at least not in the near term. Why? Because of depreciation and debt. If I spend a lot of capital on a project, I get depreciation shields to lower my taxable income in the early years of project operation. I will also almost certainly debt-finance some portion of the project, and my interest payments will also provide a tax shield. For most energy-related investments (e.g., all investments that either emit or avoid the emission of CO2), you can count on not having any taxable income for the first 7 to 10 years of the project’s operating life. And if you’re not paying a tax, a reduction in your taxes isn’t worth much.
So what do you do? You sell off your tax liabilities to someone with a “tax appetite,” in the jargon of the trade (read: someone with lots of profits that they’d prefer not to pay tax on — typically, banks). They will pay you if you assign them your rights to those tax losses, based on some discounted cash flow stream, giving you an immediate cash flow — but essentially giving away some portion of the gain to the tax equity buyer (after all, they’re not going to buy all those losses from you without getting some benefit).
Don’t get me wrong — this transaction is not a bad thing. Indeed, this is how most wind projects get financed. But the end result is that of all the dollars the government allocates from the treasury for The Good Thing, less than 100 percent of those dollars flow to the person who does The Good Thing. Which means that less than 100 percent of the investments that could theoretically be incentivized by this tax policy actually get incentivized, while the balance essentially goes to bank fees.
So how do you fix this? Two potential ways: One, make the federal payment a revenue payment rather than a tax offset. This is what Section 451 of the recently passed energy bill does, and it’s huge. The net cost to the feds is the same, but for every dollar paid by the treasury, there is a dollar going to incentivize projects. Two, allow bilateral trades between those who cause the pain and those who provide the gain.
Both of those put the incentives in the right place and create real incentives for those considering investments in carbon-reducing technologies. And neither are amenable to a tax-driven approach.
Note: This first appeared on Grist.
Sean,
Your analysis seems to come from a non-carbon emitting business point of view. Isn’t carbon taxes just a way to enlighten a consumer about their carbon consumption? The goal to lower greenhouse gases is therefore pushed from the bottom up, using the consumer as a signal for businesses to change their operations.
Albeit, carbon tax is just a part of the the greater package.
Keep on writing. I really enjoy your posts.
Darklamp
Darklamp,
The point is broadly true of any investment to lower carbon, whether from the perspective of a zero-carbon source, a low-carbon source or simply a downstream activity that lowers carbon indirectly (e.g., efficiency). In all cases, the challenge faced by a carbon tax – and, indeed, by any carbon regulation that places the regulatory burden upstream of the point of CO2 release – is that the linkage between the cost of carbon emissions and the price of the carbon-containing good/service is indirect and imprecise. (Not to mention always under political pressure to unwind.)
We see this in plenty of other venues. When fuel prices rise, airlines do not suddenly raise their fares to recoup their costs; their profits fall. Ditto for copper prices in the plumbing industry, silicon prices in the PV industry or any other sector. Cost increases only translate into price increases to the degree that businesses can pass those prices along without losing unacceptable market share. (In electricity markets, there may also be a legal component, since some have argued that utility commissions should not let utilities pass carbon prices along to their customers through rates, but should instead “eat” them as shareholders.)
The net effect of any regime in which the cost of carbon is not reflected in the price of the good is that there is no market signal to shift behavior (or at best, one that is diminished relative to the cost of the carbon), thereby removing the incentive to shift behavior – exactly the thing the tax is supposed to do! To use your words, the consumer in that instance is no more enlightened about their consumption than they are enlightened about fuel costs on airlines.
A final note – I’d argue that the goal is not to lower GHGs from the bottom up, but rather to lower GHGs as quickly and as cheaply as possible. From whence that reduction comes is a tactic rather than a strategy. If consumers push, that’s great – but the scale of infrastructure change required is such that we better make sure that we create an investment thesis for carbon reduction at the point in the economy where investments can be made. If the only lever is at the consumer, the pace and scale of GHG reduction will be blunted.
I fail to see your point concerning how the consumer will not be enlightened. I understand that the carbon tax might not be an accurate reflection of the carbon emissions, but taxing consumers on any good or service linked to those emissions will provide choices. Consumers who make choices based on price would probably be drawn to a carbon-free (if it exists) product or service. In this case, the market signal will be clear: Carbon-Free Products are not taxed.
As an example, I will draw your attention to Sweden’s carbon tax, where gasoline has a tax of 0.85 SEK/litre and diesel has 1.049 SEK/litre. If consumers had a choice, ethanol (relatively the same market price as gasoline) would have a price advantage, therefore shifting behaviour to purchase the cheaper fuel and cleaner fuel.
I agree with you that this cannot be the main driving policy for GHG emission reductions, but at the same time it creates a society that will acknowledge carbon in our products. If everyday, you see on your receipts of purchased goods or services a line indicating Carbon Tax, you can wonder how to beat it. Nowadays, stores in my area have promotions of Tax-Free Days, which people take advantage. This is the enlightening that I foresee with a carbon tax.
Darklamp,
The problem is two-fold, neither of which are explicit in your example:
1. To what degree does the price of a ton of CO2 emissions pass through to the fuel? Let’s say we put a tax of $20/ton on the fuel, but only $10/ton ends up showing up at the consumer level (e.g., because the remaining $10 is passed through by some other means – like airlines raising the costs for extra bags rather than passing fuel costs along, or because shareholders “eat” part of the total).
2. How certain are investors that the government tax will remain at a known level in the long term?
The first makes it hard for investors who seek to lower CO2 emissions to know what the value of their reduction will be, while the second makes it hard for those same investors to know how permanent that income stream will be. The net result is that while a CO2 tax induces a penalty on CO2 sources – a stick – it provides no clear carrot to those who do the right thing. And given the scale of investment required, those carrots are critical. In your example, the need is not for the consumer to shift, but for the industrial to decide to produce, distribute and market the ethanol. Because absent that decision, the consumers’ choice doesn’t exist.