How Can the US Reduce Climate Change? Carbon Pricing

Photo by Getty Images.

Q&A with Frank Wolak, director of the Freeman Spogli Institute for International Studies (FSI)’s Program on Energy and Sustainable Development (PESD), and Mark Thurber, associate director for research of PESD. Written with Joshua Kenway.

According to a recent United Nations report, the world’s temperature will increase 1.5 degrees Celsius — the maximum amount of warming Earth can handle before seeing catastrophic results — in a mere 12 years. To avoid this, countries around the world would need to drastically lower their carbon emissions.

Because the US is deeply divided on what the response to climate change should be, and since President Trump has announced the country’s withdrawal from the Paris Climate Agreement, current emissions reductions by the US will not be sufficient to avoid exceeding this limit, unless bold policy change is enacted swiftly. Carbon pricing is one of the few methods to reduce climate change that has received support from both sides of the aisle. For instance, former Secretary of State and FSI affiliate George Shultz, along with other leading Republicans, proposed a carbon dividends plan to reduce emissions without creating a financial burden for lower-income Americans.

To help us understand carbon pricing and how it could work in the US, we spoke with Frank Wolak and Mark Thurber from FSI’s Program on Energy and Sustainable Development.

What is carbon pricing?

Wolak: Carbon pricing hinges around the idea that emitting greenhouse gases (GHG) creates future costs which aren’t captured by the market. However, if government can try to enforce some of those costs then we should be able to lower the amount of carbon that people and companies emit.

How is this achieved?

Wolak: Broadly speaking there are two variations. The first — sometimes called “cap-and-trade” — involves the government specifying a certain level of carbon emissions to allow for the upcoming year. That government then issues a fixed number of annual emissions “allowances” (typically each is equivalent to one ton of CO2) which are then bought and traded by carbon-emitting firms.

If it would cost a company more to reduce their emissions by a certain amount than it would to buy allowances for their emissions output, then they’re going to buy the allowances instead of reducing their emissions. As the price of allowances increases, it’s going to make more financial sense for a firm to reduce their emissions and sell their permits to companies that still need them, until the market gets to a point of equilibrium.

The fewer permits that the government issues — the lower the level of emissions that they’ll allow — the higher the price is going to be for a firm emitting CO2. That gives companies more incentive to be creative in how they emit less and to invest in lower-emission technologies for whatever industry they’re in.

What about a carbon tax? How does that differ from cap-and-trade?

Wolak: Every ton of CO2 that a company puts out into the atmosphere would be taxed a specific dollar-amount set by the government. All GHG emissions with an abatement cost greater than this per-ton tax cost would continue to occur, because it would be cheaper for the emitter to pay the tax than to pay the abatement cost. Conversely, whenever companies can reduce their emissions for a cost lower than the level of the tax, then that’s what they’ll choose to do.

What is the difference between these two models?

Wolak: The key point to understand is that, in a carbon pricing system, the price of emitting CO2 will vary, but the amount of CO2 emissions is — theoretically, at least — fixed. Conversely, with a carbon tax system, the price of emitting a certain amount is set, while actual emissions reductions will vary based on how expensive it is for companies to lower them.

How do these differences play out in the real world?

Thurber: As Frank says, a carbon tax establishes certainty around the carbon price, while a cap-and-trade system fixes some emissions level. This suggests that cap and trade should provide more environmental certainty, but in practice this isn’t necessarily true, for several reasons.

First, a carbon cap is set through a political process just as a carbon tax is, so there is no guarantee that the chosen cap level would be the “correct” one for avoiding the worst climate risks. Moreover, since climate change is a global problem, a carbon pricing program in one jurisdiction is never sufficient on its own, though that is hardly an excuse for inaction!

Second, all real-world carbon pricing programs, including cap-and-trade systems, are subject to sources of “emissions leakage,” such as movement of emissions-intensive activities outside the capped region after a cap-and-trade system is introduced.

Third, real-world politics simply won’t tolerate carbon prices above a certain level, which means all emissions caps are ultimately “soft.” If, for example, economic growth in a region with a cap-and-trade system is greater than expected, and the price of carbon would have to rise to an extraordinary level to hold emissions under the cap, politicians are almost certain to raise the cap to lower the carbon price.

What practical steps would need to be taken to implement each of these systems and have them work as effectively as possible in the real world?

Thurber: With either the carbon tax or the cap and trade, it’s important to establish a carbon price that is politically durable. The carbon tax Australia implemented in 2012 was arguably higher than the political consensus there could tolerate at that point in time, which contributed to its repeal in 2014 by a new government. Environmentalists argue that carbon prices around the world are too low to spur the change necessary to mitigate climate change, and I agree with them. In my view, however, it’s more effective to focus first on implementing durable carbon pricing regimes globally. Once these are in place, and once everyone comes to see that carbon pricing is not the job-killing monster that (self-interested) alarmists claim it is, we can start ratcheting up the level of the carbon price over time.

Wolak: For both options, if the incentive structures are going to work as we want them to, then governments are going to have to coordinate their actions; and truthfully the whole world has to move in this direction if companies aren’t just going to export their emissions overseas. Only at that point should we really be concerned with asking which of these systems is better, because right now both are so limited in how effective they can be that there’s really not much to choose between them. The best we can do for now is to set the emissions cap or the carbon tax at levels such that low-carbon energy costs roughly the same as energy from traditional, fossil-fuel sources.

What can we do to encourage other states and other countries to get on board?

Wolak: My view is that we need a carrot-and-stick approach. On the one hand, we have pretty strong evidence now after several years of these mechanisms being in place in various parts of the world that their costs are low and the benefits, in terms of creating a cleaner, greener future for our kids and grandkids, are almost immeasurably high. If that isn’t enough to overcome the political obstacles, then we should be prepared to consider something like a border adjustment tax for carbon. This would mean that anybody importing goods into regions that have a cap-and-trade or carbon taxation system in place would have to pay a tax based on the estimated emissions given off in producing and transporting that imported good; unless the country of production also has a carbon-pricing or taxation system in place. If the United States were to adopt a single national price of carbon, border adjustments could be a very effective mechanism for encouraging China, India, and other countries to adopt similar systems.

In a hypothetical world where every jurisdiction acknowledged the threat of climate change and was determined to reduce GHG emissions, which of the options would you recommend, a carbon price set through an emissions cap or a carbon tax?

Wolak: The big take-home from my new research is that a carbon tax — creating a fixed price but allowing variation in emissions — would be the best way to go. If all regions are subject to the same global price of carbon, then all increases in the price of carbon create incentives for firms to shift toward less carbon-intensive modes of production. As a result, giving firms the clearest possible indication of the price of carbon — as would be possible with a carbon tax, but not a cap-and-trade system — is the most important factor in driving emissions reduction. Setting a high carbon tax that companies can rely on would mean more long-lived investments in carbon emissions abatement and lower carbon technologies than an uncertain price set through a low emissions cap from a cap-and-trade market.


Views expressed here do not necessarily represent those of the Freeman Spogli Institute for International Studies or Stanford University, both of which are nonpartisan institutions.