Carbon Pricing is Just One Piece of the Puzzle: Towards a Comprehensive Climate and Energy Policy – Part 5 (of 5)

by: Michael Hoexter

In the first three parts of this long piece (one, two, three), I outlined how our economic common sense has changed since the economic crisis of late 2008; monetarism/supply-side economics has given way to some newer version of Keynesianism. I went on to claim that a primary focus on carbon pricing shows traces of the idealized vision of the market that one finds in the “free market” schools of economics; climate activists have pinned most of their hopes on carbon pricing to remedy the singular catastrophic market failure of unaccounted-for carbon emissions.

In part 4, I pointed out that there are two other important market failures which block effective action on climate in the US and elsewhere. We then have the following list of market failures that are relevant to climate and energy policy:

1. Externalization of costs of climate change attributable to carbon emissions
2. Externalization of costs of infrastructure building and maintenance and high fixed capital costs of long-term private capital investment
   1. Deployment of capital intensive clean energy technologies
   2. Coordination of management and finance of upgrades to electric grid.
   3. Re-design and electrification of transport infrastructure
3. Externalization of costs of scientific research and development

Outline of a Comprehensive Climate and Energy Policy

The power sector is particularly used to and suited to traditional regulation as the building and maintenance of power plants is highly regulated in almost every country in the world. New regulations are sometimes feared and resisted but enough pressure and negotiation can make most rules effective in ways that are more difficult in other economic sectors.

If governments can and at times must take a leadership role in managing the economy, they can do so in part by imposing laws that are in our long-term benefit. Especially if ample consideration is made of the resulting costs and administrative overhead required to implement laws and new rules, these new rules can remove long-standing barriers to making progress in the area of energy, energy efficiency and climate protections.

We have seen that carbon pricing was proposed as a means of avoiding some of the supposed bureaucratic drawbacks of traditional regulation. As it turns out in the case of sulphur dioxide that traditional regulation that dictated the installation of emissions scrubbers was, in some countries, more effective than the US cap and trade system in reducing acid rain pollution. In addition to a fascination with a particular partial economic model, relying on carbon pricing alone might be simply an abdication of the authority of government in the face of resistance by industry. Sometimes leaders need to “put their foot down”, if there is an overwhelming case to be made for new rules made and administered wisely.

1. Coal Plant Moratorium – The primary regulation that must be a part of a comprehensive climate and energy policy is a moratorium on new coal-fired power plants without carbon capture and sequestration. If power utilities find this onerous, they must lobby for regulations and subsidies that make this possible for them on all levels of their businesses. There is no time to wait for the erection of a carbon pricing system to “suggest” that this should happen through an array of artfully calibrated disincentives.
2. Utility Revenue Decoupling – An additional key regulation that is often overlooked is decoupling the revenues of investor-owned power utilities from the amount of energy sales, which is the regulatory regime in California. This allows power utilities to participate in energy efficiency projects as it carries with it a fairly significant financial incentive for them to cut energy use by end users as they receive higher power rates the subsequent year from the public utilities commission if they have achieved their goals.
3. National Building Codes that Meet or Exceed California Title 24 – California has led the nation in energy efficiency requirements for new buildings and renovations with its Title 24 standard. A much more ambitious standard that would require a revolution in the home construction and renovation industry in the US would be to adopt the passive house standard in which space conditioning costs are slashed by 80 to 90%. Additionally “smart codes” may help urban planners and developers site and build buildings and communities with lower total energy requirements by developing “in-fill”.
4. National Renewable Electricity Standard (as Target) –  The adoption of a percentage minimum renewable energy for the national electric grid– is productive as long as it is
   1. ambitious (25% or greater by 2020),
   2. paired with substantial finance support for renewable energy,
   3. a rising percentage of renewable energy projects are built as replacements for fossil resources (dispatchable or synchronous with power demand)
   4. is pro-rated based on renewable resource base per region thereby balancing risk between regions dependent on their resource wealth.

This "passive house" in Germany uses high performance windows, very tight construction, super-insulation, and a high-throughput ventilation system that keeps indoor air fresh without the need for much re-heating or re-cooling. Sunlight, heat from appliances, and people keep these houses warm on all but the coldest days and shading, insulation and the ventilation system keeps out hot air in the summer. Building or renovating homes and commercial buildings to passive house standards in the US would slash heating and cooling costs by 80% or more.

5. National Energy Efficiency Standards – Utilities and government can be mandated to cut energy use by an aggressive percentage per 4 year period (10-15%). As in California, a portion of electric rates collected can be used to pay for a portion of the efficiency upgrades in the form of rebates. Additionally the Energy Star program and minimum efficiency standards for hard goods should be expanded and made more aggressive. A carbon price can hasten the implementation of an efficiency standard by raising the price of energy.

6. Aggressive Auto Efficiency Standard (CAFE) – Without high fuel prices, auto efficiency standards are difficult to impose as buyers tend to demand larger, less efficient vehicles. Still, an efficiency standard can create targets based on engineering best practices that may help automakers plan their auto line as well as function as a public expression of intent.

From a position of government authority but responsiveness about the imposed costs and implementation path, governments can generate new direct regulations that may be as effective or more effective than existing instruments. If we believe that government has a regulatory role in financial markets, it makes sense to consider how effective rule-making by the government has in the past and can continue to spur economic progress in the area of energy.

Effective Carbon Pricing (partially addresses “Market Failure 1”)

If we take away the expectation that carbon pricing will across the board address all key issues related to a future looking carbon policy, we can more easily define the parameters that would make a carbon pricing system effective. A carbon pricing model assumes a market of independent actors who have choices to make as to how to structure their business and private lives, which the price will influence to emit less carbon. Secondarily, depending on a still unfinished political process, the collected revenues may either function to displace other taxes, return a dividend or finance clean energy projects. The following then should be criteria by which the effectiveness of a carbon pricing policy should be judged (all carbon pricing systems will not qualify for every criterion):

1. Noticeably effects the price of fossil energy, carbon intensive products, carbon emitting activities and land-use practices whether in or outside the current market. Must inflict some economic “pain” in its first edition in order to be effective and this pain has to have information value for market participants.
2. Through this pricing increases the desirability of lower or non-carbon emitting activities and products
3. Enables effective choice of a broadening category of lower carbon alternatives on economic grounds alone
4. Signals a will to curb carbon emissions among the leadership, and additionally inspiring voluntary “above and beyond” cuts in carbon emissions.
5. Creates a competition between carbon emitters to emit less than their peers.
6. Generates a revenue stream and incentive structure for allowing movement towards or maintenance of carbon sequestering land use practices
7. Enables an international trade in or regulation of trade of carbon equivalents
8. Would dampen or eliminate price volatility in the carbon price to enable effective investment planning on the basis of the carbon price and/or the revenues generated therefrom.
9. Progressively raises carbon price in a planned sequence to exert pressure for further emissions cuts.
10. Creates or energizes the market for carbon-emissions reducing innovations, spurring research and development.
11. Is directly adjustable by regulators/legislators to enable the system to learn from experience.
12. Is not so onerous to the taxpayers/consumers that it becomes politically vulnerable (this is partly a function of public outreach about the link between climate change, carbon pricing, and economic development as well as design of the system)

Carbon Pricing Instruments

At a House Ways and Means committee hearing earlier today, the options associated with carbon pricing instruments were not fully laid out for lawmakers to review the interlocking parts and options available. The packages that were presented were “cap and investment” and “tax and dividend”…these are not the only options, policymakers can mix and match depending on how they weight the above criteria.

Pricing Determination and Administration

Grover Norquist, inspired by Ronald Reagan, is one of the most influential anti-tax activists in the United States. Attitudes about the value and meaning of taxation have a had profound impact on the formulation of climate policies, including the selection of an instrument to administer the carbon price. The success of libertarians like Norquist in branding taxation as an almost total loss to individuals and their wealth has until recently been almost total.

1. Carbon Tax

2. Cap and Trade – There are many variations to cap and trade — it is an exceedingly complex instrument and outlining all permutations goes beyond the scope of this analysis.

a. Full Auction of Permits

b. Partial Auction/Partial give-away

c. Full give-away of permits (no price)

3. “Hybrid” Cap and Trade (Price Ceiling and Floor for Permits) – a hybrid of a cap and trade and a carbon tax stabilizing the carbon price in a range.

The selection of the carbon price administration mechanism will emerge from political negotiations between the different interest groups involved.

Revenue Distribution

Any of the above instruments can be mated with any combination of the below mechanisms to distribute the revenue from either permit auctions or tax collection. There is no inherent relationship of the carbon tax or the cap and trade systems with any particular means to use the resulting funds collected.

1. Carbon-Emissions Mitigating Investment – devotes the proceeds of the program to emissions reduction
2. Partial or Complete Dividend – attempts to soften the effect of rising energy and goods prices by returning revenue on a per capita basis
3. Displacement of other Taxes/Revenue Streams – phasing out a payroll or other taxes by using carbon revenues.
4. Need-based Dividend or Investment – focal efforts to soften the impact of carbon pricing by either a dividend mechanism or targeted investment in energy efficiency for the neediest.

The selection of the distribution mechanism has everything to do with the political design of the ultimate carbon pricing program and how it is introduced to voters and consumers. The potential complexity of both the resulting instrument and the process by which we will arrive there makes reliance only on carbon pricing a politically risky maneuver for people who are concerned about protecting the climate.

Design, Fund, Incentivize Zero- and Lower Carbon Infrastructure and Fixed Capital Investment (Addresses Market Failure “2”)

While it would have been preferable for governments to have engaged in a full scale “countercyclical” policy of collecting tax revenue during the boom years of the last few decades to reduce debt, we are now facing a period in which it is “do or die” for economies to stimulate demand, restructure their financial systems, and halt the slide into a Global Great Depression II. Engaging in deficit spending to build or expand existing infrastructure to halt rising carbon emissions is a worthwhile cause to risk future inflation for current and mid-term economic and environmental benefits. Some private capital may be organized to build some of this infrastructure but with significant.