Summary:

  • Politics constraints carbon pricing efforts, making them fall short of the "optimal" climate policy envisioned by economists.
  • Careful attention to real-world political constraints can inform creative policy designs that improve climate and economic outcomes while increasing public support.
  • In particular, smart use of the revenues generated by a carbon tax could be just as (if not more) important than the carbon price itself.
  • Public opinion evidence indicates that the most popular use of carbon revenues is to invest in clean energy R&D and pursue additional emission-saving actions, like renewable energy deployment.
  • This "Tax and Invest" strategy also yields superior economic and environmental performance when compared to a politically-constrained carbon tax alone.

Full Spectrum: Energy Analysis and Commentary with Jesse Jenkins

When politics constraints efforts to put a price on carbon, making smart use of the revenues generated by a carbon tax (or cap and trade program) is just as important (if not more so) than the price on carbon itself, as I explain in this conclusion to a three-part series.

Economists widely consider putting a price on carbon to be the ideal, "economically optimal" climate change policy. Unfortunately, a variety of real-world political constraints mean carbon pricing rarely lives up to this ideal, as I explained in Part 1 of this series.

Indeed, by paying careful attention to these political constraints, policy makers can design creative climate policy that are both more likely to prove politically sustainable and yield better environmental and economic outcomes (see Part 2 for six tips on designing climate policy under political constraints).

Why carbon tax revenues are probably more important than the tax itself

In fact, as I hinted at at the end of my last column, the greatest potential for improved climate policy outcomes can be unlocked by making creative use of the revenues generated by a politically-constrained carbon price. 

How carbon revenues are used can impact both the political support for the carbon price itself and dramatically increase the amount of emissions abatement achievable at a given carbon price. It can also improve the overall economic performance of a politically constrained carbon pricing instrument. 

On the political front, a recent University of Michigan/Muhlenberg College poll, found that 61 percent of Americans oppose a carbon tax if the use of the revenues from such a tax are unspecified. Oppsition grows to 72 percent if the tax would "increase your energy costs by 10 percent per month." It seems that people aren’t too keen on the idea of a new tax designed primarily to change their own behavior, and as usual, support drops when a specific price tag is attached to climate policies. 

Support for a carbon tax when the use of revenues is not specified

Support for a carbon tax that increases energy costs
Source: Amdur, Rabe and Borick, 2014

Political support changes dramatically when revenues are used creatively however. Voters apparently like to see carbon tax revenues used to actually try to solve the climate problem, with 60 percent of Americans surveyed — including 51 percent of Republicans and 54 percent of Independents — supporting a carbon tax if “revenues from the tax were used to fund research and development for renewable energy programs.” 

Support for a carbon tax with revenue used for research and development for renewable energy programs
Source: Amdur, Rabe and Borick, 2014

Barring that, respondents would like to see the money raised by a carbon tax sent back to them as rebates (56 percent overall, with only 43 percent support for this option amongst Republicans). Only 38 percent support a carbon tax used to reduce the deficit. 

These results are similar to several other public opinion polls and the results of other social values research I’ve seen, including polling on Canada’s ill-fated “Green Shift” carbon tax proposal. 

The Green Shift plan would have established a new carbon tax and offset the costs by reducing income taxes for consumers and businesses. It went down in flames in the 2008 election, bringing the Liberal Party and its leader Stephane Dion down with it. 

In the midst of the national debate on the Green Shift proposal, a poll commissioned for the Pembina Institute gave voters a set of options for how the revenues from the Liberal Party’s proposed carbon tax could be used. Importantly, spending the revenues on “renewable energy like wind and solar” garnered by far the largest share of support, with 47 percent of Canadians surveyed selecting that option. Only 11 per cent of respondents said carbon tax revenues should be used to cut income taxes—which might have raised some prescient alarm bells for Canada’s Liberals! 

Carefully planning how carbon pricing revenues are used can clearly impact public support for carbon pricing proposals—and could even mean the difference between a politically-constrained but viable carbon price and no carbon price at all (as in the case of Canada’s ill-fated Green Shift).

After posting parts 1 and 2 of this series, several people asked me what I thought about “revenue-neutral” carbon tax or “cap and dividend” proposals, both of which envision using revenues from a carbon tax to reduce other taxes or send rebates to households. My reading of the available evidence is that these proposals will likely boost public support for a carbon tax or cap (relative to using funds for general budget or deficit reduction purposes). That would allow a higher price on carbon to be established than if the use of revenues is unspecified. The evidence for this proposition is mixed however, with some polls (like the UMich/Mulhenberg poll) indicating stronger support for rebates, while experiences in Canada and Australia raise questions about the political efficacy of revenue neutral tax shift proposals…

That said, based on my research, the most promising strategy — politically, economically, and environmentally — is likely to be one that uses carbon tax revenues to fund a combination of clean energy R&D and to procure additional emissions abatement beyond that secured by the carbon price itself. Let’s call this the “Tax and Invest” strategy.

Tax and Invest: the most promising route to a politically sustainable, efficient, and environmentally effective carbon price?

Tax and Invest consistently polls well in public opinion research. Indeed, in every case I’m aware of where both options are posed to voters (including the two polls presented above), some form of Tax and Invest secures even greater support than variants of the revenue neutral rebate/dividend/tax shift class of proposals (if you have any evidence to the contrary, please provide links in the comments).

Additionally, investing in clean energy R&D and in procuring higher-cost emissions abatement opportunities not secured by the constrained carbon price alone can help drive down the costs of emissions abatement opportunities (while building stronger clean energy constituencies) relaxing the political constraints over time. Those dynamics can be critical to the long-term political sustainability of any climate policy, as discussed in Part 2 (for those interested in more, see these three papers).

While Tax and Invest may be the most promising route politically, the greatest advantage of this option is that it puts the revenues to work securing further emissions reductions, improving both the environmental efficacy and economic performance of the policy.

Using carbon revenues to reduce other economic “externalities” or market failures increases the economic efficiency of a carbon pricing policy, improving the welfare outcomes. Economists have often proposed using revenues to reduce other distortionary taxes, like income taxes. But there are two other options that both improve efficiency and environmental performance. Talk about a “double dividend!” 

First, as many economist have demonstrated, knowledge spillovers, asymmetric returns, and the non-rival nature of new knowledge lead to under-investment in technological innovation. These innovation-related market failures are not fully addressed by carbon pricing instruments alone, and they can impact the pace of clean energy innovation and reduce the economic performance of carbon pricing instruments, as demonstrated by MIT economist Daron Acemoglu and colleagues. Using revenues to reduce these clean energy innovation-related market failures could therefore improve the economic and environmental performance of carbon pricing instruments, particularly when they are politically constrained.

Second, since the carbon price is constrained and can’t reach the full social cost of carbon, additional climate-related externalities remain, associated with emissions that cost more to reduce than the emissions penalty imposed by the carbon price. Using revenues to procure additional emissions abatement beyond that secured by the carbon price itself would thus further reduce the economic distortions associated with these excess GHG emissions, once again improving both the net economic and environmental performance of the policy.

This opportunity to achieve much greater abatement than accomplished by a politically constrained carbon price alone is huge. 

As a simplified example, consider what would be required to reduce annual U.S. energy-related CO2 emissions, now at roughly 5.3 billion tons, by 1 billion tons. In rough terms, this is what the Waxman–Markey bill aimed to accomplish by 2020. Assuming, for sake of example, a marginal abatement cost of $30 per ton of CO2 in 2020 (consistent with EIA estimates of emissions costs under Waxman-Markey) and a roughly linear abatement supply curve, we can infer that the average abatement cost across those 1 billion tons is roughly $15 per ton. 

If this abatement were accomplished by establishing a simple carbon price, that price would have to rise to equal the marginal cost of abatement (or the cost of achieving that last ton of CO2 reduction). This simple carbon price-only strategy would thus require a $30 per ton price to reduce CO2 by 1 billion tons. That’s obviously well in excess of apparent political constraints discussed in Part 1, which likely limit carbon prices in the U.S. to on the order of just $2 to $8 per ton of CO2.

In contrast, the same emissions mitigation level could be accomplished through direct procurement of clean energy adoption and emissions mitigation that costs on the order of $15 billion—i.e., 1 billion tons at an average cost of $15 per ton. By using reverse auctions, competitive procurement, and other market-based price discovery mechanisms, policy makers could maximize the economic efficiency of this additional emissions reduction. 

Most importantly, the requisite procurement of emissions abatement could be financed by spreading the $15 billion total abatement cost across the remaining 4.3 billion tons of U.S. emissions by establishing a carbon fee of just $3.50 per ton of CO2 in round terms. 

This Tax and Invest strategy could thus achieve 1 billion tons of emissions reduction at something on the order of one-eighth the carbon price necessary through a straight carbon tax approach—and it can do so by using revenues generated by a very modest carbon price that appears to be within the range of political constraints on carbon pricing in the United States.

(Note, in actuality, this proposal would require slightly less revenues on the one hand, as the carbon price itself achieves some abatement, reducing the amount needed for procuring abatement, which is not factored in here. On the other hand, I assume emissions are procured efficiently and that the markets are segmented such that you can achieve reductions at average rather than marginal costs. Subsidies or other policy mechanisms that are not efficiently designed or that use marginal pricing for the entire emissions market could increase the revenues required to achieve a given level of abatement. That said, even if revenues required double, the carbon price needed to raise sufficient funds would still be modest, on the order of just $7.00 per ton of CO2.)

Concluding the series: designing climate policy as if politics matters

To summarize this three part series: ignoring the very real political economy constraints facing climate policy and focusing solely on pursing an “economically efficient” (or what economists call the “first-best”) carbon pricing policy is likely to prove anything but optimal when such policy efforts collide with political constraints, as explained in Part 1

Policy makers, economists, advocates, and others should design policy as if politics matters. As real-world experience with climate policy making makes painfully clear, politics is almost always the binding constraint. We should all therefore pay closer attention to the political economy constraints on climate policy

In fact, there are likely to be any number of policy proposals that lie in the “opportunity space for improvement” in climate policy design discussed in Part 2. These creative climate policy options can exhibit superior economic efficiency, environmental efficacy, and political sustainability when compared to a traditional carbon tax-only approach. There thus remains a considerable space for creativity in climate policy design and implementation.

In particular, as discussed here in Part 3, a “Tax and Invest” strategy that devotes carbon revenues to clean energy R&D and additional emissions abatement appears to offer a powerful combination of improved political dynamics, enhanced economic efficiency, and much greater environmental performance than a constrained carbon price (or even a “revenue neutral” tax shift, rebate, or dividend approach). Paying as much attention to the use of carbon revenues as to the carbon price itself can thus yield substantial improvements in climate and economic outcomes. 

Note: this series is based largely on my paper, Jenkins (2014), “Political economy constraints on carbon pricing policies: What are the implications for economic efficiency, environmental efficacy, and climate policy design?Energy Policy (69): June 2014. Please email me if you’d like a copy and do not have access via ScienceDirect.