Climate Revenue in the Budget
February 26th, 2009Posted by: Roger Pielke, Jr.
The Obama Administration has released its proposed FY2010 budget. In it, there is a tax increase called “climate revenue” which is identified in the budget as offsetting new spending on energy R&D and a middle class tax cut (details here in PDF). The tax increase is called “cap and trade” but its net effect will be to increase the costs of energy with the revenues raised added to the treasury. The notion that the climate revenue will go to a tax cut and energy R&D is of course just symbolic as that revenue could equally be identified to offset NASA spending, health care, or the military or anything else on the spending side. The positives about the plan are the investments in clean energy technologies, an investment which I, along with Chris Green suggested be funded by a low carbon tax.
To understand why the plan has little hopes to reduce greenhouse gas emisisons, consider this comment by White House spokeman Peter Orszag, as reported by Greenwire:
But White House Office of Management and Budget Director Peter Orszag insisted that Obama’s budget takes into account projected increases in Americans’ energy bills as utilities pass on their compliance costs. The OMB chief said Obama’s cap-and-trade program would provide taxpayers with direct payments to help them cope with higher energy prices.
If (a) you raise the costs to utilities of providing energy, and (b) the utilities then pass those costs onto consumers, and (c) then the government gives people money to then help pay those increased costs, guess what is going to happen to consumer behavior? Just about nothing. Some might argue that consumers could become more efficient and save some money, and this is true, but consumers already could become more efficient today with the exact same incentive. Balancing cost increases with direct payments does nothing to alter this incentive.
More generally, as cap and trade legislation works its way through Congress you can fully expect a very loose cap to result because policy makers will never let it constrain GDP growth. So the cap will have loopholes and safety valves and other such back doors. What we will then have is a highly inefficient carbon tax, with lots or room for games and shenanigans (and making money for clever investors) in the carbon derivatives market. Only a subset of the new revenues will actually be going to clean energy technologies, the most important element of Obama’s climate policy, with the rest going into the general treasury. The plan will have very limited prospects for actually reducing emissions, unless the investments in energy technologies actually result in market-ready technological advances that change how energy is produced or consumed. Expecting large changes in technology by 2020 is a big gamble, but it must be what the Obama administration is betting on.
February 26th, 2009 at 5:43 pm
Roger -
Your first conclusion (no behavior change, same efficiency incentive) is only true if rebates (“direct payments”) are directly proportional to individuals’ increased expenditures on carbon. Admittedly, if that’s what they’re contemplating, they’re fools. However, I don’t think it is.
Under any other allocation scheme (e.g., flat rebates to all citizens, benchmarked permit distributions, etc.), there is an incentive to change behavior.
Suppose I now divide my spending between carbon intensive and carbon free goods. Congress imposes a tax that effectively doubles the price of carbon intensive goods, and refunds all the proceeds. Initially, if my carbon intensity and spending are average, I receive as much as I pay, and thus could go on as before. But why would I? What I receive depends on the national average carbon consumption, whereas what I pay depends on my personal carbon consumption.
With the relative price of carbon intensive goods increased, I should consume less of those, because they now yield half as much happiness for the buck. As long as I’m only a small fraction of national carbon consumption, I can benefit by changing my behavior (even if everyone else does as well). My incentive to get efficient is not the same as before; it’s increased by the price differential.
OTOH your second thought (complicated but loose cap likely) strikes me as entirely plausible.
February 26th, 2009 at 8:11 pm
Tomfid is correct on the economics regarding the first point. The consumer still allocates spending based on his utility curve and the price signals of the goods he considers buying. If gas costs twice as much, and his check from the govt isn’t a voucher which has to be spent on gas, he may very well choose to spend the money on a new computer rather than drive across the country on vacation.
Of course, the whole scheme is silly. Govt R&D spending like this usually ends up being wasted (per OECD study in 2003). Or see Parker in 1995.
February 26th, 2009 at 9:44 pm
1-Tom-
Your argument is a great one for a carbon tax.
Lets say you are a Congressional witness and you are asked:
“Will the direct payments that are promised be enough to offset the increase in energy costs?”
How would you answer?
Also, what are example of “carbon free goods” that might serve as substitutes for “carbon intensive goods”?
2-Stan-
The consumer can today decide to buy a new computer rather than drive across country.
February 26th, 2009 at 11:27 pm
Roger:
In your responses to #1 and #2, you might have reminded your readers that a carbon tax, AT THE SOURCE, to be refunded ‘equally’ to taxpayers, is one of Jim Hansen’s proposals to stimulate just the market response referred by Tomfid – and perhaps Peter Orszag.
Not to say that Hansen’s proposal is free of many complications that he has not addressed – like how to decides the level of tax, and ‘police’, at the source, various high-CO2-footprint bio-fuels (like corn ethanol and palm oil)
February 27th, 2009 at 1:41 am
Just how, exactly, are these “direct payments to help them cope with higher energy prices” going to work? Is this going to come at the end of the month or the year or what? Are we going to have to send in paperwork and wait like an income tax refund, or will those two procedures somehow be combined? What use is any of it to the millions of us who live hand-to-mouth from paycheck to paycheck? You would get this insane electric bill and then have to go from hot dogs and pork & beans to ramen noodle soup and going around the house or apartment wrapped in blankets all winter because you can’t afford heat, and when you get this check at the end of the year or whenever, you are going to need it just to keep your electricity from getting shut off if it hasn’t been already, or if you’ve done a bit better you could finally get your car fixed so that it doesn”t stall out at the worst possible times, and so on. But what does any of that do for the environment, and how are you going to get all the money back when so much of it will have to be used to fund whatever bureaucracy will be needed to manage all this? I want to know exactly how this is supposed to work because so far it just sounds like one big shell game.
February 27th, 2009 at 3:13 am
Policies of this nature affect consumer behaviour via 2 routes. Income and price effects accorind to Hicksian models of consumer choice.
The revenue neutral design is supposed to nulify the “income” effects.
The extent to which energy demand will be lower will hence be dependent upon the price effect (i.e. cross price elasticity of demand – which removes the implicit income effect). If this cross price elasticity is low your supposition is probably likely to be correct – simply, energy may be more expensive, but there is no real alternative in the short or medium term (remeber we are talking pure sibstitution here).
I suspect that is correct and the impact of such a policy will be virtually zero.
However, note that there might be redistribution of the revenue (would the Democrats do that??) towards lower income groups.
It is not inconceivable in that case that the combination of relative “income” and “price” effects across the income spectrum in the US could lead to increased energy consumption. (just imagine what you might expect to happen if you took 5% of income from the top 10% of income and redistributed that among the lowest 10%. Energy consumption would almost certasinly rise due to the income effect. If cross price elasticy for energy is low as you imply and I would agree, there would be little or no offsetting reduction from substitution
February 27th, 2009 at 6:16 am
[...] the WSJ edit page upset, because a carbon cap is a tax by another name. And a silly one at that, notes Roger Pielke, Jr, who sees the big rebates as counterproductive:
February 27th, 2009 at 6:31 am
4-Len-
Yes, Hansen is obviously no economist.
-6-geckko-
This is a great point, one I’ll highlight in a new post
February 27th, 2009 at 6:57 am
6- and 8-
Doesn’t the same obtain when developing countries receive money from carbon credits?
Coupled with the fact that carbon-free displacement of fossil cannot begin to meet requirements, emissions will also increase.
Assuming of course that the economic situation does turn around.
February 27th, 2009 at 7:03 am
As similar ‘carbon’ (they ar enot carbon related but on energy) taxes learn, is that they will indeed stimulate people to become more energy-slim, but that it still will not safe them.
The result is that resulting lower energy use will then mean lower tax income and therefore the need to raise those rates again. In the end the government will become dependent on high energy use for its budget. EU experience proves this. The end result is a net increase of the total % amount of the GDP that is taken by the state.
And worse is, it doesn’t help anyway. The US will compensate for more efficiency by increasing demand due to GDP growth, just as the EU did. However, realise that if there hadn’t been this tax and therefore stimulated energy efficiency increase, this means this same GDP growth would have resulted in an even higher increase in demand of energy, which would have raised the price already by itself. Look at the stress the gas prices in the first half in 2008 gave.
The only way where this policy can help is by shifting tax, not increasing it. That is every dollar you tax in addition on energy, you need to lower on income, capital investment or other productivity factor. In that case the state doesn’t become dependent on the tax and people don’t suffer.
February 27th, 2009 at 9:08 am
Roger (re #3) -
“Your argument is a great one for a carbon tax.”
It applies equally to trading. The effect on incentives is the same whether you give give a flat tax rebate, a flat allocation of allowance property rights, or any other scheme, as long as the rebate is unconnected with _current_ carbon use.
“Will the direct payments that are promised be enough to offset the increase in energy costs?”
It would be easy to say yes with a straight face, because it’s true by definition if all proceeds are rebated. The question is whether it’s true for every individual, which is of course “no”. There’s no moral imperative to bail out those on the losing side of the equation, but they will surely kick and scream.
If you don’t have the nerve to stick to a flat allocation, it’s still possible to preserve the incentive to reduce _current_ carbon by allocating based on _past_ emissions (as with grandfathered permit allocations). So, offsetting impacts does not need to eliminate the incentive to change behavior.
“Also, what are example of “carbon free goods” that might serve as substitutes for “carbon intensive goods”?”
Are you arguing that all goods and services have the same carbon intensity?
“The consumer can today decide to buy a new computer rather than drive across country.”
Are you arguing that, if the ratio of the cost of roadtrips to computers doubled, there would be no change in driving vs. computing?
You might be almost right in the short term, as Gekko argues, because the short run price elasticity of fuel demand is very low, but that’s not an incentive problem. In any case, there’s abundant evidence that elasticities are much larger in the long run, which is really what matters.
Gekko -
“However, note that there might be redistribution of the revenue (would the Democrats do that??) towards lower income groups.”
I think it’s equally likely that credits will wind up overcompensating the top bracket, as in BC. Either way, while income effects could offset price effects in the short run, that’s unlikely in the long run. Also, marginal shares of energy consumption across income groups might be quite different from average shares.
February 27th, 2009 at 9:36 am
-11-tomfid
Thanks, a few replies.
1. As a practical matter trading will be sector limited, such as to energy production, a tax could be more easily economy wide.
2. I hear you on the “straight face” but I just don’t think that it is posible in the real world of politics.
3. “Are you arguing that all goods and services have the same carbon intensity?”
Nope. I’m just curious as to what you are envisioning.
4. “Are you arguing that, if the ratio of the cost of roadtrips to computers doubled, there would be no change in driving vs. computing?”
No. If the ratio stayed the same then there would be no change. As a practical matter, road trips probably won’t fall under the sorts of cap and trade that Congress is likely to consider, though I could be wrong.
February 27th, 2009 at 4:54 pm
I am stunned that you could believe that “Balancing cost increases with direct payments does nothing to alter this incentive.”
This might be true for cigarette taxes, a notoriously inelastic good with few substitutes (though long term, very high taxes do seem to reduce smoking). Also true for the specific case of a gas tax (driving is certainly short term inelastic… the small magnitude of the drop in oil consumption and shift towards more efficient vehicles from a several dollar rise in gas prices demonstrates that a carbon price of several hundred dollars would likely be necessary to impact driving).
But let me list for you some fairly large impacts that a carbon tax would cause:
Energy production: how large a tax would you need to make natural gas competitive with coal? To make solar, wind, geothermal, etc more competitive? To make CCS worthwhile?
Efficiency projects: http://www.nytimes.com/cwire/2009/02/27/27climatewire-can-green-buildings-pass-payback-tests-9910.html notes that payback times of more than a decade make efficiency projects unpalatable to developers. How much of an energy price increase do you need to reduce the payback time to less than a decade?
Water and rail: As fossil oil prices go up, water and rail become more attractive compared to trucking.
Landfill methane: Double whammy – get charged for releasing methane at the same time as natural gas becomes a more attractive energy source compared to coal – this will stimulate landfill methane and other methane capture projects.
Biofuels: Well, it all depends on how you do the accounting. I don’t want to see corn ethanol increase, but if indirect land use changes aren’t incorporated into the accounting, ethanol use will go up once the tax passes a critical threshold.
R&D: If fossil fuels are more expensive, there are more incentives to try and find efficiency and power generation alternatives. Think solar & wind again, plus batteries and CCS and all these other things.
Recycling: As it is, aluminum recycling is pretty favorable. As energy prices rise, there are more incentives for markets to pay for all the scraps that require less energy to reprocess than to create the first time.
To sum up: the market is a powerful and subtle force when given the right incentives.
So, yes, hypothetically you could raise a tax, distribute the revenue, and everyone could do exactly the same thing that they did before the tax came around. But is this likely? No way Jose.
Mind you, I do agree that a cap & trade is likely to be too loose in early periods due to politics, and I would personally prefer a tax that was designed to increase quickly as long as emissions were above the target level… but if you really think that a tax-and-dividend would not decrease CO2 emissions, you are off your rocker. I think Hansen is not the only one who is “obviously not an economist”.
February 27th, 2009 at 4:58 pm
“As a practical matter trading will be sector limited, such as to energy production, a tax could be more easily economy wide”
My impression is that both taxes and cap-and-trade would likely be assessed fairly high upstream: oil refineries, coal mine mouth, natural gas distribution hubs. Much as I prefer a tax to a cap-and-trade, I don’t think we’ll see much difference as far as sectoral coverage. In fact, with cap-and-trade, one is more likely to see “offset projects” (which have their own issues, but might bring in more of the agriculture sector – and ag N2O and CH4 are probably more likely to be uncovered by caps or taxes than any other sector)
February 27th, 2009 at 5:24 pm
1, 2. Agreed
3. I think the list is rather long, and would include all the usual suspects (more efficient car, CFLs) as well as others (buy a mountain bike instead of an ATV). I think it’s actually not that easy to decide what works, because absent a carbon price you have to do an LCA, and even then you miss things. But that’s what markets are good at – distributing the task of figuring out how to use less of something to produce similar output.
4. If driving doesn’t fall under the cap that would be a shame (sham?). However, it does seem quite possible that things will turn out that way. Your “no” seems to imply that if relative prices change, behavior does change after all.
February 27th, 2009 at 9:26 pm
-13-Marcus
“But let me list for you some fairly large impacts that a carbon tax would cause:
Energy production: how large a tax would you need to make natural gas competitive with coal? To make solar, wind, geothermal, etc more competitive? To make CCS worthwhile?”
1. Natural gas vs. coal. Won’t affect consumer behavior as consumers don’t have choices in energy source (exception: though I can select wind here in Colorado). Would effect decisions about new supply.
2. Pretty large.
3. Pretty large.
“How much of an energy price increase do you need to reduce the payback time to less than a decade?”
Good question. I’m guessing larger than the effects of any conceivable cap and trade bill.
“As fossil oil prices go up, water and rail become more attractive compared to trucking.”
I don’t expect transport fuels to be in US cap and trade. Do you?
“Landfill methane”
Ditto
“Biofuels: Well, it all depends on how you do the accounting.”
Amen
“If fossil fuels are more expensive, there are more incentives to try and find efficiency and power generation alternatives.”
If you want more R&D, then a direct approach is preferable. Fund it.
“but if you really think that a tax-and-dividend would not decrease CO2 emissions, you are off your rocker”
Maybe, time will tell. And not too much of it.
Thanks
February 28th, 2009 at 2:24 pm
“Natural gas vs. coal. Won’t affect consumer behavior” But the point isn’t to affect consumer behavior, it is to reduce GHG emissions. And if we can reduce GHG emissions without changing consumer behavior one whit, great! That would imply that the cheapest available options are in things like changing power supply rather than reducing energy use. On the other hand, if it turns out that consumer behavior is more elastic than you assume, then that’s great too. Got to love the market (at least, once properly regulated, and with externalities internalized to the best of governmental abilities).
“If you want more R&D, then a direct approach is preferable.”
Well, if you want basic research for one kind of technology, I could believe that a direct approach might be better. But if you read the innovation literature, there is a lot more than just basic research necessary in terms of distribution, implementation, etc. that will _all_ be stimulated by a carbon price. And the government is not always the best at picking winners – whereas the market is pretty good at ferreting out good solutions among a large number of possibilities – but it has no incentive to do so as long as coal is dirt-cheap.
“I don’t expect transport fuels to be in US cap and trade. Do you?”
Well, pretty much every climate bill submitted to the Senate thus far has included transport fuels (upstream), to the best of my knowledge. Eg, Climate Security Act of 2008 (Boxer/Lieberman/Warner):
“(3) facilities that produce or entities that import petroleum- or coal-based fuel the combustion of which will emit group I GHGs; ”
Do you have a reason for believing that transport will be taken _out_ of the next set of bills?
How big a tax is needed to shift from coal to wind?
Coal: 2 lbs CO2 per kwh: http://www.eia.doe.gov/cneaf/electricity/page/co2_report/co2report.html
Wind Production Tax Credit: 1.9 cents per kwh for first 10 years of operation.
Therefore, a $10/tonCO2 ($36/tonC) price would give a larger incentive than the wind production tax credit. Will this be enough to totally switch from coal to wind? Of course not. Intermittency, transmission, and NIMBY are all issues. Plus, 1.9 cents per kwh is enough to make wind attractive, not to make it dominant. But I think this is evidence that a price within the realm of reason would be enough to bring in decent amounts of low or zero carbon technologies.
Now, your next argument might be “yeah, but all those things might shave 10 or 20% off our CO2 emissions, and some people claim we need to get to 80% reductions by 2050, and for _that_ we need big-time technology”.
And that is an argument I think is worth having. My opinion is still that a tax or cap-and-trade with a clear long term signal is necessary to actually drive this stuff – I think that government R&D alone would be unlikely do it, though it is an important supplement to the price signal. Especially if the goal is “beat coal with no carbon price”. But at least I think there is wiggle room there. The idea that a carbon price + dividend won’t reduce CO2 emissions is another beast entirely, a nice theoretical construct along the lines of a Giffen good that only exists under very special conditions.
(I will note that by design, a “cap-and-trade” bill _cannot_ lead to larger domestic emissions within the capped sectors. If cap-and-dividend really leads to larger consumption of energy for small prices and no fuel switching, then the price would just keep rising until either consumption drops or the energy supply switches to low-carbon sources or CO2 emissions drop by some other means) (not that my caveats leave open the possibility for “leakage” into international or uncapped sectors, but I think these are likely to be smaller than the domestic capped decreases)