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Putting a Price on Carbon

Updated: Oct 22, 2021

By Hamilton Steimer

Photo by Hunter So on Unsplash

Climate change is becoming an increasingly visible problem for our world. For decades, scientists and researchers have warned that the unchecked emitting of greenhouse gases is beginning to shift the planet’s fragile climate balance. Those cries of warning mostly fell on deaf ears as proponents of fossil fuels claimed that the climate science wasn’t “settled,” the warming of the planet was part of a “natural” process, or that the cost of shifting to alternative energy sources was too high. Due to generations of carbon pollution and environmental neglect, we find ourselves facing a climate crisis that threatens our way of life. If we don’t act now as the IPCC warns, we will be unable to prevent the worst imaginable impacts of climate change.

World nations are finally beginning to ramp up their use of renewable energy and phase out the use of fossil fuels in some areas. Despite recent progress, we are reducing our carbon emissions too slowly. If we want to incentivize the accelerated transformation of our society and economy, it is time we seriously considered putting a price on carbon emissions in the United States.

What are carbon prices?

We produce carbon emissions with almost every decision that we make, but for most of the United States, there is no price on our carbon emissions. Our use of fossil fuels extracts a heavy toll on the environment, but no one is being held responsible. Climate change impacts from greenhouse gas pollution represent significant negative externalities that are imposing very real, but unaccounted for costs on our society and planet. However, through carbon prices, we can internalize the environmental costs of our decision-making and provide the market signals to guide consumer and producer behavior away from fossil fuel use and towards sustainable, less carbon-intensive options.

Carbon prices can be realized via the social cost of carbon (SCC), emissions cap-and-trade programs, and carbon taxes. While these policy options are not a panacea for the climate crisis, they provide the policy justification and financial incentives to rapidly develop and pursue renewable energy sources, sustainable building options, clean transportation modes, and decarbonized supply chains.

Social Cost of Carbon

Created by the Obama administration, the social cost of carbon (SCC) represents the monetized cost per metric ton of carbon emissions, putting in precise amounts the environmental, economic, and health costs of our fossil fuel use. Since the Reagan administration, agencies have been required to implement cost-benefit analysis (CBA) in their decision-making processes, but it wasn’t until the Obama administration that the costs of carbon emissions were estimated and included in CBAs.

As seen in this recently released technical support document, the SCC escalates over time because our physical and economic systems will become increasingly stressed as the climate impacts from our GHG emissions accumulate. The SCC is important because it allows policymakers and scientists to demonstrate the monetary benefits of averting climate change, increasing the cost-effectiveness and appeal of policies like funding EV charging infrastructure expansion or providing tax credits to clean energy producers. Without the SCC, many climate-related policies would be unjustifiably expensive.

Under the Trump administration, the social cost of carbon was greatly reduced, making climate policy appear cost-prohibitive. This was because the administration used high discount rates, which will be discussed more soon, and it limited the SCC to only domestic costs from climate change. President Biden reverted to the Obama era guidelines, putting the SCC at $51/ton CO2 for 2021, and he deployed a new inter-agency working group to issue new guidance by next year. The SCC will most likely increase due to updated science and economic assumptions, with some researchers estimating the SCC should be over $100 a ton or even over $250 a ton if you include mortality costs. A higher SCC will be advantageous to President Biden’s policy agenda because many of his policy suggestions, which have high price tags, will become even more economically justified.

The Biden administration’s chosen discount rate for the SCC will be very important for future climate policymaking. For a variety of reasons, people usually value future costs and benefits less than those in the present, reflecting a discount rate. Agencies typically use discount rates of 3% and 7% when making policy decisions to determine the net social benefits from a policy option. With respect to the SCC, discount rates are part of a contentious debate as they determine whether the benefits of reducing future carbon emissions via climate policy actions are cost-effective. Climate advocates support low discount rates because they reflect a greater value of future generations’ damages from carbon emissions, and many believe the government should apply a discount rate of 2% or lower. To demonstrate the power of discount rates, a 2% discount rate would produce a social cost of carbon of $125 per ton compared to the current $51 per ton.

Cap and Trade

Cap and Trade (CAT) is another strategy to put a price on carbon and lower emissions. The government, whether that be state, national, or supranational, issues emissions allowances, each representing one ton of carbon emissions to organizations and businesses covered by the CAT system. These allowances can be distributed for free or through an auction. In total, the allowances add up to the emissions “cap” that the government has chosen for the given year. Gradually, the government can lower the cap and distributed emissions allowances, effectively guaranteeing reduced emissions if the penalties of going over are severe enough.

Organizations that reduce their emissions quickly may have excess emissions allowances, but some companies may be moving too slowly and require additional allowances. Through an allowance market, companies can then trade allowances with one another. The allowance market provides flexibility to companies as they strive to achieve their emissions reduction goals, and it incentivizes companies to reduce their emissions faster by rewarding innovation. The trading component of cap and trade ensures emissions are reduced cost-effectively because companies with excess allowances financially benefit from reducing their emissions quickly and companies short of allowances don’t suffer costly financial penalties.

Cap and trade systems are in place all over the world, with the European Union’s Emissions Trading System (ETS) being the first international emissions trading mechanism. Covering 40% of the EU’s emissions, the ETS regulates emissions from electricity and heat generation, energy-intensive sectors like steel and cement production, and commercial aviation within Europe. While the ETS has had a tumultuous history since its creation in 2005, reforms have stabilized the system, and it has helped the EU reduce its emissions by 35% since 2005. Future cap reductions will be in line with achieving the EU’s goal of reducing net emissions by 55% by 2030.

The US has a Californian cap and trade system as well as an emissions trading system involving several northeastern states called the Regional Greenhouse Gas Initiative (RGGI). The California system covers 85% of the state’s emissions, with revenues from allowance auctions deposited into the state’s GHG Reduction Fund and then appropriated to state agencies to execute additional emissions reduction programs. RGGI focuses primarily on the power sector, governing power plants over 25 MW in capacity. While the emissions cap normally is reduced, it has increased in recent years because New Jersey has rejoined the bloc, and Virginia joined this year. Pennsylvania may potentially become a new member soon.

China recently launched the world’s largest cap and trade system. Currently focusing on power sector emissions, the Chinese system governs emissions intensity instead of absolute emissions. Critics are concerned that this system enables further absolute emissions growth, but China wants to ensure that its economy remains competitive. Eventually, the allowed emissions intensity could be reduced enough to produce significant emissions reductions as the power sector, and other added sectors, are forced to switch to new energy sources.

Carbon Taxes

Similar to the social cost of carbon, which is mainly used in policy analysis and decision-making, carbon taxes reflect the price of carbon that has been charged to emissions producers for their pollution. As carbon taxes increase, polluters reduce their emissions to avoid additional costs. While cap and trade systems guarantee emissions reductions at a market-determined price, carbon taxes provide more certainty about costs, but not about the level of achieved emissions reductions. However, through modeling and monitoring, policymakers can adjust carbon taxes as necessary to achieve their emissions reduction goals.

Ideally, carbon taxes are the same or are close to the SCC and are charged upstream at the point of fuel production which covers the greatest share of emissions. Carbon taxes should annually increase several percentage points above inflation to incentivize emissions reductions early, and they should be implemented economy-wide. Border carbon adjustments or tax credits can be applied to producers of products that are energy-sensitive and internationally traded to prevent them from relocating or losing their competitive advantage.

If implemented properly, carbon taxes will generate billions of dollars in revenues for the government while drastically resulting in lower emissions. This revenue can greatly benefit the government by helping fund additional climate programs, be used for tax cuts, or be applied towards reducing the deficit. As mentioned, carbon taxes should be applied to fossil fuel producers, but their implementation can produce negative impacts on consumers, particularly low-income consumers. Producers facing higher costs from carbon taxes or the transition to more sustainable alternatives could pass costs onto consumers, effectively raising the price on almost everything. Eventually, with continued research and technological advancements, these alternatives should become more affordable, so carbon taxes would have less regressive effects in the future. However, in the meantime, policymakers could mitigate negative impacts through carbon dividends, in which low-income consumers receive dividend payments equal to or more than what they pay in increased prices from carbon taxes. While there are other options such as payroll tax cuts, some research has suggested carbon dividends are the most progressive policy option.

For those interested, Columbia University provides an excellent resource on carbon taxes.

Moving forward

Climate change will only get worse the longer we hold ourselves back because of greed and uncertainty. President Biden has taken some strong initial steps, but his administration can do more. With COP26 right around the corner, countries like the US need to be considering putting a price on carbon, whether that be through an improved SCC, national cap-and-trade system, or economy-wide carbon taxes.

I want to suggest to climate advocates that as we look for solutions, we need to remind ourselves that sometimes the demand for perfection can be just as harmful as our greed and uncertainty. As Peter Marsters of the Center for Global Energy Policy said, “Don’t let the perfect be the enemy of the good...the first order is making sure we can pass policies and get policies in place that get us on a pathway to net-zero.” Clearly, a price on carbon must be a policy priority if we want to stop climate change, but we need to get it done before figuring out what is the most effective price. We can’t let perfection get in the way of taking our first steps towards a carbon-free future.

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