America is addicted to oil… The best way to break this addiction is through technology … and we are on the threshold of incredible advances.

—George W. Bush, January, 2006

Previous chapters discarded myths: that we will wreck the economy, that peak oil will herald doom, and that miracles are imminent. Other chapters explored why it is foolish to ignore climate change or shun money-saving policies. Leaving these misconceptions behind, I will now sketch a core national energy plan that is cautious yet powerful.

Part 3 of this book lays out details of the plan. But it may help to have the sketch in mind while reading part 2, which explores real-world examples of energy policies and failures. Part 4 shows how the plan provides a base for the international agreements needed to solve the global problems of climate and security.

A good design does not rely on incredible advances in technology. Instead, a good design requires that a plan be

• Simple.

• A bargain.

• Low risk.

• A treatment for the disease, not just the symptoms.

Simplicity helps prevent mistakes and gaming. I have learned this repeatedly in my work diagnosing and adapting electricity markets. I have also learned that this principle is seldom respected in practice. But simplicity is still the right way to begin.

Asking for a bargain may seem superficial, but in fact, that is exactly what economists mean when they call for “efficiency,” their primary objective. The cost of saving a certain amount of oil or carbon should be as low as possible.

A low-risk plan addresses three principal risks: excessive cost, climate change, and the risk of oil shocks and oil wars. This requires not betting heavily on just a few technologies and on having built-in cost controls.

Unhealthy energy markets—ones that are inefficient and do not reflect social costs—develop symptoms such as gas-guzzling cars, too few wind turbines, and too many coal plants. The symptoms are the ways energy is wasted. The underlying disease involves “market failures”—basic problems with how the market works. Treating the symptoms—for example, by subsidizing ethanol—often causes unwanted side effects. And there are just too many symptoms to treat them all one by one. A better approach is to identify underlying causes—aspects of the market that are broken—and treat those rather than the symptoms.

What’s Broken?

Amory Lovins, the lead optimist in the physics camp, sees market barriers by the dozen and urges us to “clear them,” “bust them,” and “vault over them.” Market “barriers,” or “failures” as economists call them, are broken aspects of markets, such as landlords who buy appliances for tenants but do not pay their electric bills and so buy inefficient appliances. I believe most economists are open to the idea that many little things go wrong with markets, but they view such problems with caution.

Having seen many proposed and actual market “fixes,” economists tend to shy away from jumping on the fix-it bandwagon. Market fixes usually come with their own problems, and for minor market barriers, the cure is usually worse than the disease. Economists recommend identifying the worst problems and focusing policies only on those few. A good solution to an important problem puts us well ahead of a multitude of poor solutions to lesser problems. William Nordhaus identified the shortcomings of piecemeal policies in 1980 (see Sound and Fury).

The five most important energy-market failures are listed below. Although the idea of consumer myopia, discussed in chapter 6, has less backing than the others, I believe most economists will agree that the following are the energy-market problems that deserve the most attention.

The Five Energy-Market Failures

• Negative pollution side effects. The price of fossil fuel omits the environmental costs of pollution and CO₂ emissions.

• Market power. The Organization of Petroleum Exporting Countries (OPEC) overcharges for oil relative to the competitive price.

• Negative security side effects. It costs money for the United States and its allies to secure uninterrupted oil supplies.

• Consumer myopia. Consumers see the purchase price of products more clearly than they see future energy costs.

• Positive research side effects. Discoverers of basic new technologies are under-rewarded.

The first problem with the market is its failure to take into account the costs of the pollution associated with fossil-fuel use. There are many such costs, but I will focus only on the cost of CO₂ emissions—the main driver of global warming. (Economists call side effects “externalities.”)

The next two market failures—market power and negative security externalities—both point to a policy of reducing our reliance on oil, thereby reducing the world price of oil. The fourth market failure, consumer myopia, is the tendency of consumers to underestimate future energy costs and thus buy energy-inefficient products. The fifth problem with the market is that fundamental research is risky, and patents may not protect breakthrough ideas.

Combining the two oil-dependence failures, and stating things more simply, provides a more digestible list of problems.

The Four Problems Addressed by the Core National Energy Plan

• The missing costs of carbon emissions.

• The missing costs of oil addiction.

• Nearsighted purchases by consumers.

• Insufficient basic energy research.

What’s the Plan?

A simple four-part national energy policy is all we really need. Of course, there is room for add-ons, but four basic policies are essential and would do far more than we accomplish now. I will focus on its first three parts, as these are the least understood. The fourth part is simply to fund more basic research.

The Core National Energy Plan:

• An untax on carbon.

• A separate untax rate for oil.

• A carmakers’ race to fuel efficiency.

• Public funding of basic energy research.

As good market design requires, the plan is simple. Because it respects competitive market principles, it’s also a bargain. As we’ll see in a moment, it saves money by harnessing the ingenuity of every American—from CEOs to high school students. It’s also fair in that it rewards all those who help out, and to the extent the poor use the least energy, rewards the poor.

The next three sections explain the first three parts of the policy, beginning with the “untax,” which raises no revenues for the government, but refunds all revenues to consumers. After introducing the untax, I explain why the untax rate for oil should take account of OPEC’s oil prices. Finally, I explain the race to fuel efficiency, which is more fair to car companies than standards, and can be as powerful as desired.

Meet the Untax

“Among policy wonks like me, there is a broad consensus. … if we want to reduce global emissions of carbon, we need a global carbon tax.” So said Mankiw, whom I disagreed with over fuel economy in the previous chapter. I agree completely with Mankiw, on this—the central point of his article in the New York Times. He also mentions that President Reagan’s chief economist, Martin S. Feldstein, a famous opponent of tax distortions, came up with the idea of using a carbon tax back in 1992.

As Mankiw says, there is no disagreement “between environmentalists and industrialists, or between Democrats and Republicans” on the benefits of a carbon tax. He’s right. A carbon tax is the cheapest way to solve the first, and most important, energy-market problem, “the missing cost of carbon emissions.”

But, as Mankiw also reminds us, both American voters and political consultants consider “tax” a four-letter word. Can we find a way around the political lightning rod of “taxes” to save Americans tens of billions of dollars a year by implementing the best economic policy?

Mankiw comes close to finding the way. There are two halves to any tax—how it is collected and how it is spent. The benefits of the carbon tax come entirely from the first half—the charges on carbon, which increase its price and make us all look for ways to avoid using fossil fuel. So economists look for ways the government can spend the tax revenues to make voters happy. Happy enough to forget it’s a tax? Not likely.

Mankiw proposes to spend the carbon tax revenues on a “rebate of the federal payroll tax on the first $3,660 of earnings for each worker.” That is close to the right answer. Others propose reducing income taxes either personal or corporate, and some propose spending it on research and subsidies.

To find the right answer, we must go north to Alaska, where the air is cold and heads are clear. The answer—how the government should spend the money—couldn’t be simpler. Don’t spend it! Just give it back to us, thank you very much. Alaska sends identical checks, for a little over $1000, to every Alaskan resident every June. It collects these revenues from its famous oil pipeline. This is popular. This is an untax.

Taxes raise money for the government. The office football pool collects money and gives it back. That’s not a tax. That’s an incentive to correctly predict the winning team. It’s also fun.

A carbon untax is an incentive to use less carbon. Use the average amount of carbon, and your refund check will exactly cover what you contribute to the carbon pool of money collected from oil, gas and coal companies. Your contribution will not always be obvious, but these companies will raise prices to cover their carbon charges. That’s exactly what’s needed to discourage the use of fossil fuel.

Use more carbon than average, say by flying your own personal jet, and you will pay more in higher fossil prices than you get back in June. Because the rich tend to use far more than average, 60 percent of us are actually below average, and will get back more in June than we pay the rest of the year in higher fossil prices. The less carbon you use, the greater your net winnings—or if you fly your own jet, the less you lose by. That’s why, even though it gives back all the money, the untax works perfectly.

Charging OPEC

The second policy in the plan specifies a separate untax rate for oil. When OPEC pushes the price of oil high enough, that in itself is a strong global warming policy (see chapter 2). There is no need to raise the cost of oil still more, so when the oil price is high enough, the carbon charge on oil should drop to zero.

For example, when the world price is $80, the untax might be $20, but if the world price rises to $100, the untax rate would fall to zero. The sum of the world oil price plus carbon charge paid by refineries would be $100 either way. This price stability protects alternative fuel investments, such as those in advanced ethanol plants and investments in conservation such as hybrid or electric cars. Investors worry that the price of oil may collapse and leave their investments worthless. This happened in 1986. OPEC has even threatened to do this deliberately in order to discourage energy investments that would reduce our addiction.

With a variable oil-carbon charge and an untax, if OPEC lowered the world price of oil for a couple of years, the carbon charge would rise to keep the domestic price of oil high. This would protect alternative fuel suppliers, and consumers would still capture the benefits of low world prices in their untax refund checks.

As explained in part 4, an untax on oil is the right basis for a consumers’ cartel, and as such it’s an incentive for international cooperation. This is particularly true for China, which will soon be even more addicted to oil than is the United States. A successful global warming policy requires such international cooperation, especially from China, so the untax on oil serves both goals—climate stability and energy security.

The Race to Efficiency

In 1975, Congress set the Corporate Average Fuel Efficiency Economy (CAFE) standard for 1985 cars at 27.5 miles per gallon. In 2010, the standard will still be 27.5 miles per gallon. Once high OPEC prices disappeared, the CAFE machine just stopped percolating. After the return of high oil prices in 2006 and 2007, Congress passed legislation that requires the standard to increase to 35 miles per gallon in 2020. However, the bill requires nothing until 2011, and then only at the discretion of the President. The risk remains that if oil prices drop, the standards may end up lower or go into effect later, as happened in the mid-1980s.

CAFE standards have two fundamental flaws: The Big Three automobile manufacturers hate them, and they are easy to gum up. The two flaws work together all too well. As soon as the country settles down after an OPEC crisis, the Big Three gum up the standards. No good reason exists for such poor design, and after thirty-two years, it’s time for a change.

No one would think of requiring athletes to perform to standards at the Olympics. No one wants government standards saying how tasty the food should be at their favorite restaurant. Athletes compete. Restaurants compete. Car companies compete on everything else but fuel economy—the one thing they do poorly at. Competition is not a new idea, except to regulators.

Part 3 of this book explains how to turn CAFE standards into a competitive race to fuel efficiency in which losers pay for the prizes. The race mechanism eliminates standards entirely; each company simply tries to do better than the others. The better it does, the greater its prize (or the less it contributes to prizes for others). With a standard, companies lose the incentive to keep trying once they reach that standard.

To keep the Big Three happy, I will suggest rigging the race in their favor a bit. Even so, every car manufacturer will get the same reward for each extra bit of fuel efficiency, so they will all try equally hard. The incentive can be set just as strong as we want by adjusting the prize.

Also, there is no need to delay the start of a race for four years, as our government just did again with CAFE standards. All car companies can do their best, whatever that is, the very first year. Incidentally, similar legislation can make appliance standards more effective and vastly simpler.

How Much Does it Cost?

The first three policies of the Core National Energy Policy are all revenue-neutral. The two untaxes pay back to consumers exactly, to the penny, what they collect. The Department of Energy pays an administrative cost, but in Alaska this amounts to less than 1 percent of the income distributed. The third policy, the fuel-efficiency race, simply redistributes funds from losing car companies to winning car companies. The last policy, public funding of basic energy research, is fairly cheap. We can beef up the research budget for conservation and nonnuclear alternative energy by ten times, and it still comes to only $10 billion a year, which is 1/14 of 1 percent of gross domestic product.

Does being revenue-neutral mean the first three policies are free? No. Although an untax refunds all the money it collects, it still involves the indirect net costs that consumers incur to reduce their energy use. Net costs are small because they are the difference between the cost of saving energy and the value of the energy saved. Since saving energy is voluntary, people do not choose to spend much more than they save. The economics of net costs will be explained in part 3, but one more result is of interest. Revenue-neutral policies come with a sort of guarantee: If they don’t work, at least they entail no net cost.

As an example, if the untax collects $300 billion and refunds it all, and if that saves 20 percent of our carbon (a good start), the net cost to consumers will be only about $38 billion. But if we save no carbon, the net cost to consumer will be essentially zero.

If the race to fuel efficiency is designed correctly, it will have a negative net cost. The efficiency race is only intended to solve the third energy-market problem, consumer short-sightedness. If it does that, and no more, it will save consumers more money on fuel than it costs them for efficient cars. I will not attempt to estimate the net savings, but consumers spent roughly $300 billion on gasoline in 2006, leaving room to save real money.

Excluding net savings from the fuel-economy race, the total cost of the untaxes and research comes to $48 billion per year. This is only 1/3 of 1 percent of the national income—about four months of economic growth. This would be a strong policy for both energy security and climate change. If oil prices were high at the time, the cost would be considerably less because the carbon charge on oil would be low.

Can We Charge It to OPEC?

Based on a 20 percent cut in oil use, the world price of oil would be reduced a bit over 5 percent making OPEC and Big Oil each pay roughly $12 billion of the cost of these policies. But the full proposal of this book calls for an international consumers’ cartel to challenge OPEC, which is the international producers’ cartel. Such a consumers’ cartel would roughly triple the savings and result in more than full payment of the cost of this sample core energy plan.

By 2050, if climate change policies are ramped up to the level that is frequently anticipated as necessary, their cost would likely outstrip the savings from reductions in the world price of oil. But that, of course, depends on how much cheap conservation is available and what technological breakthroughs come along. But the strength of future policies can and will be left for the future. For now, we can charge it to OPEC and Big Oil.

Will the Core National Energy Policy Work?

The untax is at the heart of the policies I propose. Will the untax work? First, as Mankiw points out, the idea is close to a century old and trusted by more economists than any other approach. Second, this is very close to the policy tested by OPEC, and it passed with flying colors. It stimulated a huge amount of conservation and a significant increase in supply. It reduced carbon dioxide emissions from the United States and it crushed OPEC’s price for 18 years. OPEC put a charge on oil, just the same as the untax, but forgot to put the refund check in the mail.

A $300 billion untax would mean a $1,000-per-person refund every year. Because, it’s a more balanced approach, targeting all fossil fuels, it would accomplish more at less cost than OPEC’s approach. The untax should start gradually, allowing people to adjust. The anticipation of its increase will amplify its effectiveness, while the gradual start reduces the transition costs.

A family of four that changed from using 50 percent more carbon than average to using 25 percent less than average would save $3,000 per year and end up with a net benefit of $1000 per year from the combined fossil-fuel costs and the June refund check. This is a strong-enough incentive to cause people to buy better light bulbs, more insulation, and less thirsty cars. Businesses will have the same-strength incentive because they save the same amount when they use less fossil fuel.

The strength of the untax is the breadth of its reach. Emission caps and subsidies require regulators to target particular carbon-saving methods. The untax targets every carbon-saving method that 300 million Americans can dream up. This is the strength and beauty of a market approach. It harnesses the creativity of every entrepreneur, inventor, high school student, and parent. It motivates the rich and the poor alike. It stimulates car pools, neighborhood organizations, citywide efforts, and state programs. It promotes innovation at national laboratories, huge corporations, and little alternative-energy startups. And because the untax treats all equally, the best ideas win out.

Compared with such a massive and balanced approach, specialized approaches that target things like corn ethanol, hydrogen cars, wind turbines, or solar roofs hold little promise. In fact, the untax would appropriately reward the users and developers of each of these technologies and allow the market to select the real winner among them—if there is one. Compared with choosing technologies in the dark, according to which technology is backed by the most powerful congressional lobby, the untax is like the light of day.

Don’t Touch the Untax

I end this chapter with a strong warning about the untax. Every time the newspapers mention a gas tax or a carbon tax, the first response is often “Of course, it’s dead on arrival,” or “It’s a political third rail.” Mankiw puts it like this: “Republican consultants advise using the word ‘tax’ only if followed immediately by the word ‘cut.’ Democratic consultants recommend the word ‘tax’ be followed by ‘on the rich.’”

I favor the untax because it’s fair and it works, but in the real world, its most important virtue is that it isn’t really a tax. It’s not a tax because it doesn’t collect revenues for the government. Mankiw’s carbon tax is similar, but he wants to implement it in place of part of the payroll tax. Not a bad idea, if you ignore politics. But taxpayers would not get a check in the mail, the government would keep the money, and Mankiw’s carbon tax would be doing exactly what a real tax does now. That’s a tax, and Mankiw doesn’t deny it.

Some people will want to change the untax to pay down corporate taxes, while others will want to spend it on energy programs. Both of these options change the untax into a regular old we-hate-it tax. Let me make this as simple as possible:

• All economists know that a carbon tax or a carbon untax is best.

• If the government keeps the money, it’s a tax.

• If it’s a tax, you can forget it; it will never fly.

• It’s better for lawmakers to implement an untax than to grab for the revenues and get nothing.

As I show in part 3 of this book, the untax is more fair than a tax—even a tax that is fully offset by reductions in other taxes. But that’s not the point. As a true, verifiable, 100 percent untax, I think it has a good chance of becoming reality. As soon as anyone puts his or her hands on its revenues, the untax vanishes in a puff of politics. Don’t touch the untax revenues. They belong to the American people.