Let this be our national goal: At the end of this decade, in the year 1980, the United States will not be dependent on any other country for the energy we need.

—President Richard Nixon, January, 1974

“If all economists were laid end to end, they would not reach a conclusion.” So said George Bernard Shaw, who understood that economists famously “conclude” their recommendations with “On the other hand … .” President Harry S. Truman instituted the Council of Economic Advisers and was soon begging for a “one-armed economist.”

The propensity of economists to waffle makes N. Gregory Mankiw’s claim all the more startling: “Among policy wonks like me [economists], there is a broad consensus.” Economists can’t reach a conclusion, never mind a consensus. But he’s right—economists have reached a consensus in favor of his conclusion that “we need a global carbon tax.” (See chapter 6 for more on Mankiw’s New York Times op-ed.)

Because economists favor market-based approaches, their tilt toward a tax may seem paradoxical, especially since Mankiw explicitly argues against cap-and-trade programs. These programs are all about trading, which by conventional wisdom must be more market oriented than a tax. But Mankiw, George W. Bush’s one-time chief economist, has impeccable market-oriented credentials. With his backing and the consensus of all those economics wonks, a carbon tax must be the most market-oriented approach possible, and so it is. To explain why, this chapter unravels some of the mysteries of carbon caps and carbon taxes.

Since I favor a carbon untax rather than a carbon tax, it may seem that I am not part of Mankiw’s consensus. But an untax and a tax provide identical incentives for saving carbon, since they work the same on the tax-collection end. Since the economics consensus concerns only the collection end of the tax, I consider myself part of the consensus. Economists disagree (as usual) over what to do with the revenues. I say just return them equally to all consumers—that is, set up an untax. Since this chapter concerns only the collection end of a carbon tax or untax, every conclusion about carbon taxes applies equally to the much friendlier carbon untax.

Politicians don’t mind wasting money if that’s what it takes to be popular, while economists are concerned mainly with cost-effectiveness. So when the extraordinary happens, and economists reach not just a conclusion, but a consensus, it’s worth listening. With Congress heading straight for the cap-and-trade programs Mankiw warns us against, there’s not much time to lose.

Future Caps

To avoid confusion, I’ll tell you right off the bat that there is another type of carbon cap besides the cap-and-trade variety. Carbon caps come in two flavors, political and economic. The political kind typically caps emissions on some future date and lacks enforcement. Economists do not much analyze these future caps, as I will call them, but they deserve attention because they loom large in the public debate. Unlike future caps, the caps of cap and trade limit current emissions and are enforced with fines. Now, back to the future caps.

California initiated appliance standards, and that initiative led to federal appliance standards. California also led the way on efficient building codes and was the first state to require car companies to sell electric cars. The state tied for first in the race to open electricity markets. However, innovating is risky business. California’s new climate initiative has opened doors nationally for other energy policies, but will it be a huge success, as appliance standards are, or a disaster, as California’s famous experiment with electricity markets was? The one that caused rolling blackouts.

On September 27, 2006, Governor Arnold Schwarzenegger signed AB 32, the Global Warming Solutions Act. The act caps California’s greenhouse gas emissions in 2020 at the 1990 level. The Pew Center on Global Climate Change called it “the first enforceable state-wide program in the U.S. to cap all GHG [greenhouse gas] emissions” and noted that “comprehensive climate plans combined with enforceable GHG emissions targets provide the highest certainty of significant emissions reductions.” Caps are commonly thought to provide the “highest certainty,” perhaps because they sound so definite.

Future caps, being political, reflect optimism. In the case of the California bill, three cost studies back up that optimism. Robert N. Stavins of Harvard University reviewed the three studies and reports that the state study found that AB 32 would save $4 billion a year and create 83,000 jobs. Another study found that AB 32 would have no net cost, and a third found a savings of $55 billion per year. That would be about $1,000 per person per year.

Schwarzenegger’s bill is a typical future cap. The cap date, 2020, occurs fourteen years in the future. The bill is thought to be powerful, supposedly causing a 29 percent reduction in emissions between 2012 and 2020. But it includes no penalties for failure to comply.

One item in the state’s press release caught my eye:

The bill also provides the Governor the ability to invoke a safety valve and suspend the emissions caps for up to one year in the case of an emergency or significant economic harm.

In case of significant harm, the governor can suspend the cap. But there need be no harm at all. The law states that the threat of such harm is enough. If the governor says there’s a threat, who could prove otherwise? But still, the press release assures us that the governor can only slow things down by “up to one year.” Well … what the press release meant to say was for one year at a time for any number of years. That’s what the law allows. The cap can be suspended forever if need be, one year at a time.

If the state is about to miss its 2020 target, trying to meet it at the last minute would surely cause harm. So legally speaking, the enforcement comes down to this: California has to meet a fairly stringent cap unless it brings a note from home—I mean, from some future governor who will happily blame the problem on Schwarzenegger.

California sometimes misses its targets. It mandated that 10 percent of all cars sold in the state would be electric starting in 2003. Not even one electric car was sold in the state that year. And California estimated it would save a lot of money on its electricity market when it fired it up on April Fools’ Day 1998. Instead, the market bankrupted the state’s biggest utility (which designed the market), and then the state spent $40 billion to buy electricity for delivery over the next ten years. California paid a bit more than twice what the power would have cost had the state waited five months. That $20 billion loss is how Schwarzenegger became governor in midterm.

A bulletproof excuse was crafted into the future-cap law intentionally. That’s how the game is played. Feel good now; make excuses later. It’s an especially good game when you get to sign the bill six weeks before you’re up for reelection, and nothing much has to be done until after you leave office.

In spite of all this, I think the California bill will get something done, and some of what gets done will likely be cost-effective. The bill is probably a useful step. But what bothers me is that the California approach is seen as tough-minded, providing “the highest certainty of significant emissions reductions.” Is banking on a free lunch in the future with easy loopholes more certain than implementing a concrete program? Compare the approach in California with the approach in the Northeast. California promised more and, as with its electricity market, selected an “innovative” approach. The new approach, called “downstream cap and trade,” flies in the face of standard economics. The Northeast has spent its time implementing the more ordinary but more promising Regional Greenhouse Gas Initiative. The initiative has built-in penalties that enforce its cap. It’s not my favorite approach, but it’s a solid design and is within the range of approaches that experts are actively debating.

The opening quote of this chapter should serve as a warning to all future-cappers. President Nixon capped future oil imports at zero in 1980. President Ford capped future oil imports to zero in 1985. President Carter, in July 1979, capped oil imports at their 1977 level. This last example was a current cap, but like a future cap, it had no teeth. That cap held until 1997, but the evidence I present in chapter 8 indicates that its success was due to OPEC’s high prices and not to Jimmy Carter’s cap. Future caps are just goals. Let us turn our attention now to the real, here-and-now caps of cap-and-trade policies. They limit pollution, and they have teeth.

What Is Cap and Trade?

Cap and trade is a policy that enforces an upper limit—a cap—on the amount of pollution emitted by a group of companies, such as all the utilities in the Northeast. That’s what the Regional Greenhouse Gas Initiative does. It sets one cap for the whole group, and it issues pollution permits that add up to exactly the capped amount of total emissions. Every utility must have permits for all its emissions; otherwise it has to pay a fine.

That describes the cap. The trade part applies to the pollution permits. These can be distributed in several ways, but the key to the system is that polluters can buy and sell permits—that is, trade permits.

Trading cannot increase the number of permits, so the cap is secure. But polluters can buy as many as they like—if they are willing to pay the price. If one polluter buys more, another has fewer permits. Total pollution remains unchanged at the cap.

This system gives the regulator control of total pollution, which is what matters to society as a whole, while the polluters retain control over how much they cut back individually. The polluters who find it most expensive to reduce emissions buy permits and avoid expensive reductions. Those who find it cheapest to reduce emissions do so and sell their permits. As a result, the cleanup is done by those for whom it is the cheapest, which reduces the total cost of emission control.

Reducing costs is good, because consumers end up paying all the abatement costs. I don’t mean to puncture anyone’s belief in Santa, but no, making those big corporations clean up does not mean they are going to pay the bill. They just pass the costs on—sometimes a little more, sometimes a little less, but on average 100 percent. So when costs are reduced, consumers pay less.

Now, here’s the best part of cap and trade: Allowing a free market in permits doesn’t just reduce costs; it saves as much as possible. Nothing’s perfect, but by using a permit market, the companies cut costs more than under any regulatory directive. (See How Trading Permits Saves Money.)

The bottom line is that permit trading finds the cheapest way to meet the regulator’s cap, and all the cost savings are passed on to consumers. At least this is the simplified economic theory. Reality is not quite as rosy. But cap and trade is better than the old approach in which regulators set each company’s pollution limit—usually with a one-size-fits-all formula.

The First Consensus: Carbon Pricing Is Best

Mankiw refers to a “broad consensus” that “we need a global carbon tax.” That is the second consensus. Before that consensus, there was, and there still is, an even broader consensus. Over 2,600 economists, including nine recipients of the Nobel Memorial Prize in Economic Sciences, signed a statement that concludes, “The most efficient approach to slowing climate change is through … market mechanisms, such as carbon taxes or the auction of emissions permits.”

This is from the “Economists’ Statement on Climate Change,” which the economists circulated and signed in 1997. It states that carbon taxes and cap and trade (referred to as “the auction of emissions permits”) are the top two choices for an energy policy. They are tops because they are the only two broad carbon-pricing, market-based approaches.

Notice that the carbon tax is listed first—another indication of Mankiw’s consensus. However, the statement basically treats the two as twins. Why do economists see them as so similar?

They are twins because both are carbon-pricing policies—that is, they work by putting a price on carbon emissions. The government requires carbon users either to pay for a permit or to pay a tax. Both put a price on using carbon.

But one policy caps carbon use, and the other doesn’t, so surely they are quite different. So it seems. But carbon users don’t tend to care if the cap is 3 billion tons a year or 2 billion tons. Most users find those numbers incomprehensible, and the figures are not what influences how much gas you put in your tank or how much coal you buy for your power plant. In fact, with a hard cap, people know that somehow the cap will be met no matter what they do individually—so they have less reason to be concerned with the total national emissions.

Ignoring the concerns of environmentalists with national emissions when there is no hard cap, the only thing that matters to carbon users is the price of carbon. So a cap-and-trade policy with a $30 permit price has the same effect as a $30 carbon tax. No one cares what the government calls it. Buy a permit, pay a tax—it’s all the same to consumers.

A cap-and-trade system is just a carbon tax whose rate is set by the permit market. If permits are scarce, they will cost a lot, which means a high tax rate. If more permits are available, the tax will be low. Since both systems are just carbon taxes, a cap reduces emissions more than a straight carbon tax only when the permit market imposes a higher tax rate than the carbon tax does. So the question of strength comes down to this: Will a cap-and-trade approach help convince the public to accept a higher carbon-tax rate?

Both policies work by raising the price of carbon, and economists favor using prices. But why do economists put these two policies above all others?

Producing and burning fossil fuel does a lot of damage that no one pays for. Coal mines pollute and destroy. Burning fossil fuel warms the globe. Both impose costs. Buying oil from OPEC wastes money. Defending the oil routes and foreign oil sources costs lives and money. The oil and coal companies pay none of these costs, so fossil fuels are grossly underpriced (except for oil when OPEC jacks up its price). Underpricing is the most famous and most important problem facing energy policy. Put another way, underpricing of fossil fuel is the central energy-market failure.

The economic prescription is to fix what’s wrong. Treat the cause, not the symptoms. If the price is low, raise the price. Don’t make rules about who can use what quantity of coal or oil. Don’t throw money at solar roofs or corn ethanol. Just raise the price and fix the problem at its root.

Either a carbon tax or a cap-and-trade policy, both of which are carbon-pricing policies, fix the problem of underpricing at its root. Adjusted properly, they raise the price of carbon to what it would be if it included the costs of fossil fuel’s side effects. That’s why 2,600 economists signed on in favor of one policy or the other..

Consensus for a Carbon Tax

The consensus among economists that Mankiw refers to favors a carbon tax over a cap-and-trade policy. This consensus is less broad than the consensus for carbon pricing, but broader than it appears. Many economists who advocate a cap-and-trade approach actually prefer a carbon tax. They just think the politics of the T word—tax—rules it out. So they push instead for their second-favorite approach, cap and trade.

Just to give an idea of the extent of the carbon-tax consensus, Martin S. Feldstein, Ronald Reagan’s chief economic advisor, proposed a carbon tax back in 1992. Alan Greenspan, longtime chairman of the Federal Reserve Board, said in 2006 that he favors a tax on gasoline. Mankiw, George W. Bush’s chief economist, argued for a carbon tax in 2007. Liberal New York Times columnist Paul Krugman came out in favor of it in 2000, and liberal economist Joseph E. Stiglitz agrees with Mankiw that it’s essential for making the next Kyoto Protocol work. In 2008, economists in the Congressional Budget Office issued a report favoring a carbon tax. Among noneconomists, Al Gore is a leading proponent of a carbon tax, as is James E. Hansen, the most outspoken climate scientist.

So why do economists prefer a tax to a cap-and-trade policy when trading seems so much more market oriented? That’s been our question from the start. The answer is that required permits are a tax, and the permit price—say, $30 per ton of carbon—is the cap-and-trade tax rate. The government still controls this tax rate by how tight it sets the cap. Cap and trade is just a clumsy, complicated form of carbon tax.

Cap and trade holds a partial advantage only under special conditions, which economists think do not generally apply. In particular, cap and trade has some advantage if we know the value of a cap better than we know the value of saving carbon and if we don’t have time to adjust the tax rate. In fact, we know little about either of these values, though some pretend to know one and some pretend to know the other. Even if we knew these things and didn’t have time to adjust the tax rate, the complications of cap and trade still make it a questionable choice.

The permit market causes the complications. Markets must be set up, brokers paid, and trades tracked by the government. Although the government’s choice of cap broadly determines permit prices, the market intervenes and causes permit prices to fluctuate unpredictably. This creates risk, particularly for capital-intensive long-term projects, such as coal plants and wind and solar generators. These risks raise already high capital costs, and consumers pay what economists call a risk premium.

To dampen permit-price fluctuations, regulators and legislators will likely introduce more complications—for example, international permit trading. Trade with foreign carbon markets can reduce a permit-price spike in the United States by bringing in more permits. This effectively lowers the U.S. carbon cap. But if the permits come from eastern European countries via the European market, they may represent carbon abatement that occurred because of economic collapse. In Europe people call this buying hot air, and indeed, it simply undermines the effectiveness of the cap-and-trade system.

The Environmental Defense Fund suggests another mechanism for limiting permit prices. The government could give permits to “farmers undertaking agricultural practices that store carbon in the soil,” and the farmers could sell these at a profit. Unfortunately, it is impossible to know if carbon stored in the soil will remain for a hundred years or more. So permits given out for not plowing fields could turn out to be a mistake that affects the entire market.

In theory, it makes sense to include everything in one market or under one tax (with a negative tax for carbon capture). But all the market participants benefit from someone gaming the market with bogus permits. So permit markets invite trouble. Under a tax, only the gamer wins, and the others don’t like it.

Better to keep energy policy simple with a tax than to make it look market oriented by introducing a government-controlled permit market that could easily go wrong.

* * *

Requiring expensive permits is simply a way to tax carbon. The price of permits depends, in a complex and unpredictable way, on where the government sets the cap. This imposes risks on business, and the costs of this risk are passed on to consumers. As the market expands, it becomes more susceptible to gaming, and the government has less control. Better to keep energy policy straightforward by using a carbon tax.