With cap-and-trade on the ropes, is it time to reconsider a global tax on carbon?

Worldwatch President Chris Flavin, Dr. Bill Nordhaus of Yale University, and Center for Global Development Nancy Birdsall discuss the merits of different carbon pricing policies.

With international climate negotiations rudderless and little hope for passage of a climate bill in the current U.S. Congress, some believe the time is ripe to consider whether there might be a better way to price carbon than cap-and-trade. On March 24, at a round-table hosted by Worldwatch and the Center for Global Development, Dr. Bill Nordhaus of Yale University argued that an international system of harmonized carbon taxes could be a more economically efficient and politically feasible framework to deliver carbon emissions reductions than a cap-and-trade system.

Mr. Nordhous’ thinking is rooted in the lessons of recent history. Most ways you slice it, the last two years have not been kind to carbon markets.  Although the volume of global carbon transactions increased 80 percent between 2008 and 2009, average global carbon prices fell from US $28 to $17 per ton of carbon dioxide-equivalent (CO2e), according to our latest Vital Signs Online trend. This decline in carbon prices, driven mainly by transactions on the European Union Emissions Trading Scheme (EU-ETS), was partially a result of the global recession, which reduced industrial output and, consequently, demand for carbon allowances. But more fundamentally, some are beginning to question the vision of interconnected, international carbon markets that has dominated the discussion of carbon pricing since the 1980s.

Recent high-profile setbacks have fed this disillusionment. The highly anticipated Copenhagen Climate conference in 2009 produced no binding international agreement on emissions reductions or clear path forward for the cap-and-trade system devised under the Kyoto Protocol. In the United States, the largest industrialized holdout on the Kyoto Protocol, cap-and-trade legislation passed in the House of Representatives in the summer of 2009 but died a prolonged death in the Senate. And to add insult to injury, in a heist worthy of Carmen Sandiego, cyber-criminals managed to steal and sell US $40 million worth of carbon emissions permits from the European Union’s Emissions Trading Scheme (EU-ETS) in January 2011, throwing doubt on the security measures of some countries’ trading floors.

Carbon markets have made progress over the last few years. Carbon emissions trading systems are now in use in over 30 countries. Planning has begun for Phase III of the EU-ETS, the world’s largest and most mature carbon market. In 2008, New Zealand launched the first mandatory economy-wide emissions trading system outside Europe in 2008, initially covering forestry and then adding the energy, industrial, and transport sectors in July 2010. Several other mandatory schemes are now up and running at the sub-national level, most notably the Regional Greenhouse Gas Initiative, which covers 95 percent of power sector emissions in 10 northeastern states in the U.S. A scheme in California is set to begin in 2012. And China, which became the world’s largest CO2 emitter in 2006, has discussed setting “binding” carbon emissions targets on energy and greenhouse gas-intensive sectors in the twelfth Five-Year Period (2011-2015).

Still, the Kyoto Protocol, Nordhaus said, is not living up to its aspirations.  It was designed poorly to incorporate new countries, leading to contentious debates about the proper role responsibilities of major emerging economies such as China and India. Emissions reductions in developing countries traded through the Protocol’s Clean Development Mechanism (CDM) may not all be real.

Many of the problems the Kyoto Protocol has faced, according to Nordhaus, are fundamental flaws of cap-and-trade systems. Because it regulates the quantity of emissions rather than the price, it leaves carbon markets vulnerable to high price volatility, and creates opportunities for corrupt actors to profit from artificial scarcities. Setting caps is highly contentious, whether for countries or for industry segments, and can cause fears that wealth is being transferred from some companies or countries to others. With carbon taxes, by contrast, countries can retain all revenues and use them as they see fit, removing the international wealth transfer issue. Taxes also create price certainty for companies and investors.

In fact, Nordhaus argued, a hybrid cap-plus-tax may be the most efficient solution, albeit difficult to communicate to an already bewildered audience. Such hybrids could combine the emissions targets of a cap with the price certainty of a carbon tax. A hybrid system could look like an emissions trading system with a pre-determined number of emissions allowances, but with an ability to purchase additional allowances at a set price (an effective upper limit on the carbon price).

At the March 24 roundtable, many participants agreed with Nordhaus’ arguments but questioned the political feasibility of a carbon tax in the United States.  Others noted that by the time any carbon pricing policy becomes politically viable in the United States, there will be plenty of chance to re-think the merits of various options.  Chris Flavin of Worldwatch pointed out that several of the countries that participate in the European cap and trade system also have carbon taxes, and that around the world, a wide range of carbon pricing options are under consideration.   This is the perfect time to encourage robust discussion—and real world experience—with different approaches to solving the climate problem.

Dr. Nordhaus’s presentation may be viewed here: 2011.03.24 Bill Nordhaus Presentation Roundtable

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