How Should the US Legislate on Climate Policy?

The passing of legislation in the United States congress is crucial to reducing greenhouse gases globally, for two reasons. Firstly, the US is significant in its own right, as the second-largest global emitter of greenhouse gases. Secondly, as the richest and most powerful country in the world, many other countries wait for the lead offered by the US, and the US will have a great influence on the structure of future agreements.

This short post set out in outline what I think the US should do to reduce greenhouse gas emissions.

First, scrap the Kyoto system. In the Copenhagen negotiations the US argued in favour of the replacement of the Kyoto protocol. There are good reasons for scrapping Kyoto with its distinction between developed and developing countries, and its extensive use of 'flexible mechanisms'. I have outlined the problems with Kyoto in an earlier paper.

Secondly, introduce an upstream approach. Rather than measure the CO2 emitted by companies and individuals at point of emission ('downstream'), it's easier to measure how much carbon is extracted or imported into the country and levy the tax there. The economic incidence of the tax will be broadly the same wherever in the chain you implement it.

Thirdly, have a broad tax base for the proposals. Any carbon price/tax should include all emissions, not just some sectors. An upstream approach that taxes the carbon at source(see previous section) should catch almost all CO2 emissions. The carbon tax should include petroleum for transportation and natural gas for home heating - all fossil fuels in short.

Fourth, adopt a consumption basis for the carbon price/tax rather than a production basis. This means that taxes should in principle be levied on imports of goods from any other countries that do not have comprehensive plans to reduce greenhouse gas emissions. This means using border tax adjustments. This can be implemented by value according to the emissions intensity of the original relevant country-sector.

Fifth, reverse the direction of political realism: structure climate policy so that it is more politically acceptable the more stringent it is. Ways to achieve this might include a sectoral approach for negotiating the transitional measures to adapt to a high carbon price; and 'transformative contracts' for existing high-carbon interests (for example giving guaranteed electricity prices for solar power produced by fossil fuel companies), with 'frontloading' of subsidy and 'backloading' of costs (recognizing that political actors have a relatively short time horizon / high discount rates).

Sixth, ensure a carbon/tax price that is high enough to encourage clean fossil fuels with Carbon Capture and Storage and Concentrated Solar power, to provide scalable energy sources for the future (and possibly Air Capture of CO2 from thin air). This price would need to be at least $200/tCO2 over the next decade. Implementing carbon capture and storage with an upstream carbon tax approach requires implementing subsidies for verified carbon storage (a small proportion of which could be held in escrow pending long-term verification of carbon storage).

Implementing the preceding points may be more straightforward with a carbon tax than an emissions trading scheme. Furthermore, an international system of harmonized taxes has only one degree of freedom - the tax level - meaning that international negotiations may well be simpler when based around a common carbon tax level than level of emissions reductions. Furthermore, such an international club could be created from the 'bottom up', by agreements between the United States, Europe and Japan, and other OECD members.

Whilst in principle it is possible to adopt cap-and-trade scheme with most of the previous features, it would be very different from those adopted so far, for example the EU (in particular it would need to be upstream with a complete tax base, and a much higher carbon price). To keep things simple, therefore, my advice would therefore be to adopt a carbon tax of around $200/tCO2, with revenues rebated in the short term (1-5 years) to reduce taxes on domestic companies, and individuals and to reward resource owners for keeping carbon in the ground (so that major political actors are no worse off). In the long term (>~3 years) revenues should be used to reduce the fiscal deficit.

The carbon tax could be managed by a central agency in order to meet emissions targets, rather like a central bank sets interest rates in order to meet inflation targets. The price level would only need to be changed infrequently - every year or two - however, in order to ensure that the targets are at least met.