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William D. NordhausYale University

Center for Global DevelopmentMarch 2011

Perspectives on Carbon Taxes

The Current International Approach

Began with Framework Convention on Climate Change (1992), a voluntary agreement to “prevent dangerous” climate change.

First steps were Kyoto Protocol

Kyoto Protocol negotiated in 1997

- Limiting emissions to fraction of 1990 rates

- Limited to high-income countries

- Only agreed for 2008-2012 period

China and other developing countries have no emissions targets.

Allows trading of emissions permits among countries

Protocol went into effect in Feb 2005 after Russian ratification.

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The Copenhagen Meeting

Successor to Kyoto Protocol took place in December 2009 in Copenhagen.

There was an agreement on a goal (2 °C temperature limit).

There was no binding agreement on emissions.Countries agreed to aspirational targets.

Unresolved problems:- What are targets of rich countries?- Will the US participate?- Will middle income countries take on commitments?- What mechanism will be in place to encourage reductions in poor countries?- Who will pay for efforts in poor countries, and through what mechanism?

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US Policy on Climate Change

• US played central role in Kyoto negotiations in 1997.• However, Clinton administration did not submit for

ratification .• Bush administration withdrew US from Protocol in

2001.• Obama administration endorsed joining and supports

climate-change bills.• House passed a bill in 2009, but it did not pass

Senate.• All US bills have firmed endorsed cap and trade, with

heavy regulatory burdens and trade sanctions.• Generally viewed that legislation cannot be passed

for indefinite future.

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Kyoto Protocol is Not Living Up to Its Aspirations

• Severe attrition in international coverage of emissions.

• Price of carbon is extremely volatile.

• Many of emissions reductions come through Clean Development Mechanism (CDM), which are likely to be illusory.

• Kyoto model is poorly designed to bring new countries on board.

Two Inconvenient Economic Truths

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1. To be effective, firms and consumers must face a market price of carbon emissions that reflects the social costs.

2. Moreover, to be efficient, the price must be universal and harmonized in every sector and country.

How should we implement policies?

• Internationally harmonized carbon tax • Universal cap and trade

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• Regulatory substitutes (CAFE standards, ban on light bulbs, …) – very inefficient approaches

• Voluntary measures (carbon offsets) are difficult to calculate and verify and probably a useless diversion.

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An Alternative: Harmonized Carbon Taxes

What are “harmonized carbon taxes”?• Raise prices of GHGs proportional to carbon

content• All countries would levy a comparable tax• Level of tax set to meet environmental target • Countries would retain all revenues (this is not an

international transfer program)• Carbon tax can be used to replace existing taxes or

reduce fiscal deficits

Open issues:• How to treat trade for non-participants?• Should low-income countries receive transfers to

reduce economic impacts?

Carbon tax estimates from models

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0

20

40

60

80

100

120

140

160

180

200

2010 2015 2020 2025 2030

Carb

on p

rice

(201

0$ p

er to

n ca

rbon

) Cost-benefit optimum

2 degree limit

Source: Nordhaus, “Economics of Copenhagen Accord,” PNAS (US), 2010.

Cap and trade v. Carbon taxes

Some problems with cap and trade:

1. Cap and trade is a new and untested system at the international level. Setting country targets is contentious and difficult.

Taxes have natural units and are more easily harmonized across countries.

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2. Kyoto Protocol has suffered from extreme attrition …

0%

20%

40%

60%

80%

100%

1990 2010

Fraction of Global Emissions Covered by Kyoto

Enthusiasts

Annex I less US

Annex I

Source: Nordhaus, “Economics of Copenhagen Accord,” PNAS (US), 2010.

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… and global emissions reductions are likely to be very small

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

2005 2015 2025 2035 2045 2055 2065

Em

issi

on R

educ

tion

(% o

f ba

seline

)

< 2 degrees C

Current Kyoto Protocol

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3. Quantity-type regulations show extremely volatile prices for the trading prices of carbon emissions

4. Some technical economic issues:

- Taxes increase efficiency of fiscal system relative to allocation- Weitzman P v Q issues: structure of costs and benefits indicates that limiting emissions by price is more efficient than quantities in face of uncertainties.- With uncertainty and thresholds: If there is no reset possible and there is an established threshold for CO2 level, quantity limits may have an advantage.

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5. Corruption and alternative mechanisms

A final question concerns the administration of programs in a world of where governments vary in terms of honesty, transparency, and effective administration.

Quantity-type systems are much more susceptible to corruption than are price-type regimes. Why? An emissions-trading system creates valuable tradable assets in the form of tradable emissions permits and allocates these to different countries. Limiting emissions creates a scarcity where none previously existed and in essence prints money for those in control of the permits. Such wealth creation is dangerous because the value of the permits can be used by the country's leaders for non-environmental purposes rather than to reduce emissions. If oil ministers in corrupt countries pocket oil export revenues, why would permit ministers not pocket permit revenues?

A price approach gives less room for corruption because it does not create artificial scarcities. There are no permits handed over, so they cannot be sold abroad for wine or guns. Any revenues would need to be raised by taxation on domestic consumption of fuels. In fact, a carbon tax would add absolutely nothing to the instruments that countries have today.

The dangers of quantity as compared to price approaches have been shown frequently when quotas are compared to tariffs in international trade interventions.

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Hybrid: Cap plus tax

• Hybrids may be superior to either extreme, although more difficult to understand and persuade

• Cap-plus-tax: Quantitative limits are buttressed by a carbon tax along with a safety valve

• Example:– Auction permits corresponding to economic or

environmental target– Backstop with a $20-per-ton carbon tax – Provide ability to purchase additional permits at a

penalty price of $40 per ton of carbon.

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The conundrum of trade linkages

As countries introduce ANY climate-change policies in a non-harmonized manner, this will raise trade issues:- Carbon prices and embodied goods and services

will rise in high-carbon-price regions- E.g., if US acts, between the US and Mexico- Sarkozy: urged Europe to “examine the option of taxing

products imported from countries that do not respect the Kyoto Protocol.” (October 2007)

- Senate bill had countervailing duty for divergent policies

Countries and international organizations will have to deal with the question of border-tax adjustments- This will be particularly important for more stringent

regimes and energy-intensive industries (electricity, steel, petrochemicals and chemicals, …)

Why is global warming so hard to solve?

1. The free riding problem among countries2. The long payoff period (> 50 years to get net

benefits)3. Unrepresentative democracy4. The merchants of doubt5. The ideological anti-tax and anti-big-government

movements

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