On Balance: How Is the US Pricing Carbon? How Could We Price Carbon?

Economists have for decades recommended that carbon dioxide and other greenhouse gases be taxed to provide incentives for their reduction. The United States does not have a federal carbon tax; however, many state and federal programs to reduce carbon emissions effectively price carbon—for example, through cap-and-trade systems or regulations. There are also programs that subsidize reductions in carbon emissions. At the 2022 meetings of the American Economic Association, the Society for Benefit-Cost Analysis brought together five well-known economists—Joe Aldy, Dallas Burtraw, Carolyn Fischer, Meredith Fowlie, and Rob Williams—to discuss how the United States does, in fact, price carbon already and how it could do so more effectively. Maureen Cropper chaired the panel.

Meredith Fowlie discussed problems that a carbon tax would present if levied on the US energy sector. As Fowlie pointed out, setting a carbon tax equal to the social cost of carbon assumes that the prices of carbon-intensive goods reflect suppliers’ marginal private costs. In many US states, however, regulated retail electricity and natural gas prices exceed marginal supply costs—in the case of electricity, sometimes by a factor of two to three. Electricity prices have risen to cover the costs of upgrading generation, transmission, and distribution systems and making the grid more resilient to extreme weather events. Adding a carbon tax to these prices would slow the pace of electrification for the clean energy transition and would burden low-income households. Fowlie discussed these issues and suggested that retail rate reform is needed.

Joe Aldy presented an overview of clean energy subsidies that the federal government has provided to reduce carbon emissions. These include investment and production tax credits for renewable energy sources, loan guarantees for renewable power, and state block grants to promote energy efficiency. Aldy discussed the limitations of these subsidies relative to a carbon tax. Whereas a carbon tax would provide a price signal throughout the economy that would tend to equalize marginal abatement costs, clean energy subsidies do not. And because of their limited lifetime, clean energy subsidies do not usually provide dynamic incentives for emissions reductions. Aldy discussed how specific clean energy subsidies could be redesigned to better mimic a carbon tax. He also suggested using formal program evaluation to improve the design of subsidies to reduce carbon emissions.
Dallas Burtraw reviewed the barriers to implementing carbon pricing and noted nonetheless that it is important that we price carbon. Pricing carbon encourages cost-effective reductions in greenhouse gases (GHGs), rewards technological innovation to reduce carbon emissions, and helps coordinate activities to decarbonize the economy. To move in the direction of pricing carbon, Burtraw argued for formulating an industrial policy that mimics a carbon tax but is politically acceptable. One way to do this is to couple regulatory standards with sector-specific subsidies. Tradable emissions performance standards, such as California’s Low Carbon Fuel Standard, are an example. Burtraw discussed the extent to which tradable performance standards embody the attributes of a carbon tax.

Carolyn Fischer elaborated on how industries can be incentivized to reduce carbon emissions. Targeted rebating of carbon tax revenues to industries can overcome objections that emissions regulations give competitors in unregulated countries an advantage. Rebates can take several forms. In a cap-and-trade system, distributing permits free of charge is a common form of rebating. Rebates can also be given in proportion to output. Fischer noted that output-based rebates mute the pass-through of carbon costs into higher product prices. This weakening of the carbon price signal is generally inefficient; however, if output prices are already distorted (e.g., because of monopoly power), then rebates may entail small (or even negative) efficiency losses. Fischer also discussed intensity-based rebates—rebates proportional to reductions in emissions intensity—which have been used to encourage emissions reductions.

Rob Williams concluded by discussing the relationship between the types of carbon policies discussed by Aldy, Burtraw, and Fischer—policies that subsidize carbon reductions—and a federal carbon tax. If a federal carbon tax were levied, should such policies continue or be reduced in scope? A similar question arises with respect to subnational policies such as renewable portfolio standards and bans on natural gas connections in new construction. It is often assumed that these policies are complements to a carbon tax—and therefore should be kept in place. If, however, they are substitutes, the policies should be phased out when a carbon tax is levied. Williams argued that most other carbon reduction policies can be viewed as substitutes for a carbon tax. But a few are complements, and that group includes the utility rate reforms discussed by Fowlie.

Note: An invited paper, “How Is the US Pricing Carbon? How Could We Price Carbon?” will appear in the December 2022 Journal of Benefit-Cost Analysis.

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