To slow climate change, tax carbon

Sen. Barbara Boxer (D) of California announced this month she intends to move ahead with legislation designed to lower the emission of greenhouse gases that are linked by many scientists to climate change. But the approach she's taking is flawed, and the current financial crisis can help us understand why.

The centerpiece of this approach is the creation of a market for trading carbon emission credits. These credits would be either distributed free of charge or auctioned to major emitters of greenhouse gases. The firms could then buy and sell permits under federally mandated emissions caps. If a company is able to cut emissions, it can sell excess credits for a profit. If it needs to emit more, it can buy permits on the market from other firms.

"Cap and trade," as it is called, is advocated by several policymakers, industry leaders, and activists who want to fight global warming. But it's based on the trade of highly volatile financial instruments: risky at best.

The better approach to climate change? A direct tax placed on emissions of greenhouse gases. The tax would create a market price for carbon emissions and lead to emissions reductions or new technologies that cut greenhouse gases. This is an approach favored by many economists as the financially sensible way to go. And it is getting a closer look by some industry professionals and lawmakers.

At first blush, it might seem crazy to advocate a tax increase during a major recession. But there are several virtues of a tax on carbon emissions relative to a cap-and-trade program.

For starters, the country already has a mechanism in place to deal with taxes. Tax collection is something the government has abundant experience with. A carbon trading scheme, on the other hand, requires the creation of elaborate new markets, institutions, and regulations to oversee and enforce it.

Another relative advantage of the tax is its flexibility. It is easier to adjust the tax to adapt to changing economic, scientific, or other circumstances. If the tax is too low to be effective, it can be raised easily. If it is too burdensome it can be relaxed temporarily.

In contrast, a cap-and-trade program creates emissions permits that provide substantial economic value to firms and industries. These assets limit the program's flexibility once under way, since market actors then have an interest in maintaining the status quo to preserve the value of the assets.

What's more, they can be a recipe for trouble. As my American Enterprise Institute colleagues Ken Green, Steve Hayward, and Kevin Hassett pointed out two years ago, "sudden changes in economic conditions could lead to significant price volatility in a cap-and-trade program that would be less likely under a carbon-tax regime."

Recent experience bears this out. Europe has in place a cap-and-trade program that today looks a little like the American mortgage-backed securities market – it's a total mess. The price of carbon recently fell – plummeting from over $30 to around $12 per ton – as European firms unloaded their permits on the market in an effort to shore up deteriorating balance sheets during the credit crunch.

It is this shaky experience with cap-and-trade that might explain an unlikely advocate of a carbon tax. Earlier this year, ExxonMobil CEO Rex Tillerson pointed in a speech to the problems with Europe's cap-and-trade program – such as the program's volatility and lack of transparency – as reasons he prefers a carbon tax.

That said, new taxes are a tough sell in Washington, which helps explain the current preference for a cap-and-trade scheme.

Despite this, there are ways to make a carbon tax more politically appealing. The first is to insist that it be "revenue neutral." This means that any revenues collected from the tax are used to reduce taxes elsewhere, such as payroll taxes.

The advantage of this approach is that it places a burden on something that is believed by many to be undesirable (greenhouse-gas emissions) while relieving a burden on something that is desirable (work).

Another selling point is that the tax can justify the removal of an assortment of burdensome and costly regulations such as CAFE standards for cars. These regulations become largely redundant in an era of carbon taxes.

But it may be that a carbon tax doesn't need an elaborate sales pitch today when the alternative is trading carbon permits. The nation's recent experience with Fannie Mae, Freddie Mac, and the mortgage-backed securities market should prompt Congress to think twice when a member proposes the creation of a highly politicized market for innovative financial instruments, no matter how well intentioned the program may be.

• Nick Schulz is the DeWitt Wallace Fellow at the American Enterprise Institute and editor of The American.