The future with a serious carbon tax: Pt. 1

This article originally appeared on the Centre for Global Development blog. To see the original, please click here. Comments are welcome and should be sent to LawrenceMacDonald@gmail.com.

It’s 2030 and instead of racing toward the brink of climate catastrophe the world has begun to back away. Annual global emissions of heat-trapping gasses have fallen two-thirds—faster than anybody had dared to hope as recently as a dozen years ago—with continued steep reductions ahead. Although carbon dioxide (CO2) concentrations in the atmosphere breached 450 parts per million (ppm) last year—the level believed to offer a 50 percent chance of holding global warming below 2 degrees Centigrade this century—the rate of increase has slowed dramatically. Atmospheric CO2 was increasing by 3 ppm per year as recently as 2020; today the annual increase has fallen to just 1 ppm, and attention and investment are shifting from the need for steep emissions reductions—a global goal that has largely been attained—to large-scale, low-cost biological methods for extracting carbon from the atmosphere.

Strikingly, all of this has coincided with improved economic performance and continued reductions in global poverty—despite the absence of a binding international treaty. Although the emissions fees imposed in the United States, China, Europe, and elsewhere raised energy prices, they also sparked a technology and job-creation boom. Revenue from carbon pricing has made possible dramatic rollbacks in other taxes—especially taxes on employment and investment—giving economies a further boost. As a result, growth rates have remained robust in the big emerging market economies, making possible rapid reductions in extreme poverty and the emergence of a global middle class. In the United States and Europe, growth has accelerated from the sluggish rates that prevailed until 2018, when revenue-neutral national emissions fees were put in place as part of a grand bargain that included cuts in middle-class income tax rates.

A fantasy? Of course. But perhaps more plausible than the slim hope that UN negotiations will lead to an ambitious, binding international agreement. Read on to discover an alternative path to averting climate catastrophe. (Everything in this future history up to the publication date is real.)

Little could we have anticipated when we first met at the Center for Global Development’s Washington, DC, headquarters in 2013 that a series of events would soon begin to unfold that would bring the world to a situation in 2030 where instead of racing toward the brink of climate catastrophe we have begun to back away. Annual global emissions of heat-trapping gasses have fallen two-thirds—faster than anybody had dared to hope as recently as a dozen years ago—with continued steep reductions ahead. Although carbon dioxide (CO₂) concentrations in the atmosphere breached 450 parts per million (ppm) last year—the level believed to offer a 50 percent chance of holding global warming below 2 degrees Centigrade this century, and thus perhaps averting runaway climate change [1] —the rate of increase has slowed dramatically. Atmospheric CO₂ was increasing by 3 ppm per year as recently as 2020; today the annual increase has fallen to just 1 ppm, and attention and investment are shifting from the need for steep emissions reductions—a global goal that has largely been attained—to large-scale, low-cost biological methods for extracting carbon from the atmosphere.

Strikingly, all of this has coincided with improved economic performance and continued reductions in global poverty—and despite the absence of a binding international treaty. Although the emissions fees imposed in the United States, China, Europe, and elsewhere raised energy prices, they also sparked a technology and job-creation boom. Revenue from carbon pricing has made possible dramatic rollbacks in other taxes—especially taxes on employment and investment—giving economies a further boost. As a result, growth rates have remained robust in the big emerging market economies, making possible rapid reductions in extreme poverty and the emergence of a global middle class. In the United States and Europe, growth has accelerated from the sluggish rates that prevailed until 2018, when revenue-neutral national emissions fees were put in place as part of a grand bargain that included cuts in middle-class income tax rates.

This unexpected achievement of falling carbon emissions and dramatically improved well-being holds true even when economic performance is calculated using the now largely discarded gross domestic product (GDP) methods developed in the mid-20th century. Improvements in human welfare are even greater when calculated using the now standard green national accounts method, which takes into account such things as health, education, natural resources, environmental quality, and the value of leisure time that were absent from GDP.

Today global CO₂ ppm and national per capita emissions are tracked with the same concern once reserved for those misleading old GDP reports, except of course that the goal is lower rather than higher numbers and nations compete for bragging rights that come with large drops in per capita emissions. Last year the United Nations General Assembly called for a sustained global effort to eventually reduce atmospheric carbon concentrations to below 350 ppm, the level championed by the pioneers of the climate action movement at the start of this century.

Whether humans can eventually stabilize the climate and restore the acid–alkaline balance of the oceans remains uncertain. Because the planet has yet to feel the full effects of the huge pollution load already in the atmosphere, the high temperatures, extreme weather events, sea level rise, and ocean acidification of recent decades may be just the prelude. Pretty much everybody understands that humanity will struggle with the destructive legacy of the 20th and early 21st centuries for generations to come and that the situation is likely to get a lot worse before it eventually begins to get better. Still, there is wide satisfaction that economic activity has been unshackled from carbon emissions, and hope that the problems ahead of us can be resolved.

An emerging school of academic climate historians argues that all this might have come about sooner had it not been for the global climate negotiations. Older readers will remember this well, but for younger readers it may come as a surprise that countries once attempted to solve the climate problem using the same tools and mind-set that had been effective in cutting trade tariffs in the late 20th century: global multilateral negotiations leading to a binding agreement in which countries would mutually commit to taking actions that were politically difficult but ultimately in their own best interest. Although that approach sounded reasonable in theory—indeed it was the dominant model for addressing global problems—already in 2009 the failure of the UN Copenhagen Climate Summit made it obvious that the United States and China, then the world’s biggest emitters, would not make binding commitments to cut emissions soon enough to avert catastrophe. The international negotiation model was fatally flawed, yet the annual UN climate summits continued to absorb time and energy that might have been better used exploring alternative solutions. [2]

The climate summits didn’t just fail to produce an agreement. Worse, they created the perception that policy changes to address climate change were “concessions” to be given or extracted in adversarial negotiations. For many years that mind-set distracted policymakers and citizens from the fact that taxing “bads”—things society wants less of, like pollution—makes more sense and is less distorting for economies than taxing things that are desirable, like employment and investment. This is now conventional wisdom, of course. But concern about higher energy prices, coupled with resistance from the fossil fuel industries, long obscured this simple but important idea. As recently as 2014, the International Monetary Fund (IMF) found it necessary to issue a major report making the case that “getting energy prices right means that taxes on fossil fuels should be set at such a level that energy prices reflect their associated environmental side effects” The report noted that the potential for co-benefits from carbon pricing suggested that “countries need not wait on internationally coordinated efforts if some carbon mitigation is in their own national interests—that is, the domestic environmental benefits exceed the CO2 mitigation costs, leaving aside climate benefits.” [3]

Governments need revenue. Taxing the bad stuff that society wants to discourage—like conventional and climate pollution—makes a lot more sense than taxing good stuff that society would like to encourage, such as jobs, savings, investment, and profits. Well, duh!, as the kids used to say. Still, at the time, the political obstacles to this self-evident policy approach appeared massive. The idea that carbon emissions were a “public bad” and that therefore it was rational for nations to “free ride” and wait for others to act first was so deeply ingrained as to seem self-evident and immovable.

Fortunately, once some jurisdictions began to put a price on carbon pollution, initially at low levels, it soon became evident that such so-called Pigovian taxes [4] were politically quite popular. Making the switch, and then raising the price of emissions to a level necessary to address the climate crisis, turned out to be less difficult politically than most of us had imagined. Looking back, the remarkable thing is how unlikely this course of events seemed in 2013 and how quickly the change has come to pass. We are reminded of a famous saying of Nelson Mandela, the great 20th-century South African anti-apartheid leader: “It always seems impossible until it’s done.”

The key, of course, was the growing recognition that the policy solution to climate change—high and rising carbon prices (or carbon pollution fees, as they came to be called in the United States)—was not at odds with fixing economic problems; rather it was a means to their solution. Countries have moved to impose carbon taxes or to create emissions trading systems (ETSs) because they are sound domestic policies, are good for the economy, and are good for the environment, and because doing so gives such countries a competitive edge in global technology markets and higher standing in the international community.

This is so obvious and widely accepted today that one can hardly remember that as recently as 15 years ago putting a price on carbon emissions and fostering economic growth were often portrayed as being at odds, despite mounting evidence to the contrary. In January 2014, for example, a New York Times reporter wrote, “The energy and climate debate, which is playing out across Europe, reflects similar trade-offs being made around the world on mending economic problems today or addressing the environmental problems of tomorrow.” [5]

Policymakers and the public now understand that the so-called “co-benefits” of charging for carbon pollution are so large that doing so would be sound economic policy even if the problems of runaway climate change and ocean acidification did not exist. The path to charging for carbon emissions has varied greatly from country to country, but the benefits have been similar. Some countries have adopted carbon taxes while some have chosen emissions trading. [6] Either way, the benefits of carbon pricing fall into three classes:

• Fiscal advantages. Revenue from pricing carbon, whether generated from a tax or from the auction of tradable permits, has made it possible to roll back and even eliminate other, more distorting taxes. The tax burden has shifted from things people desire (income, jobs) to things people want less of (pollution). Rather than the economic slowdown that some had feared, this has led to a win-win solution, with more rapid economic growth and less carbon emissions. Moreover, because fees on fossil fuel carbon emissions are relatively easy to collect and hard to avoid, in many countries the tax base has broadened, generating large welfare gains. These gains have exceeded the drag on the economy from higher energy prices—like getting paid to eat a free lunch.
• A wealth-creating green industrial revolution . [7] Countries that moved early to price emissions experienced a surge of investment into climate-friendly technologies: hyper energy efficiency, cheap clean renewables, energy-saving nanotechnologies, and green biotech. Businesses across all industrial sectors are working hard to find ways of using energy and resources with increasing efficiency, spawning a new generation of billionaire success stories including tech entrepreneurs, green service providers, renewable energy project developers, and project financiers. Economic historians liken the growth surge to the Internet tech boom of the late 20th and early 21st centuries.
• Better health, reduced pollution. Reductions in noncarbon local and regional pollution, especially from coal (ultrafine particle pollution known as PM2.5, sulfur dioxide, carbon monoxide, mercury, lead, zinc, cadmium, and soot) but also from oil and natural gas, have cut cancers and cardiovascular and respiratory diseases around the world; fragile environments that would have otherwise been subject to fossil fuel extraction (coastal waters, tropical forests, the Arctic, and the arboreal forests of the Northern Hemisphere) are less in need of special protections because exploiting them has ceased to be profitable.

As we shall see, the United States and China came to recognize these advantages through very different paths, reflecting the large differences in our political systems and stage of development. In each case, however, the primary driver for imposing carbon pollution fees was not international negotiations, as climate activists early in the century had hoped. Rather there were powerful domestic policy drivers—not least growing recognition that moving quickly to charge for carbon would be a major source of national advantage.

This dynamic is familiar to those of us old enough to remember the 20th-century Cold War with its arms and space races. Today we have a carbon emissions fee race—a race to the top—in which the United States, China, and other major emitters recognize that national competitiveness requires being at the forefront of the clean tech revolution and that this can best be accelerated by imposing high and rising carbon taxes or pollution fees.

Border tax adjustments—excise taxes on the so-called embedded carbon in imports from countries that have lower effective carbon prices or none at all—have been important in deterring free riders and leakages but have played a smaller role than many policy analysts imagined. As the United States and China moved independently to charge for the negative spillover effects (“externalities”) of carbon pollution, carbon-intensive industries such as steel, cement, chemicals, and steel-intensive manufactured goods naturally feared competition from jurisdictions that did not price carbon and lobbied heavily for these offsetting border tax adjustments.

Provisions for such charges were included in both US and Chinese carbon-pricing legislation, and in similar laws passed in many other countries. At the World Trade Organization (WTO) in Geneva, negotiators spent years debating when such fees were permissible and when they were merely a veiled form of protectionism. In the end, however, it was the threat of border tax adjustments rather than the reality that mattered, providing an incentive for the two biggest emitters to raise carbon prices more or less in tandem. Europe soon followed suit, as did Brazil, India, Indonesia, South Africa, and Russia, as well as smaller countries in Southeast Asia, Latin America, and Africa, partly to reap the benefits of carbon pricing increasingly on display in the pioneering jurisdictions, and partly for fear of facing border tax adjustments if they did not. Today all 15 of the major economies that accounted for three-quarters of global emissions in 2010 have adopted some form of carbon pricing, and many smaller countries have done so as well.

Here again a Cold War analogy is useful in understanding how events unfolded. Just as the threat of mutually assured destruction restrained war in the nuclear age, preventing any nuclear power from using its arsenal, so the much smaller threat of border tax adjustments provided welcome impetus for China and the United States to price carbon at similar levels, and for their major trading partners to do the same.

Low-income countries with tiny per capita emissions have argued with varying degrees of success for exemptions, on the sound moral basis that they did not create the problem and that they should be permitted to exercise their “right” to a share of the atmosphere. In practice, however, most of their labor-intensive, job-generating exports (apparel, light electronics, produce, and agricultural commodities) had little carbon content and were largely exempt from border taxes. More important, low-income countries, with weak tax collection systems and chronically short of revenue, were quick to see the domestic advantages of collecting their own carbon-pricing revenues. In the end, border tax adjustments for embedded carbon have been highly contentious but relatively rare, similar to the once contentious antidumping tariffs of the early 21st century.

One area in which carbon taxes in the major emitter countries have had a substantial effect is on the energy exports from high-cost producers, including several developing countries with potentially large but hard-to-exploit reserves. Early in the 20th century the discovery of new hydrocarbon reserves in poor developing countries—notably oil and gas off the African coast—led many governments and investors to anticipate a natural resource boom. Along with that, however, were fears of what was widely known as the resource curse, [8] the phenomenon, epitomized in Nigeria, of oil wealth fueling massive corruption, overvalued exchange rates, slow economic growth, internal conflict, rising inequality, and environmental problems.

With the imposition of carbon taxes in major emitter markets, low-cost producers such as Saudi Arabia and Kuwait were able initially to adjust by levying compensatory excise taxes on their exports, capturing revenue that would have been captured by importers while nonetheless remaining price competitive. For marginal, higher-cost producers, however, imposing such taxes would have made their exports uncompetitive. As a result, some marginal producers, like Alberta, Canada (where oil was extracted from bitumen deposits by expensive and environmentally harmful techniques) and Uganda (located far from the major markets and lacking in oil extraction infrastructure), were crowded out of the market, their oil and gas deposits remaining in the ground. [9]

Whether this was bad news for developing countries that eagerly anticipated becoming energy exporters is a matter of fierce debate. One view holds that this was an unfair imposition on poor countries that should have been free to tap their hydrocarbon wealth just as the rich nations before them. An alternative view argues that carbon taxes had a salutary effect, even on the countries whose oil and gas exports became noncompetitive, by slowing and sometimes averting the resource boom—and thus the resource curse. Untangling cause and effect is impossible in the absence of a counterfactual. Still, it is striking that several African counties that had anticipated oil booms and did not get them are today stable democracies with rapid, poverty-reducing growth. Because of weak global demand, much of the natural gas produced on the continent is being used for a massive electrification program rather than exported.

Not unexpectedly, carbon taxation led to major trade disputes. Sharp reductions of previously astronomic levels of fossil fuel consumption in the United States made available an immense supply for export. Should these export-bound fossil fuels be subject to carbon pollution fees domestically, at the point of production? Or should they be exempt, to enable them to be competitive in those markets that did not yet tax emissions? Other fossil fuel exporters faced a similar dilemma. Should countries that had put in place carbon taxes grant exemptions to countries that had already taxed such fuels at the time of export?

Inevitably these disputes landed in the WTO, which launched a major round of carbon pollution fee trade talks following the WTO summit in Caracas in 2018. As with the prior Doha Round, however, the talks achieved little. Rather, a patchwork system of bilateral and plurilateral agreements has grown up over time, shored up by case law established in a series of WTO rulings. The result is the messy situation we have today, where some low-cost exporters reap a windfall by imposing carbon pollution fees at the point of production, while higher-cost producers forego such revenue in a desperate effort to keep their fossil fuel exports competitive in a dwindling international market.

There were of course many other important transition challenges. Notably, all the major emitter countries were home to interests whose wealth and power depended on the fossil fuel status quo, an issue we discuss at the end of this essay.

The surprising thing, however, is how quickly the energy system has transformed; starting with the early, relatively low carbon prices. As price signals changed, the market shifted, and firms that had huge investments in fossil reserves and the extraction, refining, and transportation of hydrocarbon fuels scrambled to diversify. The surge of private-sector investment into renewables, energy efficiency, and conservation has accelerated technological change, rapidly bringing down costs. Already some higher-priced fossil fuels—those with high extraction, processing, and transportation costs—would be economically uncompetitive even in the very unlikely event that carbon prices eventually come down.

Inevitably some fossil fuel firms have been more successful in negotiating the transition than others. In general, the small-to-medium-size firms proved more agile than the behemoths that had once been among the biggest and most profitable companies in the world. Few observers are surprised that the giant state-owned firms, such as Saudi Aramco, Gazprom, and the National Iranian Oil Company, are awakening too late to the fact that their vast reserves are plummeting in value. Some firms rushed to extract and sell their reserves as fast as possible, to get ahead of the coming carbon prices, in what came to be known as a “green paradox.” Fortunately, this effect was transitory and had a smaller climate impact than some had feared. Indeed, in some countries awareness of this phenomena helped bolster efforts to begin pricing carbon sooner rather than later.

More surprising is that some big private firms also largely missed the boat. It seems hard to believe that just two decades ago Exxon Mobil was the most profitable company on the planet. Today, of course, global demand for its products—and its political clout—has fallen sharply. The company also suffered a major blow in the early 2020s when it lost a multi-trillion-dollar class action suit brought by an alliance of US state attorneys general, displaced residents of submerged island states, and environmental groups seeking damages in connection with the firm’s support for climate denial junk science. BP and Royal Dutch Shell have fared somewhat better, dumping some of their fossil fuel assets relatively early and diversifying into clean renewables, but their wealth and power have been greatly reduced, as their core business continues to be providing hydrocarbon fuels to a shrinking global market.

Economic historians tell us that the sudden decline of once-dominant industries has happened many times before. Whaling, a dominant US industry in the 1830s, was brought to an end with the arrival of kerosene, which was cheaper and burned brighter than whale oil. The sleek clipper ships of the 17th and early 18th centuries gave way to steamships, which were in turn overcome by diesel-fueled cargo carriers and later container ships. On land, the railroads in the United States killed the canal business and became vastly powerful in the 19th century only to be eclipsed by the automobile, trucking, and the interstate highway system in the 20th. More recently, within the lifetime of our older readers, computers and digital communications arose so quickly that many households found themselves with boxes of outmoded recordings (first 33 rpm records, then jumbles of cassette audiotapes, videotapes, CDs, and DVDs) even as the devices on which to play them vanished. In our own time, we are witnessing a similarly rapid transformation in the production, distribution, and consumption of energy.

How did this happen so quickly? Why did so few informed observers anticipate these changes even as they were beginning to unfold? The remainder of this essay will seek to answer those questions, with a particular focus on the politics and policy process in the United States and China, the world’s two biggest emitters at the start of the period. To be sure, trying to untangle cause and effect in such a complex, multifaceted process is a fool’s errand. Future historians, with better training, better access to records, and a longer-term perspective than we have will surely find much to fault in our effort. We make no claims to this being an authoritative account. Rather we offer this brief sketch of the past 20 years as we have watched them unfold in hopes of providing useful notes for future historians seeking to understand one of the major developments of the first part of our century.

Check back tomorrow for part two of this five-part series.

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[1] Ulrich Cubasch, Donald Wuebbles, Deliang Chen, Maria Cristina Facchini, David Frame, Natalie Mahowald, and Jan-Gunnar Winther, introduction to Climate Change 2013: The Physical Science Basis. Contribution of Working Group I to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change, ed. T. F. Stocker, D. Qin, G.-K. Plattner, M. Tignor, S. K. Allen, J. Boschung, A. Nauels, Y. Xia, V. Bex, and P. M. Midgley (Cambridge, UK, and New York: Cambridge University Press, 2013), http://www.climatechange2013.org/images/repo­rt/WG1AR5_Chapter01_FINAL.pdf.

[2] Climate policy historians disagree on the relative importance of international negotiations and national politics in driving more sensible policies. Whereas some argue that the very idea of negotiations delayed national actions, others note that the talks sometimes served as a catalyst, as major emitter nations pushed to overcome domestic policy obstacles in order to put forward credible commitments at the annual negotiations. These modest steps in turn may have helped open the way for more ambitious policy responses. One example of that is the 2014 US Environmental Protection Agency effort to regulate emissions from power plants described later in this essay.