The future with a serious carbon tax: Pt. 4

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.)

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Revenue needs clinch the deal

Pollution concerns alone might not have been sufficient to overcome resistance to carbon pricing and, in particular, to high and rising taxes per ton of emissions. An additional and more urgent factor was China’s fiscal situation and the unmet needs of the central government and provincial and local governments for additional revenue. Taxing carbon emissions offered a major new revenue source that was easy to collect and had minimal impact on economic growth.

As in the United States, Chinese economists and planners had worried that taxing carbon emissions—and thus raising energy prices—would slow economic growth and hinder job creation. Two studies, one conducted by the Ministry of Finance and one by the Harvard China Project and Tsinghua University, found little basis for these concerns. Both studies reached similar conclusions, recommending that China begin with a modest carbon tax to increase substantially over time. These findings were to prove highly influential in the policy debate.

”Clearer Skies over China”, for example, ran seven scenarios at different tax levels, ranging from 10 yuan per ton to 100 yuan per ton. It concluded that while the higher energy prices had a small growth-suppressing impact, this could be alleviated by cutting other, more distortionary taxes.[58] After taking into account co-benefits, such as improvements in health and agricultural productivity, the negative impacts on growth were negligible at the national level. Distributional effects, which varied across regions and sectors, could be addressed through transfers if they would otherwise be regressive, the study suggested. Of the various scenarios it considered, the study recommended a middle path, starting with CO₂ taxes of 10 yuan (about $2) per ton in 2013 and rising to 50 yuan per ton by 2020 (all in 2013 values). Under this scenario, the study projected GDP would be just 0.14 percent lower in 2020. But coal use was projected to decline by a whopping 23 percent and overall fossil fuel use by 17.7 percent. Consumption and investment both showed small positive effects, while exports were projected to drop by 1.12 percent. CO₂ emissions were slated to fall by almost 19 percent.

Unlike in the United States, with its highly vocal small-government, anti-tax movement, the Chinese government faced fewer constraints on how it could use the resulting revenue. And fiscal needs were large: China’s total government revenues were only about a quarter of GDP, compared with 40 percent in Germany and 30 percent even in the tax-phobic United States. Moreover, while individual income taxes accounted for about 34 percent of revenue in the United States, in China, despite growing affluence in the cities, individuals accounted for a bare 4 percent of revenue. China instead relied heavily on indirect tax revenues, such as value-added tax and business taxes, as well as revenue from land leases, a bubble-prone and unsustainable source.

The unusual reliance on land leases for revenue had been possible because in China all land is government owned; as villages and farms were converted to urban use, the government reaped windfall profits on the land leases. With rapid urbanization in the late 20th and early 21st centuries, millions of traditional villages were obliterated, their residents sometimes relocated into high-rise apartments or given cash compensation, as local and provincial governments cleared land to offer long-term leases to state and private entities. One study estimated that 1.1 million villages had been destroyed in the first decade of the 21st century, about 300 villages a day in the rapid onslaught of urbanization. [59]

But these land conversion activities were not sustainable. Even with China’s breakneck urbanization the amount of rural land that could be converted to urban use and offered for lease was finite and would eventually be exhausted, meaning that a major new revenue source would soon be needed. Meanwhile, China’s rapidly aging population—a result first of the one-child policy and then of young urban dwellers’ preferences to have few or no children—meant that the government would urgently need new resources to support a burgeoning population of old people who lacked adult children to care for them. [60]

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China taxes carbon emissions

In 2015 China imposed a 10 yuan per ton tax on carbon emissions, with the proceeds split evenly between the central government and the provinces. Collections were made upstream, at the extraction points for coal and oil (mine mouths and wellheads) and at the port of entry for imports of coal, oil, and natural gas. This ease of collection from a relatively small number of locations and enterprises proved to be a valuable feature of the carbon tax. In China, as in many other developing countries, tax collections were hindered by a large informal sector and the fact that rich people could easily avoid taxes. With the carbon tax indirectly imposed on almost all commodities, the tax base expanded substantially. [61]

Though some Chinese enterprises, in particular the coal industry and a class of entrepreneurs and officials who had become wealthy because of coal, had lobbied fiercely against the measure, the tax proved broadly popular with ordinary people who understood the principle of “make the polluter pay.” As the CO₂ tax gradually increased and revenue became available for reductions in the value-added tax, support increased among firms and middle-income households. Low-income households, meanwhile, received transfers that more than compensated them for the additional costs due to higher energy prices.

Firms and households responded quickly to the resulting increased energy costs, first with simple conservation measures that had long been common in advanced economies (automatic thermostats, insulation, and double-glazed windows), then with investments in more sophisticated energy-saving technology, and finally with a burst of investment, innovation, and diffusion of renewables.

Today China has carbon taxes of 50 yuan per ton and is making the transition to a low-carbon economy much more easily, quickly, and with greater economic growth, job growth, and prosperity than the naysayers had deemed possible. Carbon taxes are generating a once unimaginable 5 percent of total government revenues. As carbon taxes have become an increasingly important part of China’s revenue mix and emissions have fallen, there is growing pressure to strengthen enforcement—to be sure that every ton is taxed—and to continually raise the price per ton.

The emissions taxes are part of a hybrid system that combines the strengths of cap-and-trade (setting a quantity cap for major emitters such as power plants, iron and steel, and cement manufacturers to meet regional targets) with the strengths of carbon taxes (predictability and incentives for firms and citizens to press for higher per ton taxes as a means to generate revenue for social services and reductions in more onerous taxes). The parallel cap-and-trade system provides flexibility so that firms with high emissions reduction costs can instead purchase certified carbon tax credits generated by the country’s massive reforestation program—thus paying for most of the reforestation effort.

Emissions have plummeted, of course, from a peak in 2015 of 7 tons per capita to 3 tons per capita in 2030, a level last scene before China’s late-20th-century industrial takeoff. China’s economy, while easing from the breakneck pace of 8 to 10 percent annual GDP growth per year in the late 20th and early 21st centuries has nonetheless continued at an impressive 5 to 7 percent annual growth.

Conventional pollution has fallen rapidly, and acute illnesses and agricultural productivity losses associated with air pollution have declined. Nonetheless, the long-term effects of the extreme pollution levels of the early 21st century will be felt for many years to come. Recent studies warn of a massive “cancer bubble” among prime-age adults—those who were children in the early part of the century. Soil pollution remains a serious problem. Despite China’s extensive investment in the development of new microbial techniques for land detoxification, large areas of farmland have been classed as unsuitable for production of food crops and livestock and are instead being used exclusively for biofuels.

Nobody pays much attention anymore to the carbon intensity of the economy, once put forward as a key measure of China’s progress, though of course it has plummeted, too. China had pledged at the 2009 Copenhagen Climate Summit to cut the carbon intensity of its economy by 40 to 45 percent by 2020. While that seemed ambitious at the time, given China’s rapid economic growth, it would nonetheless have still implied a potential doubling of emissions by 2020—an outcome incompatible with restoring climate stability. Instead, with high and rising carbon taxes we have seen an absolute reduction in emissions of roughly 50 percent.

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Europe scraps the EU ETS, opts for carbon taxes

The rapid progress on carbon taxation in the United States and China naturally had far-reaching repercussions for other major emitters. One of the more surprising was the collapse of the European ETS and its replacement in 2016 with emissions fees and cuts in other taxes. This shouldn’t have come as a surprise: the EU ETS had been on life support for years. Based on a system of tradable permits, the system had been plagued by overallocation of permits and low prices.

Soon after the launch in 2005, permit prices hit a peak of €30 per metric ton of CO₂ emissions. But it quickly became apparent that actual emissions were lower than the number of permits and demand collapsed. Within the first year, the spot price for EU allowances dropped 54 percent to €13.35 per metric ton. In May 2006, the European Commission confirmed that verified CO₂ emissions were about 80 million metric tons, or 4 percent lower than the number of allowances distributed to installations for 2005 emissions, and prices fell further to under €10 per metric ton. Oversupply of permits and weak demand continued through 2006 resulting in a trading price of €1.2 per metric ton in March 2007 and a further drop to just €0.10 in September 2007.

Carbon prices remained near zero throughout 2007 as market participants became aware that aggregate emissions were well below the number of allowances issued. The price drop dramatically weakened the incentive to continue reducing emissions. The price collapse had two causes. First, EU member states had allocated too many EU allowances, due to sustained lobbying by individual firms and uncertainty about the baseline for business-as-usual emissions. Second, firms had actually reduced their emissions, so they didn’t need as many allowances.

EU policymakers tried to rescue the scheme by reducing the number of permits and shifting to auctions instead of the free allocation of permits based on past emissions that had been used to launch the scheme. But the success of the carbon pollution emissions fees in the United States and China, combined with huge new revenue demands associated with aging populations and periodic crises such as the periodic need to bail out fiscally profligate members in the southern tier, made carbon taxes increasingly appealing. As emissions taxes increased an additional benefit became increasingly important: greater reliance on utility-scale solar from southern Europe and North Africa, and reduced reliance on Russia’s natural gas. Moreover, the EU has been able to eliminate expensive subsidies for solar, wind, and nuclear energy, which are now cheaper than their fossil fuel alternatives.

Today, the EU enjoys a situation similar to the United States, China, and other former major emitters: high and rising carbon taxes, sharp cuts in other more distortionary and growth-reducing taxes, and a boom in clean energy investment and job growth.

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The rest of the world falls in line

With the United States and China moving to put in place carbon pollution fees, and Europe rapidly moving in a similar direction, other major emitters followed suit with surprising speed. In hindsight it now seems obvious that first Brazil, then India, Indonesia, South Africa, and finally even Nigeria would move to take advantage of the potential revenue from carbon pollution fees. In many cases ease of collection was a major consideration, since the fees could be collected from a relatively small number of firms and locations, as fossil fuels were extracted from the earth, at the mine mouth or wellhead. Before it happened, of course, it seemed unlikely that countries would move with such speed.

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The IMF weighs in

An important analytical contribution to the transition had come from an institution that many people initially regarded as an unlikely source: the IMF. In a June 2012 speech at CGD, IMF managing director Christine Lagarde spoke forcefully about a “triple crisis” threatening global stability: “an economic crisis, an environmental crisis, and increasingly a social crisis.” [62]

“Getting the prices right means using fiscal policy to make sure that the harm we do is reflected in the prices we pay,” she said. “I am thinking about environmental taxes or emissions trading systems under which governments issue—and preferably sell—pollution rights. It is basically a variation of the old mantra: you break it, you buy it.” Such fees had the double advantage of raising revenue and cutting pollution, she explained, adding that the IMF would begin providing member countries policy advice on carbon pricing.

The following year the IMF released a study that quantified and sharply criticized energy subsidies [63] , the vast majority of which at that time were going to climate-damaging fossil fuels. While supporters of such subsidies often defended them on the grounds that they protected consumers, the IMF concluded that energy subsidies “aggravate fiscal imbalances, crowd out priority public spending, and depress private investment, including in the energy sector.” The subsidies also encouraged excessive energy consumption, artificially promoted capital-intensive industries, reduced incentives for investment in renewable energy, and accelerated the depletion of natural resources, the IMF study found. Moreover, “most subsidy benefits are captured by higher-income households, reinforcing inequality.”

The IMF study estimated global fossil fuel subsidies were an eye-popping $1.9 trillion a year, equivalent to 2.5 percent of global GDP. This included some $488 billion—roughly a quarter—in “direct” or consumer subsidies, those provided mostly in developing countries to hold down consumer prices. The far larger share, however, was so-called “indirect” subsidies—the lack of taxation on emissions corresponding to the damage that they were inflicting. The IMF included in these damages “the effects of energy consumption on global warming; on public health through the adverse effects on local pollution; on traffic congestion and accidents; and on road damage.” These the IMF estimated to be $1.4 trillion per year.

The IMF estimate was based on the assumption that the damages caused by a ton of carbon emissions—the social cost of carbon, or SCC—was about $25, an amount based on the findings of a US Interagency Working Group on Social Cost of Carbon. That number seems laughably small today, when the US SCC has been repeatedly revised upward and is now more than $100 a ton and the average global carbon pollution fee is already at $50 per ton and rising fast. Already in 2013 the US SCC was recognized as being too low. In 2012 a paper by Laurie Johnson and Chris Hope published in the Journal of Environmental Studies and Sciences presented evidence that the proper SCC—and therefore the appropriate level for a carbon pollution fee—should be somewhere between “2.6 to over 12 times larger” than the US government’s official figure. [64]

In August 2014 the IMF weighed in with a new book, Getting Energy Prices Right: From Principle to Practice, [65] released to a standing-room-only audience at CGD. The book, by Ian Parry, Dirk Heine, Eliza Lis, and Shanjun Li, built upon the growing consensus that fossil fuel taxes should take into account their negative impacts on problems such as climate change, air pollution, and road congestion and offered a practical methodology and tools for calculating appropriate tax levels for the four most widely used fossil fuels: coal, natural gas, diesel, and gasoline. The pathbreaking study applied the model to suggest specific tax levels for 150 countries for each of the four fuels, taking into account differing local and national conditions (for example, population density when calculating the health costs of conventional pollutants).

The report concluded that: “there is pervasive mispricing of energy across developed and developing countries alike… At a global level, implementing efficient energy prices would reduce carbon emissions by an estimated 23 percent and fossil-fuel air pollution deaths by 63 percent while raising revenues (badly needed for fiscal consolidation and reducing other burdensome taxes) averaging 2.6 percent of GDP.”

Returning to CGD in 2014 to launch the new book, Lagarde was careful to stress that the additional revenues should be offset by reductions in other taxes that put a drag on the economy. “Let me be crystal clear,” she said, “we are generally talking about smarter taxes rather than higher taxes. This means recalibrating tax systems to achieve fiscal objectives more efficiently, most obviously by using the proceeds [from fossil fuel taxes] to lower other burdensome taxes. This revenue could also be used for spending priorities, or to pay down public debt.”

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The World Bank and others

The World Bank, too, played a role, helping to bring the conclusions of climate scientists regarding the risks to developing countries of runaway climate change to the attention of a much wider audience. Soon after he became president in 2012, Jim Kim lent his authority to the release and promotion of what was soon to become the bank’s most downloaded report ever:Turn Down the Heat: Why a 4°C Warmer World Must Be Avoided. [66] “Even with the current mitigation commitments and pledges fully implemented, there is roughly a 20 percent likelihood of exceeding 4°C by 2100,” the report warned.

“A 4 degree warmer world can, and must be, avoided—we need to hold warming below 2 degrees,” Kim said at the release of the report. “Lack of action on climate change threatens to make the world our children inherit a completely different world than we are living in today. Climate change is one of the single biggest challenges facing development, and we need to assume the moral responsibility to take action on behalf of future generations, especially the poorest.” [67]

While the bank at the time saw its role primarily in terms of providing finance for climate adaptation, throughout the teens and 2020s World Bank advice and support to countries in administering direct transfers of carbon tax revenue became increasingly important. This activity complemented the IMF advice that was helping countries to generate their own revenues for development and climate change adaptation while at the same time reducing their emissions.

Besides R Street, CCL, the IMF, and the World Bank, many other research and advocacy organizations contributed to the consensus in favor of action, and carbon taxes in particular.

Already in 2006 the World Resources Institute (WRI) had published a remarkable issue brief jointly authored by Craig Hansen, a senior associate at WRI, and James Hendricks Jr., a vice president for environmental health and safety policies at Duke Energy, the largest electric power holding company in the United States and a major emitter that nonetheless backed efforts to charge for carbon pollution. Hansen and Hendricks offered a prescient summary of the advantages of carbon taxation: “policymakers should consider a type of consumption tax new to the United States—an initially modest but gradually increasing tax on the carbon content of fossil fuels—that could generate billions of dollars of revenue, which could be used to finance other reforms of the tax code.” [68]

As the movement for carbon taxes gained momentum in the United States and China, WRI played a critical behind-the-scenes role fostering information exchange and helping the two big emitters to coordinate the rollout of the new policy. WRI president Andrew Steer, an environmental economist who had previously served as the World Bank’s climate envoy and director general of the United Kingdom’s Department for International Development, used his personal connections, trust in WRI in developing countries, and the institute’s global presence, with offices in China, Brazil, India, Indonesia, and Mexico, to gain understanding and support for the new approach. WRI also conducted research and organized a series of international policy forums on critical technical issues in the collection and utilization of carbon tax revenues, accelerating the spread of the new policy approach.

Similarly Resources for the Future conducted extensive research on the design and implementation of carbon taxes, including revenue potential and the likely impacts on carbon emissions, employment, transportation, inequality, and US competitiveness. [69] These and similar studies at other think tanks and universities provided a solid analytical basis for the design of effective legislation once it became apparent—through the efforts of CCL and others—that by framing a US carbon tax as key to overall tax reform and the reduction of other, less popular taxes, a revenue-neutral carbon tax could be a political winner. [70]

Check back tomorrow for the finale of this five-part series.

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