Market efficiencies are touted as a carbon tax benefit. This is a misconception; a myth easily belied. Markets have buyers and sellers. A commodity’s price rises and falls to sync supply with demand. If supply is short, the price rises until new suppliers find the market attractive and enter or existing buyers find the market too expensive and leave. If supply is long, the price falls and the least efficient suppliers, finding the market unprofitable, leave, and new buyers, attracted by lower prices, enter.

In The Conservative Case for Carbon Dividends, the Climate Leadership Council ties its carbon tax and dividend proposal to market economics:

Any climate solution should be based on sound economic analysis and embody the principles of free markets and limited government.

A carbon tax would send a powerful market signal that encourages technological innovation and large-scale substitution of existing energy and transportation infrastructures, thereby stimulating new investment.

For the elimination of heavy-handed climate regulations to withstand the test of time and not prove highly divisive, they must be replaced by a market-based alternative.

A carbon dividends plan offers an opportunity to appeal to all three key demographics, while illustrating for them the superiority of market-based solutions.

Republicans now have a rare opportunity to set the terms of a lasting market-based climate solution that warrants bipartisan, industry and public support. No less important, this is an opportunity to demonstrate the power of the conservative canon by offering a more effective, equitable and popular climate policy based on free markets, smaller government and dividends for all Americans.

A carbon tax, however, only creates carbon tax payers and carbon tax collectors. It does not create carbon buyers and sellers, yet, a carbon market cannot exist without them. A carbon tax is largely incompatible with a carbon market. I am reserving for a later post a discussion of the auctioned cap and trade, which certainly has buyers and sellers and, therefore, a regime resembling a market. The cap and trade auction price, however, is set, not by balancing supply and demand at the lowest cost, but by the most profitable placing the highest bid. This risks placing compliance out of reach for those less profitable, but who may nevertheless be valuable to our economy.

While a carbon tax encourages tax avoidance and, therefore, emission reductions, paying a tax bill or avoiding it involves neither buyers nor sellers. Paying a tax is not a purchase; avoiding a tax is not a sale. A tax, standing alone, is not a market.

If a carbon market could be an add-on to a tax and dividend program, just how such trading could work is not clear. What would be traded? Presumably, emission reductions; there is nothing else. If, for example, my facility emitted 100 MT (metric tonnes) of CO₂ last year and this year I cut those emissions to 90 MT, have I created 10 MT of salable emission cuts? If there is to be an emissions market, yes.

Under a tax, however, the economic reward for cutting emissions is a smaller tax bill. Emission cuts that both lower my tax bill and are sold in a market, therefore, would be a double dip. Whether this is good, bad or in-between bears discussion.

Double dipping would certainly encourage me to cut more emissions. Assume a 40 $/MT tax. Without double dipping, I will pursue emission cuts costing $39 or less and, therefore, lower my overall costs by $1 or more per tonne cut. More expensive cuts will have no benefit. With double dipping, I will save $40 in tax and, in addition, reap up to $39 from selling the resulting $40 tax credit. (No one would pay $40 for a $40 tax credit; paying the $40 tax will be less complicated.) My incentive, therefore, is to pursue emission cuts costing 79 $/MT or less. With that higher incentive, I will generate more emission reductions than possible under a $40 tax without tradable credits. Voila! Double dipping has just nearly doubled the economic incentive for cutting GHG emissions. Or, has it?

What happens on the other side of the trade? The credit purchaser buys a credit for $39 and avoids a $40 tax. The buyer will not be cutting emissions with this credit. The credit has no value for that purpose. Instead, the buyer may maintain the same emissions and lower its tax bill by $40, increase emissions by a tonne and pay the same tax bill or do something in between.

All told, carbon tax collections have been reduced by up to $80 for each tonne cut — $40 in tax savings for the tonne eliminated at my plant and up to $40 for the tax credit redeemed by the purchaser. (See “Eating One’s Young” regarding lower carbon tax revenues and political consequences.) Actual emissions, on the other hand, will be cut by, at most, one tonne, with a real risk of no cuts at all. My plant will have cut emissions by a tonne, but the credit purchaser’s emissions will be the same or up to one tonne higher for every credit purchased.

Attaching a market to a carbon tax may encourage higher cost emission cuts for the credit seller but has the potential to double the tax revenue loss for each tonne cut or, worse, simply see emission cuts resurface as increases for the credit buyer. This is not how a market should work.

On the other hand, a tax and market program with no double dipping is impossible. Eliminating double dipping means an emission cut may be used either to lower one’s tax bill or to be sold, but not both. If the cut lowers one’s tax bill, there is no market transaction. On the other hand, a single-dip credit will never be traded. Under a $40 tax, a credit must fetch $40 or more in the market. If the credit trades for less, a seller will simply keep it and save $40 in taxes. A buyer, however, will not pay more than $40 for a credit worth only $40 in tax savings. A tax and market structure cannot work without double dipping.

Taxing and pricing carbon does not a market make. A carbon tax is certainly a financial incentive to cut emissions. Nothing, however, is marketed without a tortured structure that at best lowers tax revenues with no emission cuts and may double tax losses for cutting a single tonne. Describing a carbon tax as a market mechanism with market incentives and market efficiencies is simply wishful thinking, if that.

Best,

Bob