Carbon taxes a mixed blessing for the climate

The costs of human changes to the climate are becoming clearer by the day, from flooding and storm surges driven by sea level rise to temperatures in India so extreme that they cause illness and death to humans, animals and crops. So it is encouraging to see members of both political parties in the United States now taking climate change seriously enough that they are willing to break with party to propose a carbon tax.

While such a tax has many merits, including focusing attention on the need to replace fossil fuels with alternative energy sources, unless it is levied at a rate far in excess of current proposals it won’t reduce carbon emissions enough to make an impact on climate change. There are much better ways of accomplishing this.

{mosads}The economics of oil and gas in the Middle East illustrates the problems with using a carbon tax to reduce emissions. For example, Saudi Arabia can extract oil at around $5 per barrel, which will sell today for around $70. That’s a profit of $65 on a $5 investment. If a carbon tax was imposed — in the ballpark of $30 per ton of carbon dioxide emitted — it would add about $12 to the cost of a barrel of oil, reducing profits to about $53 on a $5 investment. Still a very attractive deal and not enough to discourage sales.

In fact, the only oils to be negatively affected by such a tax are oils whose costs are within $12 of the market price, which today would mean costs in excess of $58 per barrel. Sadly, relatively few oil fits into this category: oil from some very deep-water oil fields, and oil from some of the Canadian Oil Sands. Most mainstream oil fields would continue to be profitable.

If oil were a manufactured commodity, such as a computer chip or a piece of clothing, a drop in profitability would logically lead to less production, but oil is not a manufactured good. It is an exhaustible natural resource that is available to us whether we choose to use it or not. For this reason, as long as its extraction is profitable, it will be extracted. And at the rates that carbon taxes are being proposed, extraction will be profitable from most fields.

A detailed analysis does show that the tax will have some initial impact on emissions. It will lead to a rescheduling of extraction, with extraction occurring more slowly to reduce emission readings at any given time. Consumption will also decrease because some of the tax will be passed on to consumers, who will use less oil as a consequence. But this reduction will be offset by the fact that oil, as an exhaustible resource, will remain in use for longer than it would without a tax. In essence, consumers will use the same amount as before the tax, only more slowly. 

What are the policy implications of this finding? One is that if we are to rely on a carbon tax to avoid damaging climate change, it needs to be a big one, large enough to make a lot of oil reserves unprofitable. A tax of $100 per ton of carbon dioxide emitted would reduce the value of oil by about $40 per barrel, meaning that, at current prices, only oil costing less than $30 would remain profitable. This would eliminate oil sands, new deep-water oil, much new offshore oil, and most tight (fracked) oil. It would, however, leave a lot of conventional on-shore oil and offshore wells, whose capital costs have already been sunk. It would also raise the price of gasoline by about $1 per gallon, which would encourage switching to electric vehicles. This rate of carbon tax would be a good starting point, but it would need to rise over time.

An alternative would be to exchange a tax system for another market-based approach, a cap and trade system. California, the Northeastern United States and the European Union all have cap and trade systems for limiting carbon emissions, so we have plenty of experience to draw on. At the federal level, we have been successfully using cap and trade to reduce emissions of sulfur dioxide (an acid rain precursor) from power stations since the Bush 1990 Clean Air Act Amendment. The core component of a cap and trade system is the cap, a firm limit on total emissions. An environmental agency issues permits to emit up to a total equal to the cap, and anyone selling a fossil fuel has to have a permit for the emissions it will generate. For greenhouse gases, the cap can be set low enough to ensure that we reduce climate risks.

Emerging discussion of a carbon tax is promising, but let us not delude ourselves that a $30 or even $40 tax will achieve anything for the climate. To save our environment, we need a tax of at least $100 per ton of carbon dioxide, or we need to think laterally and replicate our successes with cap and trade system.

Geoffrey Heal is the Donald C. Waite III Professor of Social Enterprise and a Chazen Senior Scholar at Columbia Business School. His latest book, Endangered Economies — How the Neglect of Nature Threatens our Prosperity, sets out the economic and business case for environmental conservation.