Carbon Tax, Its Purpose, and How It Works

How a Carbon Tax Can Solve Climate Change

Jet emitting CO2
•••

Alex Williamson/Getty Images

carbon tax is a fee that a government imposes on any company that burns fossil fuels. The most widely-discussed are coal, oil, gasoline, and natural gas. When these carbon-rich fuels are burned they produce greenhouse gases. These gases, such as carbon dioxide and methane, create global warming by heating the atmosphere. The resultant climate disruption causes extreme weather such as heat waves, flooding, blizzards, and droughts.

Purpose

The purpose of a carbon tax is to reflect the true cost of burning carbon. Those costs are borne by those who suffer from the effects, such as homeowners, farmers, and ultimately the government. Carbon taxes make sure companies and consumers pay for the external costs they impose on society. It is a Pigovian tax since it returns the cost of global warming to their producers. 

The Federal Reserve blames the lack of a national carbon tax for climate change. Businesses and households are not accurately charged for using fossil fuels. The Fed calls this "a fundamental market failure."

The Fed also warns that this failure could lead to another wide-scale economic crisis. Extreme weather is forcing farms, utilities, and other companies to declare bankruptcy. As those loans go under, they will damage banks' balance sheets just like subprime mortgages did during the 2008 financial crisis.

For example, the Pacific Gas and Electric company went bankrupt in 2018. A federal judge found it responsible for the deadliest fire in California history, the Camp Fire. The company estimated it would cost between $75 billion and $150 billion to comply with the judge’s maintenance plan. Investigators found that poorly-maintained PG&E equipment had caused 17 wildfires.

How It Works

To implement a carbon tax, the government must determine the external cost for each ton of greenhouse gas emission. This is difficult because scientists and economists must first agree on which assumptions to use. 

One group, the U.S. Interagency Working Group on Social Costs of Carbon, developed an estimate of $40 per metric ton. A tax reflecting this social cost would increase gas prices by 36 cents a gallon. It would add $0.02 to the price of a kilowatt-hour of electricity. 

A United Nations report said the price should be much higher to keep temperatures from rising above 1.5 C by 2030. It recommended a carbon tax of between $135 and $5,500 per ton.

recent report from the Organization for Economic Cooperation and Development found that the average carbon price across 42 major economies was around $8 per ton in 2018. The price differential means governments find it politically difficult to charge enough to reduce emissions significantly.

Advantages

The tax reduces emissions in two ways. First, increasing the cost of carbon-based fuels will motivate companies to switch to clean energy. These include solar, wind energy, and hydro-powered sources. 

The carbon tax will also increase the price of gasoline and electricity. Consumers will then become more energy efficient, further reducing greenhouse gas emissions.

Taxes allow industries to find the most cost-effective ways to reduce carbon emissions. That's a better alternative to free-market economies than government regulation. 

For that reason, even oil companies support the tax. ExxonMobil, Shell, and BP have all called for the tax. Exxon even donated $1 million to the nonprofit that supports its preferred plan. BP’s chief executive has promised to cut emissions.

A carbon tax also boosts economic growth. For example, Sweden's carbon tax has reduced its emissions by 23% in the past 25 years. During that same period, its economy grew 55%.

A carbon tax raises substantial revenue. The Congressional Budget Office estimated that a carbon tax starting at $20 per ton and increasing to $34.40 per ton in 10 years could have raised $1.2 trillion. That's on par with the amount raised by all other excise taxes. 

The revenue can reimburse federal agencies tasked with dealing with the effects of climate change. These include:

  • The Federal Emergency Management Agency which deals with hurricane damage.
  • The U.S. Forest Service spent almost $2.5 billion in 2017. Fighting wildfires consumed 52% of its budget. This leaves little to spend on forest management.
  • The National Flood Insurance Program had accumulated $39.4 billion in debt by 2018.

Disadvantages

A carbon tax is regressive. By making fossil fuels more expensive, it imposes a harsher burden on those with low incomes. They will pay a higher percentage of their income for necessities like gasoline, electricity, and food. They can't afford to switch to electric vehicles.

For this reason, a carbon tax must be introduced gradually to be successful. A one cent per year guaranteed increase in gasoline taxes would give consumers time to shift to more economical vehicles. Knowing gas prices would always go higher would help them make that shift. Some of the revenues collected could go to lower-income families. But that's probably not enough of an increase to make a significant dent in CO2 emissions.

To meet the Intergovernmental Panel on Climate Change’s temperature-rise targets, the United States must reduce fossil-fuel-based energy demand by 85%. To do that, the prices of those sources should increase by 44 times. The government should use a carbon tax along with other alternatives. 

Doubling the price would be enough to shrink energy use by 29%. If gas prices were $5 or $6 a gallon, 29% of the users would find alternatives. But quadrupling the price would not reduce usage by 58%, as you would guess. It would only reduce it by 50%. Some people don't have alternatives and others would not give up their vehicles. That's called the price elasticity. Energy is relatively inelastic

Facts

During the past century, America emitted most of the gases that are warming the planet today. Burning oil, coal, and natural gas create 82% of U.S. greenhouse gas emissions. Methane generates 9%, nitrous oxide adds 5%, and refrigerants and other sources make up the rest.

The International Energy Agency recommended that no more than a third of the world's remaining reserves of fossil fuels should be burned by 2050. Otherwise, the CO2 will heat up the atmosphere to a dangerous level of 2 degrees Celsius above pre-industrial levels.

Today, China emits the most greenhouse gases, followed by the United States. But Americans emit the most per person. They comprise 5% of the world's population and emit 20% of its gases. That's five times more than a non-American.

The map below illustrates the annual amount of CO2 emissions by country.

Carbon Tax Plus

Given its challenges, the carbon tax should be used in conjunction with other measures. Here are five other solutions to global warming that should be implemented.

  1. End government subsidies to coal, oil, and gas companies. They cost the government $25 billion a year. But their elimination would only increase prices by 2%-3%. 
  2. Subsidize wind, solar, and hydropower. They have lowered the cost and attractiveness of these alternatives, but much more needs to be done. Subsidies have only increased wind and solar power to 8% of U.S. electricity generation. That's not enough to halt global warming.
  3. Increase energy efficiency standards. President Obama imposed standards on appliances and the U.S. auto industry. Increase auto emissions standards. Require utilities to increase their usage of renewable energy. Require improved building efficiency.
  1. Build more public transportation. Redesign cities to reduce the need to drive cars. This is also one of the four best ways to create jobs. A University of Massachusetts at Amherst study found $1 billion spent on public works created 19,975 jobs. Tax cuts created 4,600 jobs for every $1 billion in foregone tax revenue. 
  2. Implement carbon emissions trading. This policy allows companies to buy or sell government-granted allotments of carbon dioxide output. Governments distribute a finite number of CO2 “credits” to companies. That’s the “cap” part. The companies can only emit as much CO2 as they have credits for. Those below their CO2 limit can sell credits to companies that exceed the limit. That’s the “trade” part. Industries, like utilities, are the biggest traders. They burn coal and other fossil fuels that emit the most greenhouse gases.

    Status of U.S. Carbon Tax Initiatives

    On December 19, 2018, outgoing Senator Jeff Flake, R-Ariz., and Senator Chris Coons, D-Del., introduced a carbon tax bill. It would impose a tax of $15 per ton of carbon dioxide in 2019, increasing $10 each year, rising to almost $100 per ton by 2030. It would distribute the proceeds as a flat monthly rebate to American households. The rebate softens the blow of higher energy costs. The progressive rebate distributes more to low-income households.

    The Senate bill is similar to a bipartisan carbon tax bill introduced in the House in November. That bill was the first bipartisan carbon tax legislation introduced in almost a decade.

    On November 7, 2018, Washington state voters rejected a carbon fee of $15 per ton of carbon pollution. If it had passed, Washington would have been the first U.S. state to do so. The tax was to be paid by fuel distributors, utilities, and other large emitters. It would add 14 cents per gallon to the cost of gasoline. It would have started in January 2020 and increased each year by $2 per metric ton, with an adjustment for inflation. The estimated $2.3 billion collected would have paid for pollution reduction and forest health programs, according to the New York Times.

    It would have raised $1 billion a year by 2023. It would have funded proposals to reduce carbon emissions. It would also set aside funds to help low-income families, who would be hit hardest by the fees.

    Examples of Where Carbon Taxes Are Used in the World

    The World Bank reports that 40 countries and 20 municipalities use either carbon taxes or carbon emissions trading. That covers 13% of annual global greenhouse gas emissions. 

    The World Bank adds that there are a total of 88 countries who intend to use a carbon tax to meet their Paris Agreement goals. This represents 56% of global emissions. In addition, there are 51 regional and local initiatives.

    In 2018, Canada imposed a national carbon tax of $15 to $30 a ton of CO2. This will increase to $38 a ton by 2022. Most of the revenue will be refunded to individuals on their tax bills. Canada is warming twice as fast as the rest of the world.

    In 2013, Britain imposed a $25 tax per metric ton of CO2. As a result, utilities switched from coal to natural gas. Greenhouse gas emissions fell to their lowest level since 1890.

    There are at least 10 U.S. states that have capped greenhouse gas emissions from power plants. They also require companies to buy tradable pollution permits.

    The Bottom Line

    Carbon taxes should be part of any solution to slow global warming. They do work to discourage fossil fuels. But to cut usage enough to make a difference, they would have to be prohibitively high. So other measures, such as an end to subsidies for the fossil fuel industry, must also be used. Contact your U.S. Representatives and Senators and tell them your ideas.