A (hopefully) feasible plan to save the world

Our atmosphere is a global common good. We only got one, and we all have to live with the one we are creating collectively. At the moment, we are pumping a whole lot of CO2 into it. It’s the byproduct of using fossil fuels. Almost all of our economic activities, wealth and well-being rely on fossil fuels in one form or another. They have virtually cured poverty and hunger in the developed world. And developing nations are gearing up to improve the lives of billions of their citizens using them as well.

Our best current science tells us, that putting CO2 into the atmosphere will increase the average temperature of the earth. This is projected to have severely negative consequences on our or our children’s lives. Extreme weather events like floods, droughts and storms are predicted to become more common and devastating, diminished levels of food security, rising sea levels, dying coral reefs, forests, panda bears and everything else that’s living, as well as hundreds of millions of displaced “climate migrants” are anticipated.
The stakes are high, and it seems obvious that “we must do something”.

But why is it such a thorny problem then?

The economics of climate change

Let’s start with the obvious. The atmosphere is a common good. And indeed, it suffers from all the problems associated with common goods: over-usage, under-investment, diffuse responsibilities and rights.
Typically, these kinds of situations get solved by appealing to an authority that can enforce the “reasonable” usage of the common good.
But there is no global authority and it doesn’t look like there will be one soon. All efforts in that direction got stifled by national politicians …. and electorates, at least when they are asked. It just doesn’t seem like a too popular idea.

Without a global authority, managing the atmosphere becomes a multi-party coordination problem. And, unfortunately, it has the economics of another economists’ headache: the prisoner’s dilemma.

The problem is that each individual actor (=state) gains individually at the expense of other parties by doing what’s best for the individual actor and not what’s best for all.
Doing nothing but demanding that other actors do their part becomes the best, rational strategy.
Selfishness (or nationalism) pays off politically and economically. At least in the timeframes that matter for most elected politicians.

This is in my opinion the reason why the “traditional” approach towards curbing emissions, which were modeled after successful international agreements for the ozone layer, nuclear proliferation and acid rain, failed miserably.
Those successful agreements dealt with another class of problems. It seems like climate change needs a different set of tools. We had our great summits and protocols:
Rio, Kyoto, Paris. Names associated with great hopes and promises and depressingly little to show for. They never came anywhere close to Montreal or Vienna.
The incentive structure of voluntary, unenforceable agreements promote free-riding, which is exactly, what has happened and is still happening. A complete validation of what mainstream economics would predict for the class of economic problems, climate change is in.

The third major problem with the economics of “climate change” is that the costs of the economic activity are decentralized, diffuse and delayed. These costs are what economists would call a “negative externality”. Something that doesn’t immediately affect the bottom line of an economic actor, but is instead a cost to society at large.
The standard approach, if these externalities become too large, is to enact a regulation to “internalize” these costs.
This simply means: Make people pay for their pollution! The idea is, that you can manage what you can measure. If you know how much you have to pay for polluting, odds are you will try to minimize these costs.
We haven’t come up with a better idea than using the instruments of the state to enforce a price.

To recap, besides the technological challenges we will have to deal with to effectively combat climate change, which are humongously huge and the topic of a future post, there are 3 economic problems:
there is no global authority to manage global common goods, multi-party agreements suffer from the prisoner’s dilemma and the cost are invisible to individual economic actors.

Phew, that sounds hard! And of course we shouldn’t be surprised at the failures of our current attempts to manage this problem. Remember that even the voluntary, unenforecable commitments of the Paris climate accord didn’t add up to what would be necessary to keep the rise of global temperatures below 2°C.
Please stop for a second and do realize what that means: even when we are talking about lip service that comes at no real cost for any of the countries, you could not get where we need to get according to our best current science in that field!

Does that mean it’s all over? I am not there yet. Let’s look at what we can do in individual countries. Maybe something good can come from that globally.
If we think about what a government can do, collecting money form economic actors is something they excel at. What happens, if they just do that?

Putting a price on CO2

There are at least 3 major ideas for putting a price on carbon:

1. an implicit price by implementing certain technological regulations

2. A cap & trade scheme

3. and a tax on carbon.

There are of course real world examples of regulations that were put into place with the explicit goal of enforcing certain efficiency standards (think minimum standard for fuel efficiency on automobiles or standards for refrigerators) or boosting nascent technologies (solar panels or heat pumps). Such regulations give rise to vastly different prices on carbon per sector of the economy, are hardly predictable by market participants and are rife for political pork-barrelling and regulatory capture. I think this approach has too many downsides and will not be greeted with a sufficient level of enthusiasm in the electorate or the political movements to be worth considering. On the other hand, Ted Nordhaus recently argued for clandestine political backroom dealings as probably more effective way to get to a price on carbon, because it creates at least “some” price, which is preferable to “no price at all”. If these were the only options remaining, I’d support his approach, but I still got hopes for a better approach, which will be outlined later on. As for now, I will not further look into regulations to impose a price on carbon.

Next up: Cap & Trade

A Cap & Trade scheme means that a state sets an upper bound on how much CO2 it wants to be emitted within its borders. This limit is supposed to decrease every year.
Then financial instruments, so called “certificates” are created. Each of these certificates allows the owner to emit a certain amount of CO2.
So lets say a country does not want to emit more than 1 GtCO2 (~2.5% of current global annual emissions). So they could create 1 billion certificates, each allowing the owner to emit 1tCO2. There are different ways to distribute these certificates; auction them off at the beginning of each year, hold monthly or weekly auctions or distribute them for free.
It’s important to mention that these certificates are tradable.
The main idea is: if you are the holder of a certificate and there are methods to decrease your carbon footprint, like installing LED lighting, that are cheaper to implement than the current price of a certificate is, it becomes profitable to reduce emissions and sell off the certificate to somebody that has more problems in reducing CO2 emissions, like a cement kiln. Theoretically, the trading encourages the most cost efficient decrease of CO2 emissions, because the distributed market participants know best how they can reduce their CO2 emissions
There are a couple of criticisms to this:

1. Because you need to participate in a regulated market, only major emitters (power and cement plants, steel mills, other companies above a certain size etc.) are made involuntary participants. So you only ever cover a portion of the entire economy.

2. There are middlemen on the market, who might profit from this scheme, without immediate benefit on CO2 emissions or the economy at large.

3. Lobbyists of the few affected sectors of the economy could use their political clout to get lenient reduction targets.

4. The price of emission certificates is a spot price. It’s hard to predict what the long-term costs of carbon and therefore the profitability of investments will be.

Then there are carbon taxes.

The main idea: the state charges a fee for the carbon content of fossil fuels at the source. So for each gallon of oil, for each cubic foot of gas and every ton of coal you extract from the ground, you levy a fee. Additionally, you levy the same fee on imported fossil fuels at the port of entry. This fee covers every entity in an economy that uses fossil fuels.
Each and every product will “inherit” this tax in proportion to how much emissions are “embodied” in it. If you have an energy intensive good like a car, there will be a lot of embodied emissions in the steel and electronics. The price on carbon will be set according to a predictable scheme, like starting at X$ and increasing Y$ every year or Z% above the inflation rate. In contrast to the Cap & Trade approach, the price on carbon dioxide is non-volatile and insensitive to external factors like a recession, which would tank the price of CO2 emissions in the Cap & Trade scheme.
A downside is that there is no maximum amount of carbon emissions. If market participants are willing to incur the costs, every level of carbon emissions is feasible.

Both of those approaches will have a problem, if there is no globally agreed upon scheme.

If, let’s pick something randomly, Germany implemented a Cap & Trade mechanism, but another country, let’s say China, fails to do so, German steel mills will have to add the price of the carbon certificates to their product, while the Chinese steel mills would not.
This spells doom for German steel mills in a globalized market. And might even help to price the more energy efficient plant out of the market!

So for these schemes to work, there either need to be global agreements that countries promise to adhere to or another mechanism has to be found to eliminate free-riding.
Again, I’d be pleasantly surprised to see an international agreement on climate that actually works. Maybe I am too pessimistic or cynical, but I don’t hope to see this anytime soon. We’d be back at square one.
But there is another well-known mechanism left. And there is hardly anything that incurs more scorn from economists than it:

I am talking about tariffs or border-adjustment taxes.

If the price of imports gets increased by the amount of carbon in it, and each export is rebated by the carbon price (similar to how VATs are handled), every country could individually set whatever carbon price they deem appropriate.
Without such a mechanism, the introduction of carbon prices seems like an exercise in political masochism and a sure-fire way to lose the competitive edge of an economy. And probably one of the next elections.

So there might be a path to put a price on carbon locally, without automatically wrecking your economy. Of course that would also reduce your carbon emissions, but I think it’s not exactly what people would vote for.

Spending the revenue

Let’s now look at what we are going to do with the money that gets collected by the states.
Again, there are 3 major options for getting rid of the money:

• reduce other taxes

• spend

• pay dividends

If your goal is to keep the government roughly the size it is today in terms of a percentage of the GDP, you would probably like to keep the total level of taxes at the level they are at right now. There is nothing special or even optimal about the current level of taxes in my opinion, but the existence of a movement to reign in the growth of the state exists, and it might be a good idea to silence their criticism preemptively by making the price on carbon revenue neutral, i.e. the state should have the same amount of spendable resources as before the implementation of a price on carbon.

To achieve this, you could use the revenue generated by a price on carbon, either through auctions or fees, to offset other kinds of taxes, like the inheritance tax, corporate taxes or payroll taxes. While this might be popular with a lot of boardrooms around the country, the problem is that the distribution of taxes is highly unequal. A huge percentage of all taxes is paid by a rather small group of the population and, reversely, a huge part of the population doesn’t pay a lot of taxes on net.
If the revenues of a price on carbon were offset by taxes, this would probably be highly regressive, i.e. the poor and the middle class would pay the full price on carbon and have little to no reimbursement, while the better-off, who presumably produce more carbon emissions on a per capita basis than the poor, would get off-setting payments.
I think that there might be support for an idea like that in well-connected circles with a lot of political clout, but I don’t think that this would be a popular way to redistribute the money.

Alternatively, you can use the collected money and just spend it. Either on paying back debt, more social services or research on climate change mitigation and clean energy technology. There aren’t really any constraints on what you could do with the money, but I think a lot of people would want to have it at least earmarked to prevent it from going into the next bank bailout or military entanglement.
On net, you would just have levied another tax, which would probably have highly disproportional effects. While poorer people would not have extra resources to dodge the new tax, for example by upgrading their refrigerator, dryer or car to more energy efficient models, they will get hit with extra costs, which would need off-setting from other sources. Or the reduction of their spendable income is accepted by huge enough numbers to just tolerate it. But I think that’s unlikely.
The feasibility of this scheme would largely depend on how the money is spent.

The third alternative is to pay dividends.
All of the revenue of the price on carbon is divided into equal shares and handed back to the citizens. Every citizen gets the same share. Projections form the Department of the Treasury estimate the the bottom 70% of the households in the USA would earn more from the dividends than they pay in carbon prices. This would be highly progressive on net. It’s my assumption that a net positive income stream for 70% of the households might sway voters, even if they are not deeply concerned about the predicted effects of climate change.
And too many of the well-offs have publicly voiced their support for “immediate and harsh” measures to combat climate change, to credibly oppose marginal taxes on their resource consumption.

This following table is given for an easy comparison:

What plans are there?

I think the benefits of the “Fee & Dividend” scheme, especially the political feasibility and predictability of the carbon prices, are outweighing the drawback of no “guarantee” on the maximum amount on emissions.
Of course I am by no means the first to recognize this and there are already serious efforts to implement a scheme like this.

A prominent campaign that explicitly stresses its bipartisanship, is the “Climate Leadership Council“. This “climate coalition” has some prominent corporate members, like for example Microsoft, Ford, IBM, GM, Goldman Sachs, Exxon Mobil, Shell, Total, First Solar and the WWF. Individual founding members are 27 Nobel Laureates, all 4 former Chairs of the Federal Reserve and more than 3500 U.S. economists. Their so called “Baker-Shultz-Plan” is a “fee & dividend” scheme with an initial price of 40$/tCO2, a price progression of 5% points above inflation each year and border adjustment taxes. They’d also slash other regulations that put an implicit price on carbon dioxide, presumably to get more conservative leaning supporters on board. But you could also construe this as trying to get the most cost-efficient carbon reduction emissions, without the government picking which industries have to implement carbon reduction measures and which are exempt.

Another bipartisan plan, promoted by Daniel Miller and James Hansen is, at least to me, structurally the same. It starts at 15$/tCO2 and rises by 10$/y and demands a “Border Carbon Adjustment”. But it does not reduce already existing regulations.
This plan would get you to 105$/tCO2 in 10 years, while the Baker-Shultz-Plan would get you to around ~90$/tCO2, if current inflation rates are any guide for future inflation rates.

So there are ways to put a price on carbon, without wrecking your own economy that are actually looking quite feasible politically.
So is there a way to get other countries to do the same?

Getting countries to join the club

As already mentioned, the only practical and unilaterally enforceable way to make other countries pay, is to levy tariffs on their products when they enter an economy with a carbon price.
The “fair” way would to be to measure or estimate the exact carbon content of the imported products or materials (including fuels) and tax it accordingly or count it against emission certificates. And the Baker-Shultz as well as the Miller-Hansen plan call for exactly this type for adjustment.

But this is hard, complicated and will get people into the weeds of a how a certain T-Shirt was actually made using “this new process” and is therefore not weighing in at 15kg of CO2 but only at 13.6kg.
This setup would be rife with political pork-barrelling, lobbyism and inefficiencies.

Another way to set tariffs, proposed by William Nordhaus, is to use them to create a club. There is a growing literature about the economics of “clubs”. Suffice it to say that they are an effective way to get out of undesirable economic setups, like the prisoner’s dilemma.

This club has tough doors: adherence to certain, mutually verifiable carbon accounting practices and a mutually agreed upon price on carbon are needed to get in.

The focus on the price of carbon adds a non-obvious benefit: when you are in a negotiation, it is easier to bargain about one quantity; in this case the dollar amount per t/CO2. If the countries were negotiating about emission caps, they’d want a high cap for themselves and low caps for everybody else. Reducing the complexity to a single number will most likely aid in finding an agreement.

There would not be any rule about how to get to that carbon price; whether a tax, Cap & Trade scheme or regulations are used, it doesn’t matter.

Like all club owners, you have to make your club attractive, if you want to run it successfully. To make this particular club attractive, the members would levy uniform tariffs on all goods coming from countries that aren’t members. Let’s say 10%.

Bear in mind, that you have to change the global incentive structure, if you want to get anywhere with the climate question. Using the club as club to encourage non-member states to reconsider joining might lack a certain degree of diplomatic subtlety, but this is supposed to get things done.

The (hopefully) feasible plan

This leaves us with a proposal that I hope makes Ted Nordhaus’ fallback option unnecessary:

• implementation of carbon dividends

• removal of regulations that impose a higher price on carbon

• a monotonically increasing carbon price. I’d propose to use the Miller-Hansen progression initially and kick the determination of each year’s progression off to a simple, public algorithm later on. Inputs should at least be CO2 emissions, economic growth and unemployment numbers.

• uniform tariffs on imports. Set at an arbitrary value, like 10% initially, determined by a simple, public algorithm later on.

• diplomatic efforts to get other countries to form a club. These can, but don’t necessarily must be conducted before a major consumer country, like the USA, implements this or a similar scheme. Members of the club don’t levy tariffs on each other.

• net-negative CO2 emissions from sequestration are remunerated (i.e. deep geological storage, as hydrates, mass wood or charcoal) in accordance with the risk of re-release of CO2 at net-present value.

I’d like to stress that this general setup of carbon dividends can also be used for another big climate problem: methane.

Methane

Methane, or natural gas, is a potent greenhouse gas. There are debates about how potent it is compared to CO2 and most sources I could find put it in the neighborhood of 25x as potent.
In his excellent recent book “The 1oo% solution” Solomon Goldstein-Rose cited almost 100x. His justification was that methane has a life-cycle in the atmosphere and the often cited numbers are the effect of methane averaged over its entire duration. If you look at the relevant timeframe of the next 30 years, however, it will be closer to his number.
I will let the experts decide on the best proxy number to use. But just as an example let’s say it’s 50x, the exact number is not really relevant.

I propose to levy a tax on the source of CH4. These sources are wells, landfills, cows, etc. It will be 50x the current CO2 price. What happens? Here is an example:
A well frees 100 units of CH4 from the ground. We’ll assume 2 units are lost because of bad sealings. 4 additional units get lost in the pipeline on the way to a customer. The customer uses 93 units for heating water, 1 unit is lost in a poorly maintained boiler.
Here are the economics of it: The well owner has to pay CH4 taxes on 100 units, but in the long run can only push the tax for 98 units to his costumer, the grid operator.
The grid operator has to pay for 98 units, but gets only reimbursed for 94 units.
The house owner has to pay a tax on 94 units and get reimbursed the difference between CH4 and CO2 for 93 units.
So the net taxes are 7 units of CH4 and 93 units of CO2. Just what you’d want to tax.

This puts economic pain on the actors that have a handle on the emissions. If it pays to install better well sealings, they will get installed. If it almost kills a grid operator to have leaky pipes, there will suddenly be maintenance crews and inspection robots all over the place. If it pays to have a well maintained boiler, the books of service technicians will never be empty

But how are we supposed to measure all of this? Well, I’d go with Nordhaus’ club again; assume the worst and be pleasantly surprised.

Put a blanket penalty on wells, like 2 standard deviations above the mean well, unless they can produce credible, auditable measurements of CH4 concentrations near the well-head. The difference between input and output of the grid should already be documented in the accounting of grid operators. How much did they buy? How much did they store? How much did they use? How much did they sell? The loss is taxed accordingly.
For homeowners, I’d go with another blanket assumption: a well maintained boiler is a boiler, that gets regularly checked by an authorized technician. If there is no documentation of such checks, there will be a tax on the bought amount of gas. The tax authority already knows this amount from the grid operators.
The same goes for landfills and cows. If there is credible, auditable documentation about the methane emissions, we don’t have to go with the worst case estimates. Totally up to the owners to document their efforts. Again, not really subtle. But effective, I imagine.

Final tally

To summarize: Given the barrier against free-riders and the progressive income effect, there seem to be few downsides to a Fee & Dividend scheme. The added friction on international trade and on accounting for fossil fuels has to be counted as cost, but as the carbon tax behaves structurally like a VAT scheme, which is operated successfully around the world, I think it can be handled internally with reasonable efficiency.

A carbon dividend, coupled with a club setup, should suffice to put a price on carbon globally – or at least in major emitter countries -and make it economical to scrutinize every country to adhere to the agreed upon price on carbon. There are steep penalties for non-compliance. I think this could change the economics of climate change into something workable. Will it be enough to “combat” climate change?

I don’t know. A lot of it will depend on technological advancements. But I think our odds of successfully dealing with climate change will increase significantly, if we make it profitable to deal with the problem.

To avoid giving you what Scott Adams would call a halfpinion, I should of course also look at the costs this scheme might have on developing countries.

If a country like Bangladesh has to adopt a carbon price on a level that is on par with Western countries to become a club member, I personally lack the confidence in the efficiency of that state to implement a comparable scheme to distribute a carbon dividend locally. I am always open for new data and being proven wrong, though. I also think that countries like Indonesia or India, which will need to deploy massive amounts of electricity capacity in the near future, will have a problem, if no clean alternative technologies for fossil fuel power plants are available. They will either incur a penalty designed to be disproportionate or they will slow down their development, which might be translated into an awful lot of lost QALYs (quality-adjusted life years).

I believe the net result of fighting climate change can be made positive, if the developed countries use the changed economic incentives to develop technologies for clean energy that can also be deployed at scale in developing countries.

We will talk about that in a future post.