The Carbon Tax Is Appropriately Rated

Evan Soltas had a post over at Bloomberg yesterday titled "The Carbon Tax is Overrated." In the place of a carbon tax, he proposes a carbon bond system in which polluters buy bonds that allow them to emit a specified unit of carbon pollution. The price of those bonds would be set at some existing estimate of the social cost of carbon pollution. When the bonds reach maturity, the holder of the bond would get back the difference between the bond's principle and an updated estimate of the social cost of carbon pollution. This would effectively create a future markets that speculates on the social cost of carbon pollution, which would theoretically be a more efficient way to price carbon emissions.

Although conceptually neat, a carbon bond system like that runs into a whole host of problems that the carbon tax does not. Most obviously, the futures market described above does not actually speculate on the social cost of carbon pollution. Instead, it speculates on what some government agency will estimate the social cost of carbon to be decades into the future.

In a hypothetical world, we could imagine that this agency would make an apolitical, good faith effort to come up with some estimate, but seeing as estimates of this sort are already all over the map due to the inherently complicated nature of coming up with them, such an agency would almost certainly be involved in a significant amount of arbitrary decision-making. With potentially billions of dollars turning on their eventual decision, the politics of that agency would be extreme, and anyone involved in that market would surely have to expect that, an expectation which would itself undermine the ability of the futures market to provide any meaningful estimates.

The bond program also seems to misunderstand the nature of the carbon pollution problem. The bonds are supposed to be sold and redeemed based on estimates of the social cost of a given unit of carbon pollution. But carbon pollution is not the sort of thing that imparts social costs per unit. The way climate experts describe it, it is not that each unit of pollution is a problem, but that a certain aggregate level of it is a problem. So a certain amount of carbon emissions has little to no social cost, then beyond that amount, there is an accelerating social cost of each unit, and eventually there is a tipping point that creates enormous social costs. So for instance, the marginal unit of carbon pollution that puts us over the point where the permafrost thaws and releases its bottled-up carbon -- that marginal unit of carbon pollution is massive costly. Because the social cost of carbon pollution is not even remotely consistent across marginal units of pollution, a bond program premised on that notion will be both a conceptual and practical failure.

This marginal measurement problem becomes more obviously problematic when you recognize that carbon pollution is a global phenomenon with global effects. Suppose the American polluters who bought these bonds restrained their pollution such that their pollution, by itself, would not have imparted very much social cost on the people of the globe. But non-American polluters -- who are not bound by the bond system -- polluted so much that global carbon levels went way over the tipping point, and we still saw extreme social costs. What was the marginal social cost imparted by the American polluters? It is impossible to say, and the question itself is a tad bit incoherent. Due to the global nature of the carbon problem, trying to account for marginal social costs per unit via a bond program that is constrained to one country makes little sense.

What is nice about a carbon tax, in addition to its simplicity, is that it lets you easily target carbon levels. If the present levels seem too high, you just keep ratcheting up the tax until you get them where they need to be. A carbon bond system could sort of do this, but you'd have to constantly adjust up the principle of newly-issued carbon bonds, a move that itself undercuts the fundamental organizing principle of the bonds, which is that carbon pollution imposes roughly uniform social costs per unit. Because a tax is more competent at targeting aggregate carbon levels -- levels being the big problem here, not unit social costs -- it is a preferable solution.

Additionally, carbon taxes that are targeting levels should provide revenue capable of softening the blow of the price hikes caused by carbon pricing on the most vulnerable populations, something I wrote about last week. The bonds proposed by Soltas raise money, but only money equal (in theory) to the social costs of the emissions, meaning that the money should only be capable of cleaning up the damage brought about by the emissions. This would not leave any revenue left over to fund the transfers necessary to ensure that the carbon pricing scheme does not leave the poor and elderly worse off.

All things considered, it seems like the carbon tax is a policy appropriately rated as good, and that a carbon bond system makes sense only as a thought experiment and testament to the creativity of finance-minded academics.