Global Warming Policy Debacle: A Temperature Sensitive Tax Solution

The U.S. House of Representatives passed the American Clean Energy and Security Act (219 to 212) on June 26, 2009. The Act requires large emitters to reduce their aggregate carbon dioxide emissions by 3% below 2005 levels in 2012, 17% by 2020, 42% by 2030, and 83% by 2050. The Act relies upon an increasingly stringent cap-and-trade scheme, but, before it becomes law, the Senate must pass similar legislation and then the two pieces must be reconciled. Large emitters are drooling over the legislation because they will receive most allowances to emit CO2 for free, while they can pass along the value of such permits to customers as a cost. Likewise, financial institutions support cap-and-trade because they will collect 2-3% in fees on every transaction, and that is a lot of money in a trillion dollar a year market.

Citizens are beginning to realize that climate legislation, even if disguised as clean energy and energy independence initiatives, may significantly reduce their standards of living. As a result, the Senate has had trouble getting a climate bill off the ground after several attempts. Citizens are also recognizing that anything the United States does to reduce CO2 emissions will have no impact whatsoever on projected climate change – the emission reductions will be too small relative to the increases expected in rapidly developing countries such as China, India and Brazil, none of which wish to reduce their rates of growth to pander to rich countries’ desires to address climate change.

Then there is the growing literature questioning the very notion of catastrophic anthropogenic global warming. Evidence of global warming along the lines predicted by the Intergovernmental Panel on Climate Change (IPCC) is lacking. The IPCC projections of escalating temperature are well below observed trends, and even climate model ‘back-casts’ of warming over the period 1979-2006 are two to four times higher than what was actually observed.

Clearly then, the majority of people, and the majority of countries, are unlikely to vote in favor of policies that impose high upfront costs to prevent global warming. Too many people are wary of IPCC projections, do not think global warming will be catastrophic, or do not buy into the climate change rhetoric.

Cap-and-trade has adverse income distributional consequences, while regulations on everything from biofuels content in gasoline to the proportion of electricity to come from renewable sources are highly inefficient. The carbon tax is the proper instrument to use for combating climate change, but politicians do not like taxes because their constituents oppose them.

Nonetheless, a carbon tax rule proposed by Ross McKitrick from the University of Guelph could appeal to everyone. The IPCC climate models predict that global warming will first be observed in the tropical troposphere – about 10 to 15 km above the earth’s surface in tropics – and that this warming will subsequently spread around the globe. In a paper forthcoming in Energy Economics, McKitrick derives a tax rule that relies on this information to set the tax rate. The rule is as follows:

Carbon tax = marginal damage rate × current emissions/moving average of emissions × temperature.

The tax rate ($ per tonne of CO­2) is calculated and imposed each month. Global monthly emissions are available from the U.S. national research laboratory in Oak Ridge Tennessee, while temperatures are measured as the deviation from mean temperature and are available each month from satellite data. Various economists have calculated the level of the tax required for 2005. With this information and emissions and temperature data for 2005, it is possible to calculate the marginal damage rate (the damage to the global economy from emitting another tonne of CO2).

The innovation introduced by McKitrick is that he ignores abatement costs and, thus, does not seek to demonstrate that discounted benefits of taking action exceed discounted costs, as required by Sir Nicholas Stern (who headed the UK’s study of climate change) or Yale University’s William Nordhaus (who models optimal policy responses to climate change using an integrated assessment model known as DICE). McKitrick is only interested in setting the correct (optimal) price on carbon emissions.

Note that the above tax rule only links the tax rate to the state of the environment. Let me illustrate the tax with an example. First, I assume that a tax of $25 per tonne of CO2 was optimal in 2005. Using global fossil fuel emissions data from the Oak Ridge National Laboratory, I find that 29,227 mega tonnes (Mt) of CO2 were emitted globally in 2005, with average emissions over the preceding 50 years equal to 17,835 Mt of CO2. The temperature anomaly for 2005 was obtained from the UK’s Hadley Centre and was 0.482oC. Then, I can calculate the marginal damage rate to be 31.65. Given this value, information on emissions of CO2 going back to 1801, and the Hadley Centre’s temperature anomalies, which go back to 1850, I can calculate the optimal tax rates path since 1850. This is provided in the accompanying figure, where negative tax rates have been assigned a value of zero. Notice that the tax rate exceeds $25 per tCO2 on only one occasion, namely, in 1998 when there was a particularly strong El Niño event.

Fig: Optimal Tax Rate ($ per tCO2) to Address Global Warming, Annual (thin line) and Five-Year Moving Average (thick line)

As indicated in the figure, if global temperatures rise rapidly, the tax rate will also rise rapidly. While I used average annual global temperatures, a monthly average could also be employed. The monthly average will surely be more volatile than the annual temperature, which, in turn, is much more volatile than a three- or five-year moving average.

The reason that costs are ignored in setting the tax is that the tax acts as a signal to emitters of carbon dioxide. The market participants will use the information from tax trends to make decisions concerning the credibility of IPCC and other forecasters of climate change. The market will decide on the credibility of the science, because those who decide wrongly (say, by investing heavily in emission reduction equipment) incur costs that make them relatively less competitive. Rather than rely on political or scientific pronouncements, investors will use the market – the trend in tax rates – to guide their decisions, much like commodity and other prices that fluctuate significantly over time currently guide investment decisions.

The tax rule appeals to those who fear catastrophic global warming because the tax will escalate rapidly with rising temperatures. It also appeals to those who do not believe in catastrophic anthropogenic climate change because, if their view is correct, the tax will either rise very slowly or not at all, or even fall to zero. Thus, while a majority of citizens are unlikely to support actions that drastically increase energy costs, a majority will be likely to support McKitrick’s tax rule.

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