An Emissions Assurance Mechanism: Adding Environmental Certainty to a Carbon Tax Gilbert E. Metcalf JUNE 2018 An Emissions Assurance Mechanism: Adding Environmental Certainty to a Carbon Tax Gilbert E. Metcalf ∗ Abstract Interest in a hybrid carbon tax that provides some assurance that emissions reduction targets will be met has emerged recently. To better understand how such a hybrid tax could work, I describe a prototype emissions assurance mechanism (EAM) to provide policy certainty that is practical, simple to implement, and easily understood. I outline an EAM that would lead to a 45 percent reduction in energy- related carbon dioxide emissions by 2035 relative to emissions in 2005. In 2035, an assessment would be made about a target reduction in emissions for the next 15 years. Emissions are compared with an emissions pathway in each year. So long as cumulative emissions since the first year of the carbon tax do not exceed cumulative emissions along the emissions pathway, the carbon tax rate would increase at a standard escalator of 5 percent per year (plus inflation). If cumulative emissions exceed cumulative emissions along the pathway, an accelerated escalator of 10 percent would be used to increase the tax rate each year. Similarly, if cumulative emissions fall well below the pathway, the tax rate would be held constant (in real terms). The emissions pathway and EAM would be built into the carbon tax legislation. ∗ Professor of economics, Tufts University; research associate, National Bureau of Economic Research; university fellow, Resources for the Future. Metcalf received research support from the Climate Leadership Council (CLC) for this project. The views expressed here are Metcalf’s alone and do not necessarily represent those of CLC. Contact information: [email protected]. Metcalf acknowledges helpful input from Joe Aldy, David Bailey, Marc Hafstead, Ted Halstead, Noah Kaufman, Jim Stock, and Rob Williams III. He alone is responsible for any errors in the analysis. © 2018 Resources for the Future (RFF). All rights reserved. No portion of this report may be reproduced without permission of the authors. Resources for the Future (RFF) is an independent, nonprofit research institution in Washington, DC. Its mission is to improve environmental, energy, and natural resource decisions through impartial economic research and policy engagement. RFF is committed to being the most widely trusted source of research insights and policy solutions leading to a healthy environment and a thriving economy. Reports are research materials circulated by their authors for purposes of information and discussion. They have not necessarily undergone formal peer review. Unless otherwise stated, interpretations and conclusions in RFF publications are those of the authors. RFF does not take institutional positions. Contents 1. Introduction ......................................................................................................................... 1 2. Literature Review and Design Considerations................................................................. 2 3. Description of a Proposed Emissions Assurance Mechanism (EAM) ............................ 5 4. Conclusion ........................................................................................................................... 8 References .............................................................................................................................. 10 Resources for the Future | Metcalf 1. Introduction legislation, the EAM would be included in the initial legislation passed by Congress and thus When the United States gets serious about would significantly reduce the policy risk that tackling its greenhouse gas emissions a future Congress may fail to raise the carbon problem, policymakers should turn to a carbon tax rate if emissions are not falling as rapidly tax as a proven market-based instrument to cut as envisioned in the initial legislation.1 our emissions in a cost-effective and efficient manner. Economists have advocated this for Specifically, the proposed EAM component of decades, and increasingly, major companies, a carbon tax would have the following politicians, and environmental leaders are features: expressing their support as well. The shift • A 15-year target for emissions reduction toward the use of efficient, cost-effective specified in the carbon tax legislation. policy tools is evident in the Climate Specifically, energy-related carbon Leadership Council’s (CLC’s) bipartisan dioxide emissions would be reduced by proposal for a carbon tax. 45 percent below 2005 levels by 2035. The CLC’s proposal rests on four pillars: • An emissions pathway established (1) a gradually rising tax rate; (2) carbon beginning the year the carbon tax goes dividends for all Americans; (3) border carbon into effect and ending in 2035. The adjustments; and (4) regulatory simplification. emissions pathway would be designed as The last pillar is especially important if the a constant annual percentage reduction plan is to garner broad-based, bipartisan in emissions that achieves the 2035 support. While many business groups may be target. reluctant to support a carbon tax if US • An assessment undertaken before 2035 Environmental Protection Agency (EPA) to set a target for the next 15 years out to regulations of emissions (e.g., the Clean 2050 and to set an emissions pathway to Power Plan) are still in play, many achieve that target. environmental groups may be reluctant to • A tax rate that increases in a predictable support such regulatory simplification without way and that ensures progress toward the assurances that the tax will lead to emissions long-run emissions target. reductions that exceed what could be achieved over time under regulatory oversight. The rest of this paper provides the rationale for and further elaboration on this This paper proposes the inclusion of an mechanism. Section 2 discusses the academic emissions assurance mechanism (EAM) to literature on reducing uncertainty over ensure that regulatory simplification does not emissions with a carbon tax and describes key come at the cost of environmental integrity. design considerations that should be addressed This built-in mechanism would adjust the when designing an EAM. Section 3 describes carbon tax rate automatically in response to a specific EAM, and Section 4 offers a changes in the economy to ensure that long- summary assessment and concluding thoughts. term environmental goals of emissions reductions are achieved. In contrast to approaches that require Congress to enact new 1 Policy uncertainty cannot be entirely eliminated. Congress cannot pass a law that is immune from repeal or amendment by future Congresses. The EAM reduces the policy risk of future Congresses not taking steps to adjust the carbon tax rate when higher rates are required to keep emissions reductions on track toward a long-term goal. www.rff.org | 1 Resources for the Future | Metcalf 2. Literature Review and Design Congress that would be considered in a Considerations process similar to the Congressional Review Act process for expedited review of new An EAM is designed to provide greater regulations, in which Congress holds a straight certainty over environmental outcomes when a up or down vote on the recommendations with carbon tax is used to drive down carbon no opportunity for amendment or filibuster. emissions. While a carbon tax has many Aldy’s streamlined process for changing desirable features that have led most future carbon tax rates provides clarity in the economists to favor it as an efficient means to policy process for changing rates but does not reduce carbon pollution (see, for example, the fundamentally address the issue of policy risk, long list of economists who belong to Harvard which could undermine the effectiveness of economist N. Gregory Mankiw’s Pigou the carbon tax. Elements of Aldy’s approach Club2), a carbon tax does not explicitly limit do hold promise as a way to set a subsequent emissions as regulatory oversight might. target for the next control period of the Murray et al. (2017) sketch out three broad mechanism described below. approaches to reducing emissions uncertainty in a carbon tax: (1) tax rate adjustments, either With respect to mechanisms for tax rates predetermined or ad hoc in response to future to adjust automatically based on explicit congressional action; (2) the use of regulatory criteria set out in legislation, little has been authority as a backstop to the carbon tax; and written on the topic.4 In my 2009 article “Cost (3) the use of carbon tax proceeds to finance Containment in Climate Change Policy: reductions in emissions (either emissions Alternative Approaches to Mitigating Price covered by the carbon tax or emissions in Volatility,” I sketched out one of the first sectors not subject to the carbon tax). The EAM-type mechanisms in my Responsive Murray et al paper is a useful reminder that Emissions Autonomous Carbon Tax (REACT) multiple options exist and that a strategy proposal. The REACT proposal has the involving more than one approach could be following features: sensible.3 • An initial tax rate and standard rate of Aldy (2017) proposes an approach similar growth for the tax are set at the outset. in intent to that described in this paper. • Benchmark targets for cumulative Assuming a carbon tax is enacted, Aldy lays emissions are set for a control period, out a process for revising the tax rate schedule which could be 1, 5, or 10 years or some