An Introduction to the Cap versus the Tax/Fee Approach

Alan Journet, Co-facilitator, Southern Oregon Climate Action Now

Preliminary Clarifications:

The Target of Climate Reduction Efforts

Considerable confusion occurs about terms – not because there is complexity, but because there is confusion in language among politicians, journalists and, yes, even climate activists:

When we discuss reducing global warming emissions by regulation or placing a fee on them, the phrase often used is ‘pricing carbon.’

This is unfortunate because the target of our concern is greenhouse gases – and most folks involved in the effort know that.

We know that the cause of global warming is the emissions of greenhouse gases that result from human activity -mainly carbon dioxide, methane, nitrous oxide and the fluorinated hydrocarbons such as CFCs, and HCFCs.

However, because for years we understood the problem to be caused mainly by carbon dioxide, we have become lazy and refer to the problem as carbon problem…even though we know that the third most effective warming gas nitrous oxide at 300 times worse than carbon dioxide, contains no carbon, and we know the second most effective gas methane is 86 times worse than carbon dioxide on a pound for pound basis over 20 years and 34 times worse on a 100-year basis. meanwhile the CFCs and HCFCs are many thousands of times worse than carbon dioxide.

Although carbon dioxide remains the most important gas because of the combination of its concentration and warming impact, the other gases now account for some 35 – 40% of warming. Methane doubled in impact between the fourth IPCC report in 2007 and the fifth in 2013/14 even as carbon dioxide’s impact held relatively steady (increasing from 1.66 to 1.68 w/m2.

So, whenever we are confronted with a proposal to address this problem, we must first ask if it addresses greenhouse gases, or just carbon (dioxide). The much-touted Washington ballot Initiative (1631) of 2018, for example, claimed to be a GHG emissions reduction proposal but really only targeted carbon. Had it been approved, the result would have probably been to encourage a transition by utilities from coal to natural gas, which burns more efficiently than coal in terms of carbon dioxide emissions per unit of energy generated, but results in substantial methane emissions from fracking and processing – totally negating the combustion benefit.

Indeed, several programs currently in effect (the eastern states’ Regional Greenhouse Gas Initiative cap and trade program and the BC tax program, for example) only target carbon (dioxide).

Fortunately, some proposals on the other hand, that seem to target only carbon (such as those proposed by CCL) really target greenhouse gases. Unfortunately, in my opinion, they confuse the issue by not stating that they are really greenhouse gas reduction proposals.

It’s worth noting that the 2015 Paris Agreement, designed to reduce global GHG emissions, mentions greenhouse gas 24 times and carbon only five times – and then appropriately in connection with forestry sequestration. See for further discussion of ‘the carbon mistake.’

Meanwhile, the Green New Deal similarly refers to greenhouse gases 8 times as often as carbon- with the latter only mentioned once in connection with soil sequestration.

So, the first question to ask of any proposal is: exactly what is it targeting?  In oreder to answer this question it necessary to read the proposal.  Relying on the claims or proponents is an unreliable guide.

The Two-Step Solution

We often hear about Cap and Trade and Fee and Dividend as though these are the options available to us. But this, again, confuses the issue.

There are, in fact, two separate questions:

  1. How do we reduce emissions (the options are by capping them or by placing a fee on them – hence the cap approach or the tax/fee approach),
  2. If we raise funds, what do we do with them? The options are:
    1. return them to the taxpayer (the Dividend approach)
    2. use them to lower other taxes (the tax and shift / revenue neutral approach as in BC)
    3. use them to promote renewable energy R&D, address social justice issues, and promote carbon capture and sequestration projects (the Invest approach as in CA and OR).

Notice, and sorry for the confusion, but nowhere does the concept ‘trade’ appear in the discussion. That’s because it’s a commonplace component of the cap approach as I will explain below.

So, to understand a proposal, we need to know whether it’s a cap or fee program, and – if it raises funds – what it does with those funds.

What is Our Target

Regardless of the approach we take to reducing emissions, there will be a target.  This will vary from proposal to proposal. For example, the CA program targets 80% GHG emissions reductions from 1990 levels by 2050 while Oregon’s HB2020 (in 2019) followed that model as does the 2020 version, SB1530.  Meanwhile, the proposal recently passed in New York leapfrogged these to target net zero GHG emissions by 2050. This is interesting because the infamous 2018 IPCC report that has been used to argue we have to undertake substantial action within 10 years in order to have a reasonable probability of achieving a livable planet argued for a target of net zero emissions by 2050.

The target is not zero GHG emissions since that would require that we, and all animals –  stop breathing (or, at least, exhaling) a somewhat difficult and unpopular requirement.  Rather, our goal is to limit emissions to an annual amount the planet can neutralize by capturing and storing.  Hence,  the net zero emissions concept.

So, we should measure proposals in part on the basis of their goals.

Where do we impose the fee or cap?

For simplicity, the imposition should be assigned as far upstream as possible since there are fewer entities that need to be monitored. Upstream means at the point of entry of the fuel into the energy economy (point of extraction or importation into the jurisdiction in question). The assumption is, of course, that charges will be passed down to consumers.

Limiting Emissions Through a Cap & Trade Approach

We ensure emissions reductions within a given jurisdiction by issuing permits or allowances to emit greenhouse gases measured in terms of their carbon dioxide equivalent. We then reduce the number of those permits annually along a trajectory that has been agreed – towards a goal that has similarly been agreed.  This is a direct approach targeting emissions directly.

In principle, these allowances could be issued free to polluters or sold at a set price, but generally they are either auctioned or released as a combination where some are free and the remainder are auctioned, – thus they raise funds.

Entities either receiving permits or competing for them at auction are those responsible for the largest amounts of emissions – in CA and the OR proposal, this number is 25,000 metric tons annually – which meant the top 100 or so emitters in Oregon.

These polluters then compete at auction to buy the number of allowances they think they will need during the coming compliance period – usually a year.

If a polluter finds itself able to reduce emissions below the number of allowances purchased, excess allowances can either be retained for a future cycle, or traded on the open market to an entity that cannot reduce emissions to the number of allowances purchased – hence The Trade.

In addition, programs often allow a polluting entity to satisfy some small proportion of its compliance obligation through offsets.  This means they allow polluters to invest in projects that either reduce emissions (e.g. renewable energy generating projects) or capture GHGs from the atmosphere (e.g. through sustainable forestry or regenerative agriculture). In the CA program and the OR proposal, offsets are limited to 8% of an entity’s compliance obligation (total emissions).

In the distribution of allowances, some free allocations or adjustments may be designated to

  • reduce the potential rate impacts for utility users – especially low-income ratepayers
  • reduce the negative impacts on emissions intensive / trade exposed industries to protect jobs resulting from polluting entities just moving out-of-state (called leakage).
  • reduce the impact of potential fuel price rises on rural residents (agriculture & forestry).

Limiting Emissions Through a Tax or Fee Approach

The terms tax and fee are interchangeable.

The premise is that as the price of a commodity rises, users will seek cheaper alternatives.  In the case, a fee is added to fossil fuels and industrial processes that emit greenhouse gases, the fee being imposed on every metric ton of emissions measured in terms of the carbon dioxide equivalent.  There is no limit to what any entity can emit.

The fee is then raised annually to encourage further transitions from polluting fuels or processes at a rate to keep the emissions reduction on the assigned trajectory.  If emissions reductions occur faster than expected, the fee is either not increased or could be less than if the reduction is insufficiently rapid.

What Do We Do with the Funds Raised?

Now the jurisdiction has raised funds, the question is what should be done with those funds?

Option 1 is to return them to the taxpayer as a Dividend. This is what the federal Energy Innovation and Carbon Dividend Act does.  But, in addition, a proposal introduced by Chris Van Hollen (SB940) also includes a Dividend despite being a Cap approach. Hence, it’s a hybrid of the usual Cap & Invest and Fee and Dividend choices as a Cap and Dividend proposal.

Option 2 is to use the funds to lower other (e.g. personal income or corporate) taxes, the so-called tax and shift approach, sometimes called Revenue Neutral.

Option 3 is the CA and OR approach which involves using the funds to promote activities, behaviors, and projects that are consistent with the overall goals of the program. In the CA case this is very fluid, without specified activities or amounts of funds being earmarked.  In the case of Oregon’s HB2020, however, where the funds should go was rather tightly specified. The targets were:

  • Promoting renewable energy R & D
  • Promoting transitions in the industrial and transportation sector to lower emissions technology
  • Stimulating projects on our natural and working lands that would more effectively capture and sequester carbon from the atmosphere.
  • Investing in rural Oregon and disadvantaged communities by stimulating projects in such areas or communities that would serve the program goals of reducing emissions or capturing GHGs.

Some Concerns:

In the case of Oregon, a Portland State University study conducted in 2013 by the Northwest Economic Research Center indicated that even a fee of $150 per ton of emissions would be insufficient as early as 2035 to keep the state on track towards goal of 80% below the 1990 level by 2050 target.  Meanwhile, in CA, the auction price has fluctuated in the $15 to $20 per ton of emissions range and the state has already dropped below its 2020 intermediate emissions target. Apparently, in order to be effective, the tax/fee approach would need to be far more economically disruptive than the cap approach

In Oregon, passage of a bill raising a tax requires a 3/5th majority in both chambers (i.e. 36 House members, and 18 Senators) so would face a large hurdle.

The cap approach directly limits emissions to the number of allowances issued while the fee/tax achieves it indirectly by assuming that increasing the price of a commodity (i.e. fossil fuel) will reduce its use.  But, in an expanding economy, everyone might just suck up the price and continue polluting. Thus, emissions reductions are not guaranteed.

Non-regulated emissions: The entities subject to these pricing programs are those that are already regulated. Unfortunately, data suggest that substantial non-regulated emissions are also occurring. In particular, forestry activities (esp. logging) are estimated to result in greater annual emissions in Oregon than transportation – which is listed as the top emitting sector of regulated GHGs. Some climate activists argue that any effort to address emissions should include these currently non-regulated sources.  There are two concerns about imposing such a demand:  The first is whether we can afford to wait for the development of adequate protocols to address all emissions before we start placing regulated emissions on a downward trajectory?  The IPCC analysis suggests we cannot afford to wait.  The second question is more politically pragmatic:  since the emissions that are currently not regulated are largely those from agriculture and forestry, imposing a pricing on those emissions would have profound negative consequences therefore likely receive little rural support.