As the climate zealotry of the Obama administration has increased, mainly through EPA regulations, the business community has begun to look favorably on a carbon tax. Their rationale is that a carbon tax would be less complex and more efficient than the burden and inefficiency of over regulation. Implicit in this logic is the belief that there is a trade-off to be made. That might be true in theory, but the practical reality is that a carbon tax would be in addition to and not a substitute for more regulations.
The reason is simple. The carbon tax proposed by most analysts and implicit in the White House Inter-agency Workgroup Report on the Social Cost of Carbon--$38 to $46 per ton between 2015 and 2025--will not achieve the emission reduction objective of the Obama climate policy.
The U.S. target, announced last year, is to reduce our emissions by 26 to 28 percent below 2005 levels by 2025, and to make the best efforts to reduce emissions by 28 percent. In 2005, U.S. CO2 emissions were 6.1 billion metric tons. As a result of the 2008 recession, advances in technology, fuel switching, and regulations, they have been reduced to 5.4 billion in 2014 from their peak in 2005, according to EIA data.
If the Obama objective is to be achieved, CO2 emissions nine years hence will be between 4.3 billion metric tons and 4.4 billion tons, about 20 percent lower than 2014. But, EIA projects the 2025 level to be between 5.1 and 5.3 billion metric tons. So, how will the needed reduction be achieved? Continued advances in technology are part of the answer, but they are likely to produce diminishing returns with higher costs. This is where a carbon tax comes into play.
While it is conceivable that Congress could enact a relatively clean carbon tax bill, political realities make it far less likely that the tax would be large enough to have a significant effect on emissions.
The easiest way to demonstrate this is to use gasoline demand as an example. Currently, gasoline demand is running about 9.7 million barrels per day, according to EIA's weekly estimates, with emissions related to transportation representing about 26 percent of our CO2 emissions. A 20 percent reduction would take consumption back to 7.8 million barrels per day, about the level consumed in 1996.
A simple back-of-the-envelope calculation can produce an estimate of the size of a carbon tax necessary to reduce gasoline consumption from the current level to the 1996 level. According to EIA, the average price of gasoline this month is $2.13 per gallon. A number of studies have estimated the demand elasticity for gasoline. One from the University of California, Davis, published in 2013, contains a table showing various estimates of short and long run elasticity—0.26 and 0.58 to 0.8, which are consistent with other studies.
For purposes of illustration, assume an average elasticity of 0.5 between now and 2025. Based on the current price of gasoline, a carbon tax of 85 cents per gallon would be required to reduce consumption 20 percent. But, that increase would be phased in over time. Most analyses, including CBO’s assume a $20/ton tax that would increase annually. An MIT analysis by Sebastian Rausch and John Reilly concluded that such a tax would only reduce emissions 14 percent over a comparable number of years.
Gasoline consumption would have to decrease slightly more than 2 percent annually to get to 7.8 million barrels/day by 2025. If we assume the average elasticity of 0.5, the way to get to this level is a first-year price increase of 9 cents, increasing each year for nine years. Using OMB’s discount rate of 7 percent would result in a cumulative price increase of $1.03/gallon in 2025. Some might consider that reasonable. However, in 1993 President Clinton’s BTU tax would have increased gasoline prices by only 10 cents, and that proposal created a political backlash that did serious damage to the Clinton administration.
Most observers of the Washington political scene would conclude that legislation that increased gasoline prices from 10 cents to 17 cents annually over the next nine years is politically unrealistic.
A carbon tax that could be politically acceptable will be too small to matter and would have to be supplemented by additional regulatory constraints on carbon.
William O'Keefe is the President of Solutions Consulting. You can follow him on Twitter here.
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