The Evolution of the Taxation of Air Pollution

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Any tax is a discouragement and therefore a regulation so far as it goes.  ~Oliver Wendell Holmes, Jr.

Air pollution control laws date back to medieval times. King Edward I of England banned the burning of newly discovered coal by blacksmiths in 1273, because of its foul odor. An unfortunate smithy violated the ban in 1307 and was hanged, being perhaps a harbinger of environmental crimes to come.

Rita Holder

Air pollution regulation is often characterized as having come from this harsh “command and control” milieu. Akin to King Edward’s decree, command and control regulations set unyielding standards, enforced by law, making excesses unlawful. For example, the 1977 amendments to the Clean Air Act required new coal-burning plants to use flue gas desulfurization units to remove 90% of sulfur dioxide emissions from their smoke stacks.   The law commanded what the limit was and controlled how it was to be achieved. The 1977 amendments were command and control regulations.

One nearly universal criticism of air pollution command and control regulations is that they don’t incentivize industry to invent new ways of producing cleaner energy. The drawback is that companies don’t need to figure out ways to reduce pollution so long as the minimum standard is met.  More stringent regulations are needed to enforce higher levels of compliance.

Market-Based Controls

Schemes to regulate air pollution have evolved into ”market-based” practices. Market based laws identify objectives and then give businesses the leeway to choose the most cost effective method to reduce emissions — without telling them specifically how to do it. A market-based regulation strategy is thought to encourage ingenuity by allowing companies to invent new technology to meet the emission goal. For example, the 1990 amendments to the Clean Air Act embarked on regulation of SO2 emissions via a market-based approach. Companies were required to reduce their sulfur dioxide emissions by at least 90 percent but did not specifically require scrubbers or any other precise apparatus. The results were broadly heralded as SO2 emissions fell.

Cap-and-Trade

A more complicated market-based regulation of air pollution is the phenomenon known as “cap-and-trade.” A cap-and-trade (CAT) system is a type of market-based regulation used to control a specific pollutant that is spread over a discrete geographic area.

For example, the California Air Resources Board’s Scoping Plan for AB32 identifies a cap-and-trade program as one of the weapons in the attack on greenhouse gas (GHG) emissions causing climate change. California’s goal is to reduce GHG emissions to 1990 levels by the year 2020, with an 80% reduction from 1990 levels by 2050. The identified culprit here is carbon dioxide. (Other greenhouse gas sources, such as more harmful methane, are not included because carbon dioxide generates almost eighty-five percent of the over 7,000 million metric tons of greenhouse gases in the U.S.).

How will this market-based CAT system work? In short, a total GHG tonnage limit will be decreed for the air in various regions of California, based on an assortment of formulas. Focusing initially on emissions from the large industrial facilities and electricity generation sectors, each company that is emitting GHGs will be given or sold a set number of allowances. Each allowance will confer the right to give off one ton of specified GHGs for the year.

Companies will buy and sell emission allowance units to meet the ever shrinking “cap” on overall emissions. The compulsory 1990 cap imposed by the system will limit the number of allowances. If a company can reduce its emissions below its allowances, then it can either “bank” allowances and carry them forward to a future year, or put them up for sale on the established allowance market. Each business has the freedom to use better, or worse, emission control equipment so long as it has the number of allowances it needs to cover the year’s needs.  Companies that go over their limit must pay a fine — or jostle to buy more allowances before the annual deadline from a firm with extra allowances trading on the western states carbon market,.

Advocates of California’s cap-and-trade scheme tout the following advantages:

  • It will be simple to run. The program will be straightforward to design and operate.
    • Counterarguments:
      • Trading in allowances requires the drafting of voluminous regulations for set up and continuous market monitoring.
      • A new technology system needs to be devised to prevent the same allowance from being used twice and prevent the rigging of markets a là the Enron energy market-trading debacle.
  • Emissions are capped. The program places an overall ceiling on specified emissions in a defined geographic area.
    • Counterarguments:
      • Who wants more bad air! We should be seeking to improve air pollution not encouraging polluters to make more.
      • Trading pollution credits across regions or even across state lines will result in more emissions being dumped in disadvantaged communities.
  • Accountability is ensured. Emissions are quantifiable and, more importantly, there is a solid past estimate of how much pollution is already being emitted.
    • Counterarguments:
      • Accountability is complicated. Cap-and-trade introduces collateral issues like the need for the Securities and Exchange Commission to police hedging and futures trading in allowances.
      • Penalties need to be established and enforced against polluters who exceed their allowances. Environmental regulation is already saturated in litigation. A carbon cap-and-trade system would make this worse.

Taxing Carbon

A carbon tax is an environmental tax that is levied on the carbon content of fuels. Carbon atoms present in fossil fuels, are released as carbon dioxide (CO2) when they are burned. The way a carbon tax commonly works is that a tax is imposed on the oil, coal, and natural gas produced by or imported into a region, state or country. For example, a lower range tax of $10 per ton of carbon content in estimated 7000 million metric tons of greenhouse gases would pump $70 billion per year into the U.S. economy. A carbon tax can also be levied by taxing the burning of fossil fuels by manufacturers and consumers—e.g. coal, petroleum products such as gasoline, aviation fuel, natural gas and diesel—in proportion to their carbon content. England has imposed a fuel tax in this manner for some time.

Both cap-and-trade and carbon taxes give polluters a financial spur to reduce GHG emissions. Carbon taxes are said to provide “price certainty” on emissions, while a cap provides “quantity certainty” on emissions. The idea is that a pure tax fixes the price of carbon (but allows carbon emissions to fluctuate) while a cap-and-trade places a ceiling on carbon emissions (while the market price of carbon allowances fluctuates).       A carbon tax is an indirect tax—a tax on a transaction—as opposed to a direct tax, which taxes income. In economic parlance a carbon tax is a “price instrument”, since it sets a price for carbon dioxide emissions.

In theory, a carbon tax would make up for the so-called “social cost of carbon” (SCC). The SCC is estimated as the marginal cost of the harm upon society as the result of carbon dioxide emissions. As you might imagine estimates of SCC vary wildly. A carbon tax that compensates for the SCC also varies by fuel source. Many countries have already implemented a carbon tax including Denmark, Finland, Germany, Italy, the Netherlands, Norway, Slovenia, Sweden, Switzerland, and the UK.

But as with any proposed tax, the idea of carbon taxation is not an easy sell, especially in the bi-polar divide of U.S. politics.  But there are indications it may be gaining common cause. On March 18, 2011, San Francisco Superior Court Judge Ernest Goldsmith ordered the California Air Resources Board (CARB) to conduct an environmental review of other options, such as a carbon tax, and allow public comment. Judge Goldsmith admonished CARB that the “important alternative” of a carbon tax got a “scant two paragraphs” of discussion in its AB32 Scoping Plan.

Political fur is now flying. Influential green advocacy groups, like the Environmental Defense Fund, the Natural Resources Defense Council and the Nature Conservancy have always backed California’s cap-and-trade approach.  But on May 11, 2011, the Sierra Club sent a letter to Governor Brown challenging him to reexamine Schwarzenegger’s AB32 cap-and trade stand.  This aligns the Sierra Club with environmental justice groups, such as the lawsuit’s plaintiffs Association of Irritated Residents, Communities for a Better Environment and the Center on Race, Poverty and the Environment.

Upstream or Downstream?

California could impose a carbon tax and a cap-and-trade system either “upstream”, at the point of extraction or importation, or “downstream”, at the point of manufacturing or consumer use.  Each has its own cheerleaders and naysayers.  An upstream carbon tax or cap-and-trade system is imposed on fossil fuel producers (oil, coal, and natural gas). An upstream approach has the maximum ability to ensure that all sources of carbon dioxide emissions are affected, because it focuses on carbon at the point that it enters the economy as a raw natural resource.

A downstream tax hits the energy users that are the major sources of carbon dioxide emissions such as energy generators, refineries and manufacturers, and even consumers.  For example, Boulder, Colorado implemented the United States’ first household tax on carbon emissions from electricity, on April 1, 2007, at a level of approximately $7 per ton of carbon. According to the City of Boulder, the tax is costing the average household about $1.75 per month, with households that use renewable energy receiving an offset. The challenge under a downstream approach is the vast number and types of facilities to monitor and how to cast the tax net over all forms of energy use, such as cars and electricity, which add appreciably to carbon dioxide emissions.

Pros and Cons of Carbon Taxation

The main arguments favoring a carbon tax include:

  • A tax plan is simpler to initiate and operate than a cap-and-trade scheme. A carbon tax is straightforward. The tax is imposed at a set rate on the carbon content of our main sources of greenhouse gases: coal, oil, and natural gas. The IRS with its existing staff, is already up and running.  It has experience and expertise enforcing other excise taxes.
    • Counterarguments
      • The costs of administrating the tax are unknown.  It is impossible to estimate the external costs of a new carbon tax.  Furthermore, industry and consumers will complain that the tax rate (the social cost of carbon) is arbitrary.
      • A carbon tax will lead to tax evasion. Firms will begin to hide carbon emissions.
  • It will encourage use of alternative forms of energy. Rather than pay the tax, companies and households will look for ways to reduce their carbon footprint. Carbon taxes offer an easy-to-understand economic incentive to inventors and engineers to devise carbon-reduction technology.
    • Counterarguments
      • Knowing the ultimate cost of noncompliance, refiners, manufacturers and consumers will pay the tax rather than reduce emissions.
      • The tax will need to be very high to force changes in human behavior.  It will be unpopular and, if repealed, will set our energy independence efforts back for years.
  • A carbon tax will generate real revenue.  We can use this revenue to green our economy. The tax can be decreased in hard times. The revenue raised from carbon tax could be used to subsidize green energy alternatives. Tax breaks can be added if the economy enters a recession.
    • Counterarguments
      • In theory, carbon taxes could be adjusted but politicians and policymakers would need a cooperative spirit, sophistication and experience they don’t have now.
      • Political arm-twisting to define a carbon tax will result in exemptions and subsidies for upstream sectors such as drilling and mining, allowing higher emissions levels.
      • Production may shift to countries with no or lower carbon taxes. This will result in further unemployment and accompanying social problems.
      • Some argue that Big Oil will just pass an upstream tax along to consumers.  Producers and importers will have no impetus to support clean energy technology.

Conclusion

The regulation of air pollution using command and control and market-based initiatives has come a long way. The most effective and efficient cap-and-trade systems are said to have three key characteristics: placing an overall ceiling or cap on specified emissions in a defined geographic area; ensuring accountability in emissions; and being simple to run. Carbon taxation is seen as easy to implement and administer, generating revenue that can be used to subsidize alternative forms of energy, and encouraging a reduction in our collective carbon footprint.

The controversy between a carbon tax and cap-and-trade may be eventually resolved by a blend of the two.  This is not impossible to imagine. We need to forge ahead in our efforts to reduce our dependence on non-renewable sources of energy. We may make mistakes as a state or a nation but that would not be the worst outcome. The worst outcome would be doing nothing at all, stymied by our failure to take the first hesitant steps.


Rita Holder is a solo tax attorney in Concord specializing in environmental law and ERISA (pension, 401(k) and HIPAA). She is also the legislative policy analyst for the Delta Vision Foundation. There she provides expertise on natural resource, infrastructure, land use and governance for a sustainable Delta. She is an environmental scientist as well as a tax lawyer. She has 4 kids and a wonderful husband, Rich.

 

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