A Simple Market Mechanism to Clean Up Our Economy

Shilin, Taiwan. Credit: Ida Kubiszewski/Solutions

In Brief

The problem of global climate change is far more severe and immediate than we understood a few years ago. As the newest scientific data demonstrate, we have a narrow and fast-closing window in which to reduce carbon loads in the atmosphere. In order to do so, two things need to happen: first, the passage of dramatic legislation in the United States so that the largest source of the greenhouse effect begins to clean up its act; second, the subsequent rapid adoption of a powerful international accord that experts currently consider impossible. This will likely require the elimination of coal and tar sands as energy sources. This paper offers a game-changing political solution: create a trust to manage the sale of a declining number of carbon permits within the U.S., with dividends from the trust distributed equally to all Americans. The dividends would be wired monthly to bank accounts until the country solves its climate crisis. The advantage of this simple, market-based mechanism is that it creates a level playing field for clean technologies, avoids giveaways to industries with political clout, and assures broad, long-term political support for emission reductions. Using the U.S. as a model, world organizations could create a similar inter­national system that would cap carbon globally and distribute revenue to each nation in proportion to its population and developmental needs.

Key Concepts

  • Unless we change course soon, our planet has a frightening forecast: temperatures increasing by five degrees Farenheit (2.8 degrees Centigrade) by the end of the century, with polar ice caps melting and sea levels rising.

  • The reduction of global carbon dioxide concentrations will require major shifts in energy use, particularly the elimination of coal.

  • A promising system to transition the U.S. away from its dependence on fossil fuels is to cap the supply of carbon entering the economy, auction carbon permits and, from the revenue, pay equal monthly dividends to all Americans.

  • Monthly dividends will compensate for inevitable price increases and garner long-term support for emission reductions, thus allowing clean alternatives such as efficiency, wind power, and solar power to carry the day.

  • This model can promote an international system that will distribute carbon revenue fairly, while encouraging development in the poor world.

Anthropogenic global warming has a relatively short public career. Twenty years ago, in June of 1988, NASA scientist James Hansen first told Congress that global warming was a real threat, marking the start of open consideration on this issue. The formation of the Intergovernmental Panel on Climate Change gave scientists a forum for considering the data, and by 1995, their survey of the peer-reviewed research concluded that humans were heating the planet and that this was going to be a serious problem.1

That consensus has solidified steadily in subsequent years, culminating in the release of the IPCC’s fourth assessment report in the winter of 2007, which summarized research from the first five years of the new millennium. It offered a sober and frightening forecast for the century to come, predicting temperature increases of five degrees Fahrenheit by 2100, and the melt of Arctic sea ice in the summer by late in the century. There was little doubt, reading the mountain of data, that this is the most serious problem humans face—indeed, have ever faced.2

But in the 18 months since those reports began to emerge, the situation has gone from stunningly bad to sickeningly worse. The most unmistakable sign was the rapid melt of Arctic sea ice3—by the time the long Arctic night finally descended in October 2007, the Northwest passage had stayed wide open for weeks and the old record for minimum sea ice shattered by nearly 25 percent. The new prediction from the Arctic research community was that we had unexpectedly crossed a tipping point, and that the summer Arctic might be essentially ice-free by the middle of the next decade, not the end of the century.

There were other indications as well. For instance, researchers reported that atmospheric methane concentrations had begun to soar.4 This both confirms a rapid warming (the likely source of that methane was the melting permafrost of the far north) and spurs further heat, since methane, like carbon dioxide, is a potent greenhouse gas. In addition, glacial ice above Greenland and the West Antarctic appeared to be sliding seaward more quickly than models had assumed, raising the specter of very rapid sea-level rise.5

In the face of such new facts and armed with increasingly robust paleo-climatic data, researchers began offering new diagnoses of future warming. They were, once more, led by NASA’s Hansen. In a December 2007 presentation to the American Geophysical Union and in a subsequent paper co-authored with a variety of collaborators, he offered a new bottom line for the debate. Hansen stated that 350 parts per million was the maximum acceptable value for atmospheric carbon dioxide.6 Indeed, he went further than that: “If humanity wishes to preserve a planet similar to that on which civilization developed, paleo-climate evidence and ongoing climate change suggest” that 350 ppm is the upper bound of safety. That is a very tough number in two ways.

The first is that we are already past it—current atmospheric concentrations of CO2 are 385 ppm, up from 275 ppm before the Industrial Revolution. In other words, we are now deep into the zone of risk. Like a patient informed by his physician that his cholesterol is too high, we need to change our lifestyle and hope that we get back to a safe level before a heart attack or stroke (or ice cap melt) overwhelms our system. This means that the problem must be solved now, not postponed for the next generation of leaders to tackle or approached too timidly to make much difference. We will clearly need to move more quickly than is desirable from the standpoint of economics or, indeed, of politics. The standard practice of incremental change interspersed with pauses for consolidation needs to be short-circuited in favor of dramatic and transformational change. As the IPCC chairman, Rajendra Pachauri, said recently, “If there’s no action before 2012, that’s too late. What we do in the next two to three years will determine our future. This is the defining moment.”

Second, 350 ppm is a difficult number due to the extent of change it demands. Hansen’s analysis shows that returning to that number is possible. The earth cycles some carbon out of the atmosphere, much as your body filters cholesterol. However, we would need to quickly stop producing excess CO2. As he wrote, “an initial 350 ppm CO2 target may be achievable by phasing out coal use except where CO2 is captured and adopting agricultural and forestry practices that sequester carbon”.6 That short statement covers the biggest economic and political change humanity has ever faced. The burning of cheap coal, without expensive carbon capture, underpins both the energy system of the rich world–the U.S. generates more than half of its electricity with coal7–and the hopes for rapid development in the poor world. China is expected to build hundreds of new coal-fired power plants.8 Giving up that coal so suddenly will be wrenching. Hansen’s analysis further implies that we will also need to avoid turning oil shale and tar sands into petroleum, one of the most well-funded new industrial projects.

The difficulty of this transition has been thoroughly explained elsewhere—there are plenty of economists who consider it essentially impossible in any relevant time frame, and at least some scientists who think humans have already waited too long to begin. Instead, here a pair of suggestions are offered addressing how to get change underway, in the hope that it will progress more rapidly than expected.

Change in the U.S.

Given that the U.S. bears by far the largest historical responsibility for climate change, and given its status as sole world superpower, credible action from Washington is a necessity if the rest of the world is going to aggressively tackle global warming.

The cap-and-dividend proposal detailed by Barnes and McKibben is both visionary and progressive (in both social and economic senses); further, it promises accountability and transparency in its implementation. Not so—at least not yet—the American Clean Energy and Security Act of 2009 (ACES), currently being reshaped in the Senate. While ACES’s goals are solid, its compromises and complexities risk making it an energy-bill version of inside-the-Beltway business-as-usual—with potentially disastrous consequences for all. To transform ACES for the better, engaged citizens must first understand its essence and then push to make it stronger.

The political framework for federal action has been laid. Last year, 1,400 demonstrations across the country took place during campaign season; as a result the leading Democratic presidential contenders made 80 percent carbon reductions by 2050 a centerpiece of their energy platforms. The winning candidate and current President, Barack Obama, supports not only this emission reduction goal, but a cap and trade system in which 100% of the permits would be auctioned and a large part of the revenue returned to households. Similar legislation is gaining traction in the House and Senate.

Nevertheless, the political problem of passing dramatic legislation is by no means solved. Any realistic approach involves putting a price on carbon, either through a direct tax or through a cap of some kind. That price will inevitably be passed on to consumers—indeed, that is the only mechanism that will drive demand for transformative technology. Resistance to that increased price in the middle of a recession may be enough to prevent political action commensurate with the problem.

An approach has been developed that offers a way around this political logjam.9, 10 It could make middle-class families support, or at least tolerate, game-changing increases in the price of carbon-based energy.

The key to this approach lies in what economists call revenue recycling — that is, raising the price of carbon, but giving money back to households to offset the hit on their wallets.

There are several ways this can be done. For example, Al Gore supports a carbon tax that is offset by a cut in payroll taxes. Other possibilities include means-tested rebates for the poor and tax credits for moderate-income families.11 The preferred method is modeled after the Alaska Permanent Fund, which pays equal dividends to all Alaskans from state oil revenue.12 All Americans would receive equal dividends from the revenue raised by selling carbon permits.

This form of revenue recycling is known as ‘cap and dividend.’ It would be fair to poor, middle class and rich alike. Personal cost would depend on personal lifestyle. The more carbon-based energy a person uses, the more he or she would pay through higher prices. Since everyone gets the same amount back from the dividends, those who conserve would gain while those who guzzle would lose— in other words, the incentives would be exactly right, and would apply to everyone. Further, because poor people use less energy, on average, than the rich, the net distributional effect would be progressive; that is, most poor people would gain and most rich people would pay for their wasteful lifestyles.13

So how, exactly, would cap and dividend work? First, there would be an economy-wide cap on fossil-fuel supplies. This is different from a cap on CO2 emissions, and it is important to understand the difference.14

Carbon is an unusual pollutant. It does not trickle from just a few pipes, it gushes from hundreds of millions. Capping carbon emitters is, therefore extremely difficult. To the extent it can be done, it will be an administrative nightmare and will never catch all the carbon that flows into the atmosphere.

A much easier place to cap carbon is its entry into the economy. Economists call this an upstream cap. It is actually a cap on suppliers of fossil fuels rather than a cap on emitters.

This cap on fossil-fuel suppliers is far easier and cheaper to administer than a cap on emitters. The cap would work by requiring companies that sell oil, coal, and natural gas to buy permits equal to the carbon content of their fuels. Once a year these companies (there are less than 2,000) would ‘true up’ and pay a stiff penalty if they do not own enough permits. No other companies would need permits, no smokestacks would be monitored, and no large bureaucracy would be required.

Each year, the number of permits would be reduced, thereby slowing the flow of carbon into the economy. If carbon does not come into the economy, it cannot go out. A declining physical limit on carbon supplies thus guarantees we meet emission goals on time, regardless of what else happens.

Where will actual emission reductions come from? Cap and dividend does not answer this question — and does not have to. Instead, it relies on markets (and other public policies) to sort out who burns the available carbon and which technologies replace carbon. And why not? Markets work efficiently when they are supplied with accurate information. At the moment, markets do not know the atmosphere cannot absorb more CO2 — indeed, markets currently assume the atmosphere can absorb an infinite amount of CO2 since the price for emitting it is exactly zero. Capping the carbon supply will inform markets of nature’s limits. As the cap declines, the price of carbon will steadily rise, and as that happens, private capital will shift from dirty fuels to clean alternatives, plug-in cars will replace gas-guzzlers, and millions of green jobs will be created.15

Here are three reasons why an atmospheric trust should use a significant fraction of the revenues (net of administrative costs) for purposes related directly to “enhancing the asset” rather than pay out as current dividends:

1. What are “dividends” in this case?

Dividends imply the net proceeds produced by the capital after subtracting all transaction and other costs. Dividends should be paid from net profits without touching the capital asset. In order to maintain the atmospheric asset, humans need to cut emissions drastically and that will require both the development and deployment of low carbon technologies at a very rapid rate. Can we expect private markets to do this alone, even with the price signals adjusted by the carbon auction price? If research and development is left up to the private sector, new technologies will be patented. Patents are simply legal monopolies, and monopoly prices will ration use of new technologies to those who can afford them. Since information is not depleted through use, price rationing due to patents creates artificial scarcity. If the resulting prices are too high, China and India are likely to continue burning coal, in which case, we could not achieve atmospheric carbon stocks of 350 parts per million, even if the U.S. reduced emissions to zero. Patents expire in 20 years, but that may be too late. Therefore, some amount of direct investment by the trust would be necessary to restore and maintain the asset at the required rate. For example, if research and development receives a share of revenues to create carbon neutral energy technologies made freely available to all, it could dramatically trim the costs of reducing carbon emissions. Not only would this make it easier to tighten caps in the U.S., but other nations would also be more likely to adopt these technologies and reduce their own emissions. The question really boils down to this: who is best placed to develop and disseminate the necessary technologies– the private sector or the trust? There are advantages and disadvantages to both. Hedging our bets by allowing a significant role for both would be best at this point. These investments should be monitored closely. The trust can then adjust the fraction of the revenues that is devoted to direct investment, based on the relative effectiveness of its investments compared to those of the private sector.

The second element of this approach is the dividend, an equal monthly payment wired to every American’s bank account. Unlike payroll tax reductions, dividends would flow to retired and unemployed people, stay-at-home parents, and workers in the informal economy. Unlike all forms of tax reduction, dividends would arrive monthly rather than annually, helping families make ends meet. Moreover, as carbon prices rise, so — automatically — would dividends. Dividends would be noticed because they would provide cash that people can spend every month, rather than a lower tax bill. Popular support for emission reductions would thus be sustained as carbon prices rise.

The money for dividends would come from auctioning the permits that fossil fuel companies must acquire. Auction revenue would go into a trust fund that could not be diverted by the government. Each month equal shares of the fund would be wired to every American with a Social Security number.

Cap and dividend has a third feature — an independent entity that would set the yearly carbon supply based on the latest scientific findings. This entity could be called a ‘sky trust’ or a ‘Carbon Fed.’ Like the monetary Fed, it could respond to new data and make unpopular decisions. Elected politicians might happily give it the thankless job of raising carbon prices. When voters complain (as they surely will), lawmakers could honestly say, “The Carbon Fed sets the carbon supply, the market sets prices, and you determine by your own behavior whether you gain or lose. If you conserve, you come out ahead.” What could be simpler or more fair than that?

Cap and dividend would create a simple, economy-wide mechanism that reduces carbon emissions, is fair and transparent, and solves the political logjam related to higher carbon prices. Yet many environmentalists do not like it. Their contention is that, instead of returning carbon revenue to households, the government should spend it on research, job training, international aid and the like. This has led to a divide between supporters of “cap and invest” and “cap and dividend.”

Both approaches are potentially viable responses to the climate crisis, but a cap with dividends is more likely to pass during a recession, more likely to sustain higher carbon prices, and more likely to last for the decades it will take to reach the emission reduction goals that are required. While public investments can help reduce carbon emissions, money for those investments should come from sources not linked to the cap—for example, from general revenue, long-term borrowing, and shifting existing subsidies to fossil fuels.

A carbon cap has two crucially important purposes: (1) to fix the market failure that is the root cause of climate change; and (2) to establish a goal, timetable and enforcement mechanism for reducing carbon dioxide emissions. If the cap does those two things well, it will transform our economy. However, if the cap is turned into a massive spending bill, it will extract a rising amount of money from people’s pockets, a process that could easily trigger a backlash and undermine the primary purposes of the cap.

It is important for solutions advocates to appreciate this reality and this risk. The revenue that derives from a carbon cap is not manna from heaven. It comes from the higher prices everyone pays, and it is effectively a sales tax on fossil fuels. It will make millions of Americans poorer, a bad outcome in prosperous times and a politically unacceptable one in hard times. Unless those higher prices are offset in a way voters know will protect them, the chances that the cap will function effectively for 40 years are slim.

Moreover, if the money from higher carbon prices is not returned to the people, most of it will not be spent as environmentalists would wish. As in the past, the lion’s share will flow to industries with political clout: “clean coal,” “safe nuclear,” and the like. By contrast, if there is a level economic playing field with a steadily rising price of carbon, clean alternatives such as wind, solar, conservation ,and efficiency will carry the day.

In summation, the U.S. needs a climate solution that meets several tests. First and foremost, it must steadily raise the price of carbon without alienating huge numbers of American voters. Secondary tests include:

  • It must be transformative — that is, it must send an unignorable signal to every nook of our economy, and remain workable until the climate crisis is solved;
  • It must be simple to understand and administer;
  • It must be fair and transparent in its distribution of costs and benefits.

Most proposed climate policies fail one or more of these tests. By contrast, cap and dividend passes them all with flying colors.

This is not to say that cap and dividend solves every aspect of our climate challenge. It can and should be complemented with policies that improve energy efficiency in specific sectors, enhance transportation options, train workers, pay farmers and foresters to remove carbon from the atmosphere, and help developing nations go green. These complementary policies can be added once the basic framework for markets is set by a strong and politically durable carbon cap.

Change in the World

With that potentially successful strategy proposed for the U.S., we turn now to the even more difficult question of how to wrest commitment to significant action from the global community. It is more difficult because so much of the world is poor and sees its future development hinging on access to cheap energy. In the developing world, the debate on climate change is even less advanced than in the United States; it has not been seen until recently as a central problem, one requiring immediate and urgent action.

For decades, even centuries, humanity will be dealing with complex climate-change impacts, yet we lack essential democratic assets to meet the challenges. Policymakers must take great care to choose paths that build our democratic-governance muscle—the decision-making structures, policies, citizen practices, and public trust we need to avert the worst impacts and to deal creatively with those now unavoidable. Any proposal on the table needs to ask three questions:

This is especially problematic because the world is about to adopt a new set of accords on climate change. The expiration of the Kyoto Protocols in 2012 has set in motion a new international process, expected to produce a treaty in December of 2009 in Copenhagen. Much like the recent federal election in the U.S., this set of negotiations represents the last realistic bite at the climate change apple—given the new science. There will not be another chance if there is no truly transformative, as opposed to incremental, change. The difficulties of lobbying the more than 180 governments that will be involved in the process cannot be overstated.

Hence, a group scattered around the earth, has embarked on an international education/activism program. Named for the ‘safe limit’ amount of carbon, 350.org is designed to spread that number around the planet—designed, in fact, to make it the most well-known number on the earth by the time of Copenhagen. It engages artists, activists, clergy, musicians, and average citizens of all kinds. In the first few weeks of the campaign, 350 bicyclists circled American state capitols and 350 surfers posed on beaches threatened by rising seas. Similar actions have begun in other parts of the planet, from the Congo to Sweden, from Mongolia to the United Kingdom.

The point of these efforts is not to push for specific legislation. The individual circumstances of each country are so different as to make that difficult. It is, instead, to shift the psychological backdrop of the negotiations. If ‘350’ becomes recognized as the mark of success or failure, it will nudge, and perhaps shove, international negotiators in the direction of significantly more daring targets.

A version of cap and dividend might work on an international level to reduce atmospheric carbon16—but the dramatic inequalities in income that mark the start of this effort are sobering. Clearly, any agreement has to allow for and encourage development in the poor world; the most useful account of the depth of this need can be found in the work of the Greenhouse Development Rights Network (http://www.ecoequity.org).

No one can overstate the difficulties of these proposed approaches, nor can anyone overestimate the technological progress needed to make them real. However, those technological challenges will be relatively easy. The hard part of the battle is structuring the economics of carbon, and the hard part of that fight is creating a politics that allows for long-term transformation.