A Tax-Free Carbon Policy

In “Seven Reasons Why Taxing Carbon Won’t Fly (and shouldn’t)” I listed objections to a carbon tax and committed to describing a better, property-based carbon policy. Here are the how, who, what, where, and when of that policy. I start with “How.” “Why” is reserved for the third and last article in this series.

How. The policy is called Market Driven Compliance. MDC is an intensity-based emissions trading scheme, a cap and trade modeled after EPA’s averaging, banking and trading or ABT programs successfully controlling sulfur and benzene in gasoline and diesel for decades. Unlike other cap and trade structures, MDC does not allow government to distribute emission allotments by auction or otherwise. Rather, government’s role is limited to three basic functions.

First, government sets a universal performance standard for sources and a national cap for emissions. If the average polluter meets the standard, the national cap will be met. The performance standard declines over time creating a downward glide path for the cap. Second, government prosecutes violations and ensures necessary information such as reports from GHG sources and sinks meets quality standards. Third, government moderates a market where polluters emitting less than the standard sell tonnes not emitted or TNE credits and, also, maintains a registry of banked TNE balances. Government does NOT allocate emissions to individual sources. The economy does that.

The performance standard is simple. Polluters must limit annual emissions to a specified number of tonnes for every million dollars of receipts, i.e., sales. There will not be one standard for electricity generators, another for steel mills and yet another and another for cement plants, petroleum refineries, paper mills, etc. Rather, allowable emissions will be distributed based on the value to the economy of associated production. If consumers demand and purchase more steel more than gasoline, steel mills will be allowed porportionately more emissions than refineries. Polluters will squeeze the most production from every tonne emitted by minimizing emissions from every dollar of value produced. The sum of emissions from all sources must honor the cap.

Polluters emitting less than allowed by the performance standard will generate credits for the tonnes not emitted or TNE. Credits can be sold to polluters for whom abatement is more expensive or can be banked. Credits allow the least expensive means of abatement to be shared with the entire economy while still defending the cap.

Original graphic is located here, p. 2–36.

The devil of any public policy may be in the details, but the fundamentals of MDC are easily understood. In EPA’s Inventory of U.S. Greenhouse Gas Emissions and Sinks: 1990–2018, this chart tracks U.S. GHG intensity relative to 1990 as emissions per capita and emissions per dollar of GDP.

If tonnes per GDP dollar can measure GHG performance for an entire economy, can a similarly broad performance standard regulate all sources in that economy? As it turns out, MDC fits the bill. The table below shows 2017 GHG emissions for an assortment of industries, their 2017 receipts, their implied intensities and efficiencies, and composite data for the group. A full blown program would cover many more sectors, but this sampling illustrates the concept.

Original table with links to source data is available here.

The average emission intensity for these twelve sectors is 3,100 MT per million dollars of receipts. To reduce emissions by 10%, the performance standard would be 90% of 3,100 or 2,790 MT/$million. In this example, Pulp and Paper Manufacturing sources would have aggregate emission limits of 520 MMt based on multiplying the performance standard times annual receipts (2,790 x 186,245). Limits, of course, would be calculated and enforced source by source and not for an entire sector.

Since the sector emits only 25 MMT, pulp and paper sources would have 495 MMT of TNE to bank for future years or sell to sources like petroleum refineries, power plants, cement plants or lime producers whose emission intensities exceed the standard. Even if all available TNEs were sold, however, these sources would still be 416 MMT short of a 10% reduction.

Those 416 MMT would be supplied from actual reductions or verified GHG sinks. Precisely by whom one might ask? No one knows, nor should we care. The TNE might come from the smallest sources, from the largest, sources in between or from certified sinks. All that matters to the planet is that aggregate annual emissions are less than or equal to the cap. What we do know is this 10% emission reduction will be accomplished at the lowest possible overall cost to both polluters and consumers. More on this in the next article.

Two other points regarding MDC bear discussion. First, TNEs should not expire. This is not the case for current EPA ABT credits such as Renewable Fuel Standard RINs or gasoline benzene and sulfur credits. Limiting TNE lifespan, however, guarantees TNEs will be used, something not to be encouraged. If TNEs have a 5-year life, for example, we know every banked TNE will be converted into real emissions on or before its fifth birthday. No TNE will ever be allowed to expire useless and worthless. If TNEs are allowed to age, however, their value will increase, and the probability of their use will decrease with time.

Second, leakage and border adjustments must be addressed. MDC will treat imports the same as domestic production by applying the performance standard to import receipts. Compliance will be determined from emissions, not carbon content, just as is proposed for the Climate Leadership Council carbon tax. MDC adds one wrinkle to this approach borrowed from current Clean Air Act practice. All obligated parties, domestic and foreign, may opt to report emissions based on a MT/$million “allowable” emission rate indexed for each sector. For example, the optional allowable might be the ninetieth percentile intensity reported in the relevant sector.

Exports. Assume a widget maker has $60 million in domestic receipts and $40 million in receipts from exports. Assume also the performance standard is 2,000 MT/$million and the source meets the standard for all production emitting exactly 200,000 MT (2,000 MT/$million x $100 million). If the widget maker has been reporting GHG emissions under EPA’s Greenhouse Gas Reporting Program (GHGRP), it can easily calculate a pre-MDC emission intensity baseline. If that baseline is, for example, 2,500 MT/$million, its baseline emissions, based on current receipts, would be 250,000 MT or 50,000 MT higher than under MDC.

To restore pre-MDC competitiveness to exports, government would issue TNEs commensurate with exports. In this case, the widget maker would receive 40% of 50,000 MT or 20,000 MT of TNE credits. The TNEs could be sold or banked just like any other TNEs, or the widget maker could use them one time to legally emit 220,000 MT in that year.

New sources will not have historical data necessary to calculate baseline intensities. An imputed baseline intensity indexed to approved baselines in the same industrial sector could be assigned to each new source. Sources not exporting will not need an emission intensity baseline.

Exporters paying for indirect GHG reductions through higher utility and other bills present a problem. I do not have a suggestion to preserve their competitive position in international trade and welcome any and all ideas on this issue. Unlike a carbon tax rebate, which can compensate only for taxes paid but not for abatement costs, MDC’s approach does address exporters’ direct abatement costs.

Who. The policy should start by regulating emission sources currently subject to GHGRP contained in the Code of Federal Regulations. The reporting categories are in Subparts C through UU of Title 40, Part 98. Included are sources emitting 25,000 or more metric tonnes per year of CO2 and equivalents. Petroleum refineries report on-site emissions and emissions from produced fuels. Other carbon and hydrocarbon supply chains are covered from top to bottom. So are industries such as cement production having emissions in addition to those from combustion. GHGRP covers 85–90% of total U.S. emissions and, based on my experience supervising GHG reporting, may be the planet’s best GHG reporting system.

GHGRP is quite comprehensive. The largest and perhaps only source category not covered by GHGRP is agriculture. Also, GHGRP does not cover activities removing GHG from the atmosphere. Modifications may be necessary to ensure imports report separately and carry their own compliance burden. Likewise, reporting for exports must be flagged to preserve U.S. industry competitiveness in international trade. Basically, however, GHGRP is a great and comprehensive starting point.

GHGRP started in 2009. Covered entities are familiar with GHG measurement and reporting protocols. Most of the kinks have been worked out of the system. Carbon policy must start with measuring emissions. We already do that well, and there is no need to reinvent this wheel. Policy can be expanded beyond GHGRP as experience grows.

What. All GHG emissions, carbon and otherwise, now covered by GHGRP will be regulated with modifications for exports and imports. Emissions now reported under GHGRP and associated with exports will still be reported since they are necessary to calculate adjustments for preserving competition in international trade. In addition, some imports, most notably imported cement, do not appear to be covered by GHGRP. A carbon policy, however, must ensure imported goods meet the same standards as domestic goods. Emissions in the country of manufacture must be part of the program. Other modifications to the GHGRP universe of sources and emissions may become necessary as the program matures.

Where. If goods or products, domestic or imported, are sold in the U.S., the policy will apply. If emissions occur in the U.S. but the goods are exported, adjustment will be necessary to maintain a level playing field in international trade.

When. ASAP. As obvious as this is, “as soon as possible” or “as soon as practical” depends on one’s definition of possibility and practicality. To avoid venturing too far outside my experience, I only note a carbon tax requires Congressional action. Congress might enact a tax with a simple majority through the budget reconciliation process. The 2017 Tax Cuts and Jobs Act became law this way. This is the path of least resistance for Congressional action but requires Congressional action nonetheless.

There may be another route. Section 111 of the Clean Air Act directs EPA to establish performance standards based on the “best system of emission reduction” for categories of new and existing sources. I find nothing in Section 111 prohibiting a single performance standard for all categories. The trick is to find a standard equitable across all categories and, therefore, the entire economy. The previous article explained why a carbon tax fails this test.

The Obama EPA’s Clean Power Plan suggests a path forward. CPP’s legality has never been ruled on by any court. CPP proposed a three-part standard for reducing CO2 emissions from existing power plants. The first part set thermal efficiency standards for generating units. The second and third required states to adopt plans for shifting load from coal-fired units to less polluting natural gas and renewable energy generators elsewhere in the grid.

CPP was unique in utilizing many grid sources to meet an overall emission rate not achievable by any coal-fired plant acting alone. CPP was a departure from historical Section 111 practice of applying performance standards only “inside the fence” of an individual regulated source.

The Trump EPA repealed CPP asserting CPP exceeded EPA’s statutory authority. Specifically, the notice of repeal stated Section 111 applied only “inside the fence.” Whether that reasoning is correct also has not been determined by any court.

If CPP were legal, as determined by EPA lawyers when it was adopted, there may be an executive branch option for MDC more expedient than new Congressional authority. In fact, MDC has a leg up on CPP. MDC applies the same intensity standard directly to each individual source as the Trump EPA has argued is required by Section 111. CPP, on the other hand, anticipated changing the operating schedule of individual plants in addition to specifying emission levels while operating.

What is most likely to be questioned is an emissions trading scheme where superior performance by some will offset substandard performance by others. CPP included emission trading provisions. In addition, EPA has several ABT transportation fuel programs in which better than standard performance is valued and traded. Perhaps, the legal foundation of either or both will work here.

Tl;dr. So, that’s how it works. MDC is an averaging, banking and trading or intensity-based cap and trade carbon policy. Government sets the cap, but, with a performance standard based on economic value, only the economy apportions the cap among individual sources. MDC’s TNE market allows sources with high abatement costs to benefit from low cost abatement by sources or sinks responding to market incentives. Domestic production is protected from less regulated imports, and the competitive position of exports in international trade is defended.

The next and last article will dive into the “Why” of MDC. Discussion will touch on MDC’s historical and philosophical basis, on implied subsidies and economic rents, costs compared to a carbon tax, equalizing the carbon footprint of consumer spending, the concept and historical role of property in allocating resources and, perhaps, a few other things. The article will be longer than either of the first two installments. So, please be patient.

Retired environmental compliance and government relations vice president for a small petroleum refiner. I have degrees in chemical engineering and law.

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