Governments need a revenue system compatible with a low-carbon future

Editor's note:

In advance of the Oct. 19 presidential debate at UNLV, The Sunday and the Brookings Institution, in partnership with UNLV and Brookings Mountain West, are presenting a series of guest columns on state and national election issues. The columns will appear weekly.

The coming presidential election will perhaps be more pivotal for climate-change policy than any other policy arena. The next administration will decide how and whether to defend new Clean Air Act regulations in court (and whom to appoint to the courts), whether to promulgate new climate regulations, the direction of United States’ international climate commitments, and funding priorities for clean-energy technologies. One key decision, now under consideration by the U.S. Department of the Interior, will be whether to reform federal coal-leasing policies in a way that raises revenue and incorporates the cost of climatic damages into the price of federal coal.

Similar decisions are emerging at the state level, especially in the handful of states that derive a significant share of their revenue directly from the production of oil, natural gas and coal in their jurisdiction.

Adding to some states’ reliance on fossil-fuel production is a tax on mineral-related income and property. For example, Alaska generates more than 10 percent of its tax revenue from a tax specifically on oil and gas property.

Relying so heavily on oil, natural gas and coal poses real downsides for these states. Recent experience shows how mineral revenues can swing wildly with fluctuations in energy markets; overall, state severance tax and royalty revenues are roughly half their peak in 2008. When the fracking revolution and other factors sharply lowered prices of oil and natural gas, prices fell by more than production volumes rose, so revenue dropped. At the same time, low-cost natural gas is supplanting coal use in the power sector, helping drive down U.S. coal production by about 45 percent from its 2008 peak.

Some states prepared for current conditions by reserving revenue during boom times for use in leaner years. Returns from sovereign wealth and rainy day funds like those in Texas and North Dakota have insulated state budgets from energy market swings. Other states have been less disciplined, and they face budget shortfalls when just a few years ago they were flush with revenue.

But even the best approaches to manage volatility can’t indefinitely hedge against persistently lower revenues. If natural gas prices remain low, as the U.S. Department of Energy’s Energy Information Administration (EIA) projects, royalties from gas will remain low, and there will be no rebound in coal production. Fracking technology is improving, so oil prices could stay low for some time, at least until global economic growth picks up. And both natural gas and coal face increasing competition from renewables, which do not generate extraction-related taxes. Climate policy could amplify this shift, particularly away from coal. For example, EIA projects that by 2040, the Clean Power Plan regulation, if implemented as planned and extended beyond 2030, would shrink the use of coal in the power sector by more than half.

What should states do? Their options differ in the short run and the long run. Relatively quickly, states can improve the design of rainy day and permanent funds by loosening size limits, increasing deposits and generally budgeting to prioritize saving. They also can adjust the severance tax formulas to vary less with real price swings by, for example, moving from an ad valorem tax rate to an inflation-adjusted tax on the volume of production. Even more efficient would be to base the tax on the carbon-intensity of the minerals produced, or even impose an excise tax on greenhouse gas emissions, which would price carbon from fossil-fuel combustion rather than carbon embodied in the fuels produced. If the carbon tax rises gradually relative to inflation, it would provide a stable revenue stream, help states comply with new emissions regulations and raise enough revenue to balance budgets, build permanent funds and reduce other taxes, at least until emissions are far lower than they are now. For example, an illustrative carbon tax of $20 per ton of CO2 emissions in Alaska, North Dakota and Wyoming could raise about 1.3, 2.2 and 3.3 percent of GDP, respectively.

Some argue that mineral-rich states should raise more revenue by promoting greater mineral production, such as by opening new areas for exploration, drilling and approving new pipelines. This approach may expand the expected revenue base for a time, but it does not reduce its variance, and it complicates the longer-term transition to a lower-carbon economy. Further, experience shows that boosting production does not necessarily make up for decreasing prices.

In the longer run, mineral-reliant states need to adopt a revenue system that will work in a low-carbon future. They should consider reserving more of their mineral revenues in permanent trusts and begin the hard process of shifting toward a tax portfolio that does not depend as directly or disproportionately on fossil-fuel production, such as by balancing mineral taxes with sales taxes, property taxes and income taxes.

The undeniably best long-run strategy for the most fossil-intensive states is to diversify their economies, not just their tax portfolios. Of course, this is easier said than done, but it will not get easier with time.