How the EPA Can Help the Environment and State Finances

Although Congress hasn’t moved on carbon pricing at a national level, the U.S. Environmental Protection Agency (EPA) has a unique opportunity to induce states to create their own carbon taxes. The EPA is developing a proposed rule—due out June 1, 2014—to control greenhouse gases (GHGs) from existing power plants. Under Section 111(d) of the Clean Air Act, EPA will issue guidelines for states, and each state must submit a compliance plan to EPA for approval. EPA could allow states to comply by adopting an excise tax or fee on the carbon content of fuels combusted by the regulated power plants, thereby offering states a way to simultaneously implement the EPA rule and raise revenue.

EPA’s important pending power plant rule will cover about a third of U.S. GHG emissions, and it will set a precedent rules for all sorts of U.S. industrial facilities, which emit another 15 percent or so of total US GHGs. Barring unforeseen functionality in Congress, the EPA rule will also be the centerpiece of the commitments the United States makes in the next round of international climate talks in 2015.

In its rule, EPA can offer states a menu of approaches that the agency believes would satisfy the law and the principles the President laid out in a June 2013 memo. Most observers expect EPA to offer options that include an emissions performance standard (such as a limit in the form of X pounds of CO₂ per kilowatt hour generated) that states could satisfy through flexible sector-wide compliance rules. The agency could also offer an option that would accommodate the emissions cap-and-trade system adopted by California.

In addition, EPA could assure states that the agency would approve state compliance plans that use excise taxes to achieve emissions levels equivalent to the regulatory standards. EPA could even specify a minimum tax level or trajectory, imposed per ton of carbon dioxide equivalent, which any state could adopt and comply with EPA’s guidelines for power plants. The agency could also indicate its intent to offer the same price-based standard in future rules to control GHG emissions from industrial facilities, which would allow states to adopt only one law to comply with all pending GHG regulations.

What are the advantages of EPA allowing states to use a carbon tax to comply with its rules?

1. First, an excise tax or fee approach is fully consistent with all of the principles the President laid out. It’s market-based, it’s flexible, it accommodates existing fuel mixes and the “remaining useful life” of equipment, and it doesn’t undermine electricity reliability, while at the same time it provides an incentive to reduce use of fossil fuels in exact proportion to each fuel’s damage to the climate.

2. An excise tax option is feasible and consistent with the law. If EPA can allow for a cap-and-trade approach as a “standard of performance,” it can allow an excise tax. EPA can show equivalence in expectation: for every price there’s a quantity and every quantity there’s a price.

3. An excise tax creates abatement incentives on the margin at every level of emissions, even beyond the point at which any particular technical performance standard is achieved. The policy always binds and always incentivizes abatement. An excise tax also helps drive a market for new technologies, which standards based on existing technologies may not do.

4. An excise tax, without any ancillary measures, creates incentives to abate through the entire supply chain for electricity. It incentivizes energy efficiency and a transition to lower-carbon fuels at the electricity generating unit, and it induces offsite actions to reduce or avoid emissions, including via end-use energy efficiency. Moreover, an excise tax incentivizes abatement through all means, including those about which neither EPA nor states have any information.

5. For some states, an excise tax would offer easy and fast implementation. Some states already have excise taxes on fuels, including motor fuels and natural gas. Experience shows these taxes are administratively straightforward.

6. An excise tax would be easier for states to initiate and administer than other flexible compliance approaches, including a cap-and-trade system and tradable performance standards. States would not have to devise an initial allocation of allowances (such as auctions or grandfathering), create a registry or market, monitor trades, or enforce a price floor. They don’t have to account for electricity generation, transmission, or consumption. They just monitor fossil fuel use and collect the money.

7. Excise taxes are easier for regulated firms, too, because firms would not have to manage allowance price volatility, fluctuating stringency, regulatory uncertainty, or macroeconomic gyrations that would affect allowance markets. The compliance price and its trajectory would be fixed, thus fostering the long term investments that are critical to decarbonizing the economy cost effectively.

8. Offering a particular tax rate or tax trajectory fosters transparent coordination of efforts across states. Multi-state coordination can help prevent inefficiently divergent incentives across states that can drive investment from more stringent states to less stringent states, which undermines the environmental performance of the rule. The same emissions standard can have very different economic implications in different states depending on their baseline conditions. To minimize cross-state emissions leakage and competitiveness disparities, states should adopt similar price signals, and EPA can tell them in this rule what prices to coalesce around. Moreover, with harmonized excise taxes, state policies don’t have to interact directly, like they would with a multi-state cap-and-trade program in which allowances trade cross state borders. In other words, harmonized excise taxes should be easier to implement than multi-state cap-and-trade programs, and they’d yield the same harmonizing benefits.

9. Importantly, states could use the revenue however they wish. The economic literature shows that the most cost effective climate policy would use revenue generated from a carbon tax or allowance auctions to lower other taxes that burden the economy, what we call a “tax swap.” States have some revenue instruments that are likely to be more distortionary than a carbon tax, so the possibility of an efficiency-enhancing tax swap at the state level raises the prospect of net social benefits without even counting the environmental benefits. States could also use excise tax revenue to bolster precarious fiscal balances, pay down debt, fund under-capitalized pension or rainy day funds, fund other priorities, dividend the revenue to poor households, or any combination.

10. An excise tax explicitly bounds the marginal costs of the rule. EPA can use the excise tax option to benchmark the rule’s costs directly to the range of estimates of the social cost of carbon (SCC) in the Administration’s guidance for federal rulemaking. Depending on ambition of the rule, it may be helpful to allow states to ramp up their carbon tax over time to avoid premature scrapping of capital. By tying the carbon price to the Administration’s SCC guidance, EPA can directly demonstrate positive net benefits of the rule. In fact, EPA will probably have to do the implicit price calculation for an emissions performance standard anyway for the regulatory impact analysis, so EPA might as well put that price in the rule as an option for states.

11. If EPA puts an excise tax option in the rule, then the agency can signal that it expects to offer the same approach for future GHG rulemakings for industrial facilities. This immediately tells other emitters what to expect and helps them plan their long term investments efficiently. That means that a price-based option in the power plant rule could drive abatement in other sectors even before EPA starts regulating them and thus improve the rule’s overall environmental benefits.

Even if few states choose to take up the excise tax option, it’s important for EPA to put it in the rule…

12. For one thing, including the price-based standard in the rule offers strong diplomatic advantages. It is much easier to explain to other countries that the United States has adopted a specific price path on carbon — or that individual states have chosen something equivalent per official EPA guidance — across the country’s electricity sector than it is to explain that our states will meet emissions standards of X tons per kilowatt hour or whatever. Other countries keenly want to know the economic level of our ambition, and anything other than a price is hard for them to assess. Many officials from other countries say that if the United States adopted a price on carbon it would significantly change the politics in their countries in favor of something similar.

13. If all those advantages aren’t enough, how about the signal a carbon price in the rule would send to Congress? A number of carbon tax bills have been floated in Congress, and there has been talk of including a carbon tax in the context of broader fiscal reform. The Administration can use the EPA rule to indicate to Congress what the President thinks would be an appropriate federal carbon tax approach. And if some members are intent on suspending EPA’s Clean Air Act authority for greenhouse gases, the Administration can signal in this rule what it would expect as an alternative. I think it would be a major lost political opportunity for the Administration not to use this rule to communicate its expectations for new authority.

Many of the advantages of offering an excise tax option for state compliance would apply to EPA’s backup plan (known as a Federal Implementation Plan, or FIP) for states that don’t submit an acceptable compliance plan. The federal government could collect carbon fees from emitters in wayward states. Indeed, the federal government already collects a number of fuel excise taxes, including a small tax on about 93 percent of U.S. coal production that funds care for victims of black lung disease. The federal government could remit the revenues to state governments, rebate revenues directly to residents of states in which a FIP operates, or keep the revenues for the federal Treasury, in which case states would quickly see the advantage of imposing the tax themselves.

Finally, members of Congress who denounce complex and burdensome EPA regulations have an opportunity to streamline those rules with a law that would require EPA to allow states to adopt a simple reasonable carbon fee schedule in lieu of mandated emissions standards. States can choose which option suits them best, leaving the decision and the potential revenue in their control.