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11 essential questions for designing a policy to price carbon

Editor’s note: This is a discussion draft, version 1.0

Economists widely advocate establishing a price on carbon as a central means of reducing greenhouse gas emissions and the risks of global climatic disruption and ocean acidification. To be sure, a price on carbon is necessarily one part of a broader climate policy portfolio that includes diplomatic engagement, research, investments in adapting to a changing climate, assistance for vulnerable populations, and other aspects of the challenge.

But because market forces can be powerful and efficient agents for change, a policy to price carbon is arguably an indispensable part of the solution. Here we focus on one way to price carbon: through a tax or fee.

When it comes to developing an actual policy, a host of devilish details arise. Any carbon levy legislation would have to address a number of key design decisions—and serious tradeoffs arise across nearly all of them. How, for example, would the policy balance giving certainty to firms that make long-term investments, but still allow for updates as information, technology, and outcomes evolve?

What follows are eleven essential design questions to consider when designing a carbon charge. Each question has several potential answers with their own considerations, pro and con (recognizing that one person’s pro can be another person’s con). To inform your own thoughts on how a price on carbon should work, imagine you are a policymaker and think through how you would address each of the following questions. The goal here is to elucidate at a high level the options for carbon pricing policy design, not to build the case for a carbon price itself or quantify the benefits or costs of specific approaches. The hyperlinks will take you to further reading, but are not necessarily endorsements.

Click on a question below to jump to its discussion:

1. What is the name of the carbon pricing policy?

2. What greenhouse gas (GHG) sources and gases does the policy cover?

3. What’s the initial price and how does it change over time?

4. Who pays the carbon charge?

5. Who collects the revenue?

6. What happens to the revenue?

7. Does it change other Federal climate and energy policies, and if so how?

8. Does it constrain state-level policies?

9. Does it allow offsets (alternatives to paying a fee)?

10. Does it give credits or rebates for certain activities?

11. Does it include measures to reduce effects on U.S. competitiveness and emissions leakage?

1. What is the name of the carbon pricing policy?

Here we’re talking about a policy that economists typically call a carbon tax. This is shorthand; the tax is based on tons of carbon dioxide (CO2) and might cover non-CO2 greenhouse gases (such as methane, nitrous oxide, and certain industrial gases) as well, for example at a rate weighted by the global warming potential of each gas relative to CO2. A cap-and-trade or hybrid program can also impose a price on carbon emissions, but here we are focusing on the design of policy that sets a carbon price rather than an emissions quantity, recognizing that the various approaches can be designed to be similar in practice.

“Tax” is the term economists apply to most revenue instruments. Because imposing a new tax is potentially politically fraught, some people advocate calling a carbon pricing policy something besides a tax, such as a fee, levy, charge (PDF), or adder. Some would advocate referring not to carbon, but to climate pollution or some other term for greenhouse gas emissions. The best label is a judgement call; a variety of terms will appear here, but they all refer to the same thing.

A few points about using “tax” as a descriptor:

  • Most existing state and federal fuel charges (e.g., on transportation fuels and coal) are called excise taxes, i.e. taxes like cigarette and alcohol taxes that apply on goods based on their volume or quantities, not their price.
  • “Tax” is the legal term that applies to most collections by the U.S. Treasury’s Internal Revenue Service (IRS). The IRS also collects “user fees” for services it provides, such as making special determinations like whether a specific employer’s retirement plan meets IRS requirements.

Pros and cons of referring to the policy as a tax:

  • A term other than tax may improve the appeal of the policy and make it easier for policymakers to vote for it.
  • However, using a term other than tax could prompt charges of trying to hide the fact that the policy is functionally equivalent to a tax.
  • Calling the policy a “tax” may be more attractive if it is part of a tax shift or swap, meaning at least some of the revenue is used to reduce other taxes.

Finally, the terms “penalty” and “fine” have unique considerations. For one thing, they carry the inaccurate connotation of emitters being in violation of the rules; when the IRS imposes penalties, it’s because someone underpaid their taxes. Also, fines and penalties are not typically deductible against business income.

2. What greenhouse gas (GHG) sources and gases does it cover?

Every tax needs a base to which it applies. Most obvious would be carbon dioxide. CO2 is known to contribute to climatic disruption and ocean acidification: it accounts for around 81 percent of all U.S. GHG emissions from human activities (PDF); 76 percent of total U.S. GHG emissions are CO2 from fossil fuel combustion. Since not all fossil fuels have the same carbon intensity, a levy on their carbon (either the carbon content before combustion or the carbon dioxide in their combustion gases) would raise the relative price of fossil fuels in proportion to their propensity to disrupt the climate. For example, natural gas has about half the carbon per unit of energy than coal. Renewables and nuclear power don’t emit carbon, so those energy sources would not be taxed. Some sources of non-fossil CO2 (for example from cement production) and some non-CO2 gases (such as landfill and coal bed methane emissions) may be feasible to tax. Including small sources expands the administrative burden, so it may be worth establishing some emissions threshold below which emissions are not subject to the charge.

All else equal, the more greenhouse gases and sources that are subject to the price, the greater the emissions reductions it will produce. Broad coverage also equalizes marginal incentives for abatement (the cost of that last ton of emissions reduced) across the economy. This ensures that investment in emissions abatement goes to the least-cost strategies and can lower the overall cost of achieving any particular emissions goal. It also incentivizes technology development across a wide range of emissions-reducing applications. However, for any given carbon price, broader coverage raises the scope of the macroeconomic impacts of the tax.

Policymakers could limit the pricing policy to certain sectors. For example, if a regulatory approach such as the Clean Power Plan covers the electricity sector, then policymakers could control emissions in other sectors with a fee. Likewise, if policymakers want a supplement or replacement for the tax on gasoline, they could impose a carbon tax only on diesel fuel and gasoline. This approach would produce less abatement and revenue than a GHG levy with broader coverage. It would also result in inefficient disparities in abatement incentives across sectors and may neglect opportunities for cost-effective environmental benefits.

Managing carbon fluxes from terrestrial ecosystems, such as agricultural soils and industrial forests, will be important to stabilizing GHG concentrations. Some of these carbon stock changes could be included under a carbon pricing policy, but doing so would involve policy design issues unique to these sectors, like figuring out how and whether to give credit for carbon stored in forests that may burn down later. In some cases, it may be better to use policy options other than carbon pricing for these sectors.

3. What’s the initial price and how does it change over time?

The starting rate and trajectory of the price are integral to the outcomes of the policy. All else equal, research shows that higher carbon prices will produce greater economic burdens but higher emissions abatement than lower carbon prices.

Not all sectors will respond at the same speed. For example, abatement is likely to come more slowly in the transport sector than the electricity sector, owing to the greater availability of low-cost, low-carbon technologies for power generation than for transport.

A carbon price that stays constant will reduce emissions for a time, but eventually emissions will probably start going up again owing to economic growth. Emissions will be still lower than they would have been without the policy, but they won’t necessarily keep going down. Accordingly, most economists would advocate a carbon price trajectory that goes up over time at a pace that encourages continued abatement even as the economy grows.

There’s a limit to how high the price can go and still encourage additional abatement. Carbon prices that are controversially high (however that is interpreted) can raise the risk that Congress will amend or repeal the policy. If investors believe the future price might be reduced, expected carbon prices could fall significantly below the statutory price and investors would pursue less abatement than they would if they thought the statutory price path would remain intact.

Options for setting a carbon price path and their pros and cons:

1. Congress could set a carbon fee equal to the present value of the environmental and social damages produced by each additional ton of CO2 emissions (or the equivalent in other GHGs), a value called the social cost of carbon (SCC).

  • In theory, setting the tax path at the SCC would equate marginal damages to marginal costs and ensure that the abatement costs are justified by the benefits.
  • The White House has adopted an estimate of the SCC for federal agencies (PDF) to use in analyzing the costs and benefits of regulations and other policies that affect GHG emissions. The SCC grows gradually over time in real terms. Congress could use this set of values to set the trajectory of the tax.
  • In practice, using the SCC may have drawbacks. That’s because the estimated SCC is really a range of values that depend heavily on the discount rate, the appropriate value of which is much disputed. The SCC also involves large uncertainties and depends on judgements like whether to count just benefits to the United States or global benefits. It is also subject to sharp revision as new analyses become available. Also, the SCC adopted by the White House, however analytically developed, is ultimately controlled by the Executive branch. Congress may wish to control more directly the carbon price trajectory.

2. Another option is to establish a formula for the tax rate that evolves over time, for example with a specified initial value and change each year, such as a percent increase over inflation or an increase of $X per year.

  • This would have the advantage of providing clear information for businesses and households that make long-term capital decisions and investments in new technology. It would also be relatively easy to administer, parties could reliably project their tax liabilities, and budget authorities could straightforwardly score the pending revenue.
  • Without other policy measures or adjustments, this approach would not guarantee a particular emissions outcome. This could complicate ensuring compliance with an international pledge that is framed in emissions levels in a particular year.
  • A formula like this would not take into account important developments, such as new evidence on the SCC, evolving climate pledges by the United States or other countries, macroeconomic conditions, and other outcomes that are important to stakeholders. This suggests some kind of periodic review and/or revision of the price trajectory would be warranted—more on that below.
  • If the escalation is not capped at some point, the carbon price may become politically unsustainable or exceed estimates of the benefits of abatement.

3. An ambitious start and/or rapid increase would reduce emissions more quickly and spur technology development and deployment more sharply by increasing the returns to low carbon investments.

  • It would also raise more revenue in the short run, which could help jump start whatever goals the revenue is meant to pursue. An ambitious start or rapid increase could also ensure that the environmental performance of the policy quickly surpasses the regulatory alternative.
  • An ambitious start would create a bigger jump in fossil energy prices, which may galvanize opposition to the policy even as it motivates change. It would rapidly make some existing capital (like power plants or industrial facilities) uneconomic.

4. A modest start and gradual increase would allow businesses and households time to adjust their activities and lower their tax burdens.

  • A gradual start and ramp up would impose lower abatement costs and help some companies preserve their international competitiveness. It would allow U.S. diplomats time to coordinate carbon pricing policies with other countries before the prices become more ambitious.
  • It would also provide modest near-term climate benefits, particularly in sectors like transportation in which low-carbon alternatives are currently relatively costly.
  • This approach may also make it harder to achieve deep decarbonization targets by mid-century. For example, a low carbon price may not prevent the irreversible decommissioning of higher-cost nuclear power that may be important for longer-term deeper decarbonization.
  • A gradual price increase raises the probability that investors deploy lower—but not zero—carbon technologies like natural gas at greater scale. This could achieve modest climate goals cost effectively but may turn out to be uneconomic if climate policy becomes more stringent later.
  • Even a modest carbon fee that rises slowly can raise enough revenue to lower other taxes, the deficit, or accomplish other fiscal goals. For example, according to CBO (see option 35 on page 176), a greenhouse gas tax that starts at $25/ton CO2-equivalent could raise over $1 trillion in the first 10 years.

5. Tying the carbon price to other tax changes (or vice versa) could help ensure the tax shift is revenue neutral, meaning that the policy package does not increase or decrease overall revenues to the federal government.

  • This can be attractive to stakeholders who wish to ensure that the policy does not grow government.
  • Ensuring exact revenue neutrality each year may lead to fluctuations in the carbon price or rates on other taxes that complicate the administration of the program and raise uncertainty for private sector investment decisions. The approach in British Columbia suggests that some such linkages are feasible.

Especially over the long run, it’s hard to predict how emissions levels and other outcomes will respond to any particular carbon price trajectory, even one in which the real price on carbon increases predictably each year. Thus it may make sense to build in a regular review of relevant information and plan for orderly updates to the carbon price trajectory (or other policies) depending on how things turn out. Any process for updating the carbon price path would introduce uncertainty for investors. Some would end up making abatement choices or undertaking R&D projects that turn out to be ill-suited to the revised policy. Thus, the updating question involves balancing the benefits of taking into account new information in policy-setting and the costs of any uncertainty introduced into investment incentives. This is probably one of the most difficult issues in the design of a carbon price policy.

Considerations regarding the process of revising the carbon price path

Some stakeholders focus on ensuring that emissions outcomes move towards a particular annual or cumulative goal. For example, what happens if the carbon tax isn’t producing emissions levels consistent with achieving the United States’ international commitments? Is there some process by which the tax path is increased, or is there some other policy approach that kicks in? Some stakeholders may be especially concerned about this question if the carbon pricing legislation repeals, suspends, or otherwise reduces EPA’s authority to regulate GHGs via the Clean Air Act (see question #7). They want to be sure that down the road that the tradeoff was a good deal for the climate. Certainly, if the president and Congress agree, they can legislatively change the carbon pricing policy at any time. But this is likely a heavy political lift and provides little reassurance to those most worried about emissions outcomes.

Congress could delegate the updating of the tax to the Executive Branch or a third party, such as an expert panel, with guidelines on the objectives they should pursue. However, Congress generally eschews delegating tax rates, and in some cases certain legal issues arise if Congress delegates significant matters. A number of other approaches, short of delegation, could inform or prompt changes in the carbon price path, including expert reviews, fast track authority, and automatic carbon price updates. It makes sense to conduct reviews of the carbon price every few years, for example to coincide with 5-year rounds of commitments under the UN Framework Convention on Climate Change (UNFCCC). Alternatively, the policy could trigger reviews in specific circumstances, such as hitting or not hitting certain emissions outcomes.

Policymakers could set a quantitative relationship between the carbon tax rate and the emissions outcomes, for example to raise the tax or its growth rate if emissions are higher than expected. This would encourage more certain emissions outcomes and boost support for the policy amongst some stakeholders. However, it might complicate the Congressional negotiations around a carbon price bill because not only would legislators have to agree on a tax path, they’d have to agree on the update process and any potential emissions targets or triggers that are embedded in it. Making updates infrequent and setting new tax values years in advance may simplify the administration of the policy and give more certainty to investors. If prospective increases are large, emitters might hasten their activities to take advantage of lower near-term tax rates. Using cumulative emissions rather than annual emissions would make adjustments less volatile.

Another approach could link emissions outcomes to amendments to other policies, such as regulatory authority (see question #7) or how the revenue is used (question #6). For example, if emissions are higher than expected, so are revenues. Policymakers could target the extra revenue towards further emissions abatement, such as a reverse auction for emissions reductions, incentive payments for soil or forest carbon sequestration, or international funds, such as the Green Climate Fund.

In theory, an updating process could also result in a lower fee trajectory, for example if the process allows taking into account factors such as: economic outcomes are worse than expected; new technologies can decarbonize the economy at unexpectedly low cost, so a big tax isn’t necessary; or new scientific evidence suggests climate change is less damaging than previously thought. A policy design that can raise OR lower carbon prices introduces another dimension of uncertainty for investors. This could dampen investments in lower carbon technologies that would only find a market at higher carbon prices.

4. Who pays the carbon charge?

Any carbon pricing policy has to identify a particular set of actors who would be responsible for paying the charge. For example, the charge could apply to producers, processors, or distributors of fossil fuels, or it could apply to those who actually burn the fuels, such as power plants and industrial facilities – or even individuals when they put gasoline in their cars. We call this the point of taxation. In general, the economic outcomes don’t depend on which entities pay the levy to the government. Taxed firms will pass costs along to suppliers, consumers, and workers to the extent they can through prices and wages.

Pros and cons of different points of taxation:

  • Each fuel has a different chain of supply, so there are different points at which the government could impose the carbon charge. Applying the charge at the chokepoint of each fuel’s distribution system would minimize the number of taxpayers and maximize the coverage of the policy. However, it may then be appropriate to give credits to downstream firms in cases where the carbon doesn’t end up in the atmosphere (see question #10). A chokepoint approach would not work as well if certain downstream sectors are exempt from the tax. For natural gas and petroleum, the chokepoint of the distribution system may closer to midstream (at processing and refining facilities) than upstream at wellheads. The Congressional Research Service estimates (PDF) that the levy could apply to fewer than 2,300 entities and yet cover 80 percent of U.S. domestic GHG emissions.
  • An upstream charge imposes the price at the start of the fossil energy distribution system, such as at the coal mine mouth, natural gas wellheads, oil wells, and international borders. The carbon content of coal per ton produced can vary a lot across different coal deposits, as may the carbon content of oil. Thus, a well-targeted upstream approach would need to keep track of the differences and apply the appropriate fee.
  • To fully cover GHG emissions in the fossil fuel supply chain, emissions in the fuel production process, for example natural gas flaring and venting should be taxed as well.
  • A mid- to downstream approach would price fossil carbon at power plants and other large industrial facilities. This could build on EPA’s GHG reporting system for large stationary sources. It could also allow emissions to be measured by continuous emissions monitoring (CEM) equipment that these facilities use to comply with existing pollution regulations. However, in some co-firing facilities, the CEM approach might make it hard to distinguish CO2 emissions from fossil fuels and those that derive from biomass (which may not be subject to the carbon charge) in the fuel supply.
  • A fully downstream approach, such as carbon-based surcharges on household natural gas bills, would make the price signal more obvious to consumers– what economists call saliency. This could be more environmentally effective if it makes people pay more attention to (and reduce) their energy consumption, but regular reminders of the tax might also engender more opposition. The value of tax salience at the household level may be limited because many of the most significant emissions reduction strategies are further upstream, such as in the fuel choice for electricity generation. Downstream approaches could involve vastly more taxpayers and may exclude relatively small emitters.

5. Who collects the revenue?

The legislation must give authority to collect the tax or fee to a specific federal agency. The most likely candidates would be the U.S. Treasury and the Environmental Protection Agency (EPA).

The U.S. Treasury currently collects several federal fuel-related excise taxes, including a tax on most coal produced in the United States (PDF) that funds the Black Lung Disability Trust Fund. The agency has deep expertise in collecting and managing large flows of funds. It would be the logical collection authority for any policy labeled a tax, although Treasury could do the job even if the label is something other than tax.

The EPA collects emissions data from large emitters and enforces limits on those emissions. For example, EPA could collect GHG fees from the sources the agency already regulates (see question #4). Even a modest carbon charge would produce far more revenue than EPA has ever handled, and giving EPA what amounts to taxing authority (even if the policy is labeled a fee) would be opposed by some stakeholders.

6. What happens to the revenue?

One of the biggest challenges of designing a carbon charge is working out what to do with the revenue. This question has big implications for its political appeal, distributional outcomes, and overall net benefits of the policy. (Some ways to price carbon, like a cap-and-trade program that gives away free allowances or a hybrid program, wouldn’t involve the government collecting revenue, but they would involve resource allocations with similar underlying implications.)

Assuming we are in the mode of designing a tax-like policy, policymakers can pursue at least three alternative policy goals (PDF) with the considerable revenue from the tax:

  1. Offset the new burdens that a carbon price places on consumers, producers, communities, and the broader economy
  2. Support further efforts to reduce greenhouse gas emissions or build resilience to climatic disruption
  3. Fund priorities unrelated to climate

Each of these approaches has strengths and weakness, and important tradeoffs across different goals arise. One of the most important aspects of this question (although it’s not easy to predict) is how the use of revenue affects the potential for a legislative deal and, after that, the political durability of the program. Climatic disruption and ocean acidification are challenges that will span generations, so the long-term persistence of the carbon price is critical. Many emissions-reducing investments involve large expenditures on long-lived capital, such as power plants and industrial facilities. A carbon pricing policy that businesses and individuals believe will endure will be more environmentally successful and more economically efficient than one that.

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