Recently, the American Petroleum Institute has come out as the latest in a long line of energy-intensive industry stakeholders to endorse a price on carbon. Pessimists may view this as a greenwashing attempt to avoid more damaging regulations in the future, but the truth is that—as the R Street Institute has stated before—there is considerable economic wisdom in using pricing rather than regulation to abate emissions. If implemented wisely, carbon pricing in lieu of regulations and subsidies can be a far more potent policy tool for climate progress. Alternatively, poorly implemented carbon pricing risks a lot of economic pain without much benefit.

Traditionally, carbon pricing has often been framed as a punitive measure against energy consumption. Its opponents often fall into one of two camps, with some critiquing its impacts on energy costs to Americans, and others critiquing it as being not enough. While a carbon price alone does not eliminate greenhouse gas emissions, it has three advantages over the conventional central-planning approach to climate policy, which are no doubt the reason for its rising support among business interests.

The first, and perhaps most important advantage of a carbon price, is to replace less efficient climate policies. A carbon price works by creating an incentive for a consumer to adopt a lower-emitting activity to avoid paying a tax, which consequently creates a financial incentive for firms to reduce emissions associated with their products. For example, an electricity provider may switch from using coal power to natural gas—which has roughly half the carbon dioxide emissions of coal—to minimize their tax payments. Importantly, when compared to a regulation that mandates power plants reduce emissions, the carbon price and the regulation both target the same array of abatement opportunities—meaning there is no benefit to having both simultaneously.

When choosing between either a price on carbon or a regulation, the pricing scheme has obvious advantages. Whereas regulation targets specific abatement opportunities, a carbon price allows flexibility for consumers to identify what is optimal. Returning to the coal versus natural gas example, under a carbon price some coal-fired power plants would continue to operate because the cost of fuel switching exceeds the benefit from avoiding the carbon price, and those consumers end up with lower overall costs than they would under a regulation that would force the change. Conversely, there may be more opportunities for fuel switching that are incentivized by the carbon price than would be required under a regulation—which is constrained by limitations on statutory authority—meaning the carbon price can result in more emission abatement than a regulation would. Further, a carbon price delivers immediate incentives rather than a regulation that may take years to implement, and for long-lived pollutants like carbon dioxide earlier abatement yields more cumulative benefit than delayed policies.

A carbon price is also administratively simpler to implement, as the price could be applied at wellheads or minemouths, whereas a regulation requires repeated use of rulemaking processes that are subject to litigation or undoing from a later administration. And for publicly traded firms that are faced with tightening environmental corporate governance demands, the carbon price offers an easier way of assuring shareholders that the costs of their environmental impacts are accounted for in their financial estimates.

The second advantage of a carbon price is its neutral treatment of emission abatement methods, which amplifies innovation. Energy efficiency, renewable energy, carbon capture, fuel switching, direct-air-capture and every other emission mitigation technology is treated equally under an effectively implemented carbon price, meaning all technologies compete on an equal playing field—assuming no subsidies. Simply, the carbon price delivers an incentive to private investors to research, develop and deploy the best possible, least cost, emissions mitigation technology. This accelerates innovation, rather than relying on politicians to know what technology is best.

And the third advantage of a carbon price is its ability to raise revenue, especially in a manner that is economically advantageous to alternative taxes. It should be stated plainly that a carbon price would induce a significant economic harm with its implementation, since the policy implicitly raises the costs of economic inputs while reducing after-tax incomes of energy consumers—which is to say, everyone. The reason this is an advantage, rather than a fault, is that there are taxes that are even more harmful to the economy than a carbon price. Using the revenues to reduce an even worse tax equally can yield a roughly neutral economic outcome, and simultaneously reduce economic impact of pollution. Conventionally, people think corporate income taxes are the best tax to cut, as the corporate tax incentivizes firms to flee to lower-tax jurisdictions and is usually paid by corporations’ customers and employees instead of shareholders. However, supplanting payroll taxes are another significant opportunity to create new incentives for labor force participation while simultaneously replacing a regressive tax and resulting in lower overall taxes on low-income Americans.

On the other hand, if carbon price revenues were used unwisely or for political reasons, consumers would feel the full economic pain of the carbon price. Using revenues to subsidize clean energy, for example, would be among the worst uses possible, because it would simultaneously enrich politically favored firms while also forgoing the opportunity for a carbon price to be agnostic in its treatment of energy sources. And since a carbon price is not a particularly efficient revenue raiser, paying for bad economic policy with a new regressive tax would do more economic harm than good.

All in all, the Tax Foundation estimates that a $50 per ton revenue-neutral carbon tax where revenues replaced payroll taxes would result in a 0.1 percent increase in long-run GDP and a more progressive tax code, and Resources for the Future estimates a similar carbon price would reduce emissions by approximately 1.6 billion metric tons annually by year 10. Additionally, the Tax Foundation estimated far greater economic benefits—up to 0.8 percent increase in GDP—if revenues are used to further lower taxes on capital and expand expensing provisions. For comparison, the Obama administration’s energy and environmental regulations had an estimated cost of $457 billion, and claimed an estimated 1 billion metric tons of annual emission benefit. If implemented optimally, carbon prices are far more efficient than regulation, at more than twice as much benefit per dollar of impact.

When considering the economic arguments behind carbon pricing, it is no surprise that industry groups are becoming increasingly supportive. The Biden administration has demonstrated enthusiasm for using regulation to address fossil fuel emissions, and it makes sense that stakeholders would seek to support an alternative policy. The political considerations, though, are more complex.

Unfortunately, the sort of optimal approach to carbon pricing that emphasizes revenue-neutrality, regulatory preemption and an end to distortive subsidies is not one that has seen any success thus far. President Joe Biden has already opposed a carbon price, and prominent environmental groups have often opposed carbon prices because of revenue expenditure disputes, as many called for using revenues to subsidize clean energy. Conservative opposition has also been deeply skeptical of carbon pricing, citing concern that it would expand the level of interference of government in American lives. All in all, the merits and politics of a carbon tax depend on the context of an overall proposal.

It is not surprising that industry participants that are already facing government intervention in their businesses have started to come out in support of carbon pricing, but the policy fundamentals are unchanged. A carbon price that is revenue neutral, focuses on moving the tax code to something better—rather than worse—than the current state, and preempts costlier regulation makes sense. However, a carbon price by any means that uses revenues to expand government would be bad policy. As more and more groups are becoming open to the idea of carbon pricing, they must not forget that conditionality is key, and there is distinction in good ways and bad ways to implement tax policy.

Image credit: Diana Parkhouse