05/04/2010 05:12 am ET Updated May 25, 2011

Senators Kerry, Graham and Lieberman's Poor Excuse for a Carbon Tax

The Washington Post reported last weekend that Senators Kerry (D-MA), Graham (R-SC) and Lieberman (ID-CT) ("KGL") are likely to propose a multi-sector price on carbon that includes a declining cap on emissions for power generators, a carbon tax for transportation fuels and, eventually, a cap for the industrial sector. After several days of follow-up news stories, it's still unclear whether the KGL cap on power generators will be a cap- and-trade or a cap-and-dividend approach similar to that proposed by Senators Cantwell (D-WA) and Collins (R-ME) in their Carbon Limits and Energy for America's Renewal (CLEAR) Act. Speculation is rampant and analysis at this time is premature. We do know, however, that agreements are "in sight" to incorporate agricultural and forestry offsets, so there will likely be the same problems with potentially fraudulent offsets as would have occurred under Waxman-Markey/Kerry-Boxer. The use of offsets in lieu of actual emissions reductions will result in a low and ineffective price on carbon and continued emissions from coal-fired generators in the United States.

It's the carbon tax, of course, that is of greatest interest to the Carbon Tax Center. Does the prospect that KGL may propose a carbon tax represent real progress? Could this constitute a new approach combining the best of a cap-and-trade scheme with the type of easily understood and transparent, revenue-neutral carbon tax/fee that the Carbon Tax Center has long proposed -- a carbon tax/fee with steadily increasing rates that sends a clear price signal to consumers and manufacturers of energy-using products and transportation to use energy more efficiently and reduce reliance on high-carbon fuels? Or, are the senators just making the Waxman-Markey/Kerry Boxer cap-and-trade fiasco even worse?

Early indications are that the prospective KGL carbon tax on transportation fuels is the polar opposite of a well-designed, revenue-neutral carbon tax. A well-designed carbon tax would be imposed upstream where carbon enters the stream of commerce, such as the wellhead, refinery or mine mouth. The carbon tax would be imposed upon all fossil fuels based upon the carbon content of the fuel. It would gradually increase so consumers have a clear price signal that will encourage decisions to reduce carbon emissions through increased energy efficiency and switching to less carbon-intensive fuels.

In addition, an optimal carbon tax would return most of the carbon tax revenues to consumers through either a dividend or an offsetting tax deduction. A comprehensive, revenue-neutral carbon tax, imposed on all fossil fuels, lets consumers choose the least carbon intensive means to obtain needed energy, for practically all purposes, based upon the carbon content of different energy sources.

The KGL carbon tax will obviously not be comprehensive, since it will be imposed only upon the transportation sector. While the carbon tax rate will likely be based upon power sector compliance costs, that does not mean that consumers will see the same price on carbon for the transportation sector and the power generation sector. Once again, power generators are demanding free allowances and the use of offsets to protect their customers from price increases. Worse, there will be no price on carbon for industrial customers for some yet to be determined period of time. Industrial customers may actually see reduced costs for carbon fuels, if the price on carbon on other sectors is high enough to reduce demand for fossil fuels. While this may sound like good news, it would put the brakes on industry's transition to a low-carbon economy.

The KGL carbon tax will apparently not be imposed upstream. News reports indicate that it may be imposed at the gasoline pumps (with signs blaming the carbon tax on efforts to combat climate change). It's an approach rife for pleas for exemptions. An upstream tax would not be similarly vulnerable; the tax would be paid when the fossil fuel enters the marketplace and the company paying the tax would treat it as a cost of business to be passed on to customers to the extent possible.

The greatest virtue of a properly designed carbon tax is that it provides a clear price signal. Customers can count on a steadily increasing price on carbon and make economic decisions regarding investment in energy efficiency and substitution of other fuels that factor in that increasing price. In contrast, one of the major flaws in cap-and-trade is the inevitable volatility of prices, since prices will rise and fall based upon weather and the state of the economy; the volatility is increased by the gaming and speculation that are endemic to cap-and-trade systems.

Bizarrely, the KGL carbon tax is likely to incorporate one of the worst features of cap-and-trade; the carbon tax rate will apparently be based upon the compliance costs in the power generator sector. It's unclear whether there will at least be a ratchet, so that prices can only go up. If prices are allowed to decrease, consumers may see the type of volatile gas prices that they've experienced for years at the gas pump. When gasoline prices are volatile, consumers get skittish about investing in fuel-efficient cars, since they're reluctant to pay extra for an energy-efficient hybrid for fear of buyer's remorse when prices at the pump drop precipitously.

The KGL carbon tax is described as returning revenues to customers, but it apparently will do so in a convoluted and counter-productive way. An undetermined portion of the carbon tax revenues will flow to transportation projects and the Highway Trust Fund. The result could be more and bigger roads, increased driving and increased benefits for those who drive the most. You can't make this stuff up!

The good news is that Senators Kerry, Graham and Lieberman appear to recognize that carbon taxes make sense and can fly politically. The bad news is that the type of carbon tax that is likely to be proposed for the transportation sector bears little or no resemblance to a well-designed carbon tax, incorporates some of the worst elements of cap-and-trade and would be ineffectual and counterproductive. It almost makes cap-and-trade look good.