The carbon tax is a tax on CO2 emissions. It aligns incentives of business (profit) and society (stable climate) by giving businesses an opportunity to make more money if they find ways to reduce their CO2 emissions.

One open question with the carbon tax is how to choose the tax rate. Several countries already have a carbon tax, but they seem to set it at a fixed rate, or increase it by a fixed amount each year. Even the Carbon Tax Center says, “There is no magic formula or right number”. I think they're approaching it wrong. Carbon taxes are essentially prices on carbon emissions. Governments shouldn't set prices, and they shouldn't set carbon tax rates either. The market should do it, with a little help from the government.

First, we should decide what level of CO2 emissions are “sustainable”. You can think of this as the “supply” of available emissions. There is no need to go below this level, although doing so will not be harmful. We should be able to continue emitting at the sustainable level for thousands of years. This level is then set as the eventual sustainable target.

Our current emissions are rather high. We can think of this as “demand”. Since demand is higher than supply, we need to raise prices (the carbon tax rate, currently 0% in the U.S.). We need to decide when we want to reach the sustainable level, and then interpolate target levels from the current level to the sustainable target. This might be a straight line for simplicity, but could also be an S-curve or exponential decay.

For example, let's say that the current CO2 emissions are 6 billion metric tons, and we decide that 1 billion metric tons, combined with more forests, is sustainable. Let's further suppose that we want to reach this target in 10 years. That means we need to reduce emissions by 0.5 billion metric tons each year, so we set our target for 2009 to 5.5, 2010 to 5.0, 2011 to 4.5, etc., until 2018, at 1.0 billion metric tons.

Each year (or perhaps every month), we look at the current level of emissions and the target level, and increase or decrease the carbon tax rate. If we're emitting more than the target, we'll increase the tax rate. If we're emitting less (which may happen in a few years, if all the businesses are competing to increase profits by reducing emissions), then we decrease the tax rate. By altering the tax rate in this way, we can stay close to the target.

The problem on the business side is that if the tax rates change every month, there's a lot of uncertainty (just as for any prices that change suddenly every month), and it's hard to change plans that quickly. What will likely develop is an insurance market. Insurers will sell insurance that the tax rate won't go up much, and businesses will buy the insurance to hedge against sudden increases. Does this eliminate the incentives for businesses? No! They're now paying insurance and taxes. The cost of insurance is set by the likelihood at the tax rates will go up. The insurance industry is in the best position to guess this, because they'll be visiting the businesses to determine how quickly emission reductions are going into place. The insurance companies will then be able to predict the future emissions, and set insurance rates based on that. Since they're the ones making payouts when businesses (collectively) don't reduce emissions, the insurance companies will then have an incentive to push businesses to act sooner. They also have the incentive to share techniques across businesses. They make more money when businesses collectively reduce emissions.

Most carbon tax proposals use a fixed price and hope that the output will decline. Most cap-and-trade proposals use a hard limit on emissions, and a variable, potentially volatile price. The variable carbon tax rate proposal combines aspects of both approaches. It uses variable prices, but they're varying less often; it uses a target instead of a hard cap, which allows businesses to buy more time; and it generates revenue for society. With a market based scheme, incentive are aligned. Society will want reduced emissions, businesses will want to reduce tax rates (by reducing emissions), and insurance companies will want to reduce payouts (by convincing businesses to reduce emissions). If businesses fail to reduce emissions, they pay an ever increasing compensation to society for the delay. Furthermore, the open question of what to set the tax to, which is open to lobbying, is replaced by the question of how much to change the tax, which I think is harder to game. This scheme also tells you when we've achieved our goal: emissions are at the sustainable target level. Even at this level, we continue the carbon tax to prevent emissions from going up, and we continue to take in revenue from those businesses that produce emissions. This will keep our emissions near the sustainable level.

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Richard wrote at Sunday, March 23, 2008 at 2:25:00 PM PDT

Part of the problem with a carbon tax is that carbon production is an inelastic demand for most industries, especially in the short term, because changing infrastructure takes time, and, let's not forget, is expensive. Another problem is that not everyone is focused on the same problem. Because each company is paying the tax separately, they are all trying to solve the carbon problem in their own subdomains (companies), rather than collectively going for the most efficient reduction. In your method, the insurance companies provide the only means to move money around to solve the problem efficiently, but I think that process would be too opaque to encourage good efficiency. There's one other question: Where does the tax money go? It can't really go to any carbon producing entity (except govt) to improve their carbon output, because that would be unfair, and politicians would lose their jobs if they voted for it. So it's wasted, at least in terms of reducing carbon output.

In the carbon credit system (perhaps modified from the credit system of today, which some of the world has with Kyoto), where credits are traded on the open market, money to solve the problem is allocated efficiently. The cheapest (to society) solutions are performed first, and the biggest payoffs (new power generation, for example) get investment dollars because of the big release of carbon credits that they'll have in the future, when the credits will probably be more expensive because of reduced supply. The other benefit is that little of the money is wasted in a good implementation. All of it goes to decreasing carbon output.

Amit wrote at Sunday, March 23, 2008 at 4:22:00 PM PDT

Yes, I agree that it's inelastic in the short term, and that's why I think you want the carbon tax instead of a cap and trade system. The tax allows you to increase the cap in the short term in exchange for dollars, which provides an incentive to build infrastructure to reduce emissions in the future.

The tax money goes to the government, or refunded to the citizens. However, in a cap and trade system, you have the same problem, except someone gets the initial allocation.

The variable tax rate proposal is very similar to cap and trade, except that the initial allocation is the government (under cap and trade, the initial allocation is essentially a free transfer of wealth from the government to the businesses it chooses, which leads to the perverse incentive of trying to have a high carbon output now to get more allocation, and also lobbying), and it's a soft cap instead of a hard cap. The market price under cap and trade is the same price as the tax rate under the variable tax proposal. Under both systems, the low hanging fruit is addressed first, because those businesses have the most to gain by not having to pay for carbon emissions.

Anonymous wrote at Sunday, March 23, 2008 at 6:12:00 PM PDT

You never know how society will react to a carbon tax until we impose one. Whats the next alternative if carbon taxing does not help reduce our emissions?

Zijian A wrote at Wednesday, April 16, 2008 at 4:36:00 PM PDT

It is very easy to cut your carbon tax. Just outsource everything that can generate carbon to China or other developing countries as much as possible.

Anonymous wrote at Wednesday, September 24, 2008 at 10:15:00 PM PDT

I think that carbon taxes and monetary schemes to lessen ecological impacts are a lie. The big lie is that we need to pay money to sustain ecology, and this perception may be exaggerated by schemes like a carbon tax. Punishment doesn't work. I think a punitive payment plan only aggravates the problem.

Perhaps, society could treat carbon emissions like other harmful behaviours. But, putting carbon emissions addicts in a treatment program probably won't work either because we're addicted, seriously addicted.

No, I think what we need to do is stop. Stop and meditate on deep ecology. What do we really want? Do we want a polluted dying world where we continue to pay to drive petroleum powered cars? Maybe. Perhaps, you have a vision of what you would really want. What does this look like to you?

Amit wrote at Wednesday, September 24, 2008 at 11:37:00 PM PDT

Mark, I'm addicted to breathing. I keep emitting CO2 while doing so. I'm so addicted that if I stop, I'd die!

The problem with CO2 is the volume, not the existence of it. Ten people with SUVs aren't a problem. A billion people with SUVs are. Reducing volume is a problem for market-based solutions (like carbon taxes).

My ideal world is not one in which we emit no CO2. That would mean we stop breathing, and the human race dies. Nor is it one that contains no CO2. That would mean all plants die. My ideal world is about balance, not about cessation. The CO2 we emit as a society has to be balanced by the CO2 that can be used by plants, algae, and so on.

In my view, carbon taxes aren't about punishment. They're about bringing balance to the world. That balance is what the "sustainable" in the blog post is about. I want sustainable CO2 emissions just as I want sustainable agriculture, sustainable poverty reduction, sustainable forests, sustainable population, and so on.

Anonymous wrote at Thursday, September 25, 2008 at 5:05:00 PM PDT

Thanks for sharing Amit. I think that your writing is very insightful.

I thought that rather than sustaining the massive carbon emitting petroleum industry by driving carbon emitting vehicles, instead we need to make a shift. For instance, I think that a shift to wind and solar home-powered small electric vehicles would be beneficial. This is not happening, at the moment, because there is an imbalance. In my country, foreign controlled oil companies are given billion dollar grants while small locally owned companies are struggling to bring zero emission vehicles to market. I think that there may be obstacles imposed by the oil industry and that is what I think must stop.

I guess I've heard this mantra of "balancing with the 'so-called' economy" and carbon-trading schemes and such and I am not buying it. Even the word sustainable is abused in marketing literature when the only thing being sustained is the harm. We deserve better. Perhaps, I am more in tune with your vision of sustainability.

Please keep breathing.

mike3 wrote at Friday, December 12, 2008 at 9:10:00 PM PST

"My ideal world is not one in which we emit no CO2. That would mean we stop breathing, and the human race dies. Nor is it one that contains no CO2. That would mean all plants die. My ideal world is about balance, not about cessation. The CO2 we emit as a society has to be balanced by the CO2 that can be used by plants, algae, and so on."

Well obviously "emit no CO2 at all" is impossible as you mention -- then we couldn't breathe and also plants would die. I don't think that's what most have in mind. What they mean is that CO2 from _industry_ needs to stop. Ultimately we need to get off fossil fuel. It's running out, you know.

Amit wrote at Sunday, December 14, 2008 at 9:34:00 AM PST

If fossil fuel is running out soon, then we'll get off of it, no problem! The really worry is if it's not running out anytime soon. I don't know why we should treat industry and farms and individuals differently in terms of CO2 emissions. If anything, I'd expect industry to be more efficient than smaller organizations.

cde wrote at Tuesday, December 23, 2008 at 5:00:00 AM PST

Except the carbon tax only provides a further incentive to move secondary industries offshore.

China, malaysia, taiwan, even korea don't participate in the bullshit. Any country that fails to respect the carbon tax will be at an enormous advantage to others.

And of course, the country that is the source of 50% of the carbon burned in the athmosphere, saudi arabia, doesn't even care. It can only be called fortunate that they don't actually produce anything. Other than massacring maniacs who profess the "religion of peace" I mean. But we don't generally count those in economic production.