What Would a Federal Carbon Tax Mean for California Cap-and-Trade?

On March 12, 2013, Representatives Henry Waxman (D-CA), Senator Sheldon Whitehouse (D-RI) and others released a discussion draft of legislation for a federal carbon tax – sorry, a carbon “price”. This proposal comes on the heels of another bill proposing to put a price on carbon from the office of… another California lawmaker, Senator Boxer (D), jointly with Senator Sanders (I-VT), from February 2013. Of course it’s no surprise that the leaders on this issue, Sen. Boxer and Rep. Waxman, both hail for California – and yet it’s not clear what those proposals would entail for California’s state policies. Would the Golden State keep its own carbon price, a.k.a. cap-and-trade program? If so, how would the two interact? Would emitters have to pay twice? Or would action on the federal front mean trouble for state programs in California and the Regional Greenhouse Gas Initiative?

How Would a Federal Carbon Tax Price Work?

The Sanders-Boxer proposal is fairly straightforward: $20 a ton, applied to carbon dioxide or methane, rising 5.6% a year over a ten year period. The point of regulation would be upstream: at the coal mine, oil refinery or the natural gas processing point. Revenues would be used in part for energy efficiency and sustainable energy, while 3/5th of the funds would be returned to individuals as a “Family Clean Energy Rebate,” strongly reminiscent of Sen. Cantwell (D-WA)’s cap-and-dividend proposal from 2009.
The Waxman-Whitehouse proposal is more open-ended. It is intended as a starting point for a general debate, not a comprehensive solution. The price point could be anywhere between $15 and $35 a ton, increasing annually 2-8%. The point of regulation is set on the point of emission (“downstream”) for industrial sources, and fuel suppliers for residential and commercial sources. The idea is to line up the fee with the reporting obligation emitters already have with the EPA – but the fee would be collected by the IRS… you know, like a tax. But it’s not a tax, really!
Last but not least, the Waxman-Whitehouse proposal establishes that revenues should be returned to the American people, but lays out several options on how this fine goal might be accomplished:

  • Mitigate energy costs for consumers, especially low-income consumers
  • Reduce the federal deficit
  • Protect the jobs of workers at trade-vulnerable, energy intensive industries
  • Reduce the tax liability for individuals and businesses
  • Invest in other activities to reduce carbon pollution and its impacts

Who Cares About Congress?

Before I proceed with a nerdy analysis of how such a federal carbon price would interact with California’s home-grown carbon price, it is fair to ask: do we care? Since when does Congress do anything about climate change anyway? Having lived five years in DC during the worst (I hope) of partisanship and the rise of the Tea Party, and the spectacular collapse of the federal cap-and-trade bill, I’ll start by saying I’m not holding my breath on any of those bills.
But Congress can’t be ignored either, and a debate on a carbon tax is not as irrelevant as it might have been a few years back. The key here is the dire situation of the federal budget. In the context of the debate over a fiscal reform, a new tax that could bring, in my estimate, anywhere between $80 and $200 billion in 2014 – 10 to 25% of the projected deficit for that year – is nothing to sneeze at. Of course, Republicans generally don’t want new taxes and don’t believe in climate change, but if there’s ever going to be a compromise on plugging that budget deficit, they’re going to have to pick their poison and find a way to raise revenues.
Certainly it’s worth paying attention to the bills out there from a California standpoint, because there’s no easy answer to the question of how a federal carbon tax would impact the California cap-and-trade program – or its East Coast counterpart, RGGI. Let’s look at how that might work.
In my view, if Congress were to pass a carbon tax, one of three things could happen to regional programs:
1. Preemption
2. Stacking
3. Integration

California: Preempt Me Not

In a preemption scenario, the bill would include a provision stating that regional carbon pricing programs are preempted, meaning that the federal carbon price would become the only law of the land, and California would have to discontinue its cap-and-trade program.
Now, there are two immediate issues with this scenario: first, California would NOT be happy. For those who haven’t followed environmental policy in this country for the past 30 years, California feels strongly about being a leader in the field, and is quite fond of federal carve outs and exemptions to do its own (more stringent) thing. And California does carry weight in Congress, especially amongst the environmentally-minded crowd – remember who the bill sponsors are? I’d expect California to fight hard against any preemption provision.
And California might not be alone, too. At this stage, it’s hard to say how New York, Massachusetts, and the rest of the RGGI crowd would feel about preemption. Historically, they wanted to be preempted by a federal program. But that was seven years ago – and before RGGI started generating steady revenues that fund energy efficiency and renewable energy programs in those states. I wouldn’t be surprised if RGGI states now had second thoughts about losing those revenues and all their recent hard work on revamping their program.
Second issue with preemption: what happens to the banked allowances? Say the tax starts in 2015: as of today, there are already 10 million allowances Vintage 15 and 16 in circulation, many more by the time a bill is passed, let alone implemented. Whoever bought those allowances is going to want to make sure they don’t turn into worthless pieces of paper, or rather worthless serial numbers. Regulators and regulated entities interests would be well aligned here, and I would expect a US carbon tax to include a compensation mechanism or a buy-back provision – but even that is not easy to implement.
What is a fair price for buying back the allowances? The November 2012 clearing price ($10.00)? Or the allowances’ value on the secondary market at the time the tax takes effect? Or some average of prices over time? The California transaction tracking system (CITSS) actually records the purchase price of the allowances in any market participant’s bank account, but the question is more one of fairness: is it fair to ‘only’ reimburse $10/t to the forward thinking emitter (or cunning investor) if allowances are worth $15 on the secondary market three years later? I get back to this issue below.

Stacking

Another alternative would be for both programs to live side-by-side, or rather, for the fees to be stacked on top of each other. This is similar to how gasoline taxes work: the federal government taxes gasoline, states tax gasoline, and the taxes are just added on top of each other. Now, I’d expect California emitters to not be very excited about this idea of paying twice for the same ton of carbon, once to the Feds, and another time to the Air Resources Board. It’s hard to see who would support this option, from a political standpoint, which makes me think it’s an unlikely contender.
In addition, it could really mess with prices in the California program: say the Federal tax was $35 and the California market only ‘needed’ a carbon price of $20 to incentivize enough emission reduction (or offset projects) to meet that year’s cap – the California allowances would actually tank to the price floor, because the higher federal tax would incentivize even more reductions than what is needed for the California market to balance.
A lower federal price could also lower prices for California allowances below their equilibrium price. Say if California’s (theoretical) equilibrium price was $30 and the federal tax $15, California prices would go down to $15 – so that entities would end up paying a total price per ton that allows them to be in compliance, with California allowances serving as an adjustment variable on top of or below the federal fixed price. Of course California has a price floor, so CA prices would not go below the floor in any scenario.

Integration: A Little Something for Everybody

There might be a third (and better) way to deal with the overlap between a federal carbon fee and California’s cap-and-trade program. The programs could coexist, but in a way where businesses would not be double-taxed. Think about the way income taxes are handled: you pay both state and federal income taxes, but you get credited for your state tax payments when you file for your federal return, so that your taxes don’t add up, you only pay the difference to the Feds.
Similarly, I could imagine a situation in which California emitters comply with California’s program, and then would get the money they spent on allowances deducted from their federal carbon tax liability. If the price of allowances in California was higher than the U.S. tax, they’d be off the hook altogether, otherwise they would only pay the difference.
Politically, it’s a very appealing option: California gets to keep its own program and impose more stringent standards on its industry if it so desires, yet California emitters don’t get double taxed – they might still end up paying more than the rest of the country, but that’s the cost of doing business in California. It’s a better deal for California than stacking on the taxes, where California revenues would go down, but not such a big difference that the Federal government would care much. I could see such a compromise getting some traction in Congress amongst the supporters of a carbon tax.

Are the Programs Compatible?

Technically, however, not all proposals lend themselves to this kind of integration. The Waxman-Whitehouse is fairly compatible in terms of point of regulation, threshold and price points. Both the draft bill and the California program impose a compliance obligation on downstream emitters and fuel suppliers. The threshold for compliance is lower in California, at 25,000 tons of CO2e/year against 50,000 tons at the federal level, but that’s not an issue – small emitters will only be regulated in California.
For Sanders-Boxer it’s much more complicated, because the point of regulation is completely different. On the one hand coal mines and oil wells would get taxed at the federal level, on the other hand final consumers of coal and oil would be subject to a cap in California – I’m not sure those programs could be integrated, it would have to be either preemption or stacking on.
Even Waxman-Whitehouse is not without its challenges. For one thing, California’s compliance schedule is triennial, with a partial (30%) annual true up, while taxes are annual. If California emitters wanted to take advantage of the flexibility afforded by the three year compliance period, they would not be able to claim a federal tax credit right away. They’d have to pay the full federal carbon tax until they complete their California compliance obligation, which could be up to three years later. Only then would they be able to claim the rest of their federal tax credit.
Another issue, somewhat similar to the one raised in the preemption scenario: what is the fair price for ‘crediting’ allowances at the end of the year? The purchase price? The latest auction clearing price? The end-year price? I would argue that the easiest and fairest option would be a form of average of the vintage price over the calendar year (e.g. average V14 prices in 2014) in the primary (auction) and/or secondary market – but at the end of the day, it will be a political decision.
Should emitters be able to claim free allowances for credit against the federal carbon tax? I would imagine not. If there’s ever a US carbon tax, it would likely include provisions to protect trade exposed, energy intensive industries. Crediting free allowances would amount to double dipping!
The list of issues continues on – how about offsets? Should they be eligible for federal tax crediting as well? There’s no right or wrong here, only political tradeoffs. And finally, what if California proceeds and links with Quebec? Should Quebec allowances be eligible for tax credits in the US? This could raise a whole new level of political problems.

What Does this Mean for the Market?

The market implications for California today are negligible – the odds that a carbon tax bill would pass in Congress are very long, and it is probably reasonable to assume that emitters would, mostly, get compensated for their costs if the California program was shut down. But it undoubtedly adds a new flavor to the remaining political risk attached to the California cap-and-trade program, which it hasn’t completely shaken off yet. And even in a best case scenario, it would add a thick layer of complexity over an already very complex program – something to look forward to!

Photo credit: White House