If we don’t learn from history, we are doomed to repeat it. Yet when it comes to reducing carbon in the atmosphere, the current solutions fail to recognize what has worked in the past. So, what can we learn from the pollution reduction success stories in our history? What can those successes tell us about the shortcomings of existing strategies like cap-and-trade and carbon taxes? Why do our current methods of carbon pricing fail so spectacularly?
Also on this show
Aldyen Donnelly on climate-crypto, COP26, and carbon accounting rules, February 2022
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Full Transcript
Announcer: You’re listening to the Reversing Climate Change podcast by Nori, the world’s first carbon removal marketplace. Here are your hosts, Ross Kenyon and Christophe Jospe.
Ross Kenyon: Hello. Welcome to the Reversing Climate Change podcast with Nori. I’m Ross Kenyon, here with Christophe Jospe and Paul Gambill in the Seattle Nori office. We’re here today with Aldyen Donnelly, the director of carbon economics for Nori, and we are talking about cap-and-trade and the carbon tax. We get a lot of questions about what we think might be problems with these, why they don’t seem to work as well as we would hope that they would, and where Nori thinks that we can do better. Would you say that’s a fair summation here, Christophe?
Christophe Jospe: I think so. Only, only thing — because I think Aldyen is director of so much more, and it’s not just carbon economics, so we probably should reconsider her title. I mean, the impetus behind this podcast is there’s a Foreign Affairs article, “Why Carbon Pricing Isn’t Working,” and we wrote a response, and then we read it and then we said, no, this is way too nuanced, no one’s actually going to read this. We would get a lot more bang for our buck if we just did a podcast with probably the most knowledgeable person in the world, who we are humbled to have sitting across from us.
Ross Kenyon: We’re trying to make her blush. It’s slightly working, looks like, a little bit. Yeah. Okay. So where do we start? Should we start with saying, Aldyen, did you read that article?
Aldyen Donnelly: I did.
Ross Kenyon: Okay, so we read this Foreign Affairs piece and we responded to it, but it was a little too complicated. It wouldn’t make a good newspaper piece. You always need a really strong lede there. You can’t have nuance in a newspaper unless it’s like The New Yorker, where you have 10,000, 15,000 words — like, that’s where it goes. So we thought it’d be easier to do a podcast here. And this article covers the history of various carbon markets, cap-and-trade markets, and why they haven’t always done so well. Covers what Europe and California — I can’t remember the other ones that made it back in. Ontario? Did they discuss it in great detail there? I don’t think it was. Yeah, no. Talked about China’s market. Come on, [unclear]. So that was a big one, too.
Christophe Jospe: Yeah, and I remember when I first got into this space and I started looking at markets, I didn’t understand why, but my sort of spider-sense went off and I thought, intuitively it just doesn’t make sense. This is not the most effective way to address emissions. And part of that comes from very simple arithmetic that I learned from Klaus Lackner, who said, well, if you put a tonne of carbon into the atmosphere it stays there for hundreds of years, and so you need to put another tonne back. And so what I thought: all right, well, money from emitters needs to go to people who are putting tonnes back, and we could have always started there.
And that’s the premise by which Nori is operating, and probably the hook through which we were able to attract Aldyen to take these young, bright-eyed millennials seriously — that, like, oh, these guys are onto something, this is the right way to start. Even though obviously emitting carbon dioxide into the atmosphere isn’t as simple as just canceling it out — you need to do things like reduce emissions and replace emissions and all these important things — but the fundamental challenge is markets have been set up to do pricing mechanisms that have not worked. They’ve merely shifted around emissions from one place to another, all the while CO2 is accumulating into the atmosphere. That was a mouthful.
Ross Kenyon: So, Aldyen, where do we begin?
Aldyen Donnelly: I think I want to start by saying I was certainly on the team that thought cap-and-trade was the right answer. And when I formed, through experience, the opinion that cap-and-trade isn’t the right answer, being a well-trained economist, I assumed that taxing carbon would be the right answer. And it didn’t take me very long to look at the history to see it wasn’t the right answer. It took me a long, long time to start forming opinions about why it wasn’t the right answer. So all I’ve got to say is, if everybody out there that just started thinking taxing carbon was the right answer a couple of years ago figures out it’s the wrong answer in the next couple of years, that just makes them five times smarter than me, because it took me so long.
Ross Kenyon: So we love our listeners, they’re very savvy, but if I say cap-and-trade to my mother, who might be listening, she doesn’t have the slightest clue. So what is cap-and-trade?
Aldyen Donnelly: Cap-and-trade is something that’s familiar to people in countries that have dairy quota regimes. It’s a quota-based supply management regime.
Ross Kenyon: So that was what we talked about last podcast, right? Okay.
Aldyen Donnelly: Yeah. And so basically governments decide to create a limited amount of entitlements to discharge CO2 to the atmosphere. And then if you look back at the 44 precedents that I’ve looked at since 1978, they give away freely 90 to 98 percent of those entitlements to large emitters. And they create a quota supply — in every precedent up to and including, but not uniquely, the California cap-and-trade market — a supply of quota that is well in excess of the maximum physical capacity of the covered operators to emit. So you start with an oversupply and it gets bigger and bigger and bigger over time, and the markets crashed typically within seven years or less.
Paul Gambill: To put more color into it, a government that is implementing a cap-and-trade scheme tells — okay, you regulated entities, so these are like energy producers or people in the transportation industry, manufacturing industry, that sort of thing — and they say, all right, there’s a cap on the number of emissions that you’re allowed to emit every single year. We’re going to give you these allowances or entitlements, as Aldyen said, one of them represents one tonne of greenhouse gases, CO2, and you’re allowed to emit up to that many, allowed to use these allowances for your emissions. And if you go over that amount, then you need to acquire more allowances from someone who has a surplus of them.
Now, if you go over that amount — let’s say you’re given a hundred allowances in the year, you’re allowed to emit a hundred tonnes — you have a few different options for how you might deal with that as you operate your business. One way, and this is the preferred way of the people who set up these markets, is that you take some sort of action to reduce the overall amount of emissions in your operations or supply chain. That’s abatements, right?
Aldyen Donnelly: Abatements. Yes.
Paul Gambill: Yeah. So if you’re an energy producer, they want you investing in renewables and trying to get your energy customers to switch over to better conservation methods, more efficient appliances, better light bulbs, that sort of thing. You can only do so much with that, though. And so the other opportunities that you have, our options, you have, are to purchase more allowances from either people who have a surplus, or in some cases purchase them from the issuing entity — so from the government, they’ll auction off additional allowances if people can buy. You can also buy carbon offsets.
And this is a really important thing for people to understand, because carbon offsets are not the same thing as allowances. Carbon offset projects are certified by different entities, like Verified Carbon Standard, Climate Action Reserve, Gold Standard and so on, and there are projects that are either doing some sort of carbon avoidance — so that could be building a wind farm, some sort of abatement project, a dairy digester — or planting trees. There are literally hundreds of different ways that people might do an offset project. In markets like California, for example, they have a maximum percentage of meeting their obligation that they’re allowed to use by purchasing offsets. And I think it’s 8 percent in California.
Aldyen Donnelly: It’s 8 percent, but that works down to 4 percent because there’s a complicated formula.
Paul Gambill: So the government is saying, all right, you have a surplus, you need to buy something. You need to buy either allowances or offsets to represent the amount that you’ve gone over your cap, but we’re only going to let you buy a certain amount of them in terms of offsets, forcing you to buy the rest of them in allowances. And the reason that they do that is because it’s important that the price of the allowances stay high. So the government is trying to create demand for these allowances.
And if you think about it, if you were an energy producer, if you’re an emitter and you’re forced to buy these things, and you have the option of buying allowances, which are not actually representing any reduction in emissions, or you have the option of buying a carbon offset project that is a real project — there’s a narrative to it, it created jobs, it might have had some other co-benefits that helped the local community around it, you can go tell a story, it can affect your PR strategy — like, which one would you prefer to buy? The one that’s real?
Ross Kenyon: Yeah. How did you — Aldyen, was that pretty good?
Aldyen Donnelly: It was pretty good. I’d give them an A or B. Well, I would say there’s a bit of a difference between the theory and the reality. So when you read about cap-and-trade, or you go see the educational videos, basically the story you get is everybody who’s a large emitter receives so many quota units, entitlements, and if they reduce their emissions and don’t use all their quota, they can sell a real interest in that emission reduction to somebody else. So the theory is that when I buy an allowance or quota unit from you, you’ve reduced the emission and you’re selling the right to emit one more tonne because you’ve overcomplied with your limit. What’s the problem?
The problem is that in 43 out of 44 cap-and-trade systems that have been launched to control pollution — so not just CO2 but SO2, smog precursors, worldwide, and that’s me counting the European system as one as opposed to 27 — in every precedent the government supplies way more quota than everybody needs. So for the first five years of every quota regime, including the US SO2 market, which people talk about as a great success story, the pollution entitlement rights that you’re buying don’t have any pollution reduction behind them.
Ross Kenyon: Is it just politics? Is that why they oversupply? Are they worried that polluters are going to balk at the whole system?
Aldyen Donnelly: It took me a long time to understand the history. When you go back to the very first cap-and-trade regimes, it made sense. When you went to the very first regime, legislators realized that in roughly 40 states property law is state law, not federal, in the United States, and that if you adopted a regulation that essentially expropriated property rights, the government might have to compensate the asset owner.
Ross Kenyon: This is eminent domain.
Aldyen Donnelly: Yes. And so when they were contemplating putting in these limited entitlements, declining-over-time entitlements to emit pollution, obviously that, over time, if fully implemented, is going to cause a reduction in the market value of the assets that can’t fully operate without full entitlements, because they have an eminent domain case that prevents — so when the very first cap-and-trade regimes came into place, the government said, how do we design this so that when we have the quota supply declining tightly enough that there’s an eminent domain issue, we had provided enough early additional income in the oversupply to compensate — have compensated them so that we don’t have to compensate them next. It was a rational decision. It was a logical decision.
But what happened in every cap-and-trade regime without exception so far: every time they got to that point where the allowance supply was supposed to tighten up, everything stopped. Of course, right? Because I now have to actually do the expensive and hard things and I don’t want to, and I’m going to complain to the government, and the government will listen to me because I say I’m going to take my jobs elsewhere. And I’ve learned that, you know, responsible, well-meaning people that are designing cap-and-trade markets today actually don’t know that history — that there was actually logic embedded in the idea of oversupply in the market at first, but it only works out if you stick with the commitment to tighten up the supply quickly. It’s politically too hard to do that.
Ross Kenyon: So the cap — it’s too hard to do that. Cap-and-trade may work as an idea and a policy if the politics could work, but you think the politics, just when it comes time to tighten the belts, it’s politically unpalatable, it will not happen.
Aldyen Donnelly: I actively — actively — was probably one of the earliest and most aggressive leaders in the world advocating for cap-and-trade for 15 years, because I thought it could be made to work, and I had to give up.
Ross Kenyon: Yeah. Admitting you’re wrong means you’re a weaker person.
Christophe Jospe: I think I’ve been doing this thing where I interrupt a lot and I’ve just got to get my words in there first. I think I’ve spoken [unclear].
Ross Kenyon: [unclear] you right now, if you’ve earned it. Okay, so you said 43 out of 44 — so there’s one market that worked.
Aldyen Donnelly: It’s a market that the brokers hate, and it operated continuously from 1992 through March 2017, and it was the RECLAIM cap-and-trade market in the Los Angeles area.
Ross Kenyon: So tell us about that. How did it — and also define what working means.
Paul Gambill: People also need to understand that when we talk about creating a market that functions, it means that you have suppliers and there’s some sort of demand, or buyers, for whatever the asset is they’re exchanging. And if you look at, say, the California market, the demand for these allowances, it’s resulted in a situation where the government had to institute a price floor. And if you look at the trading price of the allowances in the California markets from the very beginning, it started out pretty high — I think somewhere around $22, based on speculation. It dropped down to very, very low, somewhere around a dollar, and then it goes up every year on a step function that’s clearly showing that people aren’t valuing these above whatever the price floor is that’s set by the government operators, which means that you don’t really have a functioning market.
Aldyen Donnelly: Well, and just to — going to California before I go back to what working looked like in RECLAIM. The state of California has considered and adopted some procedures to somehow reduce supply, including tightening up the limits on how many offset credits you can use, so that the allowances that are surplus have greater demand. But in the state of California there are two things that are — in their last auction, as a result of some of these tightening-up procedures, after a number of auctions where they didn’t sell out all of the allowances that were for sale, they did sell out current vintage allowances in the last couple of auctions, but the market bought less than 60 percent of all of the future vintage allowances they put up for sale. So the market’s saying, I don’t see these allowances having — this year did really well, but 2019, 2020 did really bad.
Ross Kenyon: Um, 60 percent?
Aldyen Donnelly: Yeah. Yeah. Yeah, and that’s a normal market response. The other thing — and there’s another not-so-positive lesson in RECLAIM. The California state’s own advisers are saying that with all of the adjustments they’ve made to improve the supply-demand imbalance, the market will be sitting on a bank of at least 290 million unused allowances by 2020. So the question is, are they actually willing to cut back the free allocations they issue year after 2021 to bleed out that stockpile of 290 million allowances? Whereas historically, going back to 1978, 43 out of 44 times that a government was facing that challenge, they abandoned the cap-and-trade regime rather than fix it.
Paul Gambill: So there are all these unsold allowances and they’re continuing to create new ones every year for free and giving them out, and you’re suggesting that what they need to do is stop giving out so many for free so that the people who have to buy allowances buy them from this extra surplus.
Aldyen Donnelly: They have to come up with a strategy to deal with the surplus. Again, politically, your choices become impossible choices. And RECLAIM, the market that did operate for 25 years, made a choice which I don’t like, but at least it kept the market — which is what made me decide to oppose cap-and-trade altogether. So in the RECLAIM market you really have only two choices. One, you cut back the supplies, the allowances you’re making available for free from now on. What do you do when you do that? You’re making life very, very difficult for new market entrants, and you’re providing an artificial financial windfall to the incumbent largest emitters who are able to bank all their free allowances. Now, that’s not a good solution, right?
The alternative, which is what they did in the RECLAIM market, was to say, okay, you know those 290 million allowances that you have in the bank? As of tomorrow, each one is only worth half a tonne when you go to use it, to retire it.
Ross Kenyon: Like the Cypriot haircut, that kind of thing.
Aldyen Donnelly: Yeah, and that’s what they did in RECLAIM multiple times. So in RECLAIM they kept issuing more allowances than anybody could use, and then once every three or four years they said, guess what, all those allowances you have in the bank, they’re worth half as much as compliance instruments as they were when you bought them. That’s not a good idea either, for a lot of reasons — not least of which, it communicates to the marketplace that if you overcomply and bank your allowances, you’re gonna be punished. So neither one works. I spent a lot of time saying, okay, what is a solution that works? And you know what, I couldn’t come up with one. So I had to find another way.
Ross Kenyon: This is the perfect point to put a little cherry on top and move over to carbon tax. Would you agree? You want to lead us there, or not?
Christophe Jospe: Yeah. Yeah. Can we get back to, like, what’s the point of these markets? Right, the point of these is to reduce the amount of carbon dioxide that’s going into the air. And can we look at these markets and what can we say is happening? Is it reducing the amount of CO2 in the air? And also, when we’re talking about carbon pricing and thinking that these allowances that are being traded — and, you know, look at California, people think, oh, this is such a great example, the price that people are paying, they’re like, oh, this is the price for CO2 that we’re pulling out — but it doesn’t actually represent that.
Aldyen Donnelly: So the price you’re paying per certificate — 14, almost 15 dollars a tonne right now — is a fraction of the marginal cost of actually permanently reducing emissions over the population of covered sources. So it’s really interesting. It’s where you have academics saying cap-and-trade really works well because look at how low compliance costs are compared to what people thought they would be. They’re low because you’re not getting incremental emission reductions happening at a market price of 12 bucks. You’re just trading pieces of paper for 12 bucks.
Paul Gambill: And the other thing is that what I was mentioning earlier, that if you’re a regulated entity and you’re buying these allowances to meet your cap obligations, and you’re like an energy creator, a utility —
Aldyen Donnelly: Yes.
Paul Gambill: Yeah, you’re a utility, or a refinery, something like that. You have the option of buying allowances or offsets. And what that means is that, because of what Aldyen just said, you’re just trading paper around, and so the price of this doesn’t actually really represent anything. But to the buyer of these things, the offsets and the allowances are equivalent. And so that means that because of standard market forces you’re going to see the offset prices roughly similar to the allowances, except for in many cases, particularly when you’re talking carbon removal — that certificate in an offset market that represents a tonne of carbon removed from the atmosphere and stored in a farmer’s soil has an underlying value of one tonne, but it’s being forced to compete on a par in a market with the emission certificate, the allowance, that maybe in aggregate has an underlying value of 0.25.
Aldyen Donnelly: So removing and storing carbon in croplands looks really expensive because everybody says a tonne only costs 12 bucks. No — a piece of paper that represents about 25 percent of a tonne costs 12 bucks, which is 60 bucks a tonne. Is that a hot enough take for you guys? Is that what you’re looking for here?
Paul Gambill: What I want the listeners to take away from this is that when you look at the prices that people are reporting at what is being traded for carbon, they do not actually represent real signals on what the value is for avoiding a tonne of CO2 or removing a tonne of CO2. These markets are set up with different incentive structures. So this is why what we’re doing at Nori is so interesting and can be so useful, because we’re creating a marketplace where people place real value on removing one tonne of CO2, and it actually represents one tonne of CO2. And so that means that the Nori token price can really become a reference price for the world that is truly market-driven, that actually represents one tonne of CO2. It’s not this abstracted thing, or just slips of paper that represent something else.
Ross Kenyon: Will you let me move us now to the carbon tax? Generally very satisfied.
Christophe Jospe: I want to talk about CarbonSim.
Ross Kenyon: So, no, not yet.
Christophe Jospe: CarbonSim seems like a great tool. I actually — I was off on an airplane so I could not play, but everyone else I know got to play. It was put together by Josh Margolis of the EDF, which is the Environmental Defense Fund. From my understanding, Paul, you did exactly what the quote-unquote bad actors do, which is game the system and figure out how to make money.
Paul Gambill: Yeah. So, yeah. So yeah, it’s this trading simulation game. It’s supposed to function in the same way that if you were a regulated entity in a cap-and-trade market, how it would work. And you play it over — I think we did a two-year time span, and it’s broken up into four quarters, so we had eight different time periods that you switch through. The whole Nori team was playing, and the goal of it is — it’s a competition, just like a real business — is to try to end up, at the end of the game, you want to have met your obligations for hitting your cap numbers, and you want to make the most amount of money, which is how real life works.
And so I met my obligations and I had made the most money out of everyone else, and all that I did was trade allowances. I bought low and sold high. I bought low in the auctions. I didn’t buy any offsets. I did the minimum amount of abatements that made financial sense, and in the end I made a lot of money. And I made virtually no impact on actually reducing the amount of carbon dioxide in the atmosphere. So it was a really, really useful and instructional exercise for me to see, like, what are the different incentives that are playing into this and why people make the decisions that they do.
Christophe Jospe: I got suckered into buying a bunch of the abatements that were, like, three years out in the future for the time they started to pay off. Like, why did I do this? I should have just been screwing around with these.
Paul Gambill: Yeah, that’s always one of the drawbacks of these simulations. We saw that when we did our simulation game at Reversapalooza — that if you have a defined end period then people are going to play towards the end period, they’re not going to play as if, like, time just —
Christophe Jospe: Yeah, I think I would have caught up and started to hammer you there after a while, but I missed my chance.
Aldyen Donnelly: But there’s another complication too. We talked about, in those kinds of markets, governments are creating the allowance supply, and again — starting, I’m willing to accept, with all of the best intentions and the best designers and everything — and you start with the surplus to create the compensation that you think you’re going to need later. Regardless of what the initial intention was, once governments start generating revenues from selling quota at auction, even if they’re only selling 10 percent of quota, they’re not willing to give up those revenues. And you can have the revenues from quota sales or you can have the emission reductions, but typically over time you can’t have both.
Ross Kenyon: Is this like taxing cigarettes, where you kind of hope that the people don’t stop smoking? They said it will discourage smoking, but if it does you lose a revenue source. You know, it’s like a lottery tax, or — you know what it is.
Aldyen Donnelly: The reason I would argue it’s exactly like taxing cigarettes is because two things are true. In the early 1980s, when our governments first started taxing cigarettes, they were absolutely convinced it was going to cause a reduction in smoking. Did it? No. When did the significant, measurable reductions in smoking happen? When the first company banned smoking in the office.
Ross Kenyon: Oh, really?
Aldyen Donnelly: And the first companies to say, you can’t do it here, because staff were complaining — those bans came entirely from the private sector responding to complaints by non-smoking staff, and then governments started saying that. And if you actually look at the numbers, smoking reduction happened when people, governments and companies started saying, you can’t smoke in here, you have to go over there.
Ross Kenyon: Okay, so we love metaphors. Let’s play this one out.
Christophe Jospe: Speak for yourself.
Aldyen Donnelly: Carbon is smoking. And if you start saying, you can’t put your carbon here, you need to manage the carbon in your supply chain —
Ross Kenyon: Not the emissions, but the carbon.
Aldyen Donnelly: That’s right. That takes you all the way back to, where does that carbon come from? Oh, maybe you want to keep it in the ground and track how much you have in the garage, right? Keep it there. That’s right. If it’s gonna come out, at least track it, and focus on reducing the carbon in your supply chain.
And it only took me, as I said, 15 years to figure that out. And you want to hear the dumbest thing I could ever admit? After I figured out cap-and-trade wasn’t going to work, even if it theoretically could be made to work, and then after I figured out carbon taxes don’t work — which we’ll get to — I actually finally said, you know, we have some pretty interesting historical pollution reduction success stories. We got the lead out of gasoline and the lead out of paint and the ozone-depleting substances out of the atmosphere in order to stop the growth of the hole in the ozone layer. So maybe I should look and see how we actually did those things.
And you know what? I thought I was going to find out a whole bunch of different countries did very different things. Every time we look at a historical pollution reduction success story, we did it the same way every time, whether we’re Japan, United States, Canada, Europe. Same way every time.
Ross Kenyon: Master of suspense. What was it?
Aldyen Donnelly: We didn’t put a cap on tailpipe lead emissions. We said, if you sell gasoline, you’ve got to reduce the lead content in your gasoline. When we really wanted SO2 reductions in fuel, we didn’t regulate emissions. We said, guess what, sulfur has to come out — coincident with our regulation of SO2 emissions in power plants, we regulated maximum sulfur content in the coal that goes into the plants. I actually talked to some older people, and I’m old enough, who were part of designing those. When we wanted to get ozone-depleting substances out of refrigerant chemicals, we didn’t regulate ozone discharges. We regulated the chlorofluorocarbon content — the pollution precursor — out of the supply chain. And you know what, the efficient way to get fossil carbon reductions out of the energy supply chain is to order fossil carbon reductions in the supply chain.
Ross Kenyon: So put up more no-smoking signs, effectively.
Aldyen Donnelly: And this is where there’s a connection to Nori, however much it sounds like I’m not going there. So if you were going to say, let’s repeat the lessons we learned from our pollution reduction success stories: do not go to all of this expense of trying to figure out how to measure and estimate and track emissions at the end of some stack somewhere, or a tailpipe. Say, if you sell energy in this country — I don’t care if you sell some combination of gasoline, diesel and propane, and you sell some combination of electricity and natural gas and whatever — you take your total energy sales, you tell me what they equal in millions of BTU equivalent, and your fossil carbon content in the supply you discharge into this marketplace has to go down 3 percent per annum. Then if you exceed 3 percent this year, you can sell some credits to another guy.
Government’s not issuing quota. I’m not measuring emissions. I’m saying get the fossil carbon out of the supply, and that gives the market the opportunity to figure out different ways — it might be more efficient for one company over another on how they want to do that. We are not telling them what to do, and we’re not telling them what price to pay. When we regulated in North America the lead out of gasoline, every expert in the world in every part of the economy — fuel suppliers, auto manufacturers, academics, governments — were absolutely certain that ethanol was going to replace lead as the oxygen in gasoline, and everybody was absolutely certain in North America the price of gasoline was going to increase by seven, eight, nine cents a gallon, which was a big price increase, and that they decided they were willing to make that sacrifice.
They ordered the lead out, and within four years of ordering the lead out there were four — count them, four — competing unleaded gasoline fuel formulations in the marketplace, and we got lead out ahead of schedule while the real price of gasoline fell 12 percent.
Ross Kenyon: I was always wondering when I was a kid looking at the gas pump, and I think, well, why is it unleaded? They’re all unleaded, and you can’t even buy leaded gasoline. Why are you telling me it’s unleaded? Because of the success story. So why not just do a carbon tax? Why not just do something like that? We don’t necessarily like it when the government just does things by fiat. Wouldn’t it be more market-friendly to do something with the tax?
Aldyen Donnelly: There’s two answers to that, and the more interesting one is why, in my view, a carbon tax doesn’t work. But the general response is, if you start by looking at our historical pollution reduction success stories, what you see is the private sector has only two arms to compete with: one is innovation, one is price. So anytime you regulate in a way that is dictating to the market either the solution or the price, you’re putting the private sector’s hands behind their back. So first of all, what the lessons teach you is an efficient government measure says reduce the fossil content per million BTU of energy sales, and you compete on price and through innovation. I’m not telling you what to do. So that’s the big picture.
Ross Kenyon: I’d just like to note for our listeners, Aldyen put her hands up and tied them behind her back, [unclear].
Aldyen Donnelly: When you set the market participants to compete, when you’re saying get the lead out, get the fossil carbon out, all of a sudden you’ve spawned a huge competition for market share in the new green economy. Every time we’ve done that, the market participants have come up with solutions that the brainiest people never thought of before we set them down the path. Imagine that I have very strong opinions about what the solutions will be — I will be proved wrong.
So a good regulation says two things. I don’t care about tracking emissions — it’s easy to track fossil carbon content. Reduce your fossil carbon content per million BTU units of energy sold in the supply chain. And in that regulation you have maximum three, but one essential, what we would call in regulatory terms alternative compliance options. This is sort of the offset. What’s the other thing you can do beyond changing the structure of your business and your product offering? You could earn credits towards that obligation by removing carbon from the atmosphere and storing it.
Christophe Jospe: And I think everything that you’re saying fits within the mantra of the sustainability community that is trying to do the right thing. They say reduce what you can, offset the rest. But they’re stuck in a regime that just doesn’t make them operate. So I’m kind of curious: if you were speaking to some of the heads of sustainability who might want to do the right thing, or talking to government officials and saying, hey look, this climate change, it’s a real problem and we want to do our part and we want to lead in doing our part — what sorts of things would you like them to know or to be better informed about, and what sort of advice would you want them to be giving?
Aldyen Donnelly: So one of the reasons I’m so committed to Nori is, in every possible set of solutions I can imagine, including better regulation or no regulation or whatever, we’re now at a point where the atmospheric concentrations are high enough that removing carbon from the atmosphere is an essential component of any strategy. So first of all, I’d say it’s got to be on the table. It’s got to be there for real.
Now, we live in a world right now, for example, the United States, where you actually have a budget that is offering 35 to 50 dollars a tonne of tax credit to operators of gas-fired power plants if they install carbon capture and storage, but we’re not offering 35 to 50 dollars of tax credit to farmers who can store carbon in their fields, probably more cost-effectively and efficiently than CCS will work on gas plants.
Ross Kenyon: That’s kind of theological, I think. I would imagine that — except it’s probably a lot easier for the oil and gas industry to lobby for those credits.
Aldyen Donnelly: That only works in the short term, because you know what happens if this strategy doesn’t work, which it’s not going to. How many years before finally government throws up its hands and says, okay, I’m just going to regulate the hell out of you and shut you down, and I’m going to get the regulation wrong?
Ross Kenyon: We’re trying to squeeze in there and hopefully make a dent before that happens, right?
Christophe Jospe: Yeah. Let’s cut to the chase. Why don’t carbon taxes work?
Aldyen Donnelly: A great economist, Herman Daly, will tell you it depends on how you design them. But there’s a couple of things. One, think about what we’re trying to do here. We’re trying to get suppliers to reduce the fossil carbon content in our energy and building products supply chain. One reason carbon taxes haven’t worked to date — there are multiple, but one is, putting a tax on a retail gas pump over here, trying to send a price signal to a consumer, is about as far away from the decision whether or not to have put fossil carbon into the energy supply chain. One of the reasons it doesn’t work is it’s so far away from the decisions that we’re trying to influence.
Ross Kenyon: You think the incidence of the tax would be the same, though, when they just pass it all the way to the consumer?
Aldyen Donnelly: Well, you know what, a lot of economists say that, so I offer you the following prepared response. Over the last 12 months the average retail price of gasoline in the United States has increased 56 cents a gallon. Total gasoline sales in the United States — so that’s a price increase that people have incurred — total gasoline sales in the United States are up, not down. Now, 56 cents a gallon, if you applied it — and this is one of the things — say the equivalent price at the wellhead is twenty four dollars a barrel. Now, all the modeling says on average the price of a barrel has gone up $24 in the last 12 months. Now, all of the economic models and all the economists will tell you there’s no difference between putting in a new tax or tariff that’s 24 dollars a barrel and putting in an increase in the retail price of 66 cents a gallon.
Stop for a minute. Do you think the oil industry would say a new tariff of twenty four dollars a barrel applied to the wellhead will have no impact on their investment in energy products, will have no impact on their return?
Ross Kenyon: Why wouldn’t they just pass it on to the consumer? Where does it stop, or how is it different? The market is perplexing.
Christophe Jospe: Yeah. Can you tell the audience why you’re so familiar with gas prices?
Aldyen Donnelly: Because for two years I set gas prices for 568 retail stations for a large US oil company. It is a mystery. It’s totally logical that a new tax at $24 a barrel at the wellhead is the same as 66 cents a gallon. Sort of basic medium is the same, but it’s not. It’s not, it’s not, I swear to you. Just ask anybody in the oil patch. If the government said, okay, we’re going to hit you with a new tax right at the wellhead, the new tariff, revenue, severance charge of 24 bucks a barrel, that’s going to have no impact on you, right? It’s not how they’re going to react, because that utterly changes the signals that the investors in the production in the supply chain are getting, and the retail pump price is not the same signal. I don’t care if it on paper is the same value. It’s not the same signal.
There are two reasons it’s not the same signal, and this is true in every developed nation. It took me a little while to figure out this is true — the data clearly shows it — it took me a long time to figure out why it’s true. But individual non-industrial energy demand is what we call quite price inelastic. If gas prices go up, all of the US, European, Canadian data shows that we put off other capital expenditures to bear the increased fuel prices. And in academic analysis they call it revealed internal discount rates. We have a tendency to avoid new capital expenditures, or things that feel like new capital expenditures, at all costs. So if you were trying to design a tax with the sole purpose of raising new government revenues and not actually changing behavior, you would put it at the gas pump, which is where everybody’s putting it.
Ross Kenyon: So this internal discount rate thing, that’s like saying that I’m a typical American family and I have an eight-year-old car and it doesn’t get great gas mileage, but I would rather continue driving this car instead of buying a new car and getting better gas mileage.
Aldyen Donnelly: All of that discount rate — all of 30 years of data, household expenditure data, not just for the US but all developed nations, say that rather than respond to the 60 cents a gallon price increase and replace that old car when you thought you were going to, you will save the money not replacing the old car to be able to finance the gas purchases. And when you do that, when we translate that choice into an internal discount rate, the data suggests that very well educated people who manage their stock portfolio, like, meticulously, who know the difference between a 7 percent and 8 percent return, reveal an internal discount rate on their energy-consuming equipment purchases of at least 20 percent, and over the whole population you’re looking at a revealed discount rate of 40 to 50 percent.
So when a government is choosing to tax at that point of retail out there, that’s a conscious decision to proceed with a measure that’s least likely, among all the measures you can choose, least likely to change behavior — which might explain why some of the big oil companies actually advocate for these these days.
Ross Kenyon: It’s behavioral economics, a cognitive failing.
Christophe Jospe: And it’s not like we’re just trying to estimate based on models. Like, this has been tried before, especially in Europe. Why isn’t it working over there, or what are the effects in, like, Sweden?
Aldyen Donnelly: Yes. Well, that’s interesting. Again, I argue that most of the time regulators start with the best of intentions. Sweden, Denmark and Norway, those countries with the oldest carbon taxes and highest rates, started by saying — much like we say in the United States and Canada — let’s do a hybrid of taxing retail, so residential and small business consumption, and doing cap-and-trade, this quota trading thing, for big industrials. Those governments for the most part started off thinking that’s the right way to do things. But when they start, you’ve got to give big industry a break because this is hard.
Well, by mistake they figured out, wait a second here, I can pack a load of new large energy-intensive industrial subsidies into the electricity rate infrastructure, call it my carbon policy, and my government costs of putting this subsidy in place don’t show up on any government balance sheet as debt. I just say, okay, if you’re an important large industry in Sweden, a refinery, I, government, am going to guarantee that you get your electricity on a 30-year firm price agreement for four cents a kilowatt hour, and all of the costs you don’t pay to get your electricity show up as a carbon or emission reduction or renewable energy charge in household and small business bills.
So what’s the reality today? The reality today is, first of all, a relatively small overall reduction in Swedish nationwide emissions. And if you’re the average household in Sweden right now, you’re paying the equivalent of 44 cents US a kilowatt hour, and the refinery down the street is paying the equivalent of six cents US a kilowatt hour, significantly less than the typical US refinery is paying. For context, the average American energy price is about 10 cents a kilowatt hour.
Ross Kenyon: So here in Seattle it’s six.
Aldyen Donnelly: So they’ve used their carbon pricing to package a whole bunch of opaque new subsidies for large emitters into the electricity bills that households and small businesses pay. If you’re in Denmark you’re paying closer to 50 cents a kilowatt hour. If you’re in Norway, for legacy large hydroelectricity, you’re paying 40 cents a kilowatt hour. So as soon as governments started down the path, with whatever their intentions were, they thought — oh my goodness. Well, what’s the reality? Go look at the OECD statistics. Norway, Denmark, Netherlands, Sweden — the top carbon taxing, longest carbon tax histories among developed nations in the world. We think of these as open socialist, you know, fair societies: biggest household private debt increases per dollar of disposable income in the whole OECD. Their household debt numbers are through the roof.
If you live in Sweden, you’re living typically in a home that is 70 percent to 80 percent of the square footage of an average US home, and it’s probably way more efficient than the average US home, and you’re spending twelve percent of your disposable income just to heat your space and your water. So the net effect of this is negligible emission reductions, massive shift of the cost burden of delivering electricity to all of society to the smallest consumers. So a carbon tax is about as regressive a tax as you could possibly do. Unbelievably regressive.
If you’re looking in these nations, the disposable income of the 40 percent richest families is — there’s different ways of measuring it, but it’s anywhere from 5 to 12 times the disposable income of the poorest families. But the richest families only consume one point seven to two point eight times as much carbon-containing energy as the poorest families. If you’re going to finance income tax rate cuts with carbon tax revenues, by definition you’re massively shifting tax burden from the rich to the poor. A tax rate that is significant enough to cause the wealthy families to even consider buying a more efficient car is a tax rate that’s bankrupted every family in the bottom forty percent of society. So it’s a tax rate the burden of which is borne entirely by the poor.
And if you look at British Columbia, where I come from, everybody says we’ve had this great successful carbon tax. Since we’ve had the carbon tax there’s only one 18-month period where British Columbia per capita gasoline use actually dipped, and we have publicly available household expenditure data. The dip was small; a hundred percent of the dip was low-income families no longer being able to drive their cars. And in fact gasoline used by the higher income families went up. And what happened at the same time?
Ross Kenyon: You were telling me about this yesterday.
Aldyen Donnelly: Well, British Columbia gets credit for this carbon tax. If you actually look over that period and look at the average typical cost of commuting from our biggest suburb to Vancouver downtown to go to work, over a five-year period the carbon tax added a hundred and seventeen dollars a year to the typical person’s commute by car every day. Over the same period the government of British Columbia increased the cost of doing that same commute by transit, public transit, by 480 dollars a year. So the carbon tax was just enough to force underemployed and unemployed people during the 2008 through 2011 recessionary time out of their cars, and when they found themselves unable to run their cars anymore, they faced a 480 dollars a year increase in the cost of doing that commute by transit. How does every economist in the country that has written about BC’s successful carbon tax story say that’s the picture of success? I don’t get it.
Ross Kenyon: I’d like to throw down the gauntlet on your behalf and say, if there’s anyone who wants to make the claim that it is, we welcome them on a podcast and we should talk to them about it on the air.
Aldyen Donnelly: I would love that. All of the studies that say BC’s carbon tax was successful compared what actual BC energy consumption was to a theoretical counterfactual, a hypothetical demand rate. And if you accept the hypothetical demand rate that the leading economists posit is the right comparable, you have to accept their assertion that between 2008 and 2011, during an economic recession, British Columbia, in the absence of a statistically insignificant carbon tax, would have realized the biggest three-year increase in fuel use in recorded history. Because the assumptions they’re making around the counterfactual they’re using to come to the conclusion that the carbon tax was effective is completely beyond any reasonable assertion.
Christophe Jospe: I think we can say that cap-and-trade compliance carbon markets have not reduced emissions. We can say carbon taxes have not only not reduced emissions but have also placed an enormous financial burden on the poorest of residents in those jurisdictions, and they’ve spawned some non-transparent industry subsidy behavior in governments — that even the same governments that are engaged in that, they didn’t think they were going to.
Ross Kenyon: So it’s just crony capitalism.
Christophe Jospe: Yeah. So these attempts, been made with the best of intentions, have resulted in such negative effects, and ultimately it’s 2018 and we still haven’t reduced emissions in any significant, measurable way. So what is left to us?
Aldyen Donnelly: The market has to see that we have to start removing carbon from the atmosphere, which is why Nori is so important to me — and maybe on a schedule that’s much more efficient than my own. They have to ask the question that started getting me to see things, which is, we’ve got a bunch of really, really significant pollution reduction success stories in our past. How did we do that? And you know what, the way we were successful in the past from a regulatory standpoint is exactly the way to move forward. But I can’t point to a single carbon, greenhouse gas emissions academic expert in the world who, when they’re looking at and analyzing the policy options, includes in their list of policy options the way we’ve done it well in the past. It’s not on the table.
Ross Kenyon: Excellent words to close with. Thank you so much, Aldyen.
Aldyen Donnelly: Thank you all.
