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Lessons from the Literature for State Carbon Pricing Policy Design A

Lessons from the Literature

for State Carbon Pricing

Policy Design

Kathryne Cleary, Karen Palmer, and Dallas Burtraw

Report 22-01

January 2022

Resources for the Future i

About the Authors

Kathryne Cleary is a senior research associate at Resources for the Future. She works

in RFF’s Electric Power Program. Cleary graduated from the Yale School of Forestry

and Environmental Studies in May 2018 with a Master’s of Environmental Management

with a focus on energy policy.

Karen Palmer is a senior fellow and director of the Electric Power Program at

Resources for the Future. Palmer is an expert on the economics of environmental,

climate and public utility regulation of the electric power sector. Her work seeks to

improve the design of environmental and technology regulations in the sector and the

development of new institutions to help guide the ongoing transition of the electricity

sector.

Dallas Burtraw is the Darius Gaskins Senior Fellow at Resources for the Future.

Burtraw has worked to promote eicient control of air pollution and written extensively

on electricity industry regulation and environmental outcomes. Burtraw’s current

research includes analysis of the distributional and regional consequences of climate

policy, the evolution of electricity markets including renewable integration, and the

interaction of climate policy with electricity markets.

Acknowledgements

This research was supported by the New York State Energy Research and

Development Authority (NYSERDA). We thank Vanessa Ulmer, Saptarshi Das,

Christopher Hall, and Nick Patane of NYSERDA for providing comments.

The views expressed here are those of the individual authors and may dier from those

of NYSERDA or the State of New York.

Lessons from the Literature for State Carbon Pricing Policy Design ii

About RFF

Resources for the Future (RFF) is an independent, nonprofit research institution in

Washington, DC. Its mission is to improve environmental, energy, and natural resource

decisions through impartial economic research and policy engagement. RFF is

committed to being the most widely trusted source of research insights and policy

solutions leading to a healthy environment and a thriving economy.

The views expressed here are those of the individual authors and may dier from those

of other RFF experts, its oicers, or its directors.

Sharing Our Work

Our work is available for sharing and adaptation under an Attribution-

NonCommercial-NoDerivatives 4.0 International (CC BY-NC-ND 4.0) license. You

can copy and redistribute our material in any medium or format; you must give

appropriate credit, provide a link to the license, and indicate if changes were made,

and you may not apply additional restrictions. You may do so in any reasonable

manner, but not in any way that suggests the licensor endorses you or your use.

You may not use the material for commercial purposes. If you remix, transform, or

build upon the material, you may not distribute the modified material. For more

information, visit https://creativecommons.org/licenses/by-nc-nd/4.0/.

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LessonsfromtheLiteratureforStateCarbonPricingPolicyDesignALessonsfromtheLiteratureforStateCarbonPricingPolicyDesignKathryneCleary,KarenPalmer,andDallasBurtrawReport22-01January2022ResourcesfortheFutureiAbouttheAuthorsKathryneClearyisaseniorresearchassociateatResourcesfortheFuture.SheworksinRFF’sElectricPowerProgram.ClearygraduatedfromtheYaleSchoolofForestryandEnvironmentalStudiesinMay2018withaMaster’sofEnvironmentalManagementwithafocusonenergypolicy.KarenPalmerisaseniorfellowanddirectoroftheElectricPowerProgramatResourcesfortheFuture.Palmerisanexpertontheeconomicsofenvironmental,climateandpublicutilityregulationoftheelectricpowersector.Herworkseekstoimprovethedesignofenvironmentalandtechnologyregulationsinthesectorandthedevelopmentofnewinstitutionstohelpguidetheongoingtransitionoftheelectricitysector.DallasBurtrawistheDariusGaskinsSeniorFellowatResourcesfortheFuture.Burtrawhasworkedtopromoteefficientcontrolofairpollutionandwrittenextensivelyonelectricityindustryregulationandenvironmentaloutcomes.Burtraw’scurrentresearchincludesanalysisofthedistributionalandregionalconsequencesofclimatepolicy,theevolutionofelectricitymarketsincludingrenewableintegration,andtheinteractionofclimatepolicywithelectricitymarkets.AcknowledgementsThisresearchwassupportedbytheNewYorkStateEnergyResearchandDevelopmentAuthority(NYSERDA).WethankVanessaUlmer,SaptarshiDas,ChristopherHall,andNickPataneofNYSERDAforprovidingcomments.TheviewsexpressedherearethoseoftheindividualauthorsandmaydifferfromthoseofNYSERDAortheStateofNewYork.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesigniiAboutRFFResourcesfortheFuture(RFF)isanindependent,nonprofitresearchinstitutioninWashington,DC.Itsmissionistoimproveenvironmental,energy,andnaturalresourcedecisionsthroughimpartialeconomicresearchandpolicyengagement.RFFiscommittedtobeingthemostwidelytrustedsourceofresearchinsightsandpolicysolutionsleadingtoahealthyenvironmentandathrivingeconomy.TheviewsexpressedherearethoseoftheindividualauthorsandmaydifferfromthoseofotherRFFexperts,itsofficers,oritsdirectors.SharingOurWorkOurworkisavailableforsharingandadaptationunderanAttribution-NonCommercial-NoDerivatives4.0International(CCBY-NC-ND4.0)license.Youcancopyandredistributeourmaterialinanymediumorformat;youmustgiveappropriatecredit,providealinktothelicense,andindicateifchangesweremade,andyoumaynotapplyadditionalrestrictions.Youmaydosoinanyreasonablemanner,butnotinanywaythatsuggeststhelicensorendorsesyouoryouruse.Youmaynotusethematerialforcommercialpurposes.Ifyouremix,transform,orbuilduponthematerial,youmaynotdistributethemodifiedmaterial.Formoreinformation,visithttps://creativecommons.org/licenses/by-nc-nd/4.0/.ResourcesfortheFutureiiiExecutiveSummaryIntheUS,manystateshaveadoptedambitiousdecarbonizationgoalsforthedecadestocome.Forexample,Hawaii,NewYork,andMainehavesettargetstoreducestate-widegreenhousegasemissionsby100percentinthecomingdecades.Inmanycases,stateshavenotyetimplementedpoliciesthatwillultimatelyachievetheseambitiousgoals.Asstateslooktodoso,manymayconsideradoptingsomeformofacarbonpricingpolicy,atooltypicallyrecognizedbyeconomistsasthemostefficientforachievingemissionsreductions,aspartofacollectionofpoliciestomeetstategoals.Thisliteraturereviewoffersacomprehensiveoverviewofcarbonpricingpolicydesign.Itdrawsonliteraturefromexistingcarbonpricingprograms,simulationmodelingforproposedprograms,theoreticalconcepts,anddescriptiveanalyses.Itisintendedtoguidepolicymakersinestablishingcarbonpricingprogramsaswellastoidentifygapsintheresearchandsuggestnextsteps.Theliteraturereviewoffersthefollowingkeytakeaways:•MitigatingLeakage:Carbonpricingpoliciescancreateemissionsandeconomicleakage,butpolicydesignoptions(likeabordercarbonadjustmentoroutput-basedallocation)canbeusedtomitigatethose.•DesigningforPolicyInteractions:Carbonpricingpoliciesshouldbedesignedtoworkwellwithotherpoliciestoovercomethewaterbedeffect.Oneoptionisprice-responsivesupply.•AddressingDistributionalConcerns:Usingrevenuesintheformoftaxbreaksordividendstohouseholdscanreducetheregressivityofcarbonpricing.•GarneringPoliticalSupport:Policiesthataddressotherlocalconcernssuchasairqualityorimprovesocialinequitiescanimprovepoliticalsupport.•ImprovingPolicyDurability:Policysequencingcanalsobeusedtobuildpolicysupportandacceleratetechnologicaldevelopment.•ViableAlternatives:Whencarbonpricingisnotpossible,otherpricingpolicies(suchastradableperformancestandards)canachievenearlyasefficientoutcomes.Manyoftheseotherpoliciescanalsoworkwellwithcarbonprices.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesignivContents1.Introduction12.WhyCarbonPricing?33.CarbonFeeversusCap-and-Trade54.PolicyDesign74.1.CarbonTax74.1.1.SettingtheTax74.1.2.AddressingUncertainty84.1.3.EvidencefromReal-WorldExperience84.2.Cap-and-Trade104.2.1.CapLevelandTrajectory104.2.2.BankingandBorrowing104.2.3.AllowanceAllocation114.2.4.AddressingUncertainty125.MacroeconomicEffects146.DistributionalConsequencesofCarbonPricing167.Leakage198.PolicyInteractions229.PoliticalFeasibility2510.OtherReal-WorldChallenges2711.FlexiblePolicyAlternativestoCarbonPricing2912.GapsintheLiterature3113.Conclusion3214.References33LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign11.IntroductionIntheUS,manystateshaveadoptedambitiousdecarbonizationgoalsforthedecadestocome.Forexample,Hawaii,NewYork,andMainehavesettargetstoreducestate-widegreenhousegasemissionsby100percentinthecomingdecades.Inmanycases,stateshavenotyetimplementedpoliciesthatwillultimatelyachievetheseambitiousgoals.Asstateslooktodoso,manymayconsideradoptingsomeformofacarbonpricingpolicy,atooltypicallyrecognizedbyeconomistsasthemostefficientforachievingemissionsreductions,aspartofacollectionofpoliciestomeetstategoals.Carbonpricingcantaketwomainforms:acarbontax,whichplacesataxoneachtonofcarbondioxide(CO2)equivalentemitted,oracaponaggregateemissions(typicallylabeledcap-and-tradeorcap-and-invest),inwhichemissionsallowancesareeitherauctionedorissuedtocomplianceentitiesandcanbetradedatamarket-determinedprice.Inrecentliteratureandpractice,designfeaturesforbothprogramtypeshaveemergedthataimtomakethesepoliciesadaptabletochangesincostsandemissionsreductionopportunities,which,inturn,leadthemincreasinglytoresembleeachother.Otherpolicies,particularlysector-specificpolicieslikeacleanelectricitystandardoratradableemissionsperformancestandard,canbedesignedtomimiccarbonpricingandachievesimilaroutcomes.ManycountriesandcertainpartsoftheUnitedStateshavesomeformofcarbonpricingpolicy.TheEuropeanUnionhashadacap-and-tradeprogram(EUEmissionsTradingSystem,ETS)since2005coveringelectricityandindustrysectoremissions,andmanyEuropeancountrieshaveadditionalcarbontaxesthattypicallyapplytosectorsnotcoveredbythecap(WorldBank2020).TheEuropeanUnionisalsoconsideringaproposaltomaketheETStargetsmorestringentandtointroduceanew,separatetradingsystemtocovertransportationandbuildings.OthercountrieswithsomeformofcarbonpricingprograminplaceorscheduledforimplementationincludeMexico,China,Australia,Chile,Argentina,andSouthAfrica.IntheUnitedStates,cap-and-tradeprogramsareinplaceinCalifornia,WashingtonState,andtheseveralnortheasternstatesintheRegionalGreenhouseGasInitiative(RGGI).Thisliteraturereviewoffersacomprehensiveoverviewofcarbonpricingpolicydesign.Itdrawsonliteraturefromexistingcarbonpricingprograms,simulationmodelingforproposedprograms,theoreticalconcepts,anddescriptiveanalyses.Itisintendedtoguidepolicymakersinestablishingcarbonpricingprogramsaswellastoidentifygapsintheresearchandsuggestnextsteps.Thereviewisorganizedasfollows.Section2summarizesliteraturethatexplainswhycarbonpricingisconsideredmoreefficientunderspecificconditionsthanotherpoliciesforreducingeconomy-wideemissions.Section3looksattheliteraturethatcomparesthebenefitsanddrawbacksofthetwotypesofcarbonpricing(taxvs.cap-and-tradeorcap-and-invest).Section4reviewsliteraturerelatedtopolicydesign,suchashowtosetataxorcap,optionsforusingtherevenue,andauctiondesignunderacapprogram.Section5focusesonmacroeconomiceffects.Section6discussesthedistributionaleffectsofcarbonpricingandwaystoimproveoutcomes.SectionResourcesfortheFuture27exploresissueswith“leakage”(shiftsineconomicactivitythatcauseeconomiclossesintheregionaffectedbythepolicyand/oranincreaseinemissionsinregionsorsectorsnotcoveredbythepolicy)andhowtomitigateit.Section8looksatthepolicyinteractionsbetweencap-and-tradeprogramsandoverlappingpoliciesalsodesignedtoachieveemissionsreductionsorcloselyrelatedgoals.Section9considersthepoliticalfeasibilityofcarbonpricingandwhatresearchshowsaboutovercomingoppositiontocarbonpricing.Section10looksatotherreal-worldchallenges,suchashowtoleverageexistingpoliciesinawaythatcanbebeneficialforcarbonpricing.Section11summarizesalternativestopricingcarbonthatcouldbeadoptedifoppositiontocarbonpricingisverystrong.Finally,Section12identifiesgapsintheliterature,andSection13concludes.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign32.WhyCarbonPricing?Intheenvironmentaleconomicsliterature,carbonpricingisoftenestablishedinisolationandthencomparedwithotherpricingandnonpricingapproaches,includingregulatorymandates,tocharacterizeasomewhatstylizedsituationwhereapolicymakerischoosingoneapproachortheother.Underspecificassumptionssetforthineconomictheory,includingcomprehensivecoveragewithnoorlimitedleakage,carbonpricingisamoreefficientapproachtoreducingemissionsthanregulatorymandates(PomerleauandDolan2021).Carbonpricingistechnologyneutralandencouragesthelowest-costreductionsacrossthecoveredsectorsortheentireeconomy.Itminimizescostsbyofferingentitiessubjecttothepolicyachoice:eitherreduceemissions,orpaytheprice(paythetaxorpurchasecarbonallowances)tocontinueemitting.Therefore,intheory,pollutingentitieswillreduceemissionsuptothepointthattheirmarginalabatementcostsequalthetaxorallowanceprice,andthusthepolicyencouragesfirmstoundertakeallcost-effectiveemissionsreductions.Consequently,acarbonpricingpolicyimposesthesamemarginalcostsonallcoveredentities.Otherregulations,incontrast,mayrequiresimilaractionsorsimilarperformancefromallregulatedfirmsregardlessofthecostofundertakingthoseactionsormeetingthoseperformancegoals.Carbonpricingpoliciesalsocreateanincentivetoconserveenergybecausetheyaffectthepriceoffossilenergy,whichmaynotbeafeatureofotherregulations(unlesstheydirectlytargetenergyefficiency).Additionally,becausecarbonpricingpoliciesaretechnologyneutral,theyencourageinnovationanddeploymentofanycleanTypesofPoliciesCarbonpricing:Pricingpoliciesthatdirectlytargetcarbonemissions,likecarbontaxesandemissionstradingprograms(inwhichacarbonpriceisdeterminedthroughamarket).Otherpricingpolicies:Pricingpoliciesthattypicallydonotdirectlytargetcarbonemissionsbutinsteadtargetoutcomesthatwillultimatelyleadtoemissionsreductions,suchaspromotinglow-emittingtechnologies,alternativefuels,andsometimesenergyefficiencywhenaveragedacrossaperformancecategory.Theseotherpricingpoliciesincludetradableperformancestandards(TPS)ofvarioustypes,includingtradableemissionsratepolicies,aswellascleanenergystandards,renewableportfoliostandards,andtradablerenewablefuelstandards.Nonpricingpolicies:Allpoliciesthatdonotincludeadirectpriceonemissionsorcloselyrelatedoutcomesoranyformoftrading,suchasuniformlyappliedemissionsperformancerequirements,othertypesofperformancerequirements,andtechnologyprescriptionsandbans.Specificexamplesincludebuildingelectrificationorenergyefficiencyrequirements,maximumemissionsratestandardsfornewinvestments,andpublicinvestmentinelectricvehiclechargingstations.ResourcesfortheFuture4technologiesthatwillbenefitfromthepolicy.Nonpricingpolicies,incontrast,typicallypushforalimitedsetofidentifiedtechnologytypes.Whenimplementedasthesolepolicy,awell-designedcarbonpricingpolicypricescarbonatthemarginalsocialcost,thusencouragingemissionsreductionsuptothepointthattheyaresociallyoptimal.Pigou(1920)establishedthatpricinganexternality(suchascarbonemissions)atthemarginalcostofthedamagesitimposesonsocietywouldenablethemarkettoreachthesociallyoptimaloutcomebyexposingproducersandconsumerstothefullcostsoftheiractions.Intherealworld,whencarbonpricingisadopted,italwaysispartofandprecededbyaportfolioofpolicies.Onereasonisthatpricingcarbonhighenoughtoachievetheeconomicallyefficientlevelofemissionsreductionsisdifficulttodo,andimplementingsuchacarbonpricewhenactingunilaterallyispoliticallyandeconomicallyunsustainablebecauseofthethreatofleakage.Sections8,9,and10exploreseveralreal-worldimplicationsofpricingcarbonascomplicatedbypolicyinteractions,politicalfeasibility,andotherfactors.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign53.CarbonFeeversusCap-and-TradeCarbonpricingcantaketwoforms:acarbontax,oracap-and-tradeprogram—andcap-and-tradecanbeintheformofcap-and-invest,inwhichprogramrevenuesareinvestedtoadvancethegoalsofthepolicy.Mostliteraturefocusesoncap-and-tradewithouttheinvestmentcomponent,butinpractice,mostprogramshaveanexplicitlinktodistributionorinvestmentoftherevenueraised.Intheory,eitherpolicytype(taxorcap)couldbedesignedtoyieldthesameoutcomesatthesamelevelofefficiency,andintheliteratureandinpracticetheyincreasinglyaredesignedtomimiceachother.Inacontextwithfullinformationandnouncertainty,thesepoliciesshouldachievesimilaroutcomesbecauseofthewaycoveredfirmsorindividualsareexpectedtoreact(GoulderandSchein2013).Underacap,firmswillreduceemissionsuptothepointwheretheirmarginalabatementcostsequalthepriceofanallowance,andunderacarbontax,firmswillreduceemissionsuptothepointwheretheirmarginalabatementcostequalsthetax.Thus,bothpolicieswillreduceemissionsefficiently,withthemaindifferencebeinghowthepriceisdetermined(eitherdirectly,throughatax,orindirectly,throughpricesforallowances).Specificemissionsreductionoutcomesdependonhowthetaxorcapisset.GoulderandSchein(2013)alsofindthatthetwoapproachesaremoreorlesssimilarintheireffectsoninternationalcompetitivenessandtheneedforborderadjustments,aswellasintheirdistributionaleffects(assumingnorevenuerecycling,thoughthatcouldcreatedifferencesinoutcomes,dependingonthecap-and-tradedesign).Thetwoapproachesdohaveimportantdifferencesinpractice,however.Theseincludeuncertaintyaboutenvironmentaloutcomesandprogramcosts,administrativecomplexities,anduncertaintyaboutfirms’abatementcosts.GoulderandSchein(2013)observethatacap-and-tradeprogramcanbemoreadministrativelycomplexandthuscouldbemorecostlytoimplementthanatax.Yettaxescanalsobeadministrativelycomplex—forexample,iftheyincludeexemptionsorprovisionsforfavorabletreatment.Theadministrativecostsofexistingcap-and-tradeprogramshavebeenverysmallcomparedwithnonpricingpolicies,however,andarenotlikelytobemuchdifferentfromadministeringacarbontax.However,taxescanbemoredifficulttoimposethancap-and-tradeprograms.IntheUS,imposingemissionstaxestypicallyrequiresnewlegislation,whereasimplementingacap-and-tradeprogrammaybewithintheauthorityoftheenvironmentalregulatororanotheradministrativeagency.Thisdifferenceislikelyonereasonwhycap-and-tradeapproachesaremoreprevalentintherealworldthanarecarbontaxes.GoulderandSchein(2013)identifythevolatilityofallowanceprices,asevidencedbytheEUETSexperience,asadownsideofacap-and-tradeprogram.Volatileemissionsoutcomesarelikelyananalogousdisadvantageofacarbontax.However,acap-and-tradeprogramcanbedesignedtolimitthevolatilityofpricesthatmaydriveemissionsreductionseitherupordown,makingitmorelikeacarbontax,andconversely,aResourcesfortheFuture6carbontaxcanhaveadjustmentmechanismsthatrespondtochangesinemissions.Thesedesignoptionsarediscussedinthenextsection.Anotherdifferenceinthesepoliciesinvolvestheeasewithwhichtheycanbelinkedwithapproachesinotherstates.Theadvantagestolinkingprogramsacrossjurisdictionsincludereductionsinleakageandadministrativecosts,resiliencetochangesinenergydemandandfuelsupplydisruptions,andcostsavingsoverall.However,linkingmayalsoleadtoashiftinthelocationwhereemissionsreductionsandnewinvestmentsareachieved,whichcanbeviewedcriticallybysomeparties(Mehlingetal.2018;Burtrawetal.2013).Acap-and-tradeprograminoneregioncanbeeasilylinkedtoanotherregionalprogram(Stavins2020)becauseitrequiresonlycoordinationinregulatorydesignandtradingofallowancesacrossregions.(Oneexample:inrecentyearsVirginiaandNewJerseyhavejoinedtheRGGIprogram,greatlyexpandingtheRGGImarket.)Acarbontax,incontrast,wouldbynaturebespecifictothejurisdiction.Interstatecoordinationontaxlevelsispoliticallychallengingbecauseitinvolveslegislativeoutcomes.Theacademicdebateoverwhichapproachisbetterfocuseslargelyonabilitytodealwithreal-worlduncertaintiesandapolicy’srobustnesstothoseuncertainties.In“Quantitiesvs.Prices,”Weitzman(1974)arguedthataprice-basedinstrumentlikeacarbontaxwouldlikelybeabettertoolforaddressingpollutionemissionsthancap-and-tradeifthereisrelativelygreateruncertaintyaboutfirms’marginalabatementcoststhanaboutmarginalbenefitsofemissionsreductions.KarpandTraeger(2018)revisitthisfamouspaperandsuggestthatitsconclusionsmaynotbeaccuratebecauseWeitzmanfocusedonflowpollutantsratherthanstockpollutants,likegreenhousegasemissions,thatstayintheatmosphereformanyyears.Toaddressthatdifference,theyuseadynamicprogrammingmodelandfindthattaxesarenotnecessarilysuperiortocap-and-tradebecauseofthetechnologicaluncertaintyacrossmultipleperiodsthatWeitzman(1974)failedtoaccountfor,andthatinfact,cap-and-trademightbetteraccommodatetechnologicaluncertainty.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign74.PolicyDesignThissectionreliesontheoreticalliteratureandlessonsfromexistingprogramstoinformstatesofthebestpracticesfordesigningarobustcarbonpolicy.Mostconsiderationsdependonthepolicytype—carbontaxorcap-and-trade.4.1.CarbonTax4.1.1.SettingtheTaxAcriticaldecisionastatewouldfaceinimplementingacarbontax1ishowtosettheinitialtax,howitescalatesovertime,howfarintothefuturetosetthetax,andhowthetaxraterespondstochangesintheeconomicorpoliticalspheres.Inaddition,policymakerswouldneedtodecidewhichsectorstocover,andthepointofcompliance(e.g.,fuelsuppliersorconsumers).Intheory,thetaxshouldbesetequaltothemarginaldamagesofcarbonpollutiontocorrecttheexternalityandachievethesociallyoptimalmarketoutcome(Pigou1920).Inpractice,estimatingmarginaldamagesischallenginganddependsontheapproachtaken.Usinganothermethodtosetthetaxmaybemorepractical.Thesocialcostofcarbonisanestimateofthemarginaldamagesofcarbonpollution.Theestimateheavilydependsontwocrucialassumptions:whatdiscountratetoapplytofuturedamages,andwhichdamagestoinclude.Atthefederallevel,theInteragencyWorkingGroup,acollaborativeeffortamongtheDepartmentofEnergy,theEnvironmentalProtectionAgency,andotherexecutivebranchagencies,periodicallypublishesupdatedestimatesoftheglobalsocialcostofcarbonwithvariousdiscountrates.Thecurrentfederalcentralestimateofthesocialcostofcarbonis$51pertonin2020,assuminga3percentdiscountrateisappliedtofuturedamages(IWG2021).Thefederalestimateisunderreviewcurrently,andmostobserversexpectittobeincreased,perhapssubstantially,becauseofamorecomprehensiveassessmentofclimateimpactsaswellaspotentiallyadifferentdiscountrate.Estimatesofthesocialcostofcarbonhaveevolvedconsiderablyandareexpectedtocontinuetodoso.Economictheorycontinuestoevolveaswell.Aliteraturerootedinpublicfinancesuggeststhattheefficientcarbonpricemaybebelowthemarginalsocialcostbecauseofinteractionsofthecarbonpricewithpreexistingdistortionsthatmaketheeconomylessefficient,suchaspreexistingtaxes(Goulder2013).Subsequentliteraturehasinvokedotherefficiency-reducingdistortionsinthetaxcode,suchasthehomemortgageinterestdeduction,toconcludethatthetaxpriceshouldbegreaterthanthemeasureofsocialcost(ParryandBento2000).Conversely,theliteratureondirectedtechnologicalchangesuggeststhattheoptimalpricemaybeabovemarginal1Acarbontaxcouldcoverothergreenhousegaspollutantsiftheiremissionsarecalculat-edinCO2-equivalentterms.ResourcesfortheFuture8socialcost,tocreateincentivesforinnovationandinvestmenttoovercomethebarriersembodiedinlegacyinfrastructure.(Acemogluetal.2012).Anotherwaytosetacarbontaxistoestimateacarbonpricelevelthattargetsacertainlevelofemissionsreductionsbybasingthepricesonmarginalabatementcostsinsteadofthemarginaldamagesreflectedinthesocialcostofcarbon.Kaufmanetal.(2020)estimateCO2pricesfortheyear2030fortheUnitedStatesusingatargetedemissionsapproach:theyselectanet-zeroemissionsdateof2050andanemissionstrajectorytothatdate,andthenusethesetargetsasinputsinenergy-economicmodelstoestimateaseriesofCO2pricesthatwouldachievethesereductions.Theyfindthattoreachanet-zerotargetby2050,theUSshouldpricecarbonatbetween$34to$64pertonin2025andrampupto$77to$124pertonin2030.4.1.2.AddressingUncertaintyAcarbontaxprovidesahigherlevelofcostcertaintyattheexpenseofalowerlevelofcertaintyaboutemissionsreductions.Acarbonpriceistypicallyanticipatedtoincreaseinnominaltermsovertime.Toaddressuncertaintyabouttheemissionsreductions,arecentliteraturehassuggestedthatthetaxchangeovertimetoreflectchangesinemissionstargets,abatementcosts,oreffectsofthetaxontheeconomy,amongotherthings.Kaufmanetal.(2020)suggestregularlyupdatingtheestimates.Aldy(2020)alsoproposesaframeworkinwhichacarbonpriceisupdatedeveryfiveyearstokeepupwithchangingenvironmentalandeconomicconditions.HafsteadandWilliams(2020)exploretheoptionofincorporatingataxadjustmentmechanisminacarbontaxprogramtoprovidemorecertaintyaboutemissionsreductions.Thismechanismwouldautomaticallyadjustthetaxinresponsetoemissions.Forexample,ifemissionsreductionsarelowerthanexpected,thenthetaxwouldadjustupwardaccordingtoapredeterminedformula.Usingsimulationmodeling,HafsteadandWilliams(2020)findthattheuseofataxadjustmentmechanismcangreatlyreduceemissionsuncertaintyandincreasethechancethatthecarbontaxpolicyhitsitstarget.TheSwisscarbontax,forexample,hasatax-adjustmentmechanisminplace,andthemechanismhasbeentriggeredseveraltimessincethetax’sinceptionin2008.Thetaxrosein2014,2016,and2018inresponsetohighemissions,andwillriseagainin2022because2020emissionstriggeredthemechanism.4.1.3.EvidencefromReal-WorldExperienceManyEuropeancountieshavecarbontaxesthatgenerallyapplytofossilfuelusesnotcoveredbytheEUETS.Ofthese,Swedenhasthehighestcarbontax(about$137permetrictonin2021),followedbySwitzerlandandLichtenstein($101.47permetricton)(WorldBank2021).OtherEuropeancountries,Ukraineamongthem,haveverylowcarbonprices,atonlyafewcentspermetricton.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign9Sweden’scarbontax,whichmainlycoversemissionsfromfossilfuelusefortransportationandbuildings,isacasestudyforestimatingtheeffectsofimplementingacarbonpricethatisclosetotheDECestimateofthesocialcostofcarbon.StudieshavefoundthatSweden’scarbontaxhasreducedemissionsacrossbothsectors.Andersson(2019)usestransportationemissionsdatafrom1960to2005andcomparesSweden’saverageemissionspercapitaaftertheintroductionofthecarbontaxwiththeaverageemissionspercapitaofasyntheticcontrolgroupof14developednationswithasimilaremissionstrajectorybutnocarbonprice.TheresultsshowthattransportationemissionsinSwedenfellby11percentannuallyaftertheadoptionofacarbonpricerelativetothecontrolgroup;6percentagepointswereattributedtothecarbonprice.Historically,acarbontaxonthetransportationsectorhascausedaswitchfromgasolinecarsnottoelectriccarsbuttoslightlymorefuel-efficientdieselcars—anunintendedeffectforwhichNadirovetal.(2020)foundevidencein17Europeancountriesfrom2013to2017.Andersson(2019),too,foundthatSweden’semissionsreductionsfromthecarbontaxcameprimarilyfromfuelswitchingfromgasolinetodiesel,andtheproportionofdieselcarsgrewsubstantiallyafterthetax’sintroductionin1991throughtheendofthesamplein2005.AcarbontaxthatencouragesaswitchtodieselmaynotreduceCO2emissionsbymuchandcouldalsoresultinmoreairpollutionatthelocallevel.SuchanoutcomeislesslikelytooccurintheUnitedStates,however,forseveralreasons.First,dieselfuelismoreheavilytaxedherethangasoline.AsofJuly2021,federaltaxesandfeesfordieselfuelwere6centspergallonhigherthanforgasoline(EIA2021).Additionally,theUnitedStatesimposesstricterregulationsonlocalairpollutants,particularlynitrogenoxides(NOx),thanEurope,whichhaslessstringentstandardsfordieselvehicles(Nesbeitetal.2016).Lastly,theEuropeancarbontaxeshave,insomecountries,beeninplaceforseveraldecades,andimplementingacarbonpolicytodaywouldlikelyhavedifferenteffectsbecauseconsumershavemorealternativestogasolinevehicles,likehybridsandelectricvehicles.RunstandThonipara(2020)lookattheeffectsoftheSwedishcarbontaxontheresidentialsectorandestimatethatthetaxhasreducedemissionsfromhomeenergyusebyabout800kgpercapitarelativetocountrieswithoutacarbontax,andbyabout200kgpercapitarelativetocountrieswithacarbontaxlargerthan20euros.Thestudyalsofindsthatthecarbontaxismoreeffectivethanotherpoliciesinencouragingconsumersmoveawayfromelectricresistanceheat.Forinstance,basedonpolicyevaluationstheauthorscitefromtheOdyssee-MureDatabase,thecarbontaxisestimatedtohaveencouragedconversiontoheatpumpsmoreeffectivelythansubsidiesforheatpumps(andalsobetterthansubsidiesforrenewablefuels,districtheating,orsolarheating);theresearchersnotethatheatpumpsalesskyrocketedintheearly2000s,whenthecarbontaxwasincreasingsharply.Theysuggestthatacarbontaxcanbeeffectiveatreducingemissionsfromtheresidentialsectorifitexceeds120Euros,2andthatthelevelofthetaxultimatelydeterminesitseffect.2AsofOctober2021,120eurosisapproximately$140.ResourcesfortheFuture104.2.Cap-and-TradeAcap-and-tradeprogramtypicallyhasmoredesignfeaturesthanacarbontaxandmaythereforebemoreadministrativelycomplex.Aswithacarbontax,cap-and-tradeprogramdesignmustidentifywhichsectorstocoverandthepointofcompliance.Otherimportantelementsofdesign—someofwhichlikewisehaveanaloguesincarbontaxpolicy—arethelevelofthecap,itstrajectory,rulesonbankingandborrowing,andtheallocationofemissionsallowances.Thissectiondescribesfindingsfromtheliteratureoneachofthesefeatures.4.2.1.CapLevelandTrajectorySettingthecapandthetrajectoryofthatcapwilldependonthearea,sectorscovered,currentemissionslevels,andpoliticalconsiderationsandpreferences.TheInternationalClimateActionPartnership(2021)providesacomprehensiveoverviewofhowbesttodesignacap-and-tradeprogram.Thetwomainoptionsaretop-downandbottom-up.Thetop-downapproachbasesthecaponpolicyobjectives,andthebottom-upapproachbasesacaponfeasibilitybasedoneachcoveredsector’spotentialtoreduceemissions.Capscanalsobeabsolute(measuredintons)orintensity-based(measuredintonsperunitofoutput,suchaspermegawatt-hourofelectricity).Overtime,thecaptypicallybecomesmorestringent,sopolicymakersmustdeterminethetrajectoryanddecidehowfarintothefuturetogo.Oneimportantconsiderationwhenchoosingacaplevelisbalancingambitionwithcostsoftheprogram.TheInternationalClimateActionPartnership(2021)advisesthatthecap,whichwillimposehighercostsoncoveredsectorsthestricteritis,shouldbebothenvironmentallystringentandeconomicallyfair,andmayaffectcompetitivenessintheregion.Thereportalsohighlightstheinformationneededtosetacap,whichissimilartotheinformationneededtosetacarbontaxiffairnessandcompetitivenessaretakenintoaccount:historicalemissionsandeconomicdata,projectionsforabusiness-as-usualcase,estimatesforthetechnicalfeasibilityofreductionsinbothcoveredanduncoveredsectors,and,toavoidextremelyhighcompliancecosts,estimatesofthemarginalabatementcostcurvesofcoveredsectors.4.2.2.BankingandBorrowingAcap-and-tradeprogramcanbedesignedtoallowforintertemporalbanking(allowancescanbebankedforuseinfuturecomplianceperiods)andborrowing(allowancescanbeborrowedfromfuturecomplianceperiodsforuseinthecurrentcomplianceperiod).LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign11TheInternationalClimateActionPartnership(2021)describesthebenefitsofincludingbankingandborrowingprovisionsinacap-and-tradeprogram.Bankingcanreducepricevolatilitybyenablingentitiestoholdallowancesratherthanselltheminamarketwithlowprices,anditcanalsobetterensurethatshort-termclimatetargetsaremetbecauseemissionsallowancesarebankedforfutureuseratherthanusedinthecurrentperiod.Bankingalsocreatessupportforcontinuationoftheprogram:entitiesthatbankallowanceswillsupportcontinuationoftheprogramsothatthebankedallowancesremainvaluable,thuscreatingacoalitionandmakingthepolicymoredurable.Borrowingsimilarlyincreasestheflexibilityofthepolicy,particularlyifentitiescanreasonablyachievereductionsinthefuturebut,becausetheyneedtoinvestintechnologicalupgrades,notinthepresent.However,theInternationalClimateActionPartnership(2021)notesthatborrowingcanberisky:itcanincreaseemissionsinthecurrentperiodandcouldmakeitmoredifficulttoachieveshort-termtargets.Unlikebanking,borrowingcouldcreatesupportforendingtheprogrambecause,havingborrowedagainstfutureallowances,entitieswillhavetocomplywithstricterrequirementsinsubsequentperiods.However,programsthatsetadecliningcapovertimeachievesomeofthebenefitsofborrowingfortheprogramasawhole:theyallowmoreemissionsintheneartermandtherebylimitnear-termcostsandpostponegreaterreductionstothefuture.Onewaytoimplementborrowingwithtightconstraintsisthroughmultiyearcomplianceperiods,asoneobservesintheRGGIandCaliforniaemissionstradingprograms.KuuselaandLintunen(2020)simulateeconomicwelfareunderanemissionstradingschemeandshowthatapolicythatincludesbanking,butnotborrowing,canbewelfareimprovingrelativetobothacarbontaxandapolicywithoutbanking.BankinghasbeenusedintheEUETS,RGGI,andCaliforniacap-and-tradeprograms.Lookingatdecadesofexperiencewithcap-and-trade,SchmalenseeandStavins(2017)assertthattheEUexperiencedemonstratestheimportanceofallowancebanking.Inthefirstperiod,theEUETSdidnotallowbanking,andtheallowancepricedroppedsignificantly—tonearzeroattheendofthefirstcomplianceperiod—whenthenumberofallowancesthathadtobeusedwasveryhighrelativetototalemissions.Thesecondandthirdperiods,whichdidallowbanking,sawmorepricestability.4.2.3.AllowanceAllocationAllowancesinacap-and-tradeprogramcanbeauctionedordistributedforfreetospecificpolluters(withtheassumptionthatfirmswilltradeamongthemselves).Althoughallowanceallocationshouldn’taffecttheemissionsoutcomes,itcanaffectthecost-effectivenessoftheprogram,amongotherthings.Forexample,distributingallowancesforfreecanbeenticingforpoliticalreasons,butfreeallocationcanlimittransparencyaboutcostsandlimitmarkettrading,andinefficientpricingmayresult(BurtrawandMcCormack2017).ResourcesfortheFuture12BurtrawandMcCormack(2017)explorehowconsignmentauctionscanbeusedtobetterallocatefreeallowancestopreventinefficientoutcomesandimproveprogramtransparency.Theyproposethatfirmsthatreceivefreeallowancesberequiredtoparticipateinarevenue-neutralconsignmentauctioninwhichtheyeitherauctionofftheirallowancestoothersorbuybacktheirown.Withaconsignmentauction,therevenuesarereturnedtotheentitiesthatreceivedtheallowancesforfreeinproportiontotheirshareofallallowancessoldintheauction.Byenhancingpricetransparency,theuseofaconsignmentauctioncanimproveefficiencymorethanaprograminwhichallowancesaredistributedforfreewithnoprice-revealingauction.Bynestingfreeallocationwithinaconsignmentauction,theregulatorcanenforceapricefloorintheauction—asinthecurrentCaliforniacarbonmarketforallowancesallocatedtoutilities.ThisfeaturewasalsoanelementoftheUSsulfurdioxidetradingprogram.Adrawbackoffreeallowanceallocation(oraconsignmentauction)isthatitdoesnotproviderevenue.Aregularallowanceauction,ontheotherhand,providesrevenuesthat,likeacarbontax,canbeusedforvariouspurposes(Section6).InRGGI,theprimarymethodforinitiallydistributingallowanceshasbeenthroughauctions,whichhavegeneratedseveralbilliondollarssince2009.Hibbardetal.(2018)estimatethatfromitsinceptionthrough2017,RGGIauctionproceeds(totaling$2.7billion)ledto$4.7billionineconomicbenefitsinRGGIstates.Therevenuessupportedstrategicenergyinvestments,includingenergyefficiencyupgrades.AuctiondesignfortheRGGImarketisdetailedinHoltetal.(2007)asrecommendationspriortotheprogram’sinceptionthatwerelateradopted.RGGI’suniformpriceauctions,inwhichwinnersallpaythesamepriceforallowances,areheldquarterly,andsomeallowancesoflatervintagesareauctionedinpriorperiodstohelpinformthemarketaboutfuturepriceexpectations.Acrucialfeatureisthereserveprice,whichhelpslimitpricemanipulationbylargebuyers.Thisreserveprice,whichrepresentsapricefloor,alsoprovidesamechanismtosupporttheallowancepricewhentechnologyimprovesandmarginalcostsfall,ensuringthatthisimprovementmapsintoadditionalemissionsreductions.4.2.4.AddressingUncertaintyWithcap-and-tradeprograms,compliancecostsareuncertainandmayfluctuate.Forexample,boththeRGGImarketandtheEUETShaveseenlowprices,ofteninfluencedbyoutsidemarketconditions,suchasthe2008financialcrisis,andotherpolicies.Ineverymarketforatmosphereresources,priceshavebeenlowerthaninitiallyexpectedthroughmostoftheprograms’durationandhaveoftenfalleninrealterms(BurtrawandKeyes2018).Optionsforcontrollingpricesinacap-and-tradeprogramincludeapriceceiling,whichsetsanupperboundforallowancepricesiftheyrisetoohigh,andapricefloor,whichsetsalowerboundifallowancepricesdiptoolow.Ensuringthatallowancepricesdonotdroptozerohelpssupportaminimumlevelofemissionsreductions.InallowanceLessonsfromtheLiteratureforStateCarbonPricingPolicyDesign13markets,pricefloorsandceilingsarepracticallyimplementedthroughreservepricesthatserveasaminimumacceptablepriceforallorsometrancheofallowances.Economistshaveexploredotheroptionsforcontrollingcostsundercap-and-trade.RobertsandSpence(1976)describedahybridofacarbontaxandemissionstradingapproachtoaddressuncertainty.In“QuantitieswithPrices,”Burtrawetal.(2020)buildonthisideatointroduceaprice-responsivesupplycurveforallowances,inwhichthenumberofavailableallowancesisadjustedupordowntocounteractextremeprices.Inthisframework,aprice-responsivesupplycurvecontainscostsandemissionsintwoways.First,anemissionscontainmentreserve,inwhichallowancesarewithheldfromthemarket,istriggeredifpricesfalltoolowandisintendedtoensurethatemissionsreductionsareachieved.Second,acostcontainmentreservekeepscostsfromrisingtoohighbyreleasingmoreallowancestothemarketifpricesriseaboveacertainthreshold.Burtrawetal.(2020)showthroughproofs,laboratorysimulations,andelectricitysystemmodelingthatthisprice-responsivesupplyapproachimprovesmarketefficiencywhencostsofabatementareuncertain.Burtrawetal.(2017)exploretheapplicationofanemissionscontainmentreservethatwasbeingproposedfortheRGGImarket.Theymodelanallowancesupplycurveasastep-wise,price-responsivesupplycurvewithonestep,threesteps,andaramptoaccountforunexpectedchangesindemand.Inthesecases,ifdemandfallsandthepricedipstothelevelofthereservetriggerprice,allowanceswouldberemovedfromthemarket,muchthewaythatallowancesremainunsoldwhenthepricefallstothepricefloor.Theyfindthatsuchareserve,ifimplementedintheRGGImarket,wouldmitigatesomeofthe“waterbedeffect,”wherebyreduceddemandforallowancesinonearealowersthepriceoftheallowances,whichthenincreasesdemandforallowanceselsewhereinthecoveredregion—withnopositiveeffectonemissions.ResourcesfortheFuture145.MacroeconomicEffectsAneconomy-widecarbonpolicywillraisethecostsofcarbon-intensivegoodsandservicesandthuswillaffecttheeconomybroadly.Theextenttowhicheconomicactivityisaffecteddependsonmanyfactors,includingthestringencyofthepolicy,whichsectorsarecovered,andhowrevenuesareused.Somestudiesthathavelookedatthemacroeconomiceffectsofcarbonpricingrelyonempiricalevidencefromexistingprograms;othersarebasedonsimulationmodeling.McFarlandetal.(2018)lookattheeffectsofUSeconomy-widecarbonpricingonGDPgrowth.Theyuseseveralmodelsandprojecttheeffectsunderfourcarbonpricescenarios,startingat$25or$50pertonin2020andescalatingateither1percentor5percentannually,andareferencecase.Insomescenarios,thecarbonpricesrisequitehigh,withonereaching$216pertonby2050.Inallscenarios,theadditionofacarbonpricedoesnotsignificantlyaffecteconomicgrowthrelativetothereferencecase,withonlyaveryslightestimatedreductionineconomicgrowthinallcases;thisslightreductiongrowswiththecarbonprice.Althougheconomicgrowthwasslightlylowerthanthereferencecaseacrosstheboard(andnotbyverymuch),themodelsnotablydonotincludetheeconomiceffectsofclimatechange,whichareexpectedtobemorecostlyinthereferencecasethaninthepolicyscenarios;theirinclusionwouldaffectthegrowthtrajectories.Inallcases,McFarlandetal.(2018)findthattheaverageannualgrowthratefrom2015to2050ispositivewithcarbonpricinginplaceforallscenarios(above1.9percentannually,eveninthemostaggressivepolicyscenario)andismostlysimilartoitsreferencebaselinetrajectory,deviatingonlyabout0.1percentagepoint.Theyalsofindthattheuseofrevenuedoesnotsignificantlyaffectthegrowthratesinmostmodels.Forthefewexceptions,theyobservedthatusingtherevenuetoreducecapitaltaxesshowedslightlyhighereconomicgrowthrelativetoahouseholdrebateorlaborincometaxcredit.Insomecases,themodelsshowedthatuseofacapitaltaxswapledtohighereconomicgrowthrelativetothereferencecase.MetcalfandStock(2020)useempiricalevidencefrom30yearsofexperiencewithcarbonpricingprogramsinEuropetoestimatetheeffectsontheeconomy.Theylookat31EuropeancountriesthatarepartoftheEUETS,ofwhich15countrieshaveadditionalcarbontaxesforemissionsnotcoveredbytheETS.Theyestimatetheeffectofthecarbonpricingpolicies(separatefromtheETS)onGDPgrowthandonemploymentandfindnoevidencethatthepolicieshavehadanegativeeffectoneitherGDPgrowthoremployment.BritishColumbia’sexperiencewithacarbontaxsince2008similarlyprovidesusefullessonsforevaluatingtheeffectsofacarbonpricingpolicyonemissionsandtheeconomy.Thetax,whichstartedat$10pertonin2008androseto$30pertonin2012,coversallfossilfuelsconsumedintheprovince(roughly70to75percentofallgreenhousegasemissions).Itisestimatedtohavereducedemissionsintheprovinceby5to15percentwithlittleeffectontheeconomy(MurrayandRivers2015).YamazakiLessonsfromtheLiteratureforStateCarbonPricingPolicyDesign15(2017)findsthattheprovincialprogramalsoincreasedemploymentbyastatisticallysignificantamountof0.74percentannuallyfrom2007to2013,relativetoabaselinegrowthratewithoutthetax.HafsteadandWilliams(2018)lookatemploymenteffectsofacarbonpriceinbothcoveredanduncoveredsectors.Thisstudyusesatwo-sectorgeneralequilibriummodelandassumesa$20pertoncarbontaxunderalternativescenariosforrevenueuse:lump-sumrebatestohouseholds(equalpayments,typicallytotalrevenuedividedbynumberofeligiblehouseholds),andareductioninpayrolltaxes(tobalancethegovernmentbudget).Thestudyfindsthatacarbonpricereducesemploymentincoveredsectors,butthatemploymentincreasesintheuncovered(nonpolluting)sectors,andthereforetheneteffectonoverallunemploymentisnegligible.Inastudyfocusedonastatewidecarbonpricingpolicy,Hafsteadetal.(2019)lookatpolicyoptions(carbonpricingoptionsandnonpricingoptionsthattargetspecificsectors,andbothincombination)forhelpingVermontreachitsdecarbonizationgoalsof26to28percentbelow2005levelsby2025.Theyfindthatunderallcarbonpricingpolicyscenariosandcombinations,theeffectsonemployment,economicgrowth,andeconomicwelfareareminimal.Acarbonpricewillalsoaffectenergyprices.Croninetal.(2019)findthatapriceof$25permetrictonofcarbonwouldincreasecommodityfuelpricesby27percent,44percent,and133percentforpetroleum,naturalgas,andcoal,respectively,relativeto2017prices,assumingthetaxis100percentpassedthroughtofuelprices.3Metcalf(2007)seesalessereffectonfuelpricesbutassumesalowertax($15permetricton);thisstudywasconductedwhennaturalgaspriceswerehigher.Hefindsthata$15carbontaxwouldincreasefuelpricesby13percent,6percent,and91percentforpetroleum,naturalgas,andcoal,respectively,relativeto2005averageprices.Durablecarbonpricingpoliciescanalsohavepositiveeffectsonprivateinvestment,whichisbeneficialforeconomicgrowth.Prestetal.(2021)usesimulationmodelingtounderstandhowoptionvalue—thevalueofwaitingtomakeaninvestmentdecision—playsaroleininvestmentdecisions.Theyfindthatacarbonprice,evenatamodestlevel,providesastrongsignalofpolicydurability,whichencouragesfirmstomakecleaninvestments.Theinvestments,inturn,couldleadtoshort-termeconomicgrowthandfurtherreduceemissions.Thiseffectistypicallyignoredinmosteconomicmodelinganalysesofcarbontaxeffects,whichassumecertaintyinbothabaselinescenariowithnocarbontaxandapolicyscenariothatincludesatax.3Thesepercentageswouldlikelybedifferenttodayduetochangesinfuelprices.IntheUSin2021,forexample,assumingthedollarvalueperunitincreasesresultingfromthe$25carbontaxdonotchange,theresultingincreasesinfuelcostswouldbe18percent,10percent,and86percentforoil,naturalgasandcoal,respectively.Average2021fuelpricesarefromtheUSEnergyInformationAdministration,Short-TermEnergyOutlook(Jan11,2022).https://www.eia.gov/outlooks/steo/report/prices.phpResourcesfortheFuture166.DistributionalConsequencesofCarbonPricingCarbonpricingpoliciesraisethecostsofcarbon-emittingenergy.Becauselower-incomehouseholdsspendahigherproportionoftheirincomesonenergythanwealthierhouseholds,theburdenofthepolicycanberegressive:lower-incomehouseholdsaredisproportionallyaffectedbytheincreasesinenergycosts.However,carbonpricingalsoaffectsindustries,whichcharacteristicallyareownedbyhouseholdsinthehighestincomegroups.Consequently,acarbonpricethatadverselyaffectsindustryprofitscouldalsohaveprogressiveeffects,wheretheburdenofthepolicywouldfalldisproportionallyonupper-incomehouseholds.Studiesoffervariousperspectivesonwhencarbonpricingpoliciesareregressiveorprogressive,butanoveralllessonfromtheliteratureisthatthedecisionaboutwhattodowithcarbonrevenueshasagreaterinfluenceontheregressivityorprogressivityofacarbonpricethanthedirectinfluenceoftheprice.Studieshavefoundmixedresultsonwhethercarbonpricesareregressiveorprogressive,dependingonwhicheffectstheyfocusonand,importantly,ontheuseofrevenues.Williamsetal.(2015)andWangetal.(2016)bothfindevidenceforregressiveeffectsonhouseholdswhenrevenueisnotrecycled.Wangetal.(2016)alsofinddisproportionateeffectsonenergy-intensiveindustries,relativetootherindustries.Otherstudieshavefoundtheopposite—thatcarbonpricingcanbeprogressive(Becketal.2015;Metcalf2019;Croninetal.2019).Whatdifferentiatesthesestudiesfromthoseaboveistheeffectstheyfocuson.LookingatBritishColumbia,Becketal.(2015),forexample,saythatevenwithoutrevenueredistributiontohouseholds,acarbonpricecanbeprogressivebecausetheeffectofthepolicydependsmoreonthehousehold’ssourceofincomethanitsexpenditures,andhigher-incomehouseholdsthatownstockinmorecarbon-intensiveindustrieswouldbeharmedmorethanlower-incomehouseholds.Goulderetal.(2019)showevidenceofbotheffectsandlookatthedistributionalconsequencesthroughwhattheycall“source-side”impacts,whichincludeeffectsofthepolicyoncapitalandwages,and“use-side”impacts,whichincludeeffectsofthepolicyongoodsandservices.Theyfind,consistentwithotherstudiesabove,thatthepolicyhasprogressiveeffectsonthesourcesideandregressiveeffectsontheuseside.Totheextentthatapolicyisfoundtoberegressive,studieshaveshownthattherevenueraisedbythepolicycanbeusedtooffsetitsadverseeffects.Notably,however,acap-and-tradeprogramwithfreeallowancedistributionwouldnotraiserevenue,sotheseoptionsareavailableonlyforacarbontaxorforacap-and-trade(orcap-and-invest)programthatauctionsallowances.Optionsforreusingrevenueincludereducingcapitaltaxes,makinglump-sumrebatestohouseholds,andreducingtaxesonlaborincome.Williamsetal.(2015)findthatbothlump-sumrebatesandreductionsinincometaxmakethepolicymoreprogressive,LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign17butthatreducingthelaborincometaxbythesamepercentageacrossincomegroupsismoreefficientthanmakinglump-sumrebates.Burtrawetal.(2009)exploreotheroptions,likeexpandingtheearnedincometaxcredit(increasingthecreditforeligiblehouseholdswithearnedincomebelowacertainlevel)andcap-and-dividendapproaches(returningalump-sumpaymenttohouseholds).Theyfindthattheseoptionsmakethepolicymoreprogressive.Anotherdistributionalconsequencetoconsiderinconnectionwithcap-and-tradepoliciesisequity:whataretheimplicationsoftradingforvulnerablecommunities?Ifallowancescanbetraded,andifemissionsincreaseinvulnerableareas,thosecommunitiescouldbedisproportionallyharmedbyhigheremissionsoflocalairpollutantshighlycorrelatedwithCO2emissions.Todate,studiesbasedonexistingcap-and-tradeprogramshavenotfoundevidencethattheyincreaseco-pollutantsindisadvantagedcommunities.StudiesfocusedontheRECLAIMprograminLosAngeles(Fowlieetal,2012)andCalifornia’scap-and-tradeprogram(Walch2018,Hernandez-CortesandMeng2020)findnosignificantevidencethatthoseprogramshavenegativelyaffecteddisadvantagedcommunities.Infact,Hernandez-CortesandMeng(2020)findevidencethattheprogramreducedinequitiesofairpollutionbetweendisadvantagedandothercommunities.Walch(2018)alsosuggeststhattheCaliforniaprogrammayhavecausedco-pollutantstodecreaseindisadvantagedcommunities.InEurope,whileStuhlmacheretal.(2019)findthatphase2oftheEUETSprogramdidleadtomoreclusteringofemissionsfromindustries,theseeventuallyfellwithstricteremissionscaps.Whileempiricalevidencesuggeststhatcap-and-tradeprogramsmaynotnegativelyaffectdisadvantagedcommunities,ensuringthatemissionsarereducedequitablyisanimportantconsiderationforpolicymakers.Notably,asevidencedbytheEUETSexperience,theextentofanyadversedistributionalenvironmentaloutcomeslikelydependsonhowstringentthecapis.Ifthecapisnotverystringentandallowancepricesarelow,thenpresumablyemissionsfromsomeplantscouldincreasebecausetheycancomplybybuyingallowancesfromotherentitiesthatreduceemissionselsewhere,andthecapcouldstillbemet.Ifthecapisstringent,however,allowancepriceswillbehigherandincentivestoreduceemissionswillbestrongeratallplants,increasingthelikelihoodthatemissionsfallinmorelocationsandpresumablyreducingtheoccurrenceofhigheremissionsoflocalairpollutantsincertainlocations.Itisalsopossible,however,thatemissionsfallindisadvantagedcommunities,butthattheyfallbylessthantheydoinotherless-pollutedcommunities,whichrepresentsanotherformofinequity.Somestudieshaveproposedsolutionsforaddressingtheseequityconcerns.BoyceandPastor(2013)suggestincorporatingcobenefitsintoanalysesofclimatepolicies,particularlyinthetreatmentoflocationalemissions.Inclimateprograms,onetonofCO2istreatedequallyinalllocations,butthattonofCO2isusuallyassociatedwithothercopollutantsthathavedifferentlocationaleffects,dependingonlocalairquality.BoyceandPastor(2013)thereforesuggestthatclimatepoliciesaimtoreduceemissionsinareaswherethecobenefitsaregreatest.Theybelievethiscanbedoneinnumerousways,suchasdifferentiatingbysectors(certainindustries,ResourcesfortheFuture18likemanufacturing,havethehighestcopollutants),incorporatingcopollutantsintoCO2permitsandenforcinga“tradingratio”(wheresomepermitsareworthmorethanothers),orusingprogramrevenuestomitigatecopollutantsincertainhigh-riskcommunities.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign197.LeakageCarbonreductionpoliciescancauseashiftineconomicactivitytoareasoutsidetheregulatedjurisdiction,leadingtoanincreaseinemissionsinregionsorsectorsnotcoveredbythecap.Becauseofsuchleakage,reducedemissionsarepartiallydisplacedbyincreasesinemissionselsewhere.Leakageisaseriousproblemthatdiminishestheeffectivenessofapolicyandundermineseffortstoreduceemissions.Severalstudiesseeleakagefromexistingprograms.FellandManiloff(2018)findevidenceofleakageintheRGGIprogrambecauseincreasedcoalgenerationinsurroundingstatesoffsetsroughly25percentoftheRGGIemissionsreductions.Similarly,Caronetal.(2015)findthatwithoutanyrestrictionsonimportedelectricityintoCalifornia,theCaliforniacap-and-tradeprogramwouldhaveincreasedout-of-stateemissionsinneighboringstatesbyanamountaboutequalto45percentofthein-statereductions.However,asCaronetal.note,thisamountfallsto9percentbecauseCaliforniamakeselectricityimportssubjecttothecapandprohibitsresourceshuffling.LeakagecouldalsobeanissueinRGGIasstatesaddregulationstoreduceemissionsfromelectricityproducers.Shawhanetal.(2019)findthattheemissionscontainmentreservefeatureofRGGIcoupledwithapolicytoaddressemissionsfromimportedpowerwouldhelpreduceemissionsleakagetootherstatesifNewYorkimplementedcarbonpricesetatthesocialcostofcarboninitswholesalemarket,asproposedbyNewYorkIndependentSystemOperator.Leakagecanalsodescribeashifteconomicactivity.Caseyetal.(2020)studiedtheeffectsofahypotheticalcarbonpriceof$10onmanufacturingoutput,employment,andprofitsintheNortheastandMid-Atlanticstatesusingdatafrom1982to2011.Theyfoundthatthehypotheticalpolicyreducedmanufacturingemploymentintheregulatedregion,tothebenefitofneighboringregions.AsevidencedbyexperiencesofbothCaliforniaandRGGI,emissionsleakagecanreducetheeffectivenessofaregionalpolicy.Twoofthedesignoptionstomitigatepotentialleakagefromacap-and-tradepolicyareabordercarbonadjustmentandoutput-basedallocation.Abordercarbonadjustment(BCA)addressesleakageresultingfromtradewithregionsnotcoveredbythepolicy.ABCAcanbedesignedtoaddressjustimports,justexports,orboth.DroegeandFischer(2020)exploreoptionsfordesigningaBCAthrougheithertaxingimportsorrelievingexportsoftheirobligationtopaythecarbonfee,orboth—somethingthatisunderconsiderationintheEuropeanUnion.TheInternationalCarbonActionPartnership(2020)alsooffersrecommendationsfordesigningaBCAtoavoidleakagefromcarbonpricing:keepingaBCAadministrativelysimple,whichmakesitmorefeasiblefromalegalperspectiveaswell,andsettingstandardemissionsbenchmarksforproductsratherthanusingseparateemissionsintensitiesfordifferentcountries.ResourcesfortheFuture20AlthoughaBCAisconsideredapotentialsolutiontoleakage,littleempiricalworkhasbeendonetoexplorewhetheritwouldbesuccessful,andsomemodelingstudiessuggestotherwise.FischerandFox(2012),forexample,modela$50pertontaxintheUnitedStateswithvariouscombinationsofbordercarbonadjustmentpoliciesfortradewithCanada:abordertaxonimports,aborderrebateforexports,bothtogether,andahomerebate,whichwouldapplytoalldomesticproduction,notjustexports.Theyfindlittleevidencethatanyoftheproposedmethodswouldreduceleakageandasaresultareunabletoranktheoptions.Moreover,theyfindthatthepolicieswouldbecontroversialandlegallychallengingtoimplement.Importantly,policyinCanadahasevolvedsignificantlysincethedateoftheFischerandFoxstudy,withthecountrycommittingtoanationwidecarbonpriceasabackstoptoprovincialpoliciesthatwouldhavetobeatleastasstringentasthebackstoptoescapecoverageunderthenationalprice..AconcernforanytypeofborderadjustmentforastateistheDormantCommerceClauseoftheUSConstitution,whichprecludesstateregulationofinterstatecommerce.Stateshavebeenabletonavigatethisconstraintbyimplementingpoliciesinaneutralwayandtreatingin-stateandout-of-statecommerceinalikemanner.California’saccountingofemissionsassociatedwithimportedelectricityisintendedtoconformwiththisconstraintbytreatingimportedpowerthesamewayasin-stategeneration.Thiscanbecomplicatedbythechallengeofassigningemissionsintensityoraspecificgeneratorwithelectricityimports.Thestatehascleverlymanagedtoassignmostimportedpowertospecificemissionssources,andtheresidualthatcannotbespecificallyassignedisgivenadefaultemissionsintensityvaluethatdoesnotdisadvantagethepowerrelativetoin-stategenerationsources.CompliancewiththeCommerceClausedomestically,orwiththeWorldTradeOrganizationinternationally,hassimilarimplications.AnalternativetoBCAattheinternationallevel,proposedbyNeuhoffetal.(2016),couldberelevantforstatesconsideringcarbonpricingpolicies:anexcisefee(“climatecontribution”)wouldbeappliedtomaterialsandbasicindustrialgoodsindependentoftheirorigin,whetherinsideoroutsidethestate.ThisuniformtreatmentwouldavoidCommerceClauseconcerns.Thefee,calibratedtotheemissionsintensityofthematerials,wouldincreasethecostofusingthesematerialsandencouragerecycling,reuse,reductioninuse,andtheintroductionofalternatives.Itwouldalsogeneraterevenuethatmight,forexample,beinvestedinpromotinglow-carbonmaterials.Anotheroptionforreducingleakageisanoutput-basedallocationmethod,inwhichallowancesunderacap-and-tradeprogramareinitiallydistributedtopollutingresourcescoveredbythecapbasedontheirlevelofproductioninthestate.Thisapproachcanbeappliedeitherdirectlytoallowancesortotheallocationofrevenuefromauctionedallowances.Bymakingallocationsofvaluableallowancescontingentonhowmuchafirmproduces,theoutput-basedallocationapproachcreatesanincentivetoproduceinthestateandthereforereducestheeffectofthecap-and-tradeprogramonproductprices,helpingtheregulatedindustriesstaycompetitive.Inadditiontocoveringelectricityimportsunderthecaptopreventleakage,California’sprogramhasalsoupdatedoutput-basedallocationofemissionsallowancesintheindustrialsectortoprovideaproductionincentivetoforestallshiftsineconomicactivitythatcanresultLessonsfromtheLiteratureforStateCarbonPricingPolicyDesign21inemissionsleakage.Burtrawetal.(2017)exploreoutput-basedallocationandfindthatitcanbeeffectiveatreducingleakage.TheempiricalliteratureaddressingleakageduetocarbonpricinghasprimarilybeenfocusedontheEuropeanUnion,which,likeCalifornia,freelyallocatesemissionsallowancestotheindustrialsectorbasedonoutput.Severalstudiesabroadfindlittleornoevidenceofleakageunderthisregulatoryapproach(e.g.,NaegeleandZaklan2019).Thedisadvantageofoutput-basedallocationisthatcarbonrevenueisnotavailableforinvestmentorotheruses.ResourcesfortheFuture228.PolicyInteractionsStateslookingtoimplementcarbonpricingoftenalreadyhavemanyexistingandproposedenvironmentalpoliciesthattargetemissionsandwillremaininplace.Examplesincludecleanelectricitystandardsandincentivesforcleantransportationandbuildingdecarbonization,suchasrebatesforelectricvehiclesandchargingstationsandforenergy-efficientequipmentinbuildings.Thesepoliciescanachievegoalsbeyondcarbonreductions.Forexample,theycanaddressothermarketfailures,suchasinsufficientincentivesforinnovation,andcouldpairwellwithacarbonprice.Theeffectofinteractionsbetweenotherpoliciesandanewcarbonpricingpolicydependsonthedesignofthecarbonpricingpolicy.Firstconsidercap-and-tradewithafixedcap.Iftheallowancesupplydoesnotrespondtochangesinpricesandisnotsubjecttoregularupdating,thecapwilldictatethelevelofemissionsreductions.Ifotherpolicies—say,arenewableportfoliostandard(RPS)forelectricityoracleanfuelstandardfortransportation—reduceemissionsfromasectororregioncoveredbythecap,thosereductionsfreeupallowancesforusebyothersources,thusleavingoverallemissionsunchanged(GoulderandSchein2013).Thisisthewaterbedeffect(Section4.2.4).Insuchacase,theotherpolicies—pricingornonpricing—reducethecarbonprice,notoverallemissions.Inpractice,cap-and-tradeprogramsaresubjecttoreview,andallowancesuppliesaretypicallyadjustedinresponsetochangesinprices.Consequently,lowallowancepricesresultingfromlowerdemandforemissionsallowancescouldleadtoachangeinthecapoverthelongrunasthecapevolveswithprogramreviewsandupdates.However,theotherpoliciestoreduceemissionswouldlikelynotchangetheshort-termemissionsoutcomes.Nowsupposeacarbontax.Theotherpoliciescanleadtoadditionalemissionsreductionsbecauseaggregateemissionsarenotcapped(GoulderandSchein2013).Giventhatmostjurisdictionsuseacap-and-tradeapproachinsteadofadirectpriceoncarbon,andthatmostjurisdictionswithcarbonpricingpoliciesalsohaveotherpoliciestopromotecleanenergy,theissueofoverlappingpoliciesisimportant.Overlappingpoliciescanaffecthowemissionsreductionsareachieved,andtheywilllikelyincreasecostsrelativetopricingcarbonalone(PalmerandBurtraw2005).Forexample,anRPSdrivesinvestmentinrenewablesandmaytiltemissionsreductionstowardastrategyofsubstitutingrenewablesforfossilfuels,bypassingpotentiallower-costemissionsreductionsfromsubstitutingmoreefficientgasgeneratorsforlessefficientones.WithnoRPS,compliancewiththecapcouldcomefromlessexpensivealternatives.Burtrawetal.(2018)lookatpolicyinteractionsinRGGI,California,andtheEUETS.InRGGI,theyobservethatcompanionpolicies,includingenergyefficiencyandrenewableenergyrequirements,havereducedemissionsandthusthedemandforallowances,whichhasreducedallowanceprices.CostspertonofavoidedCO2oftheseotherprogramshavebeenhighcomparedwithRGGIpricesaswell.Tohelpcounteractthewaterbedeffect,RGGIhasimplementedanemissionscontainmentreserve(Section4.2.4)thatreducesallowancesupplywhenpricesfallbelowacertainthreshold.RGGIalsohasapricefloor,whichenablesadditionalemissionsreductionswhenotherLessonsfromtheLiteratureforStateCarbonPricingPolicyDesign23policiessignificantlyreducedemandforallowances.Californiahassimilarlyseenlowallowancepricesrelativetothecostsofcompliancewithitsmanyotherregulations(Burtrawetal.2018),whichincludeanambitiousRPSof60percentrenewableelectricityby2030,alow-carbonfuelstandard,andvehiclefuelefficiencystandards.Thesecomplementarypolicieshavesimilarlyledtoallowancepricesthatarelowerthantheywouldbeotherwise.Borensteinetal.(2019)analyzeCalifornia’scap-and-tradeprograminthecontextofthecompanionpoliciesthatrequireemissionsreductionsatsourcesalsocoveredbythetradingprogram.Theauthorsdescribehistoricalvariationineconomicactivityandassociatedemissions.Becauseregulatedsourcesunderacapmayalreadybereducingemissionsbycomplyingwithotherregulations,theauthorssuggestthatpredictablevariationineconomicactivitywilllikelyleadpricesinthetradingprogramtogravitatetoeithertheceilingorthefloor.Empirically,theallowancepricehasremainedmodestlyabovethepricefloorthroughmostoftheprogram,withbriefexceptionsduringperiodsofregulatoryuncertainty.Fischeretal.(2017)lookattheinteractionsamongclimatepoliciesusinganelectricitysectormodel.Theyfindthatcomplementarypoliciestargetingothermarketfailures,suchasinnovationfailuresandinsufficientR&D,canbewelfare-improvingwhencoupledwithacarbonprice.However,intheabsenceofadditionalmarketfailuresorotherpolicygoalsthatthecarbonpricecannotaddress(e.g.,technologicaldiversity,equityacrossdifferentgroups),thestudyfindsthatadditionalpoliciescanreducesocietalwelfare.Insummary,complementarypolicescanhaveadvantagesiftheyaddressmarketfailuresotherthantheenvironmentalexternality,suchassuboptimallevelsofinnovation.Further,aswedescribeinSection10,complementarypoliciesmaybefundamentalinenablingtheultimateintroductionofcarbonpricing.However,complementarypoliciesthatalsotargetemissionsreductionswillreducethedemandforallowancesunderacap,therebyreducingtheallowancepriceandpossiblyincreasingdemandforallowanceselsewhere,resultinginnoenvironmentalbenefitintheshortterm.RGGI,California,andtheEUETSprovideevidencethatthishasoccurredtovariousdegrees.Consequently,designfeaturesforcap-and-tradeprogramsthathelpmitigatetheseeffectsareimportanttothesuccessofcarbonmarkets;onesuchfeature,anemissionscontainmentreserve,isnowbeingimplementedintheRGGImarketandwillremove10percentofparticipatingstates’allowancebudgetsifthepricefallsbelow$6in2021(thepricethresholdincreasesat7percentannually),orapricefloorofroughly$2thatpreventsallowancepricesfromfallingtoolow.Notably,thechallengesmentionedherewouldnotariseforacarbontaxpolicy.Ataxwouldlikelybetterallowforcompanionpolicesbecauseemissionsreductionsarenotfixed.Forexample,ifthereisastatewidetaxonfossilfuelsandmunicipalitiesrequirebuildingstoreducetheirenergyintensity,bothpolicieswilldriveemissionsreductions,notareshufflingofemissionsfromonesectortoanother.Thechallengesmightalsonotapplyifthecap-and-tradeprogramissostringentthatindustriescannotmeetResourcesfortheFuture24therequirementsandhavetopaythefinefornoncompliance.Thentheprogramessentiallybecomesatax,andtheotherpolicieswouldspuradditionalemissionsreductions.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign259.PoliticalFeasibilityAnyclimatepolicy,eventhebest-designedcarbonpricingpolicy,cannotbeadoptedwithoutpoliticalsupport.Carbonpricingcanbeunpopular;aproposedpolicyinWashingtonState,forexample,failedmultipletimesbeforefinallybeingadoptedin2021.Severalstudieshavesoughttobetterunderstandwhythepublicisresistanttocarbonpricingandhowtoimproveitspoliticalfeasibility.ResultsfromanationalsurveyofUSadultsshowthat62percentofAmericansrespondedinfavorofacarbontaxwhenaskedifcompaniesshouldbechargedfortheirgreenhousegasemissions(KrosnickandMacInnis2020).Thispercentageismuchlowerthansupportforotherpolicies,likegivingtaxbreakstocleanenergy(83percent)ortopowerplantsthatlowergreenhousegasemissions(81percent).Carbonpricingincreasesenergycosts,andthoseincreasestricklethroughtheeconomy,sopresumablypeoplewouldbemorereceptivetoapolicythatprovidedadividendpaymentfromtherevenuecollectedtohelpoffsetthosehighercosts.Surprisingly,KrosnickandMacInnis(2020)foundnoevidenceofgreatersupportforacarbontax(appliedtocompanies)withadividend.Askedwhethertheywouldsupportacarbontaxwithdividendamountsof$200,$600,or$800,roughly60percentofrespondentsfavoredacarbontaxregardlessoftheamountofthedividend—oreventhepresenceofone.Althoughahigherdividendmaynotmakeapolicymorepopular,severalstudieshavefoundthattheperceivedfairnessofapolicyisvitalforpopularsupport.Maestre-Andresetal.(2019)reviewliteratureontheperceptionofcarbonpricingpolicies(bothcap-and-tradeandcarbontaxes)aroundtheglobeandfindthatpeopleareconcernedaboutpotentialinequities(particularlytheeffectsonlower-incomegroups)andthatsupportforapolicyiscorrelatedwiththeperceptionthatthepolicyismoreprogressiveintermsofcosts.Counterintuitively,though,thestudyshowedthatpeopletendtofavorthegovernment’suseoftherevenuesforgreeninvestments,suchasrenewables,overdividendsthatwouldmakethepolicymoreprogressiveandeaseconcernsaboutfairness.Theauthorssuggestthatthebestwaytomakeapolicymorepopularistocombinereinvestmentinenvironmentalprojectswithredistributionoftheportionoftherevenue.Ewaldetal.(2021)provideasurveycasestudyofSweden,whichhashadacarbontaxforyears.EventhoughSwedesaregenerallyveryconcernedaboutclimatechangeandtypicallytrusttheirgovernment,somepeopleareresistanttocarbonpricingandhaveparticipatedinprotestmovements,similartotheYellowVestmovementinFrance.Researcherssurveyedprotestorswhoopposedpetroltaxesandfoundthatthebiggestfactorscorrelatedwithresistancetocarbonpricingwereeducationalbackground,ruralresidence,andmostimportantly,adistrustingovernment.LikeMaestre-Andresetal.(2019),Ewaldetal.(2021)alsofoundthatrespondentsweremoresupportiveofthegovernment’susingcarbonpricingrevenueforclimateprojectsratherthanforredistributiontohouseholds.ResourcesfortheFuture26Klenertetal.(2017),whichreviewedextensiveliteratureonthepoliticalfeasibilityanddistributionaleffectsofcarbonpricing,foundthatforgainingpoliticalsupport,contextmatters.Forinstance,theyfind,ifdistributionalconcernsarethegreatestbarrier,thenrevenueshouldbeusedfordividends.Ifthemainoppositioncomesfromconcernsabouteconomiccompetitiveness,however,thenthepolicyismorelikelytogainsupportiftherevenueisdirectedtowardfirms.Aldy(2017)providesrecommendationsforincreasingsupportforcarbonpricingandstrengtheningitsdurability.Herecommendsstartingwithamodestpolicythatrampsupinstringencyovertime,graduallyeasingthepublictowardamorerobustpolicy.Healsorecommendsupdatingthepolicyinresponsetochangingeconomicorenvironmentalconditions.Heobservesthatlinkingwithprogramsinotherstatesorregionscanimprovepricestabilityandreducepotentialleakage.Healsosuggeststhatoverlappingpolicescandepressthecostsofacarbonpricingpolicyandmightmakeitmorepalatabletothepublic.Goulder(2020)reviewsvariousapproachestomakingcarbontaxesmorepoliticallyacceptable,includingdifferentwaystousetherevenue.Hesuggeststhatiftheseapproachesaccelerateimplementationofsuchpolicies,thatthoseeffectsshouldbefactoredintoassessmentsofpolicycost-effectiveness—thatis,toreflectthispoliticalrealityandmakeexplicitthevaluetosocietyofactingsoonerratherthanlater.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign2710.OtherReal-WorldChallengesInaneconomist’sidealworld,acarbonpricingpolicy—inprinciple,themostefficientoptionforreducingcarbonemissions—wouldbetheprimarylevertoreducegreenhousegasemissions.Intherealworld,however,carbonpricingpoliciesstringentenoughtoalignwithstateornationalemissionsreductiongoalsaredifficulttoimplement.Totheextentthatcompetitivenessissuesresultinleakage,itispossiblethateconomicactivitycouldmovetojurisdictionswithgreateremissionsintensity.Moreover,carbonpricingrarelyisintroducedinamarketthatdoesnotalreadyhaveexistingenvironmentalpoliciesforreducingemissions.Someresearchsuggeststhatgiventhevarietyofobstaclestoambitiousandcomprehensivecarbonpricing,introducingotherpoliciescouldhelpcreatethepreconditionsformorestringent,morecomprehensivecarbonpricing.Indeed,ineverycasewherecarbonpricingnowexists,itwasprecededbyvariousregulatorypolicies,whichtypicallyremaininplaceandareoftenstrengthenedevenaftercarbonpricingisadopted.Onereasoncompanionregulatorypolicymayenablecarbonpricingisthepositivefeedbackloopassociatedwithintroducingenvironmentalregulations,includingsupportfornewtechnology.Kelsey(2014)callsthisa“greenspiral”—theideathatclimatepolicieswillbenefitcertaingroups(e.g.,cleanenergysuppliers)andharmothers(e.g.,fossilfuelinterests),therebyencouraginggrowthintheindustriesthatbenefitfromthepolicies,which,inturn,willenhancesupportforthosepoliciesovertime.Similarly,changesintechnologycostsmakepossiblegreaterpolicyambition.Policysequencing—theintroductionofotherpoliciesandgradualratchetingupoftheirstringencytopavethewayforcarbonpricing—isonemethodforincreasingtheroleofcarbonpricingovertime.Mecklingetal.(2017)describethepolicysequencingprocessundertakeninCalifornia,theEuropeanUnion,andtheRGGIstatesasathree-stepprocess:first,agreenindustrialpolicystage,wherelow-carbontechnologiesaresupported;second,theadditionofcarbonpricingpolicies;andthird,thereformofpricingpoliciestoincreasetheirstringency.Theynote,however,thatthesejurisdictionsmainlyexperiencedthesestagesonlyintheirelectricitysectors.InCalifornia,sector-basedpolicieslikefleetemissionstechnologystandardsandtheRPSpavedthewayforthestatetoadoptthemorestringentcap-and-tradeprogram(Pahleetal.2018).Mecklingetal.(2017),pointingtoCalifornia’sexperiencewithpolicysequencingandearlysupportforrenewableslikesolar,arguethatsuchpoliciesreducedtechnologycostsbyenablinglearning-by-doingandeconomiesofscale.Overtime,thecaphasbeentightenedandtheprogramhasbeenexpandedfromjustelectricityandsomeindustrialsourcestotransportationandhomeheatingaswell.Californiahasalsodesignatedatleast35percentofauctionproceedstobespentonprogramstobenefitdisadvantagedcommunities,andatleast25percenttobeinvestedinthosecommunities.Inpractice,morethan50percentofrevenueshasbeendedicatedtothesepurposes,creatingsupportforthecap-and-tradeprogramthatotherwisewouldbevisibleinlow-incomecommunitiesprimarilythroughhigherenergyResourcesfortheFuture28prices.AnotherformofcompanionpolicyinCaliforniaisairqualityregulation,whichdeliversnear-termbenefitswhilecoincidentallyencouragingenergyefficiencyandashiftawayfromfossilfuels.Pahleetal.(2018)describeGermany’sexperiencewithbreakingdowneconomicbarrierstocarbonpricingthroughinvestmentsintechnology.Germanypromotedrenewableenergyearlyinthe2000sthroughfeed-intariffs,andthispolicyenabledlearning-by-doingandcostreductionsforrenewabletechnologies,especiallysolar.Whenthefeed-intariffsbecametooexpensive,Germanyswitchedtoanauction-basedprogramfordistributingtechnologysubsidies,whichreducedthecostsofsubsidiesandenabledtheprogramtogrow.Policysequencingcanalsohelpovercomepoliticalresistancebarrierstocarbonpricing(Section9).Mecklingetal.andPahleetal.suggestthatimplementingpolicieswithdifferenttoolsandstringencylevelsindifferentsectors(Section11)mayeaseoppositiontopoliciesthatreduceemissionswhileprovidingbroadsignalsthatinfluenceinvestmentthroughouttheeconomy.Forexample,insectorswherecurrentoptionstoreduceemissionsarelimitedbythehighcostoflow-emittingtechnologies,amodestcarbonprice,coupledwithcomplementarypoliciestoinvestintechnologydevelopmentanddeployment,mightgrowemergingindustriesthatbecomeadvocatesovertimeforgreaterstringency,improvingthedurabilityofthepolicyaswell.Policydurabilityisimportantbecauseitprovidesamarketsignalfortheprivatesectortomakelong-terminvestmentsintechnologiesthatwillbenefitfromthepolicy.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign2911.FlexiblePolicyAlternativestoCarbonPricingInsomeinstances,resistancetocarbonpricingmaybesostrongthatthestateisunabletoimplementsuchapolicy.Inthatcase,othertypesofflexiblepricingpoliciesfocusedonsectorscanstillbebeneficialand,insomecases,nearlyasefficientascarbonpricing.Althoughtheyimplyasmallerchangeinproductpricesthancarbonpricing(becauseoftheirrelativeinefficiencyinaffectingchannelsforachievingemissionsreductionsinanonuniformway),thiscanbeanadvantageforaddressingbothdistributionalandleakageconcerns.Researchsuggeststhatacleanelectricitystandard,whichrequiresthatacertainpercentageofelectricitysalescomefromzeroorlow-carbonresources,canmimictheefficiencyofacarbonprice,especiallyifcreditingisbasedonemissionsratesratherthanontechnologytype:theformerenablesthepolicytoencouragemarginalreductionswithintechnologytypesaswell(Pauletal.2014).Ingeneral,partialcreditingofnaturalgas,basedonemissionsintensity,couldimproveefficiencyofthepolicybyencouragingfuelswitchingfromcoaltogas(totheextentthatcoalplantsarestillinoperation)andfromlessefficientgasplantstomoreefficientgasplants.Piccianoetal.(2020)showthroughelectricitysectorsimulationmodelingthatahigheremissionsintensitybenchmark,oronethatpartiallycreditshigher-emittingtechnologies,canraisethepotentialforemissionsreductions,andthosereductionscanalsobeachievedatalowercost.Outsidetheelectricitysector,tradableperformancestandards(TPS),whichtargeteitheraverageperformanceofcoveredentitiesoremissionsintensity,havebeenusedinthetransportationandbuildingsectorsinavarietyofwaysandcanbeaneffectivealternativeor,insomecases,complementtocarbonpricing.FourprominentapproachesusedfortransportationinNorthAmericaarethecorporatefueleconomy(CAFE)standardsandrenewablefuelsstandardsatthefederallevel,andzero-emissionsvehiclestandardsandlow-carbonfuelstandardsatthestatelevel.Yehetal.(2021)findthatalthoughTPSpoliciesarelessefficientthanacarbonpriceoverall,theyprovidetargetedoutcomespromotingtechnologicalchange.Forinstance,inCalifornia,whichhassimultaneouscarbonpricingontransportationfuelsandalow-carbonfuelstandard,achangeinconsumerpricesforgasolinecausedbythelow-carbonfuelstandardyields10timesgreaterincentiveforinnovationthanthesamechangecausedbyacarbontax.Adisadvantageofthelow-carbonfuelstandard,however,isthatitraisesnorevenue.TheresearchersfindthatTPSpoliciesalsopairwellwithacarbontaxtoencourageinnovation.Buildingperformancestandards(BPS),whichcanbestructuredasatypeofTPStoreduceemissionsmainlyfromcommercialandlargeresidentialbuildings,arebeingimplementedincitiesinmanycountriesbutarestillrelativelyrecent,sostudiesontheirexperiencesarelimited.AmongthestudiesofbestpracticesfordesigningaBPS,BugnionandPalmer(2020)exploreoptionsforimplementingaBPSforbuildingsResourcesfortheFuture30aboveacertainsquare-footagethreshold.Tomakethepolicymoreefficient,theysuggestincludingflexibilitymechanisms,suchasopportunitytotradeacrossbuildings,multiyearcomplianceperiodsthatallowforbanking,andtheoptiontouseoffsetstoachievecompliance.Bugnionetal.(2021)alsolookatoptionsforimplementingaBPSforfederalbuildingsacrossthecountry.Theauthorssuggestusingabuilding-specifictarget(abuildingreducesemissionsagainstitsownbaseline)ratherthanacommontarget,whichcouldmakeimplementationeasierforaprogramencompassingbuildingsindifferentclimatezoneswithdifferentenergyusepatterns.TPSscanalsobedesignedtotargetindustrialemissions.Astandardcouldsetcarbonintensityrequirementsforindustrialfacilities,rewardingthosethatoutperformwithcreditsandpenalizingthosethatunderperformbyrequiringthemtopurchasecredits(Fischer2019).Gonzalesetal.(2020)findsubstantialpotentialforpolicy-drivenemissionsreductionsinironandsteel,cement,andpetrochemicals—goodcandidatesforacleanenergystandardtakingtheformofanefficiencystandard,afeebate,oratradableperformancestandard.Inmostsectors,directpricingofemissionsatpoliticallyfeasiblelevelswouldlikelygoonlypartwaytowardachievingdecarbonizationgoals.Otherflexiblepolicyoptions,suchasaTPS,couldbenearlyasefficientandalsopavethewayforagreaterrelianceoncarbonpricinginthefuture.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign3112.GapsintheLiteratureWeseegapsintheliteraturethatmaybeimportanttothepolicydesigndecisionsthatdecisionmakersfaceinconsideringacarbonpricingpolicytohelpachievedecarbonizationgoals.Theseincludestudiesoncap-and-investprograms,theextenttowhichcomplementarytechnologypoliciesleadtolowercosts,andthesequenceoftechnologicalchangesthatwillresultfrompricingpoliciesthatdrivedecarbonization.Onereasonforcarbonpricingprograms’appealtogovernmentsisthattheygeneraterevenue,whichcanbeinvestedinprogramsthatcontributetoachievingthepolicygoals.Indeed,bothCaliforniaandseveralRGGIstatesinvestallowancerevenuesincarbon-reducingprojects—high-speedrailinCalifornia,andenergyefficiencyupgradestoreduceelectricitydemandandemissionsleakageinRGGIstates(BurtrawandSekar2014).IntheEuropeanUnion,guidelinesdirectmemberstatestoinvestatleast50percentofauctionproceedsinclimate-relatedprograms(Löfgrenetal.2018).Cap-and-invest—acap-and-tradepolicyimplementedwithanauctionthatraisesrevenueforclimate-friendlyinvestment—isnotwellstudiedintheeconomicsliterature.However,aseparateandextensiveeconomicsliteraturehasanalyzedpublicsectorinvestments:whentheymakesense,andhowtothinkabouttheircosts,giventheeconomiccostsofraisingpublicfunds.Animportantaspectofthisliteratureconcernswhensuchpublicinvestmenthelpsspurlearningorcostreductionsthatenable(“crowdin”)futureprivatesectorinvestmentandwhenit“crowdsout”privateinvestment,typicallyasituationtobeavoided.Anothergapintheexistingliteratureishowtechnologypolicies,andespeciallyinvestmentsininfrastructure,contributetotechnologydevelopmentandformsoflearningthatlowercostsoraccelerateprivateinvestment.Forexample,thedeclineinrenewablecostsoverthepastfewdecadescoincideswithasurgeinpoliciestopromoterenewablesintheUnitedStatesandpartsofEurope,buttheextenttowhichcostdeclinesaredirectlyattributabletowhichpolicyisstillindebate(Gerarden2018).Themostsalientaspectofthisliteraturegapisthelackofguidanceonwhereandhowtocost-effectivelydirectinvestmentstoaccelerateanenergytransformation.Withoutsystematicoverview,policymakersmustrelyonsector-specificstrategiestoadvanceindustrialtransformations.ArelatedgapinvolvesthepracticalimplementationofpricingpoliciesthatwilldrivedeepdecarbonizationoftheUSeconomyinthefaceofthevariousconstraintswehaveidentified.Althoughsomestudieshaveevaluatedstrategiestoreduceemissions,includingspecifictechnologychangesandassumptionsabouthumanbehavior,thetoolsusedtodevelopthesepathwaysdonotincorporatemarketsormarketequilibriumconsiderationsandthusarenotusefulforunderstandingmacroeconomicimplications,anticipatingtheeffectsonspecificproductandfuelmarkets,oroptimizingthetechnologypathway(Riberaetal.2015).Studiesthatdoincorporatemarketstypicallydonothaveenoughtechnologicalspecificitytoidentifypathwaysforinfrastructureinvestment(e.g.,Hafsteadetal.2019).ResourcesfortheFuture3213.ConclusionCarbonpricingisanefficientapproachtoreducingemissions,butstringent,comprehensivecarbonpricingfacesseveralobstacles,especiallyatthestatelevel.Nonetheless,amodestcarbonpricethatbyitselfwouldbeinsufficienttoachieveambitiousclimategoalscouldbecoupledwithsector-specificregulatorypoliciestodrivetechnologyandsocialchangesthatmayenableagreaterroleforcarbonpricingovertime.Acruciallimitationtoregulatorypoliciesistheinformationasymmetrybetweenprivateactors(firms)andtheregulator,makingitdifficulttodesignperfectregulations;amodestcarbonpricegivestheprivatesectorincentivestolookforemissionsreductionsandensuresthatthestateleavesnolow-costemissionsreductionsbehind,evenasitaimsformoreambitiousgoals.Thisreportprovidesacomprehensiveoverviewofliteratureoncarbonpricingdesignandrelatedconsiderationstohelpdecisionmakersindesigningstateclimatepolicy.Ourmainfindingsareasfollows:•Intheory,acarbontaxandacap-and-tradepolicyproducesimilaroutcomes,buttheydifferinimportantways.Carbontaxesprovidecertaintyaboutcompliancecostsandarelesslikelytointeractnegativelywithotherpolices,buttheemissionsoutcomesareuncertain.Cap-and-tradeprogramsprovidemorecertaintyoveremissionsreductionsandcanbemoreeasilylinkedtootherregionalprograms,buttheyaremorelikelytointeractwithotherpoliciesand,ifnotwelldesigned,couldmitigatetheeffectivenessofthoseotherpolicies.•Carbonpricingpoliciescancreateemissionsleakageandeconomicleakage,butpolicydesigncouldsubstantiallymitigatetheproblem.•Ifpartofaportfolio,carbonpricingshouldbedesignedtocomplementotherpoliciesandavoidthepotentialwaterbedeffectsofacap-and-tradepolicy.Price-responsivesupplyofemissionsallowancesisemergingasanapproachtoaccomplishthisgoal.•Theeffectsofcarbonpolicyonlow-andmoderate-incomehouseholdscanbemitigatedwithrevenuesfromthecarbonpricingpolicy.Additionalusesoftherevenueincludeinvestingincleantechnologiesandoffsettingimpactsonindustries,whichcanplayanimportantroleinachievingprogramgoals.•GarneringpoliticalsupportforcarbonpricingintheUnitedStatesischallenging,butdevelopingapolicythatbenefitsarangeofconstituenciesandhelpsaddressothersocialconcerns,likelocalairqualityandsocialinequities,couldhelp.•Policysequencingcanbeusedtoacceleratetechnologicaldevelopmentaswellastobuildsupporttoratchetupthestringencyofthecarbonpolicy.•Implementingacarbonpricethatissufficienttoachievetheclimatepolicygoalsisnotpossibleinmanyjurisdictionstoday.However,policymakerscanachievenearlyasefficientoutcomesbybeginningwithotherpricingpoliciesthatprovideincentivesfortechnologychangeandinvestment,suchastradableperformancestandards.Asthepolicylandscapeevolves,thesepoliciestendtobuildtechnology,infrastructure,andpoliticalsupportforcarbonpricing.Generally,otherpricingpoliciesandcarbonpricingcanbedesignedtoworkwelltogether.LessonsfromtheLiteratureforStateCarbonPricingPolicyDesign3314.ReferencesAcemoglu,D.,P.Aghion,L.Bursztyn,andD.Hemous.2012.TheEnvironmentandDirectedTechnicalChange.AmericanEconomicReview102(1):131–66.Aldy,J.E.2017.ThePoliticalEconomyofCarbonPricingPolicyDesign.DiscussionPaperES2017-7.HarvardProjectonClimateAgreements,Cambridge,MA,October.———.2020.CarbonTaxReviewandUpdating:InstitutionalizinganAct-Learn-ActApproachtoUSClimatePolicy.ReviewofEnvironmentalEconomicsandPolicy14(1):76–94.Andersson,J.J.2019.CarbonTaxesandCO2Emissions:SwedenasaCaseStudy.AmericanEconomicJournal:EconomicPolicy11(4):1-30.Beck,M.,N.Rivers,R.Wigle,andH.Yonezawa.2015.CarbonTaxandRevenueRecycling:ImpactsonHouseholdsinBritishColumbia.ResourceandEnergyEconomics41:40-69.Borenstein,S.,J.Bushnell,F.A.Wolak,andM.Zaragoza-Watkins.2019.ExpectingtheUnexpected:EmissionsUncertaintyandEnvironmentalMarketDesign.AmericanEconomicReview109(11):3953-77.Boyce,J.K.,andM.Pastor.2013.ClearingtheAir:IncorporatingAirQualityandEnvironmentalJusticeintoClimatePolicy.ClimaticChange120(4):801–14.Bugnion,V.andK.Palmer.2020.BuildingPerformanceStandards:LessonsfromCarbonPolicy.Report20-13.ResourcesfortheFuture,Washington,DC.Bugnion,V.,K.Palmer,andK.Cleary.2021.LeadingbyExample:BuildingPerformanceStandardsforDecarbonizingFederalBuildings.Report21-12.ResourcesfortheFuture,Washington,DC.Burtraw,D.,andA.Keyes.2018.RecognizingGravityasaStrongForceinAtmosphereEmissionsMarkets.AgriculturalandResourceEconomicsReview47(2):201–19.Burtraw,D.,andK.McCormack.2017.ConsignmentAuctionsofFreeEmissionsAllowances.EnergyPolicy107:337–44.Burtraw,D.,andS.Sekar.2014.TwoWorldViewsonCarbonRevenues.JournalofEnvironmentalStudiesandSciences4:110–20.Burtraw,D.,R.Sweeney,andM.Walls.2009.TheIncidenceofUSClimatePolicy:AlternativeUsesofRevenuesfromaCap-and-TradeAuction.NationalTaxJournal62(3):497–518.ResourcesfortheFuture34Burtraw,D.,K.Palmer,C.Munnings,P.Weber,andM.Woerman.2013.LinkingbyDegrees:IncrementalAlignmentofCap-and-TradeMarkets.DiscussionPaper13-04.ResourcesfortheFuture,Washington,DC.Burtraw,D.,C.Holt,K.Palmer,A.Paul,andW.Shobe.2017a.ExpandingtheToolkit:ThePotentialRoleforanEmissionsContainmentReserveinRGGI.Report36.ResourcesfortheFuture,Washington,DC.Burtraw,D.,K.Palmer,A.Paul,andH.Yin.2017b.UsingProductionIncentivestoAvoidEmissionsLeakage.EnergyEconomics68:45–56.Burtraw,D.,A.Keyes,andL.Zetterberg.2018.CompanionPoliciesunderCappedSystemsandImplicationsforEfficiency—TheNorthAmericanExperienceandLessonsintheEUContext.Report.ResourcesfortheFuture,Washington,DC.Burtraw,D.,D.Holt,K.Palmer,andW.Shobe.2020.QuantitieswithPrices:Price-ResponsiveAllowanceSupplyinEnvironmentalMarkets.WorkingPaper20-17.ResourcesfortheFuture,Washington,DC.Cronin,J.A.,D.Fullerton,andS.Sexton.2019.VerticalandHorizontalRedistributionsfromaCarbonTaxandRebate.JournaloftheAssociationofEnvironmentalandResourceEconomists6(S1):S169–S208.Caron,J.,S.Rausch,andN.Winchester.2015.Leakagefromsub-nationalclimatepolicy:ThecaseofCalifornia’scap–and–tradeprogram.TheEnergyJournal,36(2).Casey,B.J.,W.B.Gray,J.Linn,andR.Morgenstern.2020.HowDoesState-LevelCarbonPricingintheUnitedStatesAffectIndustrialCompetitiveness?(No.w26629).NationalBureauofEconomicResearch.Droege,S.andC.Fischer.2020.Pricingcarbonattheborder:KeyquestionsfortheEU.ifoDICEReport,18(01):30-34.EnergyInformationAdministration(EIA).2021.HowMuchTaxDoWePayonaGallonofGasolineandonaGallonofDieselFuel?August23.Availableat:https://www.eia.gov/tools/faqs/faq.php?id=10&t=10Ewald,J.,T.Sterner,andE.Sterner.2021.UnderstandingtheResistancetoCarbonTaxes:ACaseStudyofSweden.WorkingPaper21-18.ResourcesfortheFuture,Washington,DC.Fell,H.,andP.Maniloff.2018.LeakageinRegionalEnvironmentalPolicy:TheCaseoftheRegionalGreenhouseGasInitiative.JournalofEnvironmentalEc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