Does a system of carbon fee and dividend create incentives?

This post was first published on 03-09-15.  It is now significantly revised.

Those of us who lobby for legislation to implement a system of carbon fee and dividend (CFD) believe, that by starting low and gradually raising fees on fossil fuels, we will create long-term incentives for all economic players to conserve energy and switch to non-fossil fuels.  These actions will slow global warming and climate change.

The revenue generated from the carbon fees will be divided into equal shares and distributed to citizens as dividends.  These funds will help pay the higher prices produced by the carbon fees and for actions to use less fossil fuel.  The carbon fee will not be a tax.

I participated in a recent discussion in which a man questioned the strength of the incentives.  He argued that a public utility, that uses coal for generating electricity, would propose, and the state public utility commission would agree, that any rise in the price of coal would be passed on to the consumer in the form of a higher rate for the electricity.  The consumer, who received a share of the fees imposed on coal and other fossil fuels, would use it to pay for the more expensive electricity. No one would have incentive to use less energy produced from fossil fuel.

Many of us believed the man’s reasoning was flawed.  But we were unable to change his mind.  This prompted me to analyze how CFD could work in my family.

After reading the book Storms of My Grandchildren by climatologist James Hansen in 2010, I constructed a simple economic model to show how his recommendations for CFD would work.  (This model is described at How it works.)

Hansen recommended that we start with a fee of $11.50 per metric ton of the carbon dioxide (CO2) that is produced when a fuel is burned.  This works out to a fee of $30 per U.S. ton for typical coal.  (Explanation at Carbon Fees for CO2 and Coal.)  The average price for U.S. coal at the mine in 2013 was $37 per ton (from EIA), so the carbon fee would almost double this price to $67 in Year 1.

The model assumes that the CO2 fee would increase by $11.50 per metric ton each year, and that burning fossil fuel would stop in Year 40.  Therefore, the fee would increase the price by a factor of nine to $337 per ton in Year 10, and by a factor of thirty-three to $1,237 per ton in Year 40. People would stop burning coal long before this price was reached. (All costs in current dollars.)

Hansen estimated that the $11.50 fee would increase the cost of coal-generated electricity by 0.8 cents per kilowatt hour (kwh).  The model assumes a linear increase to 8.0 cents per kwh in Year 10 and t0 32.0 cents in Year 40.

I live with my daughter, her husband, and two grandsons.  The model assigns one dividend share to each adult and half a share to each minor.  Our household would receive four shares.

Starting with the actual electricity we used in 2014, and assuming that it was all generated from coal and that our usage would not change, I estimated our increased costs.  These and other projections from the model are in the table below.

In New Jersey we may choose from among many electricity suppliers and may assume that one or more of these suppliers would generate their power from non-fossil energy.  Their prices would not include a carbon fee and would not increase like those in the table.  We could switch to one of these suppliers and avoid the rising household cost shown in the table.  At $1,046 in Year 10, we would have strong financial incentive to switch.

The suppliers of coal-generated electricity would gradually lose all their customers and go out of business.  James Hansen has recommended that all coal-fired plants be phased out by 2030.

The table shows that our dividends would exceed our increased electricity costs, even if we did nothing to reduce our consumption.  We could use these funds in many ways.  Examples:

• Pay the increased costs of other products and services that depend on fossil fuels, which includes almost everything in the economy today.
• Improve the insulation of our house and burn less fuel oil.
• Purchase more fuel efficient appliances and vehicles.
• Save or spend on things not related to energy.

Each household would make its own decisions.  Many would act wisely and come out ahead.  Others might not.

The business community would also have incentive to use less fossil fuel and things that depend on fossil fuel (think manufacturing).  Its purchasing power, combined with that of consumers and directed towards this goal, would produce a great burst of creativity and initiative.  Overall use of fossil fuels would decline.

Big Picture:  We need a multi-decade effort to phase out fossil fuels.  Start by choosing a “phase-out year” when we in the U.S. will stop burning fossil fuel.  Then lay out a schedule of goals for fossil fuel use for the years thru the phase-out year.  Do the same for the fees on these fuels.  Every four or more years review progress towards the goals and, if appropriate, make adjustments to the fees and/or goals.

I propose that we set our goal to get completely off fossil fuels by 2050.  (OFF by 2050)  By the 2020s, the harmful effects of global warming will probably be so stark that the public will support a more aggressive plan than one we design now.

With a working system of CFD, it will be administratively easy to dial up the fee schedule and increase the incentives to burn less fossil fuel.   And we can also dial it down if it is producing some unexpected and harmful outcome.  But the decision to change the fee schedule must follow a rigorous process of review, that is laid out in the enabling CFD legislation.  It is essential that everyone understand that the commitment to phase out fossil fuels is firm, and that only changes in the speed will be considered.

I remember 1961 when President John Kennedy called for a national program to land a man on the moon and bring him back “before this decade is out.”  This became the Apollo program.  Americans accepted and met the challenge.  Along the way they overcame difficult problems, invented new technologies, and produced good jobs.

We can do this again.  We can become the world leader in ways to conserve energy and use non-fossil energies.  Economic and political leadership will follow.

Bill Allen    03-21-15 revised    <OFFby2050>