Federal Climate Policy 102: Economy-Wide Policy

The United States emits billions of metric tons of greenhouse gases into the atmosphere every year—6.5 billion metric tons of carbon dioxide-equivalent in 2019 alone. Figure 1 breaks down these emissions by economic sector. To reduce emissions and help mitigate climate change, the federal government can implement several types of policies.

Federal emissions reduction policies can be designed to cover the entire economy or target specific sectors. Economy-wide policy options include carbon pricing, along with other comprehensive policy portfolios that combine sector-specific policies across the entire economy. This explainer provides an overview of economy-wide policy options, comparing pricing programs to a portfolio approach that seeks to reduce emissions, sector by sector, throughout the economy.

Carbon pricing is widely recognized as the most economically efficient approach to reducing carbon dioxide (CO₂) emissions, meaning that this approach achieves emissions reduction at the lowest possible cost to society. By giving all emitters the same incentive to reduce their emissions, a pricing mechanism can cost-effectively reduce emissions. However, many climate advocates and others do not think that carbon pricing should be the primary mechanism to reduce emissions. As an alternative to carbon pricing, a sectoral portfolio approach seeks to reduce emissions economy-wide, with a targeted approach for each specific source of emissions. Opponents of carbon pricing often favor the sectoral portfolio approach.

The Basics

Two forms of economy-wide carbon pricing are available: a carbon tax and a cap-and-trade program.

A carbon tax is a set price that each emitting entity must pay per ton of CO₂ they release into the atmosphere. A $3 tax per ton of CO₂ is equal to an $11 tax per ton of carbon, because carbon constitutes roughly 3/11 of the weight of CO₂.

A cap-and-trade program limits the total amount of CO₂ that can be emitted by a certain set of facilities. In a cap-and-trade program, the government issues a limited number of emissions allowances (also known as permits), each of which grants the holder the right to emit one ton of CO₂. Allowances can be distributed in various ways: they can be directly allocated to firms or facilities (a method called free allocation of allowances) or sold through auction markets. The limited, government-controlled supply of allowances “caps” the total amount of emissions. Allowances can be traded, and these sales and purchases (supply and demand) yield a market price for allowances—essentially the price of one ton of CO₂ emissions.

An economy-wide carbon price would cover all sources of energy-related CO2 emissions from all sectors—power sector, transportation, industry, and buildings (commercial and residential). It could be implemented through an upstream price that requires fossil fuel producers to pay taxes or submit allowances for the carbon content of their fuels (for example, oil wells or coal mines), a midstream price that requires the first purchaser of the fuel to pay for the carbon content of the purchased fuels through taxes or allowances (for example, refiners would pay a tax that reflects the carbon content of each barrel of oil purchased), or a downstream price that applies directly to the emitter (for example, coal-fired power plant, households, or firms).

Carbon taxes and cap-and-trade programs differ primarily by the type of certainty they provide. Carbon taxes provide price certainty, as entities subject to the tax know how much they’ll have to pay per ton emitted—but simply setting a tax rate doesn’t guarantee any particular level of emissions reductions. Cap-and-trade programs, on the other hand, set a cap on emissions and therefore provide quantity certainty—but price fluctuations under the trading market structure can provide a less solid basis for business planning decisions. Hybrid systems, however, can be used to reduce price or emissions uncertainty. Under cap-and-trade programs, price floors and ceilings have been proposed and utilized to prevent prices from being “too low” or “too high.” Carbon taxes can also be designed to automatically adjust if actual emissions miss some predetermined emissions path.

Benefits and Challenges

As explained in “Carbon Pricing 101,” economy-wide carbon pricing comes with many benefits. In particular, the flexibility of carbon pricing allows firms to choose the most efficient method to reduce emissions—or not reduce emissions—and it does not impose a one-size-fits-all policy across firms within a sector or across sectors. In addition, carbon pricing equalizes the marginal abatement cost (the cost of avoiding one ton of emissions) across firms. This is a necessary condition to minimize the cost of reductions, and it allows for some sectors that can reduce emissions inexpensively (such as the power sector) to achieve greater reductions than those that cannot (such as the transportation sector).

Economy-wide carbon pricing also has downsides. Both carbon taxes and cap-and-trade programs lead to price increases for energy- and carbon-intensive goods; for example, a $1 carbon tax will increase the price of gasoline by 1 cent per gallon, with all else kept equal. These price increases are salient to consumers—everyone sees changes to the price of gasoline—and can impact the competitiveness of energy-intensive firms (though policy design can offset some of the competitiveness issues).

Further, some argue that economy-wide carbon pricing policies are unfair to lower-income households because they consume more energy as a fraction of their income than high-income households. The impact of carbon pricing on lower-income households, however, depends on how the revenues are used. When revenues are returned to households in an equal dividend, many (if not most) households are better off than without a carbon price, because the dividend will exceed the increase in their energy costs. If revenues are used to reduce corporate taxes, however, the benefits primarily accrue to wealthier households.

The other primary challenge for economy-wide carbon pricing is that most currently proposed pricing policies are unlikely to drive significant decarbonization across all sectors of the economy, which leads some commentators to dismiss carbon pricing as an ineffective climate policy tool.

To see the likely effects of different revenue uses, and the projected emissions effects of proposed policies, please see RFF’s Carbon Pricing Calculator.

Key Considerations

The two most important design considerations for carbon pricing policies are the stringency of the policy—either the level of the tax and how it escalates over time, or the amount of allowances and how they decrease over time—and how the revenues are used, if any are raised. Revenue use can be as important as program stringency in determining the overall costs and how those costs are distributed. Tax swaps (using the revenue to reduce pre-existing labor, capital, or excise taxes) can reduce the overall costs of the policy. Dividends (direct payments to households) can offset increased energy costs for low-income households, and many studies find that most households would benefit from a carbon dividend. To learn about other key considerations for carbon pricing policy design, read “Carbon Pricing 101.”

Past, Current, and Potential Economy-Wide Carbon Prices

Sixty-four carbon pricing initiatives currently exist across the world, in 46 national jurisdictions. Many of the policies are not true economy-wide policies and cover just a subset of emissions. The EU Emissions Trading System, for example, covers only 40 percent of Europe’s emissions. In the United States, no federal carbon pricing policies are in place, though several have been proposed in Congress. Several states and regions have implemented carbon pricing programs in some form, such as the Regional Greenhouse Gas Initiative and California’s cap-and-trade program.

The Basics

An alternative to economy-wide carbon pricing is to pursue a portfolio of sector-specific policies that systematically cover emissions from the power sector, transportation, industry, and buildings. The Green New Deal and the CLEAN Future Act are examples of a portfolio approach to emissions reductions. This type of approach would combine many of the different policy instruments discussed in “Federal Climate Policy 101,” and further explanation of many of these policy tools will be provided throughout this explainer series.

Benefits and Challenges

The benefits and challenges of a comprehensive sectoral approach are nearly the inverse of those of a carbon price.

One benefit of the sectoral approach is that it might be easier to pass a collection of smaller policies in individual sectors than to pass an economy-wide carbon price as one law or in multiple pieces of legislation. A regulatory approach also gives assurance that targets will be met, which could persuade those who may be skeptical of the effectiveness of a carbon price. Additionally, the opportunity to tailor different policies for each sector, or multiple policies for different parts of a sector, can allow policymakers to account for challenges faced by different sectors and take advantage of many different policy tools.

Another benefit of sectoral policies is that prices for energy or energy-intensive goods most likely would increase less than under a carbon price, which is beneficial for domestic production and employment. Further, price increases caused by sectoral policies may be less salient for the average consumer. For example, fuel economy standards increase the cost of new cars, but not everyone buys new cars; however, most people purchase gasoline regularly.

On the other hand, a sectoral approach might be very expensive, as it does not equalize marginal abatement costs across sectors, resulting in expensive reductions from sectors that are particularly difficult to decarbonize.

Further, sectoral approaches are unlikely to generate revenue for the federal government; therefore, no revenue accrues that can be used to mitigate impacts on disadvantaged communities, as is the case with carbon dividends. Some policy packages (e.g., the Green New Deal) address these concerns in different ways, such as through job creation programs and other measures aimed at more progressive policy. However, such programs require funding.

Key Considerations

The types of policies pursued in each sector have important implications for the overall costs of this type of approach. Some policies, such as clean energy standards, may be nearly as cost-effective as a carbon price, while others may be much more expensive. Prescriptive regulatory policies require regulators to decide ex-ante (beforehand) which methods of emissions reductions are both feasible and cost-effective, whereas other policies such as the clean energy standard or tradable performance standards offer similar types of flexibility to firms to decide how to reduce their emissions. Another consideration is that different policies vary in how much of the total emissions they cover; to be most effective, all (or nearly all) emissions need to be covered.

It may be possible to pursue a portfolio approach through existing legislative authority, such as the Clean Air Act (CAA). For example, the legal authority of the Obama-era Clean Power Plan—which was designed to force states to reduce the emissions intensity of their power sectors—is established in Section 111(d) of the CAA. Others argue that Section 115 of the CAA could be used to regulate greenhouse gas emissions because the impacts of greenhouse gas emissions are global. However, any such rulemaking would face significant legal scrutiny and most likely would require the Supreme Court to weigh in on the legality of the rules, and there's no consensus that the CAA is a reliable vehicle for enduring and effective climate policy.

For the remaining Federal Climate Policy explainers in this series, we will dive deeper into the key considerations required for each set of sectoral policies.

Past, Current, and Potential Portfolio Approaches

California has adopted both an economy-wide carbon price through the Western Climate Initiative cap-and-trade program and has adopted a myriad of sector-specific policies including, but not limited to, a clean energy standard, a low-carbon fuels standard, and requirements for new buildings to be both energy efficient and have solar capacity.

Both carbon pricing policies and sectoral portfolios have benefits and challenges. A regulatory, portfolio approach to emissions reductions is likely to be much less cost-effective than an economy-wide carbon price, due to the inability to equalize marginal abatement costs across firms within and across sectors and the inflexibility of some regulatory approaches. Carbon pricing at sufficiently high levels, however, may not be politically feasible: it has many detractors across the political spectrum, and most efforts to pass economy-wide carbon pricing in the United States at both the federal and state levels have failed to date.

A final consideration is that opportunities exist to achieve emissions goals through a combination of these options. As in California, economy-wide carbon pricing and a sectoral approach are not mutually exclusive. The federal government could pursue a similar approach that combines carbon pricing with sector-specific policies, but with care to prevent redundancies across overlapping policies.

This explainer was featured in the 207th issue of Resources magazine.