Blog Post

Taxing Electricity’s Carbon Emissions at Social Cost

Nov 22, 2013 | Anthony Paul, Karen L. Palmer

A national tax on carbon emissions would offer an opportunity for deficit reduction and/or tax reform, as well as climate change mitigation. Economists studying taxes on environmental harms, such as carbon emissions, often suggest that the tax be set according to the damage inflicted by the last unit of emissions. In the case of carbon, the economic harm inflicted by an incremental ton of emissions is referred to as the social cost of carbon (SCC).

In order to inform the benefit–cost analysis of new environmental regulations proposed by federal agencies, the president established an Interagency Working Group (IWG) that published estimates of the SCC (initially in 2010 and updated in 2013)—and how it evolves over time. In a recent paper, together with Blair Beasley, we analyzed the effects of taxing carbon emissions from the power sector, the largest emitter of carbon dioxide in the United States, at the most recent values of the SCC. The 2013 IWG report presents multiple possible SCC estimates that grow over time, and we analyzed them all.

Our analysis reveals that imposing an SCC-based carbon tax on the electricity sector would cause a large initial reduction in emissions from power generation in the first year of the tax, followed by much slower rates of further emissions reductions in later years. Emissions reductions are primarily a result of lower power consumption due to higher electricity prices and fuel switching from coal to natural gas. The amount of federal tax revenue from an SCC-based carbon tax in the power sector would range from $21 billion to $82 billion in 2020, while also causing electricity prices to climb between 7 and 50 percent. Price increases are especially large in the middle of the country and in those states that rely heavily on coal generation, while the coasts are least affected by a carbon tax.

The dual environmental and fiscal effects of a carbon tax for the electricity sector provide the context for our paper, but we focus on the environmental consequences and their costs and benefits. We find that even without accounting for the fiscal benefits, the environmental benefits of a power-sector carbon tax exceed its economic costs.

We invite the intrepid inquisitor about welfare economics to explore our analysis of the optimality of taxing carbon emissions at the SCC (the first-best model doesn't hold for obvious reasons, but it might still be close). We also explore the differences between SCC-based carbon taxes and Hotelling-type carbon prices that could emerge from a cap-and-trade program with identical environmental outcomes.