Insurance policy: Revenue-neutral carbon tax with global temperature indexation by Richard Hobbs

1. Cap and trade was effectively branded as "cap and tax." It has all of the political disadvantages of a carbon tax, but a revenue-neutral carbon tax has a shot at being presented as new and different from the failure of cap and trade. Still, does branding it a cap and tax make it any more politically palatable? My concern is that cap and trade is basically dead on the Republican side, very hard to resurrect. 2. Intellectually developed, but what exactly is this cap and trade proposal adding that is genuinely new? At least it is revenue neutral. 3. This is a well-presented proposal, but it largely restates the typical emissions trading package that has been passed internationally to date. There is very little that seems novel or creative here, and it resembles in some ways the failed Waxman-Markey bill (except, admittedly, in its revenue-neutrality). The most underdeveloped aspect is likely the floor/ceiling which is presented somewhat uncritically given the complications that floor and ceilings have created in other carbon pricing schemes.

Thanks richardhobbs, We are looking forward to reading your updated proposal. ~Noel (Fellow)

Hi Frank, Thanks for the comment. With regards to the novelty aspect, I have to agree with the judges as they initially judged me on a rather vanilla cap-and-trade proposal that put me through to the finals! I have subsequently changed it quite drastically to this model because I think it is a more innovative solution. Yes with the price index set for one decade at a time I was thinking that it does leave out an aspect of flexibility. Do you think the private sector would be able to organise some form of hedging product for future tax rates? Something like weather derivatives where HDDs and CDDs are equivalent to global temperatures outside expected bounds. Or would you see this requiring government intervention? As I have pitched this to Republicans I wonder whether the non-government option may be more politically palatable to them. You raise a good point on temperatures determining prices, which is that it actually drives people and businesses to seek reliable sources of data on climate change. They can no longer put their heads in the sand, which will increase climate literacy.

Hi Richard, I have a quick question about the proposal. In the proposal you say that temperature-indexation will mitigate risk. Although there are other important factors such as our ability to adapt, the impact of carbon pricing on economies etc - all of which we will learn more about as time passes. How do you propose to incorporate these risks?

Hi MMazengarb, Yes you are correct that temperature is not the only factor that should be incorporated into a risk-based approach to pricing carbon. For example, in two decade's time if we find out that we are able to adapt to a warmer world at a cheaper cost than initially thought, this would factor into a risk-based assessment. Conversely if we find out that the economic costs of pricing carbon are much less than we initially thought, this would also be factored in to a risk-based assessment. However, for the purposes of political feasibility we can't get too technical. The public needs a simple, transparent proposal for pricing carbon. People would switch off pretty quickly if we tried to explain the exact way to price carbon correctly from a risk-based perspective. The reason this proposal works is because it improves political feasibility through temperature indexation. The more complex and convoluted the idea becomes, the more distrusting the public would become in the Government to implement it correctly. I do mention in my proposal that the panel of risk experts and NASA will be able to able update the non-linearity models for indexation (or more accurately, the gradient at particular points on the index curve) based on economic outcomes. But I do think it is important from a messaging perspective to keep this as simplified as possible and to focus predominantly on temperature indexation as the core focus of mitigating risks posed by climate change. The question of incorporating these other risks will be elucidated more from the review on the economics of climate change. It would then be up to the panel, comprising of economic and business managers (see previous comment in response to jhocking), to translate these proposals into a simple, transparent and pragmatic method for pricing risk. Cheers Richard

Thank you Richard. Your ideas are quite valid. The notion of establishing a risk management group (alongside a economic and business managers panel) should permit for a feasible review on the economics of climate change.

Hi ghorvits, Thanks for the points. IPCC predictions exhibit quite disparate ranges of possible temperature contingencies for the same level of ppm present in the atmosphere. So the point of the temperature indexation is to manage temperature risk as and when it occurs, and as we gain a better understanding of how the climate reacts to certain atmospheric concentrations of CO2. I do understand your point as CO2 has a long atmospheric lifetime and its impacts will likely be felt for millennia. But we won't have to wait too long to see which way it will go because the index is adaptive to changes in temperature. So we will be acting commensurate to the risks posed. One of the main reasons for a temperature indexed price is political feasibility. Many Republicans do not believe in anthropogenic climate change. They think the scientists are wrong. But with a temperature indexed price it can act as an insurance policy. If they are wrong and the scientists are right there is something there in place. The same can't be said for CO2 because many Republicans don't even believe this affects climate. When the world warms further into the future they will be more likely to believe climate change is anthropogenic, but then as you say, it might be too late by the time they come around to this. So yes, we need to price carbon now and urgently. I see this as the most politically appealing option to get Republicans on board. I also think that the proposed review on climate change risk with NASA, economists and risk experts will elucidate the way to temperature index correctly, potentially to account for future expected changes. This would provide more accurate risk profiling. Unfortunately I can't see the Republicans supporting this as one of the reasons some of them don't support action on climate change in the first place is because they don't believe the scientists' future predictions. Therefore to make it more politically palatable I have chosen it to be based on actual temperatures. An interesting dynamic occurs here as companies wanting to know the future decade's carbon price must follow the best climate change science to determine the likely future index. Therefore, through this very aspect, future temperature predictions are actually being factored into present day business decisions, particularly for longer term infrastructure projects, such as electricity projects with 25-30 year horizons. To this degree both historic and projected temperatures are factored into the carbon price by business ensuring risk mitigation from temperature rises is maximized. I don't agree that it is a fiscal hazard. The same thing could be said about income tax and CGT revenue neutral options. The point is that the carbon tax is revenue neutral now and into the future. It will be legislated on this basis. So if revenue changes from the carbon tax (lower or higher), the corporate tax rate changes accordingly. This is how British Columbia's carbon tax operates, allowing for cuts in income tax and corporate taxes and it adjusts to changes in carbon tax revenue. This is quite a standard aspect to account for. The degree to which balancing of revenue neutrality is done on an ex-ante and ex-post basis is a legitimate question. BC's carbon tax was revenue negative for quite a while due to this. But revenues can be re-calibrated over time to ensure neutrality. And yes when the economy weans itself off fossil fuels it will be a very joyous day! Cheers Richard

I think another important point to make is that temperature is the hazard, not CO2. It is temperature that will drive the most adverse impacts of climate change. While CO2 is the main contributor to temperature increases, the uncertainty over future temperature responses to different concentrations of CO2 in the atmosphere renders temperature as the most relevant factor for indexation. The IPCC 5th assessment report states, "Increase of global mean surface temperatures for 2081–2100 relative to 1986–2005 is projected to likely be in the ranges derived from the concentration-driven CMIP5 model simulations, that is, 0.3°C to 1.7°C (RCP2.6), 1.1°C to 2.6°C(RCP4.5), 1.4°C to 3.1°C (RCP6.0), 2.6°C to 4.8°C (RCP8.5)." This future uncertainty illustrates that we need to manage risk in terms of temperature responses to different levels of atmospheric concentrations of CO2. Temperature indexation manages the risk as it adapts the price to real changes in temperature. Future expected temperature rises are also somewhat priced into present day business decisions due to the expectation of future indexing.

Richard, thanks for the detailed response. I had not browsed this thread nor was I notified of your comment, so I am just getting around to responding. While your reasoning for choosing a temperature index vs CO2 content is appreciated, particularly as in our case because of the political considerations (and we both have remaining issues in that area), it occurred to me that while temperature is certainly a significant driver of climate impacts, the CO2 content of the oceans may be even more important than atmospheric CO2 and is or will also be a significant determining factor of the future of life on earth. I can't imagine higher temps without higher oceanic CO2 content, but is the oceanic sink delaying an atmospheric response? On the issue of fiscal risk, the notion of fluctuating corporate taxes corresponding to adjustments in the carbon tax is an interesting approach. Is that what is already in effect in BC? So, as the revenue from a carbon tax subsides, will corporate taxes then rise? Your proposal has undergone significant modification from its first iteration. Well done. Gary

Hi Richard Hobbs and friends, kindly consider to vote for my proposal shown in the link below https://www.climatecolab.org/web/guest/plans/-/plans/contestId/1300206/planId/1002 Thanks in advance.

Hi Judges, Thanks for your comments. A positive aspect of my proposed temperature indexation model is that is indexes the per annum percentage. A traditional commodities linked index will alter the price of the underlying commodity based on a linear basis. This model indexes against the 5% p.a. figure. For example a change of 0.06 degrees celsius from the underlying mean (i.e. 0.17 C/decade to 0.23 C/decade) would result in the index rising form 5% p.a. to 7% p.a. for the next decade. If the carbon price was at $20.00 at the beginning of the decade it would be $32.60 by the end of the decade with a 5% p.a. index and $39.30 with a 7% p.a. index. This would be the difference between a 63% decadal rise and a 96.5% decadal rise. I believe this would be sufficient to mitigate the difference between 0.17C/decade and 0.23C/decade. If these indexes remained for 30 years the carbon price would be $86.40 under a 5%p.a. scenario and $152.25 under a 7% scenario. However, the compounding nature of the indexation may still not appropriately price risk as you have suggested. You make a good point that a higher priced index may be less politically palatable. The key is striking the correct balance between a temperature-indexed price that is high enough to sufficiently address the risks posed by climate change and low enough to be politically palatable. Remember many Republicans say they don’t even believe the world is warming so they should like this policy. The foundation for getting this balance correct rests on a review of the economics of climate change commissioned by the Republican party with primarily conservative leaning experts being involved. The review would differ quite significantly from the 'standard' review of the economics of climate change (Garnaut, Stern etc). The panel would comprise of economic and business managers (i.e. Hank Paulson and Michael Bloomberg) and would focus on a risk-based approach to temperature indexing carbon. This panel would make 'management' decisions based on advice from three teams: scientists, economists and risk experts. These teams would work collaboratively in a transdisciplinary manner. Why choose economic and business managers to make the final recommendations as opposed to economists? It is not the risk manager or the economist that would call the shots at Goldman Sachs, but the management board who would make decisions based on input from these divisions. This management style ensures that the final proposal is pragmatic, feasible and sensible. To further ensure pragmatism the review would use risk management experts from the financial sector, insurance sector and acturial sector. A traditional review tends to have two main groups, climate scientists and economists. The scientists tell the economists the science and then the economists go and model outcomes based on this science. As mentioned this review differs and it would have the following participants: Lead panel of economic and business managers: Receives input from the scientists, economists and risk experts in order to make final recommendations to the Republican party. Climate change scientists (NASA): Informs the economists and risk experts on the science. Economists: Models the economic impacts of climate change and apply an appropriate price to emissions. Risk experts: Provides input on the science and the economics to create a risk management tool to adjust carbon prices accordingly as circumstances change. Ultimately the temperature indexation tool would be built by NASA, economists and risk experts. This would produce a balanced and informed method for pricing carbon commensurate with the risks posed by climate change. It also adds to the political feasibility of the proposal as climate skeptics would be more supportive due to the fact that if they are correct the price would trend to $0 or to low levels. Once the temperature indexation model is approved by the panel the report will be completed. It will be made public and will be provided to the Republicans. Conservative members of the public will be more likely to endorse climate policy if it is presented after a public, independent review. The Republicans can then choose to accept the recommended temperature indexation model in its proposed carbon price legislation. Once operational, the temperature indexation model would be managed by NASA. NASA would update the indexation every decade with the help of top economists and risk management. NASA would publish its observed GISS data at timely intervals throughout the decade. In order for business to factor future potential carbon prices into present day business decisions it would need data on future potential temperature changes. The market would need to choose this data wisely and the sources providing the most accurate data would be more likely to receive financial benefit. The carbon tax would be implemented by the EPA. The EPA would receive the temperature indexation for the next decade from NASA in time for implementation. For example, if the indexation for the 2030s is set by NASA at 8% p.a., the EPA would levy this index onto the carbon price for that decade. This model is likely to be politically palatable for most Republicans. Firstly, it is based on a formal publicized review conducted by predominantly conservative members. Secondly, the review is led by business and economic managers which is likely to be seen as more pragmatic and business friendly. Thirdly, it indexes the carbon price to temperature changes, which Republicans should like if their predictions on climate are correct. Fourthly, the temperature index is managed by NASA, a reputable agency in the eyes of most conservatives. I have also provided an example of members that could be included on the initial review below: The Panel: Michael Bloomberg, Hank Paulson, Bob Inglis Economists: Bill Nordhaus, Art Laffer, Greg Mankiw, Glenn Hubbard Climate Scientists: NASA Risk experts: Bob Litterman, Mark Freedman, Erwann Michel-Kerjan Regards Richard