2014: The Year for a Smart Carbon Tax

The federal government in Washington, DC is at an all-time low in public esteem. This has to do with a lot of things, from intransigent right-wing ideology (e.g., debt ceiling debacle) to bureaucratic incompetence (e.g., Affordable Care Act website), to partisan gamesmanship (e.g., gerrymandered congressional districts), to outright, willful ignorance (e.g., climate change deniers), to a campaign finance system that produces policy makers held captive to the very special interests they are supposed to regulate (e.g., Wall Street, agribusiness, energy companies). The result is a crisis of legitimacy where ordinary citizens have lost faith in the capacity of government to solve their problems.

There is no issue where this legitimation crisis is more apparent, or more consequential, than the looming disaster of climate change. While the Obama administration has proposed carbon pollution standards for new coal-fired power plants and may issue regulations governing existing plants, climate change has hardly been an administration priority. Nor is it realistic to expect any action whatsoever, for the foreseeable future, from our deadlocked, paralyzed Congress.

Meanwhile, the scientific consensus is that increasing global temperature by more than 2°C will likely cause irreversible, potentially catastrophic damage – and we are now more than halfway there. The International Energy Agency has determined that staying below this 2°C warming threshold will require a global “carbon budget” that limits fossil-fuel consumption to one-third of known reserves by 2050. This means that some two-thirds of coal, oil and gas reserves would have to be left in the ground, at least until 2050.

Some have begun calling this the “carbon bubble.” If two-thirds of known reserves must stay in the ground, then this “unburnable carbon” would not be monetized, becoming instead a stranded asset or liability that is not being priced into the current valuations of fossil-fuel companies. Fossil-fuel companies, and an economy that subsidizes these (and other emitters) by letting them dump their carbon pollution into the atmosphere for free, would see significant disruptions if and when these externalities are accounted for.

There is also a burgeoning movement, led by Bill McKibben’s 350.org, advocating that colleges and universities, and investors more broadly, divest fossil-fuel companies from their portfolios. Such divestment is clearly advocated on moral grounds – to save the planet – but is increasingly premised on financial grounds as well – to avoid the risks associated with the carbon bubble and what these stranded assets or unburnable carbon will do to investment portfolios holding fossil-fuel company stocks.

There is some debate within the sustainable investment community about which strategy – divestment or engagement – is best. My own view is that neither strategy is sufficient but both make sense and need to be pursued in tandem. At my company, Pax World, we are pursuing a combination of strategies including (1) partial divestment [we offer a fossil fuel-free fund], (2) investments in energy efficiency, alternative energy and low-carbon technologies, (3) carbon reduction strategies across portfolios, (4) shareholder engagement, and (5) public policy advocacy.

The sustainable investment community needs to take such a multi-pronged approach. We can’t let the perfect strategy become the enemy of the good strategy. One can divest fossil fuels and still own a portfolio that remains very carbon intensive. One can engage with companies until the cows come home and make no discernible progress. There is no perfect solution, there are only solutions. What we need to do is design such solutions for investors.

We have an historic opportunity to help investors “green” their investment portfolios by offering an array of strategies that reduce exposure to fossil fuels, reduce the carbon intensity within portfolios, invest in renewable energy, energy efficiency and other resource optimization strategies, and raise investor voices to advocate for stronger corporate and public policies to address climate change. In this latter regard, credit must go to Ceres and its offshoot, the Investor Network on Climate Risk, as well as to the Carbon Tracker Initiative (CTI) and others for their work engaging with companies and institutional investors on climate. Ceres and CTI recently led a coalition of some 70 institutional investors (including my company, Pax World), representing approximately $3 trillion in assets, who sent letters to 45 fossil-fuel companies asking them to examine their exposure to the risks associated with unburnable carbon.

Whatever strategies we pursue must be practical, however, and it is important that the whole “unburnable carbon” framework, as well as the fossil-fuel divestment campaign, not become unhinged from reality. The unburnable carbon thesis (if the risk of owning fossil-fuel companies is to be more than simply hypothetical) is premised on a credible threat of government action to put a price on carbon – but such action is at best a remote possibility, at least in the U.S. The fossil-fuel divestment campaign (if it is to be more than simply symbolic) is premised on the notion that the fossil fuel industry can be brought to its knees as a result of popular pressure – an equally remote possibility.

The New York Times recently reported that some of the nation’s largest companies, including Microsoft, Walmart, General Electric, Walt Disney and Google, but also including Exxon Mobil and the big oil companies, are beginning to incorporate into their business plans the expectation that more governments will regulate or put a price on carbon. It is hard to imagine enough businesses taking significant steps, however, without a substantial prod from government, or a substantial prod from investors, or preferably both. Because effective government action is not likely for some time to come, this is where investors come in.

But if investors are to wield adequate clout, divestment alone is an insufficient strategy. In fact, any strategy that tries to make the fossil-fuel companies the bad guys rather than winning them over to the good guys column strikes me as the wrong way to go. We need carrots as well as sticks; we need engagement as well as divestment.

Prevailing in a head-to-head contest against the fossil-fuel industry in sufficient time to prevent irreversible climate damage is highly unlikely.

Given our current political divide, our campaign finance system, our evolutionary bias in favor of focusing on immediate rather than long-term threats, it is unrealistic to think that climate change can be successfully tackled if fossil-fuel interests remain aligned in steadfast opposition. When it comes to climate, the race is against time, and the fossil-fuel industry will simply dump too much carbon pollution into the atmosphere before they can be successfully subdued. They will harvest and burn all of their known reserves – and continue to invest billions of dollars in further exploration – unless they are given incentives to pursue a different course.

Moreover, if government is unprepared to act – if instead of putting a price on carbon it continues to subsidize it – then investors face considerably less risk than the “unburnable carbon” thesis advances, and may continue to make gobs of money from investing in fossil-fuel companies for many years to come.

So, neither the “unburnable carbon” framework nor fossil fuel divestment is sufficient. If our core strategies are premised either on government action or routing the fossil-fuel lobby, we could be in for a long haul. We need a better strategy. This will require not simply confronting the fossil-fuel industry but working with them to fashion solutions. Moreover, any truly effective strategy to combat climate change will require a carbon tax. Without a carbon tax, there is no clear pathway forward.

Exxon Mobil and some of the other large oil companies have tepidly endorsed a carbon tax, at least as preferable to cap and trade. Other companies could be persuaded as well, and this strikes me as one area where we should be focusing our efforts – on turning the biggest opponents of a sane climate policy into its biggest proponents. To do this, we must fashion a strategy – and a carbon tax – that is actually in their interests. We need to align interests – isn’t that what we in the sustainable investment community have always preached?

So, how do we convince the fossil-fuel industry that a carbon tax is in their interests? In my view, the only way the fossil-fuel industry is going to embrace a carbon tax and leave two-thirds of its known reserves in the ground is if it is paid to do so. Essentially, we need to make it as profitable for them to produce clean energy as it is to produce dirty energy.

A well-crafted carbon tax – what we might call a Smart Carbon Tax – may be the key. Not only would such a tax put a price on carbon so that clean energy can effectively compete, but it would also generate significant revenues, a portion of which could be assigned or recycled right back to the energy companies in the form of transition subsidies that enable them to convert over to sustainable energy. A Smart Carbon Tax would be designed so that a significant portion of proceeds is earmarked for investments in renewable energy, energy efficiency, resource efficiency more broadly, green infrastructure, and so forth. The fossil-fuel companies, as well as others, would be eligible to participate in this revenue stream from the Smart Carbon Tax. These transition subsidies could include expanded investment tax credits, low-interest loans, price supports, and so forth – and should obviously replace current fossil-fuel subsidies. But for such a plan to work, the amount transferred would have to be meaningful and may have to approach or approximate the profits the energy companies forego by leaving the fossil fuels in the ground.

For a Smart Carbon Tax to work, we would have to abandon the notion advocated by some that to make the idea more fiscally palatable, a carbon tax should be revenue neutral. It shouldn’t be. Similarly, we should resist efforts to enlist carbon tax revenues to address a wish list of other social objectives. The revenues from carbon levies should be primarily directed at hastening the transition from carbon-based energy to clean energy, pure and simple. A Smart Carbon tax should be designed to accomplish precisely this.

Some will complain that the fossil-fuel industry has been subsidized for too long and will be skeptical of a plan that further bolsters the fortunes of the perceived bad guys. But not all the subsidies and incentives would go to fossil-fuel companies – many renewable energy developers, for example, may be in other sectors such as industrials or materials and are not, strictly speaking, energy companies. Some of the revenues would go to green infrastructure projects, and so forth. Moreover, the fossil-fuel companies were in the energy business long before we knew their products contributed to global warming. They didn’t set out to warm the planet. Plus, their behavior is probably rational from a short-term, profit-driven perspective. What we need to do is alter their behavior, which requires that we redraw markets in a way that allows long-term value to trump short-term profit. A Smart Carbon Tax may be the most effective way to accomplish this.

What we desperately need is a strategy to transform the energy companies of today into the energy companies of tomorrow. Although many of these companies are currently in the fossil-fuel business, that doesn’t mean they can’t switch over to the clean energy business. To the contrary, success in the fight against climate change requires that we help them do precisely that. This, in turn, will require a Smart Carbon Tax – smart for the planet, smart for investors and smart for industry – where the revenue generated by the tax is intelligently deployed to facilitate the transition to a sustainable energy economy.

With government on the sidelines, perhaps for the foreseeable future, a credible alliance between sustainable investors and the fossil fuel industry might step into the breach and help fashion climate change solutions. A Smart Carbon Tax may be just such a solution. It seems to me worth a try.

This article original appeared in GreenMoney Journal.

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