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Market-Based Solutions to Vital Economic Issues


Kenan Institute 2024 Grand Challenge: Business Resilience
Market-Based Solutions to Vital Economic Issues
Jan 12, 2023

Use Carbon Taxes to Solve the Short/Long Fossil Fuel Investment Dilemma

A daunting tangle of problems defines the global energy space as 2022 winds down. On the one hand, the war in the Ukraine combined with curtailed Russian oil/gas supplies into Europe has reminded many that unfriendly energy suppliers can also deliver inflation and hardship to their customers. On another side, efforts to increase oil/gas supplies both in Europe and globally, face stout resistance to anything that might further entrench hydrocarbons into national economies. Inflation is prompting monetary policies to tighten even as fiscal indiscipline continues via historically high government deficit spending. Concerns over climate change remain an article of faith among leaders of many countries. Other voices decry the folly of calls to suppress oil/gas production when greener alternatives are not ready to replace them. Electorates seem both confused and restless. The risk that they vote in leaders less insistent on decarbonizing economies is palpable.

If this seems like a recipe for policy vacillation and gridlock, it is. The risks are real. In the face of this thicket of problems, one may reasonably ask ‘is there no way to address several of these problems simultaneously?’ Said differently, is it possible to design policy measures and political compromises that might lead out of the thicket, allowing progress on several fronts?

It is possible to conceive of such a path forward. The necessary policy design involves a tradeoff – the introduction of carbon taxes on traditional energy in return for regulatory relief. There is a new ingredient which should enable this compromise to be politically possible; it involves the design of the carbon taxes. These taxes should be introduced by imposing them directly on the polluters in the oil/gas industry. However, the taxes will have a particular design. Initially, they will be applied only to new investment projects. Second, the tax specifics will be customized by class of new assets, e.g., new drilling, pipelines, refining capacity and LNG export plants. Third, the taxes will be ‘backend loaded.’ This means that the carbon levies will be light for the first 10-15 years of new project life. After year 15 they escalate sharply and remain high thereafter.

Why adopt this particular design? The answer has to do with the policy dilemma facing many governments today. With energy prices soaring, many quietly acknowledge that more

hydrocarbon production is needed in the short to medium term. No less an opponent of the oil/gas industry than President Joe Biden has called repeatedly for U.S. producers to increase production. Yet, many leaders are reluctant to enact policy measures that would encourage higher production. These leaders continue to heed calls from environmental groups and activists to avoid steps which might ‘lock their economies’ into a hydrocarbon future.

A deadlock of sorts has resulted. Leaders call for more production. However, they do little to address private company reluctance to commit capital to projects whose lives may be curtailed by hostile regulation. The companies read the signals – fracking bans remain in place throughout Europe. Pipelines are blocked by court challenges and governments do little to unsnarl the tie-ups. Exploration acreage is held back and permitting held up. The same governments who want more production talk in the next breath about windfall profits taxes.

Oil/gas consuming country governments are caught on the horns of a dilemma – the short to medium oil/gas production they seek involves companies committing to projects that require long lives to generate a return. Most economics for the such projects involve 20-year operating lives. To green light, let alone incentivize such long-life projects seems to contradict commitments many leaders have made to the Energy Transition. Even worse, it will come with the political cost of seeming to capitulate to an industry seen as polluting and an enemy of the climate. It should then come as no surprise that leaders who call for more immediate oil/gas production shrink from sending the signals that might actually bring it about.

The carbon tax described above provides a pathway out of this dilemma. It will encourage new investment in the assets needed now for the short/medium term. At the same time, it will encourage the owners of these assets either to plan for their phase-out or more likely for their decarbonization. The result should be what is needed on several fronts – higher oil/gas production in the short to medium term and then a decarbonized longer-term outcome. To see how this is accomplished, let us look at the carbon tax’ design in more detail.

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