This is the third post in a series about details we are still getting wrong in the climate policy discussion. See also part one and part two.

There is no shortage of economic analysis and policy discourse that shows that carbon tax and cap-and-trade methodologies can deliver economically equivalent outcomes. The general consensus — at least today — seems to be that since they’re equivalent, it really comes down to politics, and it’s politically difficult to do anything with the word “tax” in it, so we’ll do cap-and-trade. I like the conclusion, but the rationale is pure bunkum.

To understand why, we need only go back to my simple test of any climate policy proposal: the degree to which it encourages investment in capital that lowers atmospheric greenhouse gas concentrations.

Cap-and-trade and carbon taxes do not pass the test equally.

A carbon tax provides no direct revenue to carbon reducers

Suppose you’re me. You’ve got investors who want you to invest in projects that reduce GHG emissions. They also want to invest their money as rapidly as possible, and to earn as much money as possible from those investments. All of that makes them very keen to figure out how different carbon policies affect their investment thesis.

You now find yourself in a board meeting, trying to explain to them how you will realize financial value from a carbon tax, given your expertise identifying and building projects that reduce GHG emissions. Let’s walk through your conversation:

Q: Will your projects get paid for their beneficial GHG impacts?

A: No. The tax gets charged to emitters. Since my projects don’t emit carbon, I don’t have to pay the tax. But I don’t get any of the revenue.

Q: That still gives you a cost advantage relative to your competition, right?

A: Not precisely. In the long run, the tax could increase the cost of electricity as produced by more carbon-intensive suppliers.

Q: “Long run”? “Could”?

A: Yes. Utility costs don’t immediately translate into higher rates. First they have to go through rate cases, and there is a time lag between when their cost structure goes up, when they file for a new rate case, and when that rate case gets approved.

Q: But you can at least assume it will have a demonstrable impact on the competing price of power, right?

A: Not really. I don’t know how the rate case will apportion rates across different rate classes, so I don’t know whether my customers will be affected in a predictable way by the carbon tax. It is possible that they will simply impose those costs on other rate payers.

There is also a move afoot in the environmental community that would prohibit utilities passing the costs of greenhouse-gas abatement along to their rate payers; in that case, the impact of the tax would be to lower the profit margins of regulated utilities, but it would not have any impact on the competing price of electricity.

Q: But surely you can structure power contracts with your hosts such that they give you some upside from the resulting carbon tax, should it come, right?

A: Maybe, but that’s a hard commercial sell. Would you pay me money today on a gamble about the direction that Congress will take on tax treatment for carried interests to private equity funds? Probably not — and for the same reasons, it’s unlikely that my customers would give me upside on a tax bet.

Q: So what value should we place on carbon reductions for your projects, given this carbon tax?

A: Zero.

This (Socratically) is the crux of the problem with carbon taxes. It is a stick upon the emitter, without any direct carrot for the reducer. And the financial value to the reducer is therefore only realized depending upon the manner in which the emitter’s prices change — but this is far from precise. (Witness all the manufacturers whose profits get squeezed when fuel costs rise because they have no direct way to pass those costs along to consumers.) By contrast, a system that allows emitters and reducers to trade allows for direct financial benefits to those who do the right thing — and a benefit that can be negotiated, built into contracts, and used to affect investment decisions.

Tax policy is a blunt tool

So suppose we could fix all the above. Maybe we do a balancing tax and use tax increases on one side to offset tax reductions on the other side. Does that solve the problem?

Directionally, it’s an improvement. But it is still a poor substitute for a market-based trading system, for the simple reason that tax policy is an indirect tool.

Tax incentives are a great vehicle, if you are a taxpayer. Individuals pay income tax, and mortgage interest tax deductions are a nice perk. But people who invest in energy projects are not taxpayers, at least not in the near term. Why? Because of depreciation and debt. If I spend a lot of capital on a project, I get depreciation shields to lower my taxable income in the early years of project operation. I will also almost certainly debt-finance some portion of the project, and my interest payments will also provide a tax shield. For most energy-related investments (e.g., all investments that either emit or avoid the emission of CO2), you can count on not having any taxable income for the first 7 to 10 years of the project’s operating life. And if you’re not paying a tax, a reduction in your taxes isn’t worth much.

So what do you do? You sell off your tax liabilities to someone with a “tax appetite,” in the jargon of the trade (read: someone with lots of profits that they’d prefer not to pay tax on — typically, banks). They will pay you if you assign them your rights to those tax losses, based on some discounted cash flow stream, giving you an immediate cash flow — but essentially giving away some portion of the gain to the tax equity buyer (after all, they’re not going to buy all those losses from you without getting some benefit).

Don’t get me wrong — this transaction is not a bad thing. Indeed, this is how most wind projects get financed. But the end result is that of all the dollars the government allocates from the treasury for The Good Thing, less than 100 percent of those dollars flow to the person who does The Good Thing. Which means that less than 100 percent of the investments that could theoretically be incentivized by this tax policy actually get incentivized, while the balance essentially goes to bank fees.

So how do you fix this? Two potential ways: One, make the federal payment a revenue payment rather than a tax offset. This is what Section 451 of the recently passed energy bill does, and it’s huge. The net cost to the feds is the same, but for every dollar paid by the treasury, there is a dollar going to incentivize projects. Two, allow bilateral trades between those who cause the pain and those who provide the gain.

Both of those put the incentives in the right place and create real incentives for those considering investments in carbon-reducing technologies. And neither are amenable to a tax-driven approach.