I should preface by saying that I am a fan of Peter Barnes. He’s an emeritus board member of Redefining Progress. He’s a smart and thoughtful guy. But I’m not a fan of his cap and dividend idea, mostly from an economic perspective.

First, the idea that a price on carbon would be transformative, and that we should do that first and then come in with other complementary policies later, is dangerously wrong. Transportation and building heating/electricity are the two largest contributors to carbon emissions, accounting for well over half the total. The price elasticity on transportation fuels is very low, as we’ve seen. With gas prices up $2 per gallon in the last three years, we’re now finally seeing small reductions in driving, somewhere in the neighborhood of 4%. $2 per gallon of gas is roughly the equivalent of $200 per ton of carbon, a price impact that the failed Lieberman Warner bill wouldn’t have brought until beyond 2040, if then.

Home energy use is not only terribly price inelastic (people light and heat their homes out of habit and necessity, not on the basis of price), so that we’d need very high prices to induce behavior changes, but is also characterized by a terrible market failure in information, where people have no idea what appliance costs them what in terms of electricity. As everyone should now be aware, rental units are subject to other serious energy market failures due to renter/owner split incentives and the liquidity constraints of many renters.

Second, and equally important, are the macroeconomic impacts of rising energy prices. Even with efficiency investments, the price per unit of energy will go up, and as will the price per unit of energy services for many applications. This will reduce the economic viability of some industries currently on the economic edge and make the bust part of the boom-and-bust cycle unbearable for others. Bad as it is that households might see their disposable income go down by 1 or 2% as a result of higher energy prices ($50 per ton of CO2 translates to about $1000 per year on average household income of $63,000), it will be far worse when a sizable minority of households lose 100% of their disposable income when plants start laying off. Unless we use the bulk of carbon revenues to reduce the costs of employment, we’ll be driving a wedge between the blue collar left and the green left, destabilizing first the support for climate legislation, and then the climate itself.

Giving permits away to corporations is a lump-sum transfer of wealth that creates no incentives to do anything new. Giving permits away for free to individuals (or, equivalently, a cash payment of a share of carbon revenues) is another form of lump-sum transfer that only creates an incentive to remain alive, for which there is already ample incentive. The slightly higher marginal propensity to consume of the average individual as compared to the upper income owners of polluting corporations is not enough of a difference to stimulate sufficiently higher demand to offset the impacts of higher energy prices.

To make climate policy work economically, the money must be invested in energy efficiency and renewables (deployment of existing technologies should be the priority). It should also be used to keep low income households already living on the economic edge from falling into a hole they can’t climb out of, for job retention and retraining for workers and industries with high energy intensity. The rest (65% or so) should be used to reduce existing taxes that currently create disincentives for job creation. I prefer cutting the payroll tax because it is the most regressive tax we have, though I’m not sure I want to wade into the social security debate.

One big potential advantage of cap and dividend (I think it needs a much better name, by the way) is that it could raise some support among a certain class of Republican who believes that the government can do no good and should be shrunk wherever possible. But I am virtually certain that, despite the fact that it is easily understandable and very good in terms of income distribution, it won’t attract massive public support from people who would not support other forms of cap and trade. Telling people that climate policy won’t be as bad as they think is not a message that will drive people to get on board with enthusiasm.