A Smart Tax: Pricing Oil for a Safe Climate

June 22, 2016

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by Deborah Gordon, Jessica Tuchman Mathews (Carnegie Endowment for International Peace) Because of the growing chemical and geological diversity of the new oils, the lack of alternative liquid fuels for transportation, and the size and global scope of oil production and trade, a tax is most needed in the oil sector.

Regulation and government funding of R&D are necessary but not sufficient to slow climate change. To transform energy use and supply across the economy, greenhouse gas (GHG) emissions will have to be priced and the power of the market brought to bear.

Oil is the most demanding fossil fuel in this regard. It is largely used for a single purpose—transportation—for which it has few substitutes. It is the most diverse of all fuels—chemically, geologically, and geographically. And it is heavily capitalized and the most traded global commodity. Each characteristic makes the design of an effective and fair tax particularly difficult.

Moreover, the United States faces a hydrocarbon landscape transformed by new, unconventional oils. The long-standing expectation of a gradual, shortage-driven shift to clean fuels has been replaced by the need for a swift transformation in the face of abundant supply. National policy making has not begun to catch up. A new smart tax design offers a way to do so.

From Blunt Tax to Smart Tax

Traditional tax designs are blunt instruments that treat all oils alike and tax only consumption of end products.
Blunt taxes leave major unconventional oil emissions untaxed, treat dirtier oils more favorably than cleaner ones, provide no incentive for technological innovation, and offer no incentive for refiners to consider climate in determining product mix.
For the first time it is possible to quantify the amount and profile of GHG emissions from all oils throughout the supply chain using the Oil-Climate Index developed by researchers at the Carnegie Endowment for International Peace, Stanford University, and the University of Calgary, allowing replacement of blunt taxes with a smart tax design.
A smart tax differentiates among the chemical entities called “oil,” accounts for GHG emissions along the entire oil supply chain, and includes byproducts that do not fuel transport, thereby correcting the shortcomings of a blunt tax.

Moving Ahead in the United States

A smart tax can be simply administered at the refinery level, allowing refiners to pass the charges up the supply chain to producers and crude transporters and down to product transporters and consumers in a mechanism comparable to netback pricing.
A means of applying border tax adjustments will be necessary. A range of new data must be standardized, collected, and made available, and a lead government agency made responsible for the task.
Political barriers to enactment can be lowered by making the smart tax revenue neutral with a formula for returning revenues to the economy that is simple, transparent to the public, and equally attractive to both major political parties.

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Defining a Carbon Tax

For simplicity and ease of recognition, we use the shorthand term “carbon tax” throughout to signify a tax on all GHG emissions. The GHGs considered here and in the Oil-Climate Index include carbon dioxide (CO₂), methane (CH₄), and nitrous oxide (N₂O). The emission figures referenced in this report are carbon dioxide equivalent (CO₂e) emissions that are calculated using the global warming potential (GWP) with one-hundred-year warming and climate feedback. The GWP represents the combined effect of the differing times these substances remain in the atmosphere and their effectiveness in causing radiative forcing. GWPs for each greenhouse gas are CO₂ = 1, CH₄ = 34, and N₂O = 298. Other GHGs emitted through the supply chain (for example, black carbon) exist, but they can be difficult to quantify and have not been included here. Similarly, the term “carbon pricing” means pricing of all content that produces GHGs.

For more information see: Gunnar Myhre et al., “Anthropogenic and Natural Radiative Forcing,” in Climate Change 2013: The Physical Science Basis. Contribution of Working Group I to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change, eds. Thomas F. Stocker et al. (Cambridge, UK: Cambridge University Press, 2013), https://www.ipcc.ch/pdf/assessment-report/ar5/wg1/drafts/WG1AR5_SOD_Ch08_All_Final.pdf.

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Because of these large differences in the quantity and sources of emissions in the supply chain, a smart tax on oil must have the following three characteristics:

It must differentiate among the very different chemical entities that today all go by the name “a barrel of oil.”
It must account for GHG emissions along the entire oil supply chain: production, refining, transport, and end product use.
It must include the emissions from oil byproducts that do not fuel the transport sector, the most important of which is the bottom-of-the-barrel material known as petcoke (which is sold, exported, and burned, but is classified and is often used as a solid fuel to blend with or displace coal).

Blunt taxes and a smart tax differ dramatically in economic efficiency, equity, and effectiveness in curbing GHG emissions.

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How, in practical terms, could a smart tax, levied throughout the whole supply chain, be collected? Would it require millions of collection points? In fact, there is an elegantly simple way to manage such a tax. It could be levied on the very small number of refiners, allowing them to pass the charges up the supply chain to producers and crude transporters, and down the chain to product transporters and consumers. There were just 137 refineries, run by 59 corporate entities, in the United States processing 18 million barrels of oil a day as of January 2015. Just seventeen of these companies accounted for 85 percent of all refining capacity.¹²

Refiners know oil. In order to process crude into products, they need to accurately characterize it, both chemically and physically. And because they can procure crude oils from a wide array of producers, refiners have leverage over those from whom they choose to buy. The price they charge is based on the crude’s quality and its transport costs (known as netback pricing).

This amounts to the same variable pricing mechanism that would be applied through a smart tax.

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Thus, until or unless a uniform price on carbon is adopted worldwide, countries that choose to use the market will also have to consider the use of border tax adjustments in order to avoid a loss of competitiveness if oil production and/or manufacturing enterprises move to countries that do not charge a carbon tax. These adjustments at the border are also needed to prevent some emissions from escaping taxation entirely. READ MORE