When it comes to the issue of global warming, a carbon tax that forces all sides to put their money where their mouth is on the futures market could help to resolve a long-running debate.

A carbon tax proposal has to answer two questions: where should it start, and how should the rate change over time. Since a low carbon tax coupled with reductions in income taxes would likely be neutral or mildly beneficial for the macroeconomy, it is conceivable that people could agree on a small carbon tax, even if they are otherwise divided about the underlying seriousness of the global warming issue. But once questions are asked how the rate should change over time, views become polarised and agreements breaks down. One side considers carbon dioxide a great threat to the planet and wants a rapid increase in the tax. The other side does not see global warming as a problem, and wants the tax to stay small or disappear altogether.

Here is how to give both sides what they want: suppose a small tax on carbon dioxide emissions is introduced and its subsequent evolution is tied in to a suitable measure of atmospheric temperatures. If temperatures go up, so does the tax. If they don’t, the tax stays low. Everybody expects to get the policy they prefer, and whoever turns out to be right deserves to win.

Sceptics won’t expect the tax to go up, and might even expect it to go down. Environmentalists will expect the tax to soar. Managers of factories and power plants will have to figure out who is more likely to be right, because billions of dollars of potential tax liabilities will hang in the balance. Forecasts might even be guided by mainstream climate models.

But are they accurate? Here is where things get really interesting. Industry will have an incentive to scrutinise the science and search for the most reliable theories, because biased forecasts will lead to financial losses. In one stroke, the politicisation of climate science will be solved by using the market to weed out bad models.

Precise predictions

Now suppose a futures market were to be opened in which firms could buy contracts to cover the per-tonne costs of the emissions tax up to, say, 30 years ahead. Not only would investors have complete pricing certainty for the long run, but the futures market would become the world’s most accurate climate model. With billions of dollars at stake, investors will ruthlessly sift information sources for an edge in predicting the value of such contracts, thereby bringing the best expert knowledge to bear on the future path of climate.

This is also the most forward-looking policy possible, because investors are forward looking. A firm building a power plant or a pulp mill will not care what the tax rate is today, much less last year; instead it will want to know what the rate is likely to be 10 years from now, and beyond. The market will force investors to make the best possible use of information about the climate, and to press for improvements in climate forecasting in the process.

Suppose the futures market implies a forecast of zero warming for the coming decades. If, based on his analysis, a climatologist thinks the world is actually facing a greenhouse catastrophe, he could show it by investing his pension in carbon tax futures while they are still – according to his model – cheap. But if he doesn’t trust his own science enough to bet his pension on it, then he can hardly blame others for ignoring it too.

But which temperature index should be used? An ideal candidate responds quickly to carbon dioxide emissions, measures accurately and does not respond much to other changes in the climate system. Climate models identify the mean temperature in the tropical troposphere as the best option. There is good quality data for this vast region of the atmosphere (which makes up half of the free atmosphere of our planet) from independent satellites and weather balloons, so it would be easy to obtain reliable numbers.

This idea does not need to be globally adopted to be globally beneficial. All it would take is for one country to implement it to induce the formation of the futures market, thus allowing every other country to observe the implied climate forecast path. But any country that implements it, even unilaterally, gets the benefit of knowing that it did the right thing, without knowing in advance what the right thing is.

Ross McKitrick is a professor of economics at the University of Guelph in Canada. He is author of An Evidence-Based Approach to Pricing CO2 Emissions published by the Global Warming Policy Foundation (UK).

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