Jeff Meli: Welcome to The Flip Side. My name is Jeff Meli. I'm the head of research at Barclays. I'm joined today by Deborah Lucas, Sloan Distinguished Professor of Finance at MIT and Director of the Golub Center for Finance and Policy.

The Golub Center is hosting a conference which Barclays is a co-host of on financial policy and climate, a topic which has gained a lot of traction lately.

Thanks for joining me Debbie.

Deborah Lucas: Thanks, Jeff. It's good to be with you here again.

Jeff Meli: Now, there has been a lot of traction on climate in general. For example, we've seen new interest in international agreements like the Paris Accords. We have a very significant climate component, the spending bill that's currently being debated in Congress.

We've had companies across a whole swath of different industries making net zero commitments. And we've also seen some activity that's very specific to the intersection between finance and climate.

So, one example is central banks incorporating climate risks into their regulatory framework. We've had a massive flow of money into ESG funds. We've also started to see some progress globally on disclosures on frameworks necessary to help that investment process, particularly in Europe but we've now gotten some momentum in the US

Deborah Lucas: Well, Jeff, that's a remarkable list. And clearly the state of play is evolving very quickly on all of this. And not to throw cold water on it, but I think it's still very hard to know how much of these actions, particularly the parts that are voluntary and unsubsidized, will translate to meaningful reduction in greenhouse gas levels.

Now, for example, there is a lot of activity now of companies selling off dirty divisions to private companies that are less visible. So those kinds of transactions which simply transfer an operation that's producing a lot of pollution to a place of high visibility to low visibility isn't going to address the problem.

So, as a practitioner of the dismal profession, it seems clear that it's going to cost a lot to get the world to where it needs to be. And that money has to come from somewhere and we need to realize that.

Jeff Meli: Again, as we've talked about, some type of a carbon tax seems like the natural solution to economists. But a carbon tax has not really been part of the plan. And today, we're going to talk about why a carbon tax is such an elegant solution as far as economists are concerned as well as what are the sources of resistance that we see to getting something like that enacted here in the US.

Now, I'd say, in advance, there are some chance it will now be included as part of that spending bill in Congress as other parts of the bill meet some resistance, but it's not really a new idea. I look back through history; the first carbon tax was proposed in the United States in 1973.

So that's nearly 50 years ago. Since then the US has emitted something like 250 billion metric tons of carbon, all of which has effectively been untaxed. Meanwhile, the rest of the G7 has a version of the carbon tax. The US stands out.

And I know, Debbie, that you're bullish on carbon taxes for what I think are pretty good reasons. Greenhouse gas emissions are really a classic negative externality. They generate substantial costs that are borne by society at large rather than whomever is responsible for the emissions and the result is that we overuse carbon.

And the benefit of a carbon tax is that it would force the user to consider the full costs and then it allows market forces to determine the best response. So the activities which could be most cheaply migrated away from carbon will do so. And those that can't will continue to use it. But in the end, we get an efficient transition.

Deborah Lucas: Yes, Jeff. Those are really important points. And I just want to add a little to your list. Some other ideas about carbon taxes and why they're useful that sometimes gets forgotten, and one is just a pure transparency of a carbon tax. Unlike regulations, it actually costs businesses a lot of money.

You don't really see those costs. And you don't – you can't tell what they are. With carbon taxes, you can see how much aggregate revenue is being collected and then you can also see how the costs are being distributed across the different entities that are paying those carbon taxes.

Kind of relatedly, with carbon taxes, you get explicit revenues and you can decide how to use those revenues. So, I think it's important to remember that in a lot of these proposals we're not yet seeing how those revenues are going to be used. And I think the best way to use them is going to be to come to an agreement about what's important to support.

So, for instance, there is rightly concern from the progressive side that higher energy costs are going to be very tough on low-income families. And one thing to understand about a carbon tax is you can take some of those revenues and use it to subsidize the poor who are going to have these higher costs of energy.

Thirdly, I want to mention that carbon taxes are very useful and that they're adjustable. We still don't know exactly how much carbon we need to abate and we don't know how people will respond to taxes or other measures and how much carbon is really going to be reduced. So with the tax, you can dynamically adjust it over time as new information comes in.

You can raise it if you're not getting enough reduction in emissions. And you can lower it if you're not. And it's harder to make those kinds of adjustments to other sorts of policies that I think we're going to talk about later.

Jeff Meli: Now, one alternative to a carbon tax that gets discussed a lot is a cap and trade system, which have some similarities but also some important differences. One difference is that within a cap and trade system you would set a limit on emissions and then allow companies to sort of trade those emissions back and forth versus taxing the emissions and then seeing how much – how much carbon emissions could actually go down.

And so, how do you think about the tradeoffs between those two proposals? And is there a clear and obvious reasons to prefer one over the other?

Deborah Lucas: Yes, Jeff, that's a great question. So, I think economists have shown pretty clearly that you can make a carbon tax and a cap and trade system equivalent. And maybe the intuitive way to see that is with a cap and trade system, you're paying for emissions and those payments you're making to buy the permits are equivalent to the carbon taxes.

So you can structure them both to be fairly equivalent. Now, people argue over which will work out better in practice, for instance, there is concern that cap and trade will apply too narrowly. It's harder to get it to be used by smaller firms and the like.

But I think with carbon taxes, there'll also be carve outs to protect those for whom it's just too much of a burden. So I think as the first approximation, they're about the same. And I don't strongly support one over the other. I would be very happy to see either become the law.

Jeff Meli: Yes. It would seem to me that the devil is going to be in the details on either side, and so you could probably structure well or structure poorly either. And so, well-structured would be more important than which exact version you picked.

I guess I have a separate question because I mentioned this trend lately of corporations making net zero commitments. I think it's been quite widespread across a variety of different sectors. Maybe started with some of the sectors that are more obvious in terms of their carbon usage, but it's spread pretty rapidly across sectors.

And some of these are relatively long-dated, so at times even 30 or 50 years in the future in terms of when that corporation would intend to have no net carbon emissions associated with activity. If we – look at these commitments and believe that corporations are going to achieve them, why do we need a carbon tax. I mean, I think if we could say that the corporate sector in 30 or 50 years would have net zero carbon footprint, isn't that good enough.

Deborah Lucas: Well, I think the big question, Jeff, is they can say what they want but why are those commitments credible? When they are very costly, do you really believe that companies can do them? Are they in conflict with their fiduciary responsibilities to their shareholders if they do cost a lot? There's really no enforcement mechanism.

Jeff Meli: Yes, Debbie, there is something of a sordid history associated with these kinds of corporate commitments. And as an example you could look at the plastics usage of beverage industry. And as long ago as the late 1960s or early 1970s, we started to see companies make commitments to use 100 percent recycled plastic. And even today that usage has never really gotten above 10 percent. So I think there is room for some healthy skepticism on these commitments.

Deborah Lucas: Yes. And I also want to add that net zero is very hard to measure. Different companies will take different actions and it's hard to compare those actions or verify that they really do what they're intended to do.

The beauty of a carbon tax or a cap and trade system is that you can design it to make it easy to measure what you need to do and how to get there. And you know what? Also with net zero, what you don't want really is every company individually going to zero, we still are going to need some oil. And oil companies are intrinsically dirty. So we don't want them to take their activities to zero. What we want is for things to be dirty in some sectors, less dirty than they are today, certainly, but still dirty, and then sectors where there's low cost avoidance, they can take the large actions.

And the whole beauty of carbon taxes or cap and trade is that it provides an incentive for what economists call the lowest cost avoider to make the adjustments, and in that way we get what we need with the least cost over all to society.

Jeff Meli: Well, Debbie, if we agree that this is the most efficient policy to address the risks associated with climate change and it's a well understood one. It's been out there in the public sphere for nearly 50 years, why haven't we passed it?

Deborah Lucas: Yes. That's an interesting question. I think though it's pretty clear why. Taxes are anathema. Read my lips, no new taxes. Basically, what we've been trying to do, hoping to do is to think of things that would be costless or even profitable in order to get to where we need to be.

I personally think that that's very over-optimistic. Any kind of transition is going to be significantly costly. And the longer we refuse to recognize that we have to address that squarely is just slowing things down.

Jeff Meli: I think that's an interesting point. I would say there's been some recent news that is illustrative of what you're talking about. So gas prices in the United States have gone up quite a bit recently.

And we've seen steps taken by the administration to try to address that, so they've done things like jawbone OPEC into trying to get them to drill more oil or call the CEOs of energy companies into the White House to try to talk about how to get gas prices down.

But if we really think climate change as an existential threat, we need gas prices to be higher. That's why they did things like cancel the Keystone Pipeline and restrict fracking and drilling on federal land.

So I kind of feel like that's a very real example of the phenomenon you're talking about and it's coming from an administration that ostensibly takes this threat very seriously.

Deborah Lucas: Yes, Jeff, I agree with you completely, but let me just defend the administration a little bit. The administration is always going to have to respond to what's in the news today and to look like it's acting in the interests of the American people.

But I think the way we're going to ultimately judge them is the policies that they affirmatively adopt to deal with these things and that will be kind of longer term kinds of actions.

Jeff Meli: You know, Debbie, I see actually the political barriers to passing a carbon tax growing despite the fact that the general attention on climate risks seems to be heightened right now. And I see the barriers really emerging from both sides of the aisle.

Now the right, which would normally support a market-based solution over a patch work of regulations and subsidies criticizes a carbon tax because they're opposed to the notion that there's a problem to be solved.

So they think that the costs associated with climate change are overstated and the risk are overstated and the science isn't advance enough to justify the major cost associated with the transition.

Now, on the left where I think they disagree with all of that and think climate change is a really serious threat that does need to be addressed, I think is increasingly opposed to markets-based solutions.

So as an example, just to sort of digging around I found a coalition of five progressive groups that's been very vocally opposed to a carbon tax. And they think it won't reduce emissions, in part because they see that it's supported by the energy industry which I think they're sort of skeptical of.

And then they also don't want to create a dependence on the revenues. So if you get hooked on the spending then you'd be reluctant to, sort of, tax the fossil fuel industry out of existence, which I think would be their ultimate goal.

And finally, there's a concern about the tax being regressive, which is something you mentioned earlier that not structured correctly you end up overtaxing lower income people who tend to spend the larger share of their income on energy.

Deborah Lucas: Yes. So those are really important points and my response to that is actually, kind of, optimistic, which is we have to remember that carbon taxes are likely to raise a lot of money. And I think the reason there is a potential that we will get there is that basically that money can be used to buy agreement across the political spectrum.

So on the right, you might not believe that you need to pay to cut carbon but you might realize that that's where society is going. So let's refocus things on what are we going to do with the money that we raise.

Well, if we use it to cut other taxes that's consistent with the priorities of, one, conservatives. It could be used to avoid some of the higher marginal tax rates that are being proposed now. It could be used to reduce debt and deficits which is certainly also a priority.

So, I think if the emphasis is, well, we're not actually going to be increasing necessarily total taxes but rather we're going to be shifting taxes, that could go a long way to making people in the center, center right more comfortable.

On the other side, center left or progressives. I think money can also very much help to get people pass their objections. As I mentioned before, some of that money could be used for redistribution, particularly to those that are hurt most by a rise in energy prices, but it could also be used to address other progressive goals.

I also want to give a historical perspective on that. That if you think about the history of all large federal programs, they've all started out, really, trying to find compromises across the political spectrum. Think about health care, universal health care, which has taken so many decades to be enacted and in the end, it was a matter of compromises and it started small.

And from there it has grown – may continue to grow. I know some people may not like that but the fact is if we can just get enough agreement to get an effective type of policy solution legislated, I think we can make good progress from there.

Jeff Meli: Well, it's interesting that the energy industry has sort of turned the corner on a carbon tax, so that the American Petroleum Institute, the API, for example, supports that program. And to be cynical, you could imagine that faced with all of this activity on carbon and increasing skepticism from society about the costs associated with the use of carbon that the energy industry maybe would support such a policy precisely because of a statement you made earlier, which is that people don't like to be taxed.

So they might presume that we really wouldn't be able to pass a tax sufficient to actually discourage the use of carbon in any material way, and so that would be a preferable policy to some of these other ideas that are being floated. Is there a more – I don't know, hopeful or positive or optimistic take on their support for this policy?

Deborah Lucas: I do have a more positive take on it, which is I think a carbon tax really reduces the uncertainties for the industry. It gives them something they can plan to. If they don't have a tax, they're going to be hit with policies that are less predictable, potentially more onerous, more inefficient.

Imagine that they're asked to switch to a lot of wind, a lot of solar, but that they don't have the battery capacity to store these renewable sources that are very expensive unless you do have that storage capacity.

Well, they're probably afraid they're going to be forced to do things that aren't economical, that aren't effective and maybe they would be better off with something which, in fact, they can work with.

I mean, I think this is one – another way to describe this is the alternative to the tax they might see as industrial policy. And industrial policy comes with a lot of risks.

Jeff Meli: Well, actually that's a good segue to the next, I think point which is that really if we don't pass a carbon tax, how much hope should we have that the United States can actually take the steps it needs to take, because it appears to me that the alternative right now is basically in the form of industrial policy.

It's a series of fees, subsidies, of enhanced regulations where they're meant to try to effect the same change but to do it in a patchwork way that's targeted at very specific activities. That is exactly the, sort of, situation that a carbon tax is meant to avoid, right, that that ends up being very inefficient. How much hope should we have that that second best will actually allow us to make that, sort of, transition that we need?

Deborah Lucas: That's a big and difficult question, Jeff. I don't think we're ever going to get to a first best solution. The hope is that in that second best, we'll have a mix of taxes and subsidies and regulations that are effective enough to get us where we need to be.

In fact, I'll count it as a win for everyone if we can overcome the collective action problem enough to do what needs to be done. There are more or less efficient ways that we can get there. And I really hope that policymakers and the public will settle on approaches that are effective, efficient, and perceived as fair.

Jeff Meli: Well, I hope you're right, certainly. I think that is a more optimistic take. Thanks, Debbie, very much for joining me today. And clients who are interested in Barclays Research latest take on carbon pricing can look at our recent ESG research "Carbon Pricing Preparing for the Inevitable" which is available on Barclays Live. And I'm looking forward to the conference.