If Rates Stay Higher for Longer, Then the US Will Need a Carbon Tax. By Matthew Yglesias

Read time: 4 minutes

The longer interest rates stay higher, the stronger the case grows for … a carbon tax.

Hear me out. The one great legislative push for carbon pricing, in 2010, came at a time of sky-high unemployment and low interest rates. It fell apart, but US emissions decreased anyway as newly plentiful natural gas started to crowd out more emissions-intensive coal. Over the next decade, the world’s entrepreneurs and engineers — assisted by modest government programs in the US and elsewhere — made considerable progress on bringing down the cost of manufacturing photovoltaic panels and batteries, helping to accelerate global investment in clean energy.

This mix of technological progress and cheap money laid the conceptual groundwork for the approach of President Joe Biden’s administration: Subsidize innovation and deployment, and let God and the Federal Reserve sort out the rest.

What’s not cheap anymore is money itself, with interest rates up as part of the Fed’s effort to control inflation. Now the central bank says it expects just one rate cut this year. But even if it cuts twice, there’s no prospect of rates going all the way back down to their pre-Covid levels, especially with the budget deficit both high and rising.

High interest rates are a problem for a lot of businesses and industries, but they are a particular problem for clean energy. A fossil-fuel plant has two kinds of costs: First you have to build it, then you have to buy the raw materials it needs to operate. Wind and sunshine are free, which means the cost of a renewable project is essentially a function of the initial cost of construction. Those costs are heavily influenced by interest rates. When rates are low, it’s easy to make the financial case for a large initial outlay that pays off in long-term fuel savings. When rates are high, it’s hard to make that case.

Nuclear energy, which is still the largest source of zero-carbon electricity in the US, is similarly disadvantaged but for different reasons. Nuclear plants are expensive to build, but they provide electricity for very long periods of time — three to four times as long as renewables — so once again, financing costs are crucial.

There are other reasons to adopt a carbon tax, of course, as my Bloomberg Opinion colleague Mark Gongloff has noted. Some 50 countries now have either a carbon tax, a carbon-trading system, or some combination thereof, so it may well be inevitable that some form of one comes to the US. And as my colleague Liam Denning has noted, some Republicans will support a carbon tax as long as it’s called something else.

There is another argument that may appeal to Republicans, or at least pre-Trump Era Republicans: A carbon tax will help reduce the federal deficit. I’m not naïve enough to argue that Republicans really care about deficits, but if Biden wins re-election, they will pretend to. Either way, deficits will matter: The kind of full-employment, high-pressure economy that the Biden administration has engineered means living in a world of tradeoffs.

When it comes to deficit reduction, there’s no politically painless way to do it. That’s why Donald Trump is campaigning on a set of promises that, if enacted, would explode the deficit. And it’s why Joe Biden, though hewing to a more responsible approach, has been reluctant to put any really big deficit-reduction ideas on the table.

Still, doing nothing is not a particularly palatable option — especially if it means higher mortgage costs and more expensive auto loans for the middle class. Of the options on the table, Republicans would probably prefer carbon taxes to higher ones on business and investment income. And Democrats would certainly prefer carbon taxes to cutting Medicaid and other vital social safety-net programs. Under the circumstances, phasing out clean-energy subsidies while phasing in taxes on dirty energy could be an appealing win-win that meets Democrats’ climate goals and delivers substantial deficit reduction.

A swap of that sort would also be closer to the original stated purpose of the subsidies as an effort to drive innovation. Technological progress is at the core of the world’s progress on climate change, but that justifies temporary rather than permanent subsidies.

Last but by no means least, a carbon tax is by far the best way to deal with the huge increase in electricity demand spurred by AI data centers. On the one hand, this rising demand threatens to torpedo various environmental goals. On the other, the prospect of environmental litigation and roadblocks stymieing AI deployment risks America’s broader place in the global economy.

The longtime technocratic appeal of a carbon tax is precisely that it lets a country strike an appropriate balance. It can allow genuinely valuable uses of fossil fuels to go forward while also making those who use them pay their true costs.

But pouring open-ended subsidies into a growing pool of electricity demand would be financially ruinous. Trying to cap the total amount of electricity use in the face of technological progress would be economically ruinous. And ignoring the impact of electricity generation on the climate would be ecologically ruinous. Charging fees that are scaled to the social cost of carbon, and using the revenue to help balance the national books and provide services, is still the best and most prudent way to balance all the various considerations.

America’s sojourn into the world of near-zero interest rates and free money made other approaches to climate policy look superficially attractive. Now that we’re back in the real world of tradeoffs, the old solution — a carbon tax — is still the best.