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The Progressive Economics Forum

Carbon tax vs cap-and-trade

Carbon tax or cap-and-trade? Oh, my ass gets sore sitting on this particular fence. Each has its pros and cons, and for each the Devil is in the details of implementation. And maybe it does not have to be either-or.

With data now telling us that things (like arctic ice cover) are worse than the most pessimistic scenarios of a few years ago, serious efforts to reduce total GHG emissions are in order and will likely need to be 90-95% reductions by 2050. So anything that gets us along the right path is worth a long, hard look, but we want to get it right so that we do not waste a decade fiddling. My lenses are attuned to the distributional impacts of such measures, and it seems to me that either carbon tax or cap-and-trade could be regressive (they would have a bigger hit for lower income families). But suitably designed they could reduce inequality, too: we need to pay close attention to who gets the proceeds and how that money is spent.

Both carbon taxation and cap-and-trade systems are variants on carbon pricing, which is based on the principle that the external costs associated with emissions be internalized into market prices. All mitigation costs will ultimately be borne by households through higher prices, or changes in employment income or corporate profits. The appeal of market-based measures is a capacity to resolve millions of individual decisions on the consumer and producer sides of the market. Carbon taxes affect the price and let the market determine the quantity of emissions; cap-and-trade systems set the quantity of emissions and let the market determine the price, through trading or auctions.

Both pose a degree of uncertainly. With a carbon tax we would know the price but we would not have a good handle on exactly how this will affect the total quantity of emissions. From the estimates I have seen the price would have to be pretty high (above $100 per tonne; in the political arena, the Greens are calling for a tax of $25 per tonne) for there to be a change in behaviour, although the fact that there will be a schedule of rising prices over time will encourage behavioural change at lower levels of the tax.

With cap-and-trade we set the quantity of emissions but do not know what the resulting price of carbon would be. One concern I have for cap-and-trade systems is if everyone expects to purchase credits to cover their shortfalls. Governments are pushing to widen the potential market for making such purchases, such as BC’s decision to join the Western Climate Initiative (with five US states) and the EU emissions trading regime, on the presumption that we will miss our industrial targets and will need to buy the difference. But if everyone, or the major players, assume the same strategy, then the market price will be extremely high, and the market could fail in that there is not enough trade to meet the predetermined cap.

Cap-and-trade systems also have distributional issues that critically depend on how the initial rights are allocated. In the European trading system, the worst polluters were given the most credits. Alternatively, rights to emit CO2 could be allocated as equal per capita amounts. On this basis, redistribution is inherent in the model, as intensive emitters (the carbon rich) would effectively have to pay low emitters (the carbon poor) in order to emit more than their allocated share. Such schemes may in fact be necessary in order to achieve the objective of sustainability – shared sacrifice, rather than individual choices on the margin, may be a prerequisite to getting people to accept radical change. A historical precursor is the widespread acceptance of rationing during World War II.

More fundamentally, cap-and-trade also has enforcement issues and is more susceptible to cheating on the part of polluters. These options are not necessarily black and white, and there may be some combination of the two (for example, carbon taxes on major consumer items, but cap-and-trade for industry) that is most effective or efficient. A carbon tax would be the easiest to administer, though equity considerations also need some thinking through. Thus, some or all of the proceeds of a carbon tax can be used to (i) reduce other taxes (“tax shifting”), or (ii) provide a direct income transfer to low-income households (for example, building on the GST refundable tax credit), or (iii) make direct expenditures on, for example, public transit, home retrofits and basic research on alternative technologies.

Because of the cultivated antipathy towards taxes and the public sector these days, most carbon tax proponents package it with tax cuts elsewhere (option i), though I do not see what this need be the case. I prefer some combination of (ii) and (iii), though there is some modelling that needs to be done around this. There is ample evidence from Nordic countries that regressive taxes can lead to progressive outcomes – if the proceeds are spent in a progressive manner. In other words, a carbon tax, with progressive spending of revenues, could become a Nordic-type strategic bargain that addresses both ecology and equity.

I’m not sure I’ve talked myself off the fence yet. But it is important to consider that markets can have shortcomings, and one important one is a failure to account for a fair distribution. And some fairness in how the burden is shared will be needed to maintain the political momentum for change. Market prices are inherently about determining who is willing to pay for a scarce good, meaning the poorest (and perhaps a sizable share of the population) could get priced out. So either carbon tax or cap-and-trade may worsen inequality if unaccompanied by deliberate measures or policy design that address distribution.

Comments

Comment from paul t.
Time: November 27, 2007, 9:31 pm

In a would be democratic society, failure to account for equity is the death blow for political momentum. We are already witnessing that with oil. It has risen to some drastic heights of late. I sometimes sit and think this may be the international oil communities response to global warming. Raise the price, max out profits in a collusionary fashion and make an attempt at cutting into the co2 count. Of course that is most likely a cynical scenario. But we have found out that there is not much elasticity to the price of oil. Our car culture and the dimensions of urban design (or should I say the antithesis of it) has provided us with a legacy that prevents such car convenience adjustments from occurring. However, if the price rises further I am sure we will hit some threshold whereby people will be forced to change their transportation habits. (public transport, car pooling and others such devices). That is not to say that adjustments have not been made yet, say in income and budget reallocation on personal consumption patterns. I am sure somewhere right now a whole lot of lower income family are having tough times making ends meet with the rising costs of energy. But transport patterns, according to the data, are still showing no major changes in distributions. With the polarization in wealth that has occurred and is accelerating, it will be these issues that may actually get the vote out for the those lower on the income scale who traditionally display a significantly lower proportion in participating in their democratic right to vote. So this threat I believe potentially makes these kinds of adjustment non-starters. As they should be, unless they are somehow progressively designed, I do not see these being highly viable in a pure market based setting. Again I go back to polanyi, the markets are not self regulating, they are regulated by somebody, and for the sake of social cohesion, and the environment, I am hoping that when and if we ever get around to policy formation on the environment, that we go much deeper in policy thought than leaving it up to markets regulated by the business world. I read last summer that air pollution in Mexico City is so bad on some days that they were selling fresh oxygen on the streets. Commodification of nature has done nothing but destroy it over our past history. It is too complicated to leave up to the flimsy and simplistic notions of markets. As an alternative we need some deep thinking on the issue. I think the way forward is research, quantification, accountability, leadership, innovation, experimentation, and lots and lots of money for experimentation, implementation, feedback and correction.

We have the wealth in the developed world to figure out solutions. We have some good ideas in place now, we now need the political will and the abilities through monetary means to take us forward. Put your head out the window and have a look, not many of our leaders are taking any serious action. Canada is the perfect example, we had an opportunity with the mini-budget last month to make some financial commitment, yet we did nothing with 60 billion dollars.

Day by day I am falling into the camp that in 50 years from now, we are going to have some major calamities and it will only be through the shock doctrine that we change our ways. A majority of the motivation these days comes from these min-shocks like Katrina, and strange weather patterns and the like. Unfortunately for us we are not within the same conscious time frame as the planet, it operates quite slow (centuries) and we our quite fast (moments- what was I talking about again?). MAybe if we all slowed down quite a bit and put our ears to the ground we might hear its call.

paul

Comment from Dave T
Time: November 28, 2007, 11:11 pm

Good points Marc.

There is nothing *inherently* regressive about carbon pricing, but a poorly designed instrument certainly can lead to a regressive outcome. It is important that progressive economists be involved in the carbon pricing design discussion, because carbon pricing is coming – without a doubt. Standing on the sidelines and booing is not a particularly effective strategy; engaging in the design debate is. Great to see you engaged.

There are two levels at which progressivity can be built into a carbon tax. First is in the tax itself: it can be progressive, based on carbon emissions. Have the tax increase in rate with increasing carbon emissions (or a fuel consumption proxy). This is generally called a “lifeline” structure; people whose fuel consumption is low pay lower rates, while those who consume a lot of fuel pay higher rates per unit of emissions. Generally this will work because lower income households tend to have smaller residences and fewer and smaller cars, if any. There are some exceptions, as always, but generally single moms aren’t living in McMansions and driving Hummers; they are living in apartments and taking transit – or walking.

Second place to build in progressivity, as you mention, is the allocation of those tax revenues, which can be to income supplements, housing, health care (removing premiums / user fees), raising the income tax basic personal exemption, GST credit (as you point out) etc, etc.

Finally, it’s important to remember that the poor will suffer more than the wealthy from global warming (http://www.ens-newswire.com/ens/apr2007/2007-04-06-01.asp), as they do from many other environmental problems, e.g. smog, toxics, etc. Global warming and the environment are not elite issues, despite the right’s attempts to frame it that way (and thereby drive a wedge between the environmental and social justice movements). Global warming and the environment are about justice.

Comment from paul tulloch
Time: November 29, 2007, 11:02 pm

in the age of information, I just do not get what all the large problems have in planning change rather than markets. Markets unless thoroughly regulated, in this setting, for progressiveness, end up being pretty much planned. Why not just drop the notion of markets and go with planned. i’e’ as soon as we start getting into the whole notion of markets, we fall face forward into the business acumen, and open the door to regressiveness. I hate to open the can of worms, but I will, with the amount of information technology and the first stirrings of some notion of a knowledge economy, do these tools not empower us with new abilities. From a societal level, I wish somebody somewhere would resurrect the notion that planning is not a dirty word, especially here in the progressive world. Fundamentally when we are talking about a heavily regulated market, are we not just planning. We need to build on that in the progressive world when we get further down this road of taking on the environment. As sson as you start talking about regulated markets, the right wingers within the environmental magic bullet camp, will throw you out onto the pitch with me anyway. So why not pick up the ball and start our own game with rules that work. Planning a balance between the economic and ecosystem is the only way forward. This is all new territory and throwing the bull of the market into the environmentally friendly china shop as a starting point is a huge mistake.

It is too complicated for markets, highly regulated maybe, but why not just admit it and start with planned.

This has got to be fundamental for progressives.

Comment from Darwin O’Connor
Time: November 30, 2007, 7:40 am

While there are many markets where we could go 100% planned, fossil fuels is one of the most difficult because so much of it is used by individuals rather then industry.

It’s one thing to regulate a few dozen or hundred industrial users, but how do you regulate 30 million Canadians when you have to deal with, how much the drive, how fast they drive, where they live, the exposed surface area of their house, how they heat their house, how they set their thermostat, what fruit they buy, where they go on vacation, etc., etc…

Even in a glorious communist worker’s paradise, a carbon tax is still the best way to control greenhouse gases.

Comment from Marc Lee
Time: November 30, 2007, 11:19 am

We shouldn’t view the options as either-or, as in markets versus regulation. I think both are going to be required. One issue of going with a fully regulatory approach is that there will be a flow though to higher consumer prices anyway that will be regressive, but the government will not be collecting any revenues in order to offset that regressivity through income transfers or direct spending.

Comment from paul tulloch
Time: November 30, 2007, 12:54 pm

If you say they cannot regulate how 30 million Canadians use energy, then why are they installing smart meters. They are employing technology to basically price discriminant and introduce a regressiveness into the daily life of 30 million Canadian households.(at least in Ontario) But this is through a passageway to unleash a more market based approach into an space that was typically regulated, or lets say planned. So what is with the communist worker’s paradise, comment.

Mr. O’conner missed the point, markets are regulating in and of themselves. Somebody must set prices, collect, administer, set policy and pay for the transaction and distribution costs and determine who is allowed to have access and consume this scarcity. Markets are not self regulating. They are just disguised in a neo-con discourse to be self-regulated and the most efficient means of dealing with scarcity. All with the ingrained notion that those that have the resources should not have to be subjected to the constraints of scarcity. So again I go back to my premise that a market based approach, without heavy regulation (or planning) will be just the out that those within this world that have the resources can opt out of the scarcity constraints.

I believe it is called social democracy.

pt

Comment from Darwin O’Connor
Time: November 30, 2007, 3:11 pm

I don’t think the problems of income distribution should mean we should reject a carbon tax. How we implement a carbon tax can effect make income distribution worse or better, depending on how it is implemented, but we should also be trying to make income distribution better independently of the problems of global warming.

What I meant was that even in a communist worker’s paradise where there was no income distribution problems, a market based approach would be the best one to reduce individual greenhouse gas emissions.

How would you suggest we regulate greenhouse gases? Allocate everyone the same carbon limit? I don’t see how it could work without trading (which brings back the market). People have very real variations in the amount of greenhouse gases they use, and that isn’t going to change without excessive restriction on people’s lifestyle. As socialists we want people to have more real freedom, not less.

Comment from paul tulloch
Time: December 1, 2007, 1:28 pm

This is not the forum for outlining such a grandiose plan. (it’s not quite finished yet,lol) However I do acknowledge, that in some fashion, a market functionality will be needed to play a role in the co2 scarcity dynamics. We must however as progressives strive to ensure that the regressive nature of these policies are clearly outlined and minimized. If the impending crisis allowed for more time, like in extra decades than I would suggest that a lot more focus would be centered on the supply side of the co2 generation and the cultural aspects of the demand side. It would take me a few pages to go into this all, but let me state this. The culture and the society that we have grown in the developed economies of the world that use the highest per capita co2 and other GHG, must undergo some baseline culture changes. There is a lot of heavy lifting that is required, and a lot of cultural concrete that needs to be busted up and redone. Conservation is only a start down the cultural change road. We need producers, consumers and policy makers to undergo some dramatic rethinking. Nothing short of some kind of enlightenment type period, followed by a peaceful french revolution (not sure if that works actually without the violence) type metamorphosis in the large will be necessary. A qualitative and quantitative transformation is needed. It will make polanyi’s great transformation, look like small potatoes.

I also believe that the whole carbon trading issue is like a giant sponge mopping up all the debate and discourse development surrounding the high profile climate change debates. It is constricting the solution space for climate change. In my opinion it is becoming some kind of feel good magic bullet solution, without any solutions. Merely an endless goal setting exercise without ever getting a goal.
A final point, income dynamics are intrinsically wrapped up within the co2, climate change debate. The progressive nature of these policies is a dependant variable at least in my equation for successful implementation for change.

The last comment regarding freedom, I could not agree more on your assessment but I am not too sure about the logic. If the end results are regressive, is that not the definition of regressiveness. Freedom for some, but sacrifice for the many.

Comment from Barb Mitchell
Time: February 19, 2008, 11:26 pm

A carbon tax? Sure…but Ms. Taylor has left out something very important:

My ability to send the government an additional invoice:
For the trees I’ve planted that consume CO2 = $/tree/year.
For the trees I’ve planted that emit O2 = $/tree/year.

This would be an equitable application of a true carbon tax. Legislation to allow us to bill government for the strides we are making on our properties.

At least it would be considered to be equitable by the everyday working person.

Victoria’s carbon tax has no impact on the rich.
Or on corporations whose lobbyists silently whittle away at government policy.

Reminds me of what I recently heard about recycling:
Only the middle class recycles.
The rich? Ask the cleaning lady.
The poor? (laughing) You know what those blue bags cost?

Comment from Marina
Time: June 27, 2008, 6:12 am

If the carbon tax hurts the business, it will hurt the employees too. The employees will be unemployer, or has less income.

Maybe the business will not have any operation inside Canada. We’ll drive the business away from Canada

Comment from Shane
Time: April 18, 2011, 10:48 pm

You talk too much about redistribution when your topic is carbon emissions. To give counterexamples, Switzerland, Australia, and South Korea have low taxes and have equality on par with high tax countries like Sweden, Hungary, and Denmark (considering both income and wealth distributions). It’s not cultivated antipathy, it’s just that you don’t see the other side of the argument clearly. Many economists see the high taxes of around 50% (the so-called top of the Laffer curve) as the result of a tragedy-of-the-commons with politicians and bureaucrats playing the role of the shepherds. They think a society funded solely on Pigovian taxes is better, and besides it satisfies the non-aggression condition. Check out the Pigou Club, which includes Greenspan and Nader.

Comment from Marc Lee
Time: April 19, 2011, 8:22 am

Shane, I think you are looking too much at models that do not consider distribution. Most standard economic models assume everyone is the same, with similar endowments. If that was the world we lived in then one could just go with a Pigouvian tax.

Alas, reality is not that simple.

Our starting point is in fact vast inequality, so policy needs to recognize the impacts on people who already pay more as a share of their income in energy costs. Policy should aim to protect the most vulnerable — a widely held principle of justice.

Channeling money to low-income households is not only the right thing to do it makes for good macro policy.

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