Carbon taxes vs. cap-and-trade

Down in Seattle, at the Sightline Institute, Clark Williams-Derry chews on those bones of cap-and-trade and carbon tax options. Clark gets it that the Devil is in the details when it comes to design of such instruments to avoid adverse distributional impacts.

Carbon Taxes: The Good and The Bad

Last week’s Washington Post carried an interesting op-ed that argued for a carbon tax. The nut graph:

The only effective way to begin reducing greenhouse gas emissions and slow global climate change is to make it more expensive to emit carbon dioxide. Unless businesses and consumers pay a price for carbon dioxide, neither will make the investments in technology and changes in energy use needed to dramatically reduce emissions.

Well stated!

The authors — two researchers from RAND Corporation — also put forth a nifty idea about how to cushion the economic impacts of new taxes:

[A]ll the proceeds collected by the government would be returned to Americans each year when they file income taxes….

A carbon dioxide tax with refund is fair because the people responsible for the most emissions would pay the most. The tax would also be progressive. Many Americans with lower incomes would find the refund would more than defray the higher costs of gasoline and electric power.

In short, they call for a per-head rebate, kind of like the Sky Trust idea we’ve written about already (e.g., deep in the bowels of this post).  I love the Sky Trust idea (and, by extension, the idea of a per-head carbon tax refund) since it focuses policymakers’ attention on one of the core challenges of climate change policy:  how to make it fair, especially to low income folks.

Still, you know me:  I love to quibble…

To a large extent, I agree completely with the arguments the authors make in favor of carbon taxes.

First, a tax is a lot easier to administer than a cap and trade system. With a tax, there’s no auction, no grandfathering worries, fewer wacky complications within the electricity sector. Taxes are just plain simpler — and where climate policy is concerned, simplicity is a virtue.

And second, a tax gives a better guarantee of price stability. There’s no chance of a carbon “price shock” with a tax, nor of a collapse in carbon prices (as happened in the early stages of the European emissions trading system). And businesses love predictability — without it, it’s hard to plan investments. So a cap & trade system has to be designed very carefully in order to reduce the chance of wild price swings — something that a tax does by design.

But what I don’t like about this op-ed is that it elevates the principle of price stability over effectiveness.

For example, the authors stress the difficulty of setting the initial emissions limits right — particularly, that a limit that’s too high or low may send inconsistent price signals at the outset of the program. That’s fair enough, I suppose.

But how is that any more worrisome than a system that sends consistent price signals, if it turns out later that those price signals were too low to be effective?

I’m willing to be proven wrong here. But in my view, if we use carbon taxes as the only pricing mechanism to slow global warming, we may never get the emissions reductions we need. And by the time we figure out that any particular level of carbon tax is just too low to be effective — and to generate the political will needed to adjust the tax rate upwards — North Americans may have emitted literally billions of tons of additional CO2.

I, for one, would be willing to accept a little bit of price fluctuation to prevent that from happening.

Clark also gets it that a cap-and-trade system that allocates permits based on past emissions is a really bad idea:

Important Lesson on Cap & Trade  


From an awesomely meaty article on cap and trade from the San Francisco Chronicle, comes this pearl of wisdom (in bold at the bottom of the quote):

The thorniest issue for regulators in California and elsewhere is whether to give away credits to emit carbon dioxide or to sell them. Some European power producers reaped windfall profits when allowances were given away. Several Northeast states are now moving toward auctioning all the allowances. California officials are considering a mix of auction and allocation – and even carbon taxes or fees – and may use different approaches for different groups of emitters.

[Resources for the Future economist Dallas] Burtraw, who serves on a committee that’s advising California regulators, said the lesson of the acid rain program is to keep the plan simple and easy for all parties to understand.

“If it starts to employ a lot of special provisions to take care of every party’s special needs … and if it starts to look like the Chicago phone book, then throw it out,” he said. “A poorly designed market is worse than no market at all.

I’m not sure I’d go quite that far — a carbon market’s a pretty important thing, and I’d be willing to live with a less-than-perfect system if it’s the only one that’s politically feasible.

That said — Amen to the virtues of simplicity!  In my view, politicians designing a cap and trade program should be extremely wary of special-interest loopholes, or a system that caters to any particular category of fossil fuel users.  Over the long term, the political drawbacks of a clunky, unworkable program will far exceed any short-term benefits from handing out goodies to favored constituencies.

Take, for example, the idea of “grandfathering” the right to pollute — a process that would hand out future emissions rights based on past pollution levels.

As we’ve noted before, grandfathering raises all sorts of equity and fairness issues. But grandfathering is also terrifyingly complicated — which, in my view, is reason enough all by itself to avoid it.

To make grandfathering work in an economy-wide cap, the government will have to require firms to provide evidence of their past emissions — which would be a data-intensive morass for lots of companies. Plus, there will have to be some sort of system to give extra credit to firms that took steps years ago to reduce their emission, so that they won’t be penalized compared with their more slow-moving competitors.

On top of that, there will have to be some sort of process to reduce the pollution allotments to companies that aren’t doing so well for other reasons.  A company with a failing business model & plummeting sales may see its emissions fall, but only because it’s losing business to competitors. There’s simply no reason to grant emissions rights to a failing business — so calculations of profitability, productivity and output may need to enter into any grandfathering system.

And remember, the stakes involved are huge!!! Once we create a carbon market, emissions rights will be worth money — so pollution allotments could make or break a company’s bottom line.  And to raise the stakes even higher:  since the supply of emissions allowances will be fixed, any credits that a firm doesn’t get for itself could, in theory, go to their competitors.  A company that fails to fight for its fair share will let its competitors gain an edge.  (Time to lawyer up, CEOs!)

So to me, “grandfathering” is synonymous with “endless lawsuits.” And it won’t serve anyone’s interests to create a emissions framework that virtually guarantees decades of legal wrangling over minutiae.

More generally, any cap-and-trade system that directly regulates lots of small- to mid-sized businesses is going to create all sorts of administrative hassles; yet a system that exempts emissions from such businesses just won’t be effective at reaching emissions targets.

Simplicity is one of the key reasons we’ve been supportive of upstream regulation, with full auctioning of emissions permits. An upstream auction would reduce administrative hassles for downstream businesses, limit loopholes, reduce complexity — and almost certainly prevent lots and lots of litigation.


One comment

  • An upstream auction is much closer to the gold standard of carbon pricing — a carbon tax. An upstream auction does not eliminate the need to create the infrastructure for a marketplace and it does not necessarily eliminate the issue of credits for early action. Since allowances are capped, cap and auction is likely to lead to volatile prices as weather and economic conditions affect the demand for allowances. Businesses will be far more likely to make investments in energy efficiency and in generation facilities using less carbon-intensive fuels if they were instead confronting the certainty of a steadily increasing carbon tax.

    Simplicity is certainly a positive attribute, but it leads to a carbon tax as opposed to cap and auction.

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