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  • Published: Jan 31st, 2009
  • Category: Global
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Carbon tax vs. cap-and-trade

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Standards-based regulations and public investment are superior to either carbon taxes or cap-and-trade. But we need some form of carbon pricing to reinforce public action, and a carbon tax is superior to carbon trading.

The main policy advantage cap-and-traders offer over a carbon tax is certainty. They claim that it is better to fix the ceiling on emissions and let the price vary than to fix the price and hope it produces the reduction you want. However, most cap-and-trade advocates favor an escape clause, a price ceiling which would trigger the issue of more permits, either because they see it as the price you have to pay to get a bill through, or because they honestly favor the policy. In either case, once you have an escape clause, you no longer have the certainty advocates tout so highly.

What, you think you can set the ceiling high enough that the permit price will never reach it? Then you think we can guess pretty well what carbon price will produce what reduction, but a carbon tax could be set at the same level. So when David Roberts talks of “minimizing the use of offsets and off-ramps” he implicitly acknowledges that the main policy advantages claimed by trading advocates have to be traded away to get an actual bill passed. Later in this post I will describe why those advantages are imaginary to begin with. But even if they exist, they seem to be the first policy items to go in any actual cap-and-trade bill likely to pass.

Giving up the cap also gives up the biggest political advantage. Because an auctioned permit bill with a price ceiling that undermines any nominal cap is just a highly inefficient carbon tax with an unpredictable price. The political advantage no longer comes from not being a carbon tax, but from not being called a carbon tax. And an efficient carbon tax could do the same thing.

You could take Charles Komanoff’s proposal and rename it a “climate impact fee” — call it “Chicken soup” if that is politically advantageous. Mind you polluters would still complain about it. “I had to pay my quarterly chicken soup last week. Too damn much chicken soup and bureaucracy!” What, you say we could never get away with it? We have the same chance of passing a well designed carbon tax as a “carbon impact fee” as carbon trading advocates have of calling a badly designed carbon tax “cap-and-trade.” Let’s delve further into both policy and politics:

Roberts claims in the same post that “a well-designed C&T system is preferable to a well-designed tax.” With what advantages? Absent the “escape clause” compromise, perhaps he means the certainty. A cap-and-trade provides “certainty” via an automatic escalator. You issue a certain number of permits. Those permits expire. You replace them with fewer permits. The fewer permits expire. Rinse, lather, repeat until you are down to zero or nearly zero permits. The key for this to work: don’t negotiate the permits each time. When you first pass the law, include a schedule of emission cuts so that attempts to push for additional permits will have to repeal or modify the existing law rather than stymie negotiations for the next phase.

How can a tax provide the same emissions certainty? Pass a law setting an emissions reduction schedule with an escalating emissions tax intended to produce reductions on that schedule. Include a formula that recalculates the rate-of-increase if emissions do not drop to or below target. A bit complicated?

Permit auctioning has its own problems that add complexity: volatility. Trading is simply another form of carbon pricing. Yes the nominal driver is the cap. But from the point of businesses and consumers, what drives their behavior is how much it costs to buy a permit. Just as a carbon tax can be set too low, even a carbon cap whose ultimate target is stringent can be set too low. And, as happened with RECLAIM, too low an initial cap results in too low an initial price. Too low an initial price means that when caps ultimately tighten, the needed investments will not have been made, and so the cap won’t be complied with. Ultimately in the RECLAIM case, new schedules were set. Command-and-control standards were put in place. And emissions reductions fell behind schedule just as they can with a carbon tax. The early, excessively low prices led to excessively high prices later, and non-compliance.

Now there are ways to prevent volatility in cap-and-trade. Put on a minimum price as close to what you expect the ultimate clearing price to be as you can calculate for the number of permits you intend to sell. Note that this is exactly the calculation made for a carbon tax

There are other problems with cap-and-trade. One is the “trade” part. That is not “trade” as in “omygod someone is buying a permit.” But “trade” as in the permit passes through the hands of five carbon traders before it reaches the hands of the polluter, and derivative traders and hedge fund managers leverage carbon permits at ratios of 30 to 1. If emission permits end up controlled by the same people who created our current crash, than this is a problem. One problem with duplicating things of real value by means of a wilderness of mirrors is that the real things can lose value alongside the phantoms when the impostor is detected. In the meantime the real things will share the natural volatility of the counterfeits. More fundamentally, even if the same exact same infringements that led to the current depression are not repeated, this rule still applies: get into bed with financial industry, and wake up a eunuch.

If nothing else, creating a carbon trading sector creates an entire subset of the financial sector opposed to fast emissions reductions. First, past a certain point a successful emissions reduction policy will reduce volume faster than prices increase. Secondly, even if values hold constant (and values holding constant will be a sign of failure) all things being equal, traders like volume. More volume equals more trading opportunities. One-thousand shares worth $100 a piece will (on average) generate more trades than 100 shares worth $1,000 a piece. For that matter, more volume tends to generate more total value. (Consider stock splits. What advantage do they have other than if you take 1,000 shares worth $100 a piece and split then into 2,000 shares worth $50 a piece, you can count on them rising to $75 a piece pretty quickly? ) We have enough problems with our current carbon lobby. We don’t need to grow our own problems as well.

Now there are ways to minimize this. Start by selling permits as far upstream as possible (something we should do with a carbon tax as well). Make it easy to bypass traders by auctioning most permits quarterly and the remainder (one-fifth or less) daily on the Internet. Put a 0.25 percent tax on each resale of a carbon permit to discourage constant trading of the same permit. Put in place a rule which forbids resale of instruments derived from a permit — you could loan money on a permit, or buy an option on it. But then you have to collect the loan, and you have to choose to exercise or not the option. You cannot term and resell them and turn them into financial instruments.

Now if you do all this you may indeed have something superior to a carbon tax because you have both the certainty a cap provides and the lower volatility of a carbon tax. But you no longer have a simple cap-and-trade proposal. You have a hybrid system with features of both, hung with more restraints than Rhianna in the “Disturbia” video. And it is true that an absolutely perfect cap-and-tax proposal is superior to either a carbon tax or a cap-and-trade alone.

But you are not likely to get a perfect system. The best you can hope for is a good system, or maybe a mediocre system.

A good cap-and-trade will have 100 percent auctioning of permits — no offsets, no escape clause, expiration dates for permits, and maybe a very low floor. It may auction quarterly, but is unlikely to have restrictions on resale. That means you end up with a lot of volatility and a large carbon trading sector that will join the carbon lobby to try and weaken the first iteration of cap tightening. A good carbon tax will have both scheduled escalation and special escalation when emissions drop more slowly than intended.

A mediocre cap-and-trade will auction 80 percent or more of permits, allow few offsets, and have lengthy or zero expiration dates for permits. Banking will reduce volatility a little, but at the expense of keeping prices lower on average. Offsets and grandfathered permits will increase volatility much more than banking will reduce it. And the imaginary reductions produced by offsets will both lower permit prices and real emissions reductions. A mediocre carbon tax will only have scheduled escalation, and it will require legislative intervention to raise carbon prices more than that.

So while a perfect cap-and-tax system is better than either cap-and-trade or carbon tax alone, a decent carbon tax is simpler and more workable than a decent cap-and-trade. A mediocre carbon tax is definitely preferable to a mediocre cap-and-trade.

A lot of people think we won’t get any kind of carbon price this year. Maybe what we should focus on in 2009 is really pushing for green infrastructure, paid for the moment by 10-year bonds with a 3 percent interest rate. As I said at the beginning of this post, public investment and regulation are more important anyway.

Carbon taxes have worked reasonably well in the Scandinavian countries. Sweden, for example, repealed one-half of its general tax and replaced the lost revenue with a tax on carbon. CO2 emissions have gone down there, and renewables are up.

Swedes, et. al. have enjoyed greatest success with “feebates” in which relatively high polluters pay into a fund that sends the money to relatively low polluters. Was a tremendous success with sulfur in vehicle fuels and industrial NOx emissions. The key is that such a system must be completely revenue neutral, with the government keep none of the money. Used in the context of global warming, dirty coal-fired powerplants would start paying money in, while cleaner ways of generating electricity–not just wind and solar, but higher efficiency coal technologies like IGCC and PFBC–would get money back.

In terms of non-CO2 causes of global warming, old fashioned command and control is the best, as the Californians are demonstrating with their increasingly stringent diesel soot and NOx standards. There is no reason, for example, why SF-6 in excess of the minimum technologically required amount should not simply be banned. Existing stocks should be removed and destroyed.

Similarly, Europeans are banning -134a as a refrigerant in motor vehicles starting with model year 2011. The U.S., or acting individually, states could do the same. The Montreal Protocol is non-preemptive, and since -134a is neither a fuel nor a defined pollutant, the Clean Air Act is non-preemptive as well.

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One Response to “Carbon tax vs. cap-and-trade”

  1. Michael F. Keller
    on Feb 2nd, 2009
    @ 1:40 pm

    Perhaps using the Regional Transmission Operators (RTO) could work, as they already administer power sales transactions. The general concept:

    A fee is deducted by the RTO from payments made to generators with excessive CO2 emissions, with the fee based on a sliding scale of CO2 versus a unit of energy, e.g. one kilowatt-hour. The fee money would be placed in a pool. Conversely, cleaner generators receive a sliding scale payment from the pool; the cleaner the generation, the higher the payment for a unit of energy.

    Currently, in the power markets the most polluting generators make the highest profits because they invariably have the lowest cost of production.

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