A Magical Self-Adjusting Carbon Tax?

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One of the problems with carbon taxes is that they’re static. Let’s say you set a tax at $20 per ton of CO-2. It’s going to stay at $20 when the economy is hot, even if the tax rate doesn’t do much to reduce emissions. Conversely, when the economy goes south, the carbon tax will persist at $20, even though emissions may be dropping fast on their own — and companies may need some breathing room.

The first scenario is bad for the climate. The second scenario is bad for the economy.

If only there were a way for carbon pricing to respond to changing economic conditions in real time without any intervention from policymakers. If only. That would be like magic.

But I have good news for you: magic exists! There is such a thing as a magical self-adjusting carbon tax. It tracks economic conditions precisely and it always ensures the right amount of reductions. It’s called “cap and trade.”

This isn’t just a theoretical point. The New York Times recently reported that carbon prices have been tumbling during the economic downturn. For some reason, commentators keep treating this as a bad thing. But it’s not. It’s a very good thing. It’s evidence that cap and trade systems are responding dynamically, exactly as they are supposed to.

A carbon allowance in the European ETS system is now selling for less than 12 euros. It’s shed about half its value over the last few months, which is precisely what we would hope for. The reason the price has fallen is because the demand for carbon emissions has also fallen preciptiously as manufacturers and others scale back to meet the recession-era realities of the marketplace.

Similary, allowances in the RGGI system in the northeast US are going for well under $4. RGGI hasn’t been around long enough for us to observe a long-term trend, but the low price of RGGI carbon likely owes a good deal to the reduced demand for electricity-sector carbon. Some of that demand reduction was due to generators taking early action before the cap took effect, but some is almost certainly due to the deteriorating economy.

When the economy is on the ropes, it’s wise to reduce the price of carbon — and as long as the price is tethered to a firm cap, there’s no environmental downside.

But there may be a potential downside to keeping the price fixed, as a tax would. During a recession, it might be hard for policymakers to justify continuing a carbon tax on struggling firms. It’s not hard to imagine a tax being stricken from the books. A cap and trade system, by contrast, is probably less vulnerable to political gaming, if only because carbon prices will mirror the economic reality.

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Update, 3:50: As commenter Barry rightly notes below, there are pros and cons to both carbon taxes and cap & trade. With this post, I was just trying to point out one commonly overlooked “pro” for cap & trade.

In the holy war that’s raging between the two carbon pricing camps, Sightline can fairly be described as something of a Carbon Unitarian. We prefer cap & trade, but we also believe there are merits to carbon taxes. In fact, we’ve spilled a lot of positive cyber-ink on carbon taxes. See here, for example.