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Carbon taxes or cap-&-trade?

I have not regarded the issue of choosing between a ‘cap-and-trade’ scheme and a ‘carbon tax’ for managing carbon emissions as one of first-order importance.   Under certain conditions setting carbon quotas and auctioning them off at some equilibrium price has exactly the same effect as setting a tax on carbon equal to the equilibrium price. It results in the same emissions costs and the same transfer of revenue to the government.   

This work has been translated into a set of studies that compare carbon taxes with carbon quotas – a seminal early study is due to Parry, Williams and Goulder.

In international trade theory the result amounts to claiming the equivalence of a tariff and quotas in restricting international transactions – in fact a vast literature has developed showing when in fact this equivalence breaks down.  The main issue in the trade literature seems to be how the respective systems perform when demand changes.

Increasingly however the debate is hotting up on the issue. A survey is here and Joshua Gans discusses what seems to be a derived report for CEDA. European arguments are summarised here. Robert Shapiro of the Climate Task Force provides arguments favouring a tax (here and here).  Both articles are reprinted in today’s AFR page 56 (subscription required).

The Shapiro piece interested me particularly.  

One argument for a tax is that horse-trading for free-entitlements under the Waxman-Markey bill has weakened the cap on emissions.  This horse-trading Shapiro argues was an endogenous consequence of the scheme’s complexity.  Taxes are a more transparent instrument making it harder for sweetheart deals with polluters to be made.

Taxes can also be matched by transparent cuts in payroll tax or by lump-sum handouts to households.  Revenues yielded by auctioned permits can do the same thing provided that horse trading does not eliminate most of the revenue gains through the distribution of free permits. In contrast a revenue neutral carbon tax looks appealing.

In addition the equilibrium price of carbon under an emissions trading scheme depends on unstable world energy markets.  The macroeconomic destabilisation effects of volatile of energy prices would thus be compounded by the effects of volatile carbon prices.  In the European Trading System’s first 3 years priced moved up and down by an average of 20% per month.

In a globalised cap-and-trade system the instability would be amplified.

The alternative argument – put by John Quiggin – is that the instability of carbon prices can operate as an automatic stabiliser of the economy.

At the international level cap-and-trade can be criticised because it creates the potential for horse-trading among countries.  The Kyoto Protocol for example exempted all developing countries from the need to mitigate and hence, Shapiro claims, was ineffective in cutting global emissions.  I’d question this argument – there are sound reasons for exempting a country like India from emission cutback requirements given that its energy consumption is 1/21st that of the US.

From a microeconomic perspective ‘real option pricing’ literature suggests that firms would additionally have difficulty making long-term conservation investments given this volatility.  In the face of such price uncertainty it would pay to be conservative in making irreversible sunk investments.  A fixed carbon price time path would remove this difficulty.

This last advantage is tempered by Shapiro’s acknowledgement that fixed carbon taxes might need to be adjusted from time-to-time, for example to meet unexpected changes in energy demands.

Tradeable emission permits will become a huge market – a trillion dollars or so in new financial instruments.  Given the attendant price instability this market would encourage speculation and would be vulnerable to insider trading and manipulation by large utilities and energy producers who will be the first to notice shifts in demand.

At the global level cap and trade may not be acceptable because, Shapiro argues, different countries have different emission goals.  Developing countries were exempted under Kyoto which led to the non-ratification of this agreement by the US and Australia.  Maybe developing countries would find a carbon tax more appealing given their needs for the revenue it would provide.

Finally, empirically, Shapiro argues that Europe’s cap-and-trade scheme has been a flop whereas Swedish carbon taxes have worked well.  Since Sweden introduced its taxes in 1990 its emissions have fallen 8% while its economy has grown 48%. The French – among others – are now reconsidering the case for a tax.

My overall assessment of the case for a particular climate change policy format is strongly conditioned by the view that doing something is decidedly better than doing nothing.  I might post again on this issue but my main interest is in which of the choices discussed above makes most sense in terms of the forthcoming negotiations in Copenhagen.  I’ll almost certainly post again on this issue.

8 comments to Carbon taxes or cap-&-trade?

  • Uncle Milton

    A lot of these comparisons compare a theoretical pure tax with an actual bastardised cap and trade system. If we ever tried to implement a carbon tax, I predict a the same special deals, carve outs, exemptions and rebates that we have under the CPRS, or indeed in the income tax system.

    But if we are going to compare the two in theory, the ability to borrow and bank permits in cap and trade must yield some intertemporal efficiencies that are absent with a carbon tax. Or not?

  • hc

    Uncle Milton, Can you more easily bargain for a tax break than for a handout?

    I’d have to think about the capital market issues. My instincts are that the alternatives will have the same implications with a half decent capital market.

  • […] View original post here: Harry Clarke » Carbon taxes or cap-&-trade? […]

  • The countries in Europe that have carbon taxes, or are considering carbon taxes, including Sweden, Norway, the Netherlands and France, are also covered by the EU ETS. So they have both a carbon tax and a cap and trade system. Having both is equivalent to having a cap and trade system with a price floor. I expect that a growing number of countries will go down the route of having hybrids between an ETS and a carbon tax.

  • hc

    Peter, Isn’t that better thought of as McKibben style cap-and-trade scheme with a ceiling carbon price.

  • CTF

    While I applaud all efforts to address global climate change, I’m with Shapiro–the cap-and-trade system outlined in Waxman-Markey cannot both mitigate carbon emissions and protect the economy at the same time.

  • Peter Wood & hc (not to mention JQ) – you always manage to get it wrong. The underlying principle of the EU’s ETS as of now is that it only “taxes” emissions above the permitted ceiling. That is because Europeans dimly remember the principles of marginalist economics, long forgotten in Australia since W.S. Jevons left these shores c 1865. Instead we have the lugubrious Garnaut still rabitting on (last Monday at ANU) about auctioning permits for firms’ TOTAL emissions (both above and below the target level), with the resulting enormous proceeds creating a gigantic slush fund that he had hoped to administer (through his eponymous Garnaut Bank, util pre-empted by the wondrous Penny Wong).

    Because native Australian economists do not understand marginal economics, let me try to explain.

    If you want to reduce emissions of a harmless trace gas like CO2(the basis of ALL life on this planet), then it is SUFFICIENT to tax (via an ETS auction) ONLY all emissions above the current targetted level (5% below 2000 by 2020.

    But Garnaut was driven by his ambition to be CEO of the Garnaut Bank collecting auctioned permits for 100% of ALL emissions, even those within the 95% or 80% target level, until Penny W outsmarted him by realising she would control the mother of all slush funds by taking over his 100% auctions.

    Naturally all native Australian economists, few of whom have ever heard of Jevons of the Sydney Mint c 1860, like Quiggin and Harry Clarke, cannot grasp that it makes no sense – if your aim is to cut emissions rather than raise a huge slush fund – to tax total emissions rather than MARGINAL emissions (i.e above the prescribed ceiling, al la Jevons).

    To spell it out for people like Peter J. Wood and the handful of others who visit this Blog, the Garnaut-Wong ETS is tantamount to requiring us all to buy permits even to begin to move our cars, however big or small, from our garages, instead of as now having to buy permits (i.e. pay fines) only when we exceed the permitted speed (emissions) limit (as in the EU).

    Such is the deplorable level of economics education engendered by the likes of the Garnauts, Quiggins, and Clarkes of this country.

  • hc

    I’ve had enough Tim. No more silly comments on climate change posts.

    This is a really silly comment. You tax externalities to get to the optimal level of pollution. You don’t only tax emissions above the optimal level unless you can enforce an infinite tax or ban. Then it becomes a regulation with well known inefficiencies. The remark is just plain bloody silly and shows that yuou don’t understand the sort of economics taught in undergraduate environmental economics units.

    Your comments also has a rudeness that I cannot be bothered putting up with.

    You are on permanent moderation and I will delete stuff that endlessly repeats your well-understood positions on climate.

    Its boring and has a fanatical edge that I don’t want on my blog.

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