Carbon Tax Vs. Cap-and-trade, Again

Michael Giberson

The U.S. Climate Action Partnership report, mentioned by Lynne last Friday,  has stimulated a spate of new newspaper stories comparing cap-and-trade and carbon taxes as ways to regulated greenhouse gases.  A story by Tom Fowler in the Houston Chronicle looks pretty good as an overview of “carbon tax vs. cap-and-trade.”

One thing to notice about some of the points raised on one side of the argument or the other is that they apply pretty strongly to both.  Rice University’s Amy Meyers Jaffe is right to be worried about “aberrations that can be created when you design a market through the political process” – see the initial California ISO power market design for an example – but the carbon tax would similarly be designed and imposed through the political process.  I don’t see much reason to believe that the tax code is less susceptible to lobbying than other parts of the political process.

According to the Chronicle, “many are skeptical that the government would make good use of tax proceeds,” but the same people should also be skeptical that the government would make good use of permit auction proceeds. Similarly, emissions will have to be monitored under both programs, either to ensure sufficient taxes are paid or that sufficient permits are acquired.

S. David Freeman is worried that a permit system would be unpoliceable.  The example quoted refers to offset programs, not the cap-and-trade system itself, and design of offset credits raise separate issues.  Freeman worries about manipulation of a permit market, but I’d say manipulation of a permit market (which would be show up in market prices and be accomplished through registered market participants) is likely to be more transparent than manipulation of the tax code by lobbyists and their Congressional  pals in Washington (which could be snuck into obscure tax code amendments inserted during late-night conference committee mash-ups).

Craig Pirrong is quoted as saying “just like any large commodity market, CO2 prices could be highly volatile.” In a Washington Post story, Rob Shapiro also suggests that cap and trade would introduce “enormous volatility” and would allow “a lot of mechanisms for gaming the system.”   Yes, if badly designed, then a cap-and-trade market could be volatile and susceptible to gaming.  A well-designed CO2 market would not likely pose significant problems on volatility or gaming.

The RGGI market appears reasonably well designed and carefully monitored; if Shapiro knows of ways to game the RGGI design, then why didn’t he raise them during design of that system?  It will be a few years before the RGGI cap begins to bite and the market is really tested, but it looks like a reasonably sound design.

Pirrong is also quoted in the Chronicle saying, “Banks like the volatility and complexity, because the more volatile and complex, the more money they could make.  But volatility may make companies put off investing in cleaner technology because they can’t get an accurate estimate on the costs.”  On the other hand, volatility raises the value of options, which may increase the value of investing in cleaner technology.

Perhaps it bears mentioning that while a carbon tax would vary more or less directly in proportion to macroeconomic activity, a cap-and-trade approach would likely have a modest counter-cyclical effect.  The cap would become less binding during recessions – permit prices would fall – and the cap would become more binding during economic booms.

I may sound like a cap-and-trade advocate, but not really. I don’t have a hard conclusion on whether cap-and-trade or carbon taxes would work best.  But like Rob Stavins, I am opposed “to the confused and misleading straw-man arguments that have sometimes been used against cap-and-trade by carbon-tax proponents.”

Stavins also writes:

Proponents of carbon taxes worry about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax is sensitive to the same political pressures, and may be expected to succumb in ways that are ultimately more harmful:  reducing environmental achievement and driving up costs.

The Hamilton Project staff concluded in an overview paper (which I highly recommend) that a well-designed carbon tax and a well-designed cap-and-trade system would have similar economic effects.  Hence, they said, the two primary questions to use in deciding between them should be:  (1) which is more politically feasible; and (2) which is more likely to be well-designed?

Stavins answers the two questions in favor of cap-and-trade, citing “real world political forces” as the reason to think cap-and-trade would be better designed.  For more by Stavins on the topic, see “A U.S. Cap-and-Trade System to Address Global Climate Change.”

On the carbon tax side of the issue, Greg Mankiw is probably most prominent among economist-advocates.

At Environmental Economics, John Whitehead advises: the “economic case for cap-and-trade (or a carbon tax) is clear.”