Cap & Trade v. Carbon Taxes

There’s a sort of epic environmentalist civil war that’s arisen over the past few days, ignited by a column by climate scientist James Hansen in which he skewers the House cap-and-trade bill:

Because cap and trade is enforced through the selling and trading of permits, it actually perpetuates the pollution it is supposed to eliminate. If every polluter’s emissions fell below the incrementally lowered cap, then the price of pollution credits would collapse and the economic rationale to keep reducing pollution would disappear. [Emphasis mine]

Worse yet, polluters’ lobbyists ensured that the clean air amendments allowed existing power plants to be “grandfathered,” avoiding many pollution regulations. These old plants would soon be retired anyway, the utilities claimed. That’s hardly been the case: Two-thirds of today’s coal-fired power plants were constructed before 1975…

To compound matters, the Congressional carbon cap would also encourage “offsets” — alternatives to emission reductions, like planting trees on degraded land or avoiding deforestation in Brazil. Caps would be raised by the offset amount, even if such offsets are imaginary or unverifiable. Stopping deforestation in one area does not reduce demand for lumber or food-growing land, so deforestation simply moves elsewhere.

Let me get this out of the way first: I’m completely baffled by the italicized paragraph. If everyone pollutes below the cap, that’s an indication of the success — nay, the monumental success — of cap-and-trade. Now, an unaggressive cap may be insufficient to curb emissions significantly, but that’s a problem with the cap, not the system itself. Beyond that, there’s always an economic rationale to stay below the cap: the monetary penalty if you get caught above it without a permit. Indeed, the penalty is the only reason firms have an incentive to go along with carbon trading in the first place.

Hansen makes more valid points in the next two paragraphs. There’s little question that the House bill is far from a “pure” cap-and-trade regime that applies equally to everyone. It’s cholk-full of delays, exceptions, and loop holes. The “offset” issue alone knocks a significant number of the bill’s teeth out. Hansen suggests instead a “tax-and-dividend” approach, which assumes that the government is better at taxing than at setting up markets. I probably agree, but one need only look at our income tax system to realize that even if a carbon tax weren’t DOA when it got to Congress, it would never leave Congress without being muddied up in much the same manner as, if not the degree to which, cap-and-trade has.

Meanwhile, Paul Krugman goes on the war path:

What the basic economic analysis says is that an emissions tax of the form Hansen wants and a system of tradable emission permits, aka cap and trade, are essentially equivalent in their effects… A tax puts a price on emissions, leading to less pollution. Cap and trade puts a quantitative limit on emissions, but from the point of view of any individual, emitting requires that you buy more permits (or forgo the sale of permits, if you have an excess), so the incentives are the same as if you faced a tax. Contrary to what Hansen seems to believe, the incentives for individual action to reduce emissions are the same under the two systems.

This is true even if some emitters are “grandfathered” with free allocations of permits, as will surely be the case. They still have an incentive to cut their emissions, so that they can sell their excess permits to others.

The only difference is the nature of uncertainty over the aggregate outcome. If you use a tax, you know what the price of emissions will be, but you don’t know the quantity of emissions; if you use a cap, you know the quantity but not the price. Yes, this means that if some people do more than expected to reduce emissions, they’ll just free up permits for others — which worries Hansen. But it also means that if some people do less to reduce emissions than expected, someone else will have to make up the shortfall. It’s symmetric; there’s no reason to emphasize only one side of the story. [Emphasis mine]

The italicized paragraph is the best layman’s summary I’ve read of the differences between a “pure” cap-and-trade system and a “pure” carbon tax: there is none. Given the same level of pollution, the public raises the same amount of funds from a tax or a permit auction. They are completely, entirely, and absolutely equivalent… in theory. Therein lies the rub, however. We’re not operating in a theoretical world here. We’re operating in a political world where any proposal before Congress is going to be influenced and exploited by interest groups and rent seekers. That changes the equation quite a bit. Take this sentence from Krugman’s post:

This is true even if some emitters are “grandfathered” with free allocations of permits, as will surely be the case. They still have an incentive to cut their emissions, so that they can sell their excess permits to others.

Krugman’s right that the incentives are the same even when you give away permits, but you cannot both give away permits and claim that cap-and-trade is equivalent to a carbon tax. Pollution permits have intrinsic value, so “grandfathering” in firms rather than auctioning off permits is no different from corporate welfare, a give-away that would have gone to the public instead under a carbon tax. Now, Krugman may believe that a carbon tax would also be susceptible to loopholes added in the legislative process, but he doesn’t argue this, and again, perhaps I’m naive, but I tend to believe that the less complex the legislation is, the less opportunity there is to hide exceptions and loopholes. Unless someone corrects me, I know of no one arguing that a cap-and-trade regime would be legally less-complex than a straight carbon tax.

The one sticking point for me on the carbon tax is implementation. We’re not trying to raise revenue here, we’re trying to limit emissions. The beauty of cap-and-trade, as Krugman explains, is that the government can determine the sustainable CO2e level, allocate that amount of permits, and then let the market set the corresponding price level. The risk is that the price will be significantly higher than you expected, but at least you’ve achieved your emissions goal in a straight-forward manner. With a carbon tax, you have to play around with the price level year after year until you find the “right” one. It’s an approach that requires a frequency of change for which I don’t think Congress has the stomach, and so in reality I’d be afraid that the U.S. would be stuck with a sub-optimal carbon tax rate. Still, maybe that’s better than a cap-and-trade regime so burdened with “offsets” that it’s all but useless.