Friday, 8 January 2010

Carbon Taxes vs. Cap-and-Trade

In 2009, the promise of serious climate change legislation in the United States and the scheduled UN Climate Change summit in Copenhagen helped to focus attention on the tools governments can bring to bear to reduce greenhouse gas emissions. We've talked in the past about the potential for massive government subsidies to bring about a rapid transition to a lower-carbon economy. But with coffers emptied by bank bail-outs, few Western governments seem serious about this approach.

Instead, there has been a marked increase in discussion about the merits of cap-and-trade mechanisms versus carbon taxes. (See this post for a discussion of how cap-and-trade works). To be more accurate, there have been a lot of comments on blogs, news sites and NGO websites arguing that carbon taxes are a superior solution compared to setting a cap and letting polluters trade amongst themselves.

One argument claims that cap-and-trade will not lead to actual emission reductions. Another is that cap-and-trade has been subject to manipulation and lobbying by special interests that weaken its effectiveness. Yet another is thatinvestment bankers and speculators will use a cap-and-trade system to reap vast profits. A tax on carbon - preferably at the well-head, mine mouth or port would in theory avoid this turn of events.

My considered view is that these arguments are misinformed, at best. First, the theory.

Economists use a demand curve to illustrate the relationship between the price of a product and the quantity of that product customers are willing to purchase. An idealised demand curve might look like the figure below:

There is a finite pool of carbon that can be released into the atmosphere without triggering potentially catastrophic global impacts. However, the cost of emitting greenhouse gas emissions has historically been borne by society as a whole, not by polluters. Polluters, faced with a low or zero carbon cost, have been consuming far too much of the total allowance (Q1 on the illustrative demand curve).

There are two ways in which we can force polluters to move up this demand curve and reduce their consumption.

A cap sets a limit on the quantity of carbon (Q2) and watches the price rise to the appropriate point on the curve (P2) as polluters invest in emissions reduction technology and buy or sell their allowances. A tax, on the other hand sets the price (P2) and watches demand shift in response as polluters make investments to lower their tax bill. In theory, both achieve exactly the same result. So much for the first argument - in theory, a carbon tax and a carbon cap can achieve exactly the same emission reductions at exactly the same cost.

But what is the reality?

As America's attempts to pass climate change legislation illustrate, the theoretically elegant cap-and-trade model is unlikely to make it unscathed through the meat-grinder of special interest politics. No politician, after all, wants to alienate potential voters or donors. The House and Senate climate change bills have introduced a bevy of set-asides, subsidies, free allowances, and other measures to ease the sting that would be felt by politically influential constituencies.

Do these concessions make the resulting cap and trade legislation less effective?

Yes, but the legislation is still projected to drive significant emission reductions, and without some concessions to special interests, it is unlikely the legislation would pass at all. The same holds true in Europe. The first phase of the EU ETS gave away allowances for free and make a number of other concessions in order to ease passage. In both the EU and the US, the aim is to gradually tighten the provisions over time and close loopholes in order to drive greater emission reductions.

Would a carbon tax be preferable, as some critics of cap and trade argue? With a carbon tax, there are no allowances to give away for free, and you don't have commodities brokers making money trading carbon credits.

So is it better? France provides a useful case study, as the government there announced a carbon tax just last autumn.

Within weeks of the initial announcement a French magistrate struck down the plans. It seems the legislation exempted companies covered under the EU Emission Trading Scheme despite the fact that they are responsible for the lion's share of the country's emissions, and their EU allowances had been given away for free. In addition, other sectors, like transport, received subsidies or rebates that reduced the impact of the tax.

What is more, a report comissioned by the government recommended that the carbon tax be set at €32 per tonne CO2 equivalent in order to drive significant reductions, and increasing to €100 per tonne by 2030. The French government, however, decided to reduce the tax rate to €17 to make it more palatable politically. Faced with a setback in the courts, the French are already at work to close some of these loopholes. It is a safe bet, however, that the government will continue to make concessions to special interests.

There's another challenge with carbon taxes. As impossible as it may seen in the wake of a rancourous Copenhangen conference, using carbon taxes instead of national caps makes it more difficult to secure international consensus on climate change policy.

The main reason is that nations will disagree on the appropriate carbon tax rate to achieve their individual reduction targets. Imagine if instead of pledging to achieve a reduction target, each country pledged to impose a domestic carbon tax. The U.S. might argue that India's carbon tax is set too low to drive a low-carbon shift, while the Japanese might not believe, for example, that the Australia will keep its promise to raise carbon tax rates during an economic downturn. The EU, meanwhile, might argue that China is keeping its carbon tax rate low to benefit local industry, and impose a punitive import duty to reflect what it feels is a more accurate price for Chinese carbon in products.

As for bankers and speculators profiting from climate change legislation, someone is going to have to lend companies the money to invest in all the new technology that will lower their carbon tax bill. It is not a tremendous stretch to imagine those loans collateralised against the anticipated future tax savings, and then securitised and sold off to third parties.

It appears, then, that the critics are right. A theoretical carbon tax is indeed superior to a (real world) cap and trade system that has loopholes for special interests. In fact, a theoretical tax is perfect, except for one problem - it has to work in the real world. It is not clear that a real-world carbon tax would offer much improvement.

Scrapping all the work done to date on making cap and trade effective would, at best, delay progress and result in an equally compromise-riddled carbon tax. At worst, it could embolden opponents of rapid action to fight climate change, and cause governments to abandon both approaches in favour of much less effective piecemeal efforts.

We can't afford to make the perfect the enemy of the good.

(Carbon Clear Website)