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Why cap-and-trade instead of a carbon tax?

Why cap-and-trade instead of a carbon tax?
(Abhishek Uppal)

Some local governments (e.g. Boulder, Colorado, USA; British Columbia, Canada) and early-action countries (Sweden, Finland, and Netherlands in the 1990s) have implemented carbon taxes. Over time, however, a cap-and-trade orientation has begun to dominate policy approaches.

In simple terms, a cap-and-trade sets a target for emissions in a geographic region consistent with a carbon stabilization level (i.e. 450 ppm). The cap is then pushed down to individual industries and companies that are given permits to emit that can be traded. These permits can be auctioned or provided for free. In either case, for markets to function properly, clear rules of private ownership must be established for what was, initially, a public good. Once emissions permits have been allocated, companies can then trade excess or deficits in their permits. The trading system can also include credits from other geographies. There are other important issues, such as sector coverage and banking and borrowing of credits that are important parts of the architecture of cap-and-trade regimes.

While either a tax or a cap-and-trade system can address greenhouse gas reductions, cap-and-trade has a number of advantages. Cap-and-trade drives efficient mitigation by encouraging businesses with inexpensive mitigation opportunities to reduce emissions as much as possible and sell excess credits to businesses with higher marginal mitigation costs. It allows Ricardo’s theory of comparative advantage to work with emissions mitigation. We recognize that markets with public goods are less efficient than standard markets, but believe that the advantages of a market approach outweigh the disadvantages. The result of a carbon market – even one with suboptimal efficiency – is that those who can reduce emissions most efficiently are able to free up resources for those who cannot, and emissions reductions are therefore achieved at the lowest total cost to the economy.

A cap-and-trade system also allows the market to set the appropriate price of carbon, whereas in a tax regime, regulators would need to try to derive that price. The principal disadvantage of cap-and-trade is that price is less certain, and there is potential volatility. Inclusion of flexible mechanisms in a cap-and-trade regime, such as offsets, banking and borrowing, brings measures of stability to the market and mitigates the biggest disadvantage of cap-and-trade. Clear signals from regulators – which are at the origin of demand for carbon credits – can also help to bring long-term stability to the markets. While faith in market mechanisms has been shaken by the credit crisis, and there has been talk that could potentially lead to more focus on a carbon tax rather than a cap-and-trade regime, we believe that the benefits of cap-and-trade outweigh the disadvantages.

While the UNFCCC and Kyoto Protocol do not specify that carbon must be priced, the Kyoto Protocol includes explicit mechanisms to permit emissions trading. Policy options such as the Clean Development Mechanism and Joint Implementation enable international cap-and-trade mitigation at least cost. Through these mechanisms – and the growing European Union Emissions Trading Scheme (EU-ETS) – cap-and-trade is growing in prominence year by year. The International Carbon Action Partnership (ICAP), which shares best practice in carbon trading schemes across borders, and other initiatives are promoting global linkages between and scaling of cap-and-trade regimes. The US is looking at its options for creating a cap-and-trade system through the Liebermann-Warner and the Dingell-Boucher bills, and as well as other proposals before the House and Senate. The importance of a robust global solution continues to grow.

Why carbon pricing isn’t enough at the initial stage.
While in theory, an adequate carbon price should be all that is required to achieve efficient mitigation. In the real economy, this is not always the case.

There are a number of mitigation policy options that are viable at a negative carbon price in 2030 (i.e. they save costs). Many of these opportunities – such as improved insulation – are economic today. In a perfectly efficient market, these mitigation policy options should already be ideally fully utilized and profitable even without a carbon price. While the recent rise in energy prices has led to an increase in uptake of these measures, as reported in The Observer on August 3, 2008, we are far from capturing the total potential savings represented by energy efficiency.
The fact that these methods are still not fully employed demonstrates that, for a variety of reasons (lack of information, short-term up-front costs and other behavioural factors), carbon prices may not be sufficient initially to promote adequate greenhouse gas mitigation in the real world. This leaves a role for energy efficiency standards and some incentives. At the other end of the curve, some technology solutions are currently very expensive and innovation theory suggests they should be incentivized directly.

Carbon pricing is only one part of the solution, and that the regulatory policies used in traditional regulation and innovation policy are both vital tools in the climate change toolkit. Carbon pricing is only one part of a strategy to tackle climate change. It must be complemented by measures to support the development of technologies, and to remove the barriers to behavioural change, particularly around take-up of energy efficiency.

Long-term optimal carbon price
Using carbon prices alone to incentivize the early development of emerging technologies – some of which could require carbon prices of nearly €100/ton to prompt inefficient, as such a high carbon price may put a disproportionate drag on the overall economy. This would also entail enormous transfer payments – potentially larger in scale than those that flow from the OECD to petroleum exporting countries today. The recipients of these payments would benefit from enormous windfall profits at very high carbon prices. And the poor may be hit harder than the rich, as carbon pricing is without compensating transfer, a regressive tax. This is unlikely to be politically or socially acceptable, unless it comes about gradually.

“Optimum” or even “acceptable” long-term carbon prices are therefore likely to be well below €100/ton, although during the process of establishing the trend, they may spike to high levels if the market does not move fast enough towards mitigation. Other regulatory instruments, such as R&D subsidies, can be used to drive innovation of what are currently more expensive opportunities such as CCS; this will allow government to buy promising technologies down the learning curve without subjecting the entire economy to very high carbon prices. The economy-wide costs of the subsidies and incentives associated with such a policy are likely to be much lower than the economic drag associated with a very high carbon price.

Therefore, climate change mitigation policy will need to include two distinct sets of regulation to compliment carbon pricing: Traditional regulation and innovation policy. These policy options will overcome market failures and prevent imposition of an initial carbon price so high that it could have negative consequences for the entire economy.

About the Author

Abhishek Uppal college graduate from Cornell University.

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