Tradable emissions permits are a popular, but inferior, way to tackle global warming

The Economist, June 14, 2007

The pressure for political action on climate change has never looked stronger. Even George Bush has now joined the leaders of other rich countries in their quest to negotiate a successor regime to the Kyoto protocol, the treaty on curbing greenhouse gases that expires in 2012.

Too bad, then, that politicians seem set on a second-best route to a greener world. That is the path of cap-and-trade, where the quantity of emissions is limited (the cap) and the right to emit is distributed through a system of tradable permits. The original Kyoto treaty set up such a mechanism and its signatories are keen to expand it. The main market-based alternativea carbon taxhas virtually no political support.

A pity, because most economists agree that carbon taxes are a better way to reduce greenhouse gases than cap-and-trade schemes. That is because taxes deal more efficiently than do permits with the uncertainty surrounding carbon control. In the neat world of economic theory, carbon reduction makes sense until the marginal cost of cutting carbon emissions is equal to the marginal benefit of cutting carbon emissions. If policymakers knew the exact shape of these cost and benefit curves, it would matter little whether they reached this optimal level by targeting the quantity of emissions (through a cap) or setting the price (through a tax).

But in the real world, politicians are fumbling in the dark. And that fumbling favours a tax. If policymakers set a carbon tax too low, too much carbon will be emitted. But since the environmental effect of greenhouse gases builds up over time, a temporary excess will make little difference to the overall path of global warming. Before much damage is done to the environment, the carbon tax can be raised.

Misjudging the number of permits, in contrast, could send permit prices either skywards or through the floor, with immediate, and costly, economic consequences. Worse, a fixed allotment of permits makes no adjustment for the business cycle (firms produce and pollute less during a recession).

Cap-and-trade schemes cause unnecessary economic damage because the price of permits can be volatile. Both big cap-and-trade schemes in existence todayEurope's Emissions-Trading Scheme for carbon and America's market for trading sulphur-dioxide permits (to reduce acid rain) suggest this volatility can be acute. America has had tradable permits for SO₂ since the mid-1990s. Their price has varied, on average, by more than 40% a year. Given carbon's importance in the economy, similar fluctuations could significantly affect everything from inflation to consumer spending. Extreme price volatility might also deter people from investing in green technology.

Even without the volatility, some economists reckon that a cap-and-trade system produces fewer incentives than a carbon tax for climate-friendly innovation. A tax provides a clear price floor for carbon and hence a minimum return for any innovation. Under a cap-and-trade system, in contrast, an invention that reduced the cost of cutting carbon emissions could itself push down the price of permits, reducing investors' returns.

To avoid these pitfalls, some cap-and-trade advocates want to set price floors and ceilings within carbon-trading systems. One of the most prominent bills in America's Congress, for instance, includes a safety valve. If the price of carbon rises beyond a threshold, the government will allocate an unlimited supply of permits at that price. Such reforms, in effect, make a cap-and-trade system work more like a carbon tax.

A third advantage of carbon taxes is that they raise revenue. Governments can use this cash to reduce other inefficient taxes, thereby cutting the economic costs of carbon abatement. Or they can use the money to compensate those, such as the poor, who are hit disproportionately hard by higher fuel costs.

The great green giveaway

Cap-and-trade schemes, in contrast, have traditionally given away permits, which leaves no room to reduce the economic costs of climate control by cutting taxes elsewhere. But here, too, change may be afoot. To mimic the advantage of a carbon tax, many cap-and-trade fans now want governments to auction at least a share of the permits.

All of which raises an important question. If cap-and-trade schemes are to be reformed so that they look more like carbon taxes, why are politicians so reluctant to impose carbon taxes in the first place? One reason is that their environmental benefits are harder to explain. It is intuitively easier to grasp how a carbon cap will slow global warming. Taxes are also more prone to ideological caricature, particularly in America, where many conservatives argue instinctively that all taxes are bad. Too many politicians pretend that carbon taxes will hurt consumers more than a cap-and-trade scheme, even though the cost of carbon permits will be passed on to consumers just as quickly as a tax.

But the biggest problem, at least politically, is that carbon taxes are transparent and simple, whereas cap-and-trade systems are complicated and conveniently opaque. Under a cap-and-trade scheme, governments can pay off politically powerful polluters (such as the coal industry) by giving them permits. Even more important, rich countries can pay poorer ones to cut their emissions without any cash changing hands between governments. Under a carbon tax such transfers must go through the government's budget. And that can be politically tricky. However sensible it sounds to an economist, American voters may be loth to see their tax dollars funding fat cheques for China. Add in these political arguments and the choice between a carbon tax and cap-and-trade becomes less obvious. Politicians are heading down the second-best path to combat climate change, but it may be the only one that leads anywhere.

(c ) 2007 The Economist Newspaper and The Economist Group. All rights reserved.