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
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
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
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
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.
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
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
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