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WEALTH OF NATIONS
How To Do Cap-And-Trade
There is a way to reap all the benefits of a carbon tax without ever having to call it a carbon tax.
The prospects for legislation to limit emissions of greenhouse gases are still uncertain. The American Clean Energy and Security Act, introduced by Reps. Henry Waxman, D-Calif., and Edward Markey, D-Mass., has encountered not just the expected hostility from House Republicans but doubts among Democrats as well. Changes are likely, and Waxman, chairman of the House Energy and Commerce Committee, moved to delay panel consideration this week. The full House seems certain to pass a version in the end, but its chances in the Senate are then much in doubt.
The core of the House bill is a cap-and-trade system. The basic idea is to issue permits for emissions, with the total capped at a level that comes down over time. Holders of the permits can sell them.
The owner will sell if the market value of the permit is greater than its worth to him. The result is that emissions are cut where the cost is least. Compared with setting a uniform ceiling and applying it to all emitters, cap-and-trade is a much more efficient way of reducing emissions.
This approach would make it easier to coordinate international efforts at carbon mitigation.
The mood in Congress is to do something about global warming, but nobody is quite sure what. Those who favor action have settled on this cap-and-trade model even though it has some drawbacks (more on this in a moment). But critical questions about the way the system would work are unresolved. These are not narrow technical points; they will decide the fundamental character of the system.
The most important question, of course, is what the limits should be. The draft bill envisages a cut in emissions of 20 percent from 2005 levels by 2020, with much deeper cuts to follow by midcentury. Some Democrats want to see the 2020 reduction lowered to 6 percent.
Another key question is how the permits are allocated. Should all of them be auctioned, or only some of them? And what should be done with the revenues, if any? This part of the bill is still blank.
It seems certain that at least some of the permits will be given away to a variety of supposedly worthy recipients. The fight over that windfall is already joined. In addition, instead of regarding auction proceeds as general revenue, the bill will probably tag at least some of them for specific purposes -- tax rebates for less prosperous households, or subsidies for favored industries and/or alternative-energy technologies, and so forth. Even before the bill is written, it is confirming fears that cap-and-trade will open whole new vistas of pork-barrel politics.
Many economists would prefer a carbon tax to cap-and-trade. One reason is that it makes this kind of fiscal gaming a bit more difficult and -- saying the same thing in another way -- a bit easier for the general public to spot.
A more fundamental difference is that a carbon tax sets a price on greenhouse-gas emissions and, in effect, lets quantities fall where they may. Cap-and-trade does the opposite: It sets a quantitative ceiling, and then the price of a permit -- in effect, the tax rate on carbon, by another name -- moves up and down according to the severity of the limit and economic circumstances. If the ceiling presses down very hard at a time of rapid economic growth, the permit price will be high; set the ceiling high enough in relation to economic activity, and the permit price would fall to zero, because nobody would have to reduce their emissions to comply.
The notion of keeping the tax constant and letting quantities vary also fits with the idea that additional carbon emissions have a known environmental cost. In principle, if you set the tax rate equal to that cost, the market can be left to decide what the correct ceiling on emissions should be. Most environmental scientists, however, would prefer to set a ceiling for the sake of extra certainty in achieving cuts of a particular size. The case for this is stronger if the damage caused by carbon emissions has so-called threshold effects -- that is, if the damage rises discontinuously once a certain line is crossed, which is a distinct possibility. You set a ceiling to ensure that the threshold is not crossed.
The trouble is, using that approach, the implicit carbon tax may then fluctuate so much that it disrupts the economy and makes energy planning for the future more difficult. Moreover, the logic of threshold effects is a little dubious when you are setting limits for the U.S. economy in isolation. Global carbon emissions, not national carbon emissions, drive global warming. The United States can set a quantitative ceiling for its own emissions, but even if it complies with that target, emissions elsewhere will decide whether a critical global threshold is crossed.
The draft bill actually envisages a compromise between the two approaches. It would create a "strategic reserve" of extra permits that could be allocated to prevent "unexpected allowance-price fluctuations." If this reserve were of sufficient size, and if it were used to hold the prices of permits steady at a specific amount -- say, $20 per ton of carbon -- then the result would be akin to an outright carbon tax set at that rate. If the architects of cap-and-trade have something along these lines in mind, the case for cap-and-trade over an explicit carbon tax collapses, and vice versa: The two become one.
If cap-and-trade were administered this way, the only remaining differences would be whether you use the word "tax," and how much cover you give to Congress in creating and disbursing pork.
Suppose that Congress cannot say "carbon tax," and that whatever happens, it will find a way to shower favors on its preferred recipients. Then the best way forward is to build on and systematize this "strategic reserve" idea. A hybrid scheme somewhat along these lines has been proposed by the economists Warwick McKibbin and Peter Wilcoxen. In their plan, the government would issue two kinds of permits: multiyear and annual. The total of the multiyear permits would be set low enough to make them scarce, and then each year additional annual permits would be sold without limit at a price set by the government. In effect, like an outright carbon tax, the system would set the price and let the amount of allowed permissions adjust to it.
The clever aspect of this scheme is that the market value of the multiyear permits -- holders would be allowed to trade them, of course -- would depend on the price of the annual permits set by the government. The more expensive the annual permits, the more valuable the multiyear permits. As a result, this approach would create a corporate constituency for maintaining and tightening the carbon-reduction regime. Buyers of annual permits will be pressing for the emissions limits to be eased -- a feature of both the carbon tax and the cap-and-trade approach. Introducing long-term permits into the mix gives you most of the advantages of a carbon tax, plus this countervailing pressure to maintain the effectiveness of the system.
This approach would also make it easier to coordinate international efforts at carbon mitigation. The biggest problem with national cap-and-trade regimes is making them fit together as part of a well-designed global effort. If you start with quantities and let prices fluctuate, the basis for international agreement is shaky. It is unfair, and makes no economic sense, to insist that all countries, rich or poor, cut their emissions by the same proportion. But it is not unfair, and from a global point of view makes perfect economic sense, to ask all countries to set the same implicit tax on carbon, and then do as they wish with the revenues this raises. Coordinating around a global price of carbon is far simpler than coordinating a global system of national ceilings.
Some Democrats as well as most Republicans are worried about the economic consequences of limiting carbon emissions. In the long term, the economic costs of a gradually tightening system may be quite affordable; but in the short term, there is a lot of uncertainty, and those "unexpected allowance-price fluctuations" could be large and damaging. The draft bill acknowledges this: hence its proposed reserve of permits. Why not go further and build the system around a fully flexible reserve and a predictable schedule of rising permit prices?
Industries could plan with more certainty, greatly reducing the economic burden of the switch to low-carbon energy. International cooperation on carbon abatement worldwide, without which this whole enterprise is a complete waste of time, would be much simpler. Add the McKibbin-Wilcoxen twist of multiyear permits and you create a corporate constituency for the system. You get all the benefits of a carbon tax, and you never have to call it a carbon tax.