Carbon Tax vs. Carbon Caps: Dissecting the Rhetoric

Like many public policy debates, the one over how to best reduce carbon emissions is too complex to be properly treated in an Op-Ed article. That’s why yesterday’s piece in the Wall Street Journal by Fred Krupp, president of Environmental Defense Fund, is misleading.

Under Krupp’s leadership, EDF has been an amazingly effective organization. They are distinguished by having won the trust of both environmental advocates and business leaders on many issues. On the issue of cutting carbon emissions, they prefer a cap-and-trade system over a carbon tax, and Krupp laid out his reasons in the aforementioned Op-Ed. But his argument has flaws which, taken together, make a case for cap-and-trade that seems no stronger than for carbon tax, at least for me.

More Environmental Certainty

Krupp says, for example:

From an environmental point of view, the difference is stark. A cap is a legal limit on pollution. There is no guessing what will happen — the level of emissions is set in law, and enforcement of that limit proceeds accordingly.

Current experience with the European Union Emission Trading Scheme (EU ETS),however, suggests that there is less certainty than meets the eye. Since polluters can purchase permits to offset their emissions, and those permits can be created, via the Clean Development Mechanism (CDM), by developers of clean projects, often in the developing world, whose net impact on emissions can be difficult to ascertain, the true effective of cap and trade on annual emissions is not entirely as certain as one would expect.

How to Cooperate with Other Countries

Krupp makes the valid point that countries need to work together to reduce carbon emissions:

…to require that other countries make the reciprocal commitments necessary to lower global pollution, we have to enact our cap–and have other nations to the same in a transparent, verifiable and enforceable way. A carbon tax doesn’t make such a system of commitments possible.

But there is no reason why taxes can’t be as transparent and enforceable as caps. After all, our global trade regime depends on transparency and enforceability of trade tarrifs, a form of taxation. That seems eminently applicable to carbon as well.

Greater Flexibility

Krupp maintains that “from an economic point of view, the case for a cap is strong. A well-designed cap will push our economy towards clean, domestic energy in the most flexible way possible.” But a carbon tax is at least as flexible: it is agnostic regarding technology and industry . It too would flexibly push our economy toward clean energy. (His assertion that it would push us toward clean, domestic energy is an interesting one. I do not know of a reason why cap-and-trade would favor domestic energy sources over foreign ones any more than a tax would.)

Engaging the Profit Motive

He repeats an off-stated claim that an advantage of the cap-and-trade system is that it’s “essential nature” is positive, that it “directly engages the profit motive” because companies could profit by cutting emissions more than legally required and sell the carbon credits they would generate in the process.

I don’t find this argument terribly persuasive either. Here’s why:

For a cap and trade system to bring about emissions reductions, it needs to establish emissions levels lower than where they are today, and to allow companies to exceed their limits only by purchasing carbon credits.  So just to continue business as usual, companies would need to buy carbon credits, which imposes costs just as a tax would. Firms can turn a profit from this system only if the cost of cutting their emissions is less than their profit on the resale of the credits.

If a company finds low-cost ways of reducing emissions, it could also profit in a carbon-tax regime: It would reduce emissions to reduce taxes and thus deliver more profit to the bottom line. I suspect that if there were a ton of profit to be made in a cap-and-trade system that would probably mean that the price of carbon credits soared higher than anyone expected, with unpredictable consequences on industry.

Providing Greater Economic Certainty

That goes to another of his points, about economic certainy: “…establishing the cap level in law will give companies the certainty necessary to make major, job-creating capital investments now.” The reality, however, is different. If markets set carbon prices, where is your certainty about costs? There is certainly no more certainty than if the law sets carbon taxes. Indeed, the experience in Europe so far has been one of uncertainty: a collapse in the price of carbon followed by an expected share rise, according to The Economist.

Self-Adjusting Elegance

Krupp also makes the fallacious argument that cap-and-trade systems are self-adjusting. “While a carbon tax could only be modified through the cumbersome legislative process, the market price of emissions perfmits under a cap will fluctuate with the economy.” That sounds good, if you believe that a single, cumbersome legislative process could create immutably perfect level of carbon caps.

But experience shows that some trial and error are unavoidable. Europe is going through multiple cumbersome, legislative processes, which are of course subject to the influence of lobbyists, to establish appropriate caps.  This does not seem any more elegant than the process by which the appropriate level of taxes are established.

If it Worked Once, it Will Work Again

Perhaps the strongest points of Krupp’s are arguments are these:

  1. “No air pollution problem has every been solved except by imposing a legal limit on emissions.” I don’t have a counter argument for that
  2. The cap-and-trade system passed in 1990 to limit acid rain has worked well. There is broad consensus on this point. But it’s worth noting that the scope of the system, covering just about 530 power plants (see study here) is substantially smaller than anything currently contemplated.

Alas, my point in picking apart Krupp’s argument is not to establish definitively that a carbon tax is superior to cap-and-trade as a mechanism for reducing carbon emissions.  (I suspect either can work and the devil is in navigating the political details).  I think all I’ve done here, perhaps, is to show that any 690-word argument on a topic as complex as this is bound to be oversimplified.

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6 Comments

Filed under carbon, emissions

6 responses to “Carbon Tax vs. Carbon Caps: Dissecting the Rhetoric

  1. David Ocampo G

    There is one major advantage of the Carbon Tax vis-a-vis Cap’n Trade: price stability. At present, carbon fuel consumption is falling and as a result carbon emission permit prices are falling. This means that fuel prices fall even faster, making carbon-stingy investments far less attractive. This pushes carbon-reduction effectiveness even further down the road.

    Conversely, booming carbon fuel consumption would result in rapid increases in carbon emission permit prices, right along with pre-emission fuel taxes, for spectacular increases in energy costs to ultimate consumers. This would spook public acceptance to a fare-thee-well.

    By and large I agree with Mr Schatsky. Nevertheless, this one single “otherwise” is enough to knock the entire rationale for Cap’n Trade all golliwompus.

  2. This is a very useful post among fields of misconceptions. Thank you!

  3. David Schatsky

    Thanks for your nice comment. I welcome any suggestions you might have for other topics to dig into.

  4. Charlenne Hal

    How do u feel about the impact of increase carbon taxes will effect on low-income households and small businesses?

    • David Schatsky

      Both both carbon tax and cap-and-trade will increase the cost of carbon-based fuels. Neither is inherently worse than the other for low-income households and small businesses. If there are grounds for shielding particular groups from the full costs of these programs, there are a variety of ways of doing so.

  5. Al Gore makes the point that Cap-and-trade is easier to create a harmonized international system for than a harmonized tax. I suspect he’s right.

    With a tax, AND with a cap-and-trade system, there’s the question of where the revenues go. The whole thing is dangerous and inefficient if those revenues don’t go into actions (R&D, assistance, etc.) to reduce CO2 emissions. If it relies purely on the deterrent effect of economic pressure to change behavior, you’re only getting half the benefit, but all of the economic disruption. And probably funding bloated government as well.

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