Carbon Taxes or a Cap-and-Trade Permit Scheme?

Robert Stavins opened his new blog with a call for serious policy to curb greenhouse gas emissions. It's well worth reading the whole thing. Here's the meat in the middle:

The only politically feasible approach that can make a real dent in the problem is a comprehensive, upstream cap-and-trade system to reduce carbon dioxide emissions 50 to 80 percent below 1990 levels by 2050. The declining cap will increase the cost of polluting, thereby discouraging the use of the most carbon-intensive fossil fuels and providing powerful incentives for energy conservation and technology innovation.

The system could start with a 50-50 split of auctioned and free allowances, gradually moving to 100% auction over 25 years. To establish political support in the short term, free allowances should be targeted to sectors that are most burdened by the policy. And the auction revenue — which will increase over time — can be used to compensate low-income consumers, finance research and development, reduce the federal deficit, or cut taxes.

The best option may be to make the program revenue-neutral by returning all of the auction revenue to citizens through direct cash dividends or annual tax credits. This can go a long way towards making the legislation palatable to Republicans and Democrats alike who are reticent to take any actions that even resemble a tax increase.

By making the overall emissions cap gradually become more stringent over time, costs can be greatly reduced by avoiding premature retirement of existing capital stock, reducing vulnerability to siting bottlenecks, and ensuring that long-lived capital investments incorporate appropriate advanced technology.

Still, the costs of meaningful action will be significant, with impacts on gross domestic product eventually reaching up to 1 percent per year. But the longer the world waits to begin taking serious action, the more ambitious will emission reduction targets inevitably become, as atmospheric greenhouse gases continue to accumulate.

I like the revenue-neutral part--someting Stavins has advocated in the past. But some carbon permits may be allocated rather than auctioned, limiting revenues somewhat--that will surely be part of the negotiating process.

Stavins argues for a cap-and-trade system, which is what most economists have long advocated. Some argue instead for a carbon tax. At present I don't have a strong opinion on the matter. But for those who are interested, the latest issue of REEP has a nice symposium on this topic. I especially like the article by Nathaniel Keohane of EDF (one of Stavins' former students, I think).

To a first approximation, both of these approaches do the same thing: they put a price on the marginal unit of CO2 emissions that doesn't currently exist. Taxes do this directly--the tax becomes the price of carbon. A cap-and-trade system fixes quantity of emissions and a secondary market for emissions permits effectively sets the market price for carbon. Both can achieve emission reductions in a reasonably efficient and market-friendly way.

Two good alternatives. Which to choose? These kinds of questions keep environmental economists employed.

I've always liked taxes, but for admittedly superficial reasons. I like taxes because they are simple. I think implementing a cap-and-trade will be somewhat more costly. But I imagine the biggest cost will be tracking down all the carbon, including sequestrations and emissions from agriculture and forestry. This would be necessary for both approaches.

There are other considerations. One is that if we want to be really strict about meeting a particular emissions goal, it will be hard to get the tax just right. If the tax is too low, we'll emit too much; if the tax is too high, we may emit too little, incurring more costs than necessary to hit the target. Under cap-and-trade, we just set the cap at the target and we're done.

Why might we want a firm target level of emissions? Well, there's probably a tipping point toward accelerated global warming. For example, as snow and ice recedes from mountains and polar regions less sunlight is reflected, which causes more heat absorption and more warming. No one is sure about where the tipping point might. Some say it may be as little as 2 degrees Celcius, in which case shutting down CO2 emissions before its too late will be very tough to do.

The other main reason for a cap and trade system is supposed political feasibility. This may be. I'm really not sure. I was surprised to learn recently that Exxon is now favoring a tax over cap-and-trade system. This surprised me a lot. But that fact does make me wonder whether cap-and-trade is actually more politically feasible. We need to learn more about why Exxon has this preference.

Welcome to the the blogosphere Professor Stavins! I look forward to reading more from you.