Why a Cap-And-Trade System Beats a Carbon Tax

The International Emissions Trading Association, or IETA, had its board meeting in Lower Manhattan today, and decided to spend an hour or so afterwards answering questions from journalists. I was one of them, and I found the meeting very helpful. In fact, it might have finally tipped me away from carbon taxes and towards a cap-and-trade system in terms of which would best minimize carbon emissions.

To get a good idea of how and why a cap-and-trade system could and should work, the best backgrounder I know is this one, from the Milken Institute. It's particularly good on the crucial details: any such system should be as wide-ranging as possible; be as internationally fungible as possible; should allow offsets from non-participating countries such as China and India; and should not have any price caps on emissions.

And after spending some time with the IETA board today, I do think that they will be very good in terms of being a useful resource for US legislators: they're much more than a pressure group including some of the world's biggest polluters. In fact, they include a lot of companies such as Ecosecurities and DNV which have every incentive to maximize mandated reductions in carbon emissions.

What the Milken Institute report does not do is lay out clearly the case for a cap-and-trade system as opposed to a simple carbon tax. There will always be a place for some carbon taxes: even in the EU, the prime example of an area where carbon trading is already happening, only half of total European emissions are covered by the cap-and-trade system. The rest should be taxed.

But if you want to be certain about reducing carbon emissions, and you want to do it in the most economically efficient way possible, then cap-and-trade is the way to go. The certainty comes with the "cap" part: you limit total carbon emissions to some number lower than present carbon emissions, and as a result total emissions are forced to fall. (This is where the EU system got off to a bad start, by the way: legislators were unclear on the acutal level of carbon emissions, and set the cap too high. Better transparency and reporting should solve that problem.)

The efficiency comes with the "trade" part. Let's say you have two power plants, each emitting 100 tons of carbon per hour. The first can reduce its emissions by 20 tons at a cost of $5 per ton, and the second can reduce its emissions by only 10 tons, at a cost of $30 per ton. Clearly the efficient thing to do is to make the former reduction rather than the latter, with the owner of the second plant paying the owner of the first plant to offset the first owner's extra costs. That kind of thing happens much less under a carbon-tax regime, where the incentive for the first owner to maximize his carbon reductions is limited, if only because he's still paying 80% of the carbon tax anyway.

If you look at the Carbon Tax Center's reasons for preferring a tax to a cap-and-trade system, they're not quite as convincing as they look at first glance. There's no real reason to believe that energy prices will be more volatile under a cap-and-trade system than they are already. It's geopolitics which sets energy prices, not regulatory regimes.

It's also not true that a cap-and-trade system is harder to implement than a carbon tax. There are many cap-and-trade bills already making their way through Congress, while prospects for a carbon tax are dim indeed.

As for a cap-and-trade system offering opportunities for energy companies and other polluters to make money, that's the whole point. A market-based mechanism which gives companies a profit incentive to reduce emissions is likely to be more effective than a tax which will hit them hard anyway.

Finally, the Carbon Tax Center talks about all the good that could come from the government revenues associated with a carbon tax. Well, the government can also get revenues from a cap-and-trade system, if it auctions some part of the carbon rights rather than allocating them freely to polluters.

The Carbon Tax Center admiringly quotes Holman Jenkins saying that cap-and-trade limits would give polluters, for free, "a property right worth billions." The fact is that insofar as such polluters get a new asset, they also get a new liability, which is the cost under the new system of their present emissions. If the goal is to reduce emissions, then a cap-and-trade system is a very good way of achieving that end.