The Carbon Tax Debate: Why a Cap-and-Trade System is Better

I spent more three hours this morning at a debate hosted by the New York City Bar Association which was narrowly focused on a single issue: whether the US government should implement a carbon tax or whether it should go with a cap-and-trade system. I went into the debate on the side of the cap-and-traders, but alive to the fact that a lot of very smart people have put their weight behind a carbon tax. So I was willing to change my mind if I heard some good arguments in favor of the tax. I didn't.

That said, however, the two debaters on the side of the carbon tax, Dan Rosenblum and Jim Barrett, were very impressive and made some great points. Barrett, in particular, seemed to be very plugged in to political considerations, and was compelling on the question of the impact of climate change, and climate change legislation, on America's poorest. Environmental groups, he pointed out, tend to lead with pictures of windmills and polar bears, not the 700 diesel trucks per hour which drive directly in front of an elementary school in Trenton, New Jersey. It's in places like that – and of course New Orleans – that the ill effects of our carbon-spewing lifestyle are most keenly felt, and they're felt disproportionately by poor, black Americans. Yet it's also the case that poor black Americans have significantly larger carbon footprints than their poor white counterparts, which means that unless legislation is designed very carefully indeed, they will also bear the regressive brunt of any carbon tax or cap-and-trade system.

And there's no doubt that either system, if it is to work in its avowed aim of reducing carbon emissions, will raise prices for consumers. Cap-and-trade might not have the word "tax" in its name, but it has the same effect. In fact, as Billy Pizer noted in the debate, one of the huge advantages that a cap-and-trade system has over a carbon tax is that, tweaked enough, you could use a cap-and-trade system to exactly replicate a carbon tax. (Auction everything, put in a safety valve, measure as far upstream as you like, etc.) In other words, anything you can achieve with a carbon tax you can achieve with a cap-and-trade system – but the opposite is most emphatically not the case.

Specifically, both sides agreed that given the way that the US government is constructed, one can't expect much in the way of innovative ongoing legislation on this front. One a system is set up, that system is going to remain for decades. A carbon tax might be raised or lowered, but it will remain a carbon tax. A cap-and-trade system, by contrast, would be much more flexible. At the outset, it might behave quite similarly to a carbon tax, targeting carbon prices rather than emissions reductions. But if you used a cap-and-trade system to do that, it would me much, much easier to move over time to a system which targeted emission reductions rather than carbon prices.

This was one of Jon Anda's main points. Any successful policy, he said, has to at least keep open the possibility that we will choose in future to restrict global warming to 2 degrees celsius more than pre-industrial levels. It's entirely possible that scientists investigating feedback loops will discover that any warming above that level would be catastrophic. We don't know. But only a cap-and-trade system would create a mechanism which would make that possibility achievable. "I don't want to tell my grandchildren that we tried taxing CO2 and it didn't do much good, and sorry," he said.

Anda even came prepared with a (not very catchy) slogan: a successful policy, he said, "has to be a dynamic hedge of fat-tail CO2 risk". If it turns out that our carbon emissions are rising too far, too fast – or not falling fast enough – then the system has to be able to dymaically adjust to that, and that's something a carbon tax finds pretty much impossible to do.

What's more, most of the most exciting carbon-reduction technologies only become economically efficient when carbon-emission prices get very high indeed: around $75 per ton or so. Now Anda isn't advocating a cap-and-trade system where prices start off that high. But the genius of any cap-and-trade system is that even if prices aren't there today, there's a non-zero chance that they will be there in the future. So it can make economic sense to invest in those technologies, after discounting for the likelihood that they will be profitable in the future. If a carbon tax, by contrast, is never slated to reach $75 per ton, then no research on those technologies will ever get market funding.

The best argument for a carbon tax, by contrast, was that it is less legislative work: it could be built in to a big 2009 tax bill. But given the number of cap-and-trade proposals already in front of Congress, and the fact that there seems to be very little real Congressional support for a carbon tax, that argument is pretty weak. It might also be easier to slap import tariffs on high-carbon-footprint goods from the likes of China if the US was operating a carbon tax system rather than a cap-and-trade system. But that's a question of the way that WTO regulations are worded, and I'm pretty sure that no one thinks the wording of WTO regulations should drive a question as important as this one.

Ultimately, the most compelling argument is the flexibility/optionality argument. Think of a cap-and-trade system, Pizer says, as a big machine with a whole bunch of dials. "You can dial certainty on the cap versus certainty on the cost, and you can dial free allocations versus auctioned allocations," he says. By fiddling with the controls, you can basically get anything you want – which is a crucial feature given that we really don't know exactly what problems the cap-and-trade system is going to be asked to solve in the future. If Congress is worried about the price uncertainty inherent in a cap-and-trade system, they should be much more worried about the cost-of-environmental-damage uncertainty inherent in global warming mechanisms – something which demands flexibility in terms of our response.

It's also worth noting that Pizer's dials can be adjusted to match other cap-and-trade systems globally, creating a worldwide liquid and fungible market in carbon credits.

In the wake of my visit to Carnegie Hall last night, I'm reminded of the case of Zankel Hall, its new underground venue with flexible seating. Rather than simply construct an old-fashioned shoebox, the architects of Zankel Hall ensured that all manner of different performance and seating configurations would be possible. Now in practice the hall opened with the old-fashioned shoebox configuration, and has stubbornly stayed that way ever since, despite many performers and performances which might have been better served with different seating arrangements. (I suspect the reason for this has something to do with the stagehands' union; I'm not sure, though.) But this doesn't mean that building a flexible hall was a bad idea. The hall might not get changed at the moment, but it's likely to achieve its potential in the future. And that possibility alone justifies the architects' decision to build in that flexibility.

Similarly, if you want to impose a carbon tax, do it using a cap-and-trade mechanism, and then turn the dials as much as you need to in order to replicate the tax. In a couple of decades' time, you'll be thankful.