The CBO Prefers a Carbon Tax to Cap-and-Trade

I'm a supporter of a cap-and-trade system over a carbon tax. But I have to say that Terry Dinan, of CBO's Microeconomic Studies Division, has the best argument in favor of a carbon tax over cap-and-trade that I've yet seen. (Her paper is here; the CBO director's blog entry on the subject is here.)

Analysts generally conclude that a tax would be a more efficient method of reducing CO2 emissions than an inflexible cap. The efficiency advantage of a tax stems from the contrast between the long-term cumulative nature of climate change and the short-term sensitivity of the cost of emission reductions. Climate change results from the buildup of CO2 in the atmosphere over several decades; emissions in any given year are only a small portion of that total. As a result, limiting climate change would require making substantial reductions in those emissions over many years, but ensuring that any particular limit was met in any particular year would result in little, if any, additional benefit (avoided damage). In contrast, the cost of cutting emissions by a particular amount in a given year could vary significantly depending on a host of factors, including the weather, disruptions in energy markets, the level of economic activity, and the availability of new low-carbon technologies (such as improvements in wind-power technology).
Relative to a cap-and-trade program with prespecified emission limits each year, a steadily rising tax could better accommodate cost fluctuations while simultaneously achieving a long-term target for emissions. Such a tax would provide firms with an incentive to undertake more emission reductions when the cost of doing so was relatively low and allow them to reduce emissions less when the cost of doing so was particularly high. In contrast, an inflexible cap-and-trade program would require that annual caps were met regardless of the cost, thereby failing to take advantage of low-cost opportunities to cut more emissions than were required by the cap and failing to provide firms with leeway in years when costs were higher.
The efficiency advantage of a tax over an inflexible cap depends on how likely it is that actual costs will differ from what policymakers anticipated when they set the level of the cap. Given the uncertainties involved, such differences are likely to be large--and, therefore, analysts generally conclude that the efficiency advantage of a tax is likely to be quite large. Specifically, available research suggests that in the near term, the net benefits (benefits minus costs) of a tax could be roughly five times greater than the net benefits of an inflexible cap. Put another way, a given long-term emission-reduction target could be met by a tax at a fraction of the cost of an inflexible cap-and-trade program.

As I say, this is a good argument. But it's also a bit weird: in my mind, the whole point of using a cap-and-trade system rather than a carbon tax is that no one knows what the actual costs of carbon emissions reduction are going to be. If those costs turn out to be much higher than anticipated, a carbon tax will simply fail, since it will have been set too low. A cap-and-trade system, by contrast, is dynamic: it can be adjusted in real time to reflect new information about the costs and benefits of certain levels of carbon emissions.

Dinan's arguments do mitigate in favor of some flexibility in a cap-and-trade system, perhaps by being able to borrow or bank future carbon credits. And if they persuade the US government to implement a carbon tax, that would be wonderful: while I'm a supporter of cap-and-trade, a carbon tax is very nearly as good, and much better than the most likely outcome, which is nothing at all.