Cap v FTax

The Financial Times' lead editorial today argues for prices over command-and-control (duh!) and then goes on to say a tax would be better than a cap (d'oh!). Where to begin?

Well, first, let me once again point anyone interested to an ongoing debate over at The Bulletin of the Atomic Scientists on this issue. There are arguments pro and con. I strongly believe the pro-cap arguments have the upper hand, but then again, I'm helping write them.

Second, I'm guilty as charged. I wrote for the FT editorial board in 2007. Let's just say that there may have been an editorial printed during that time that threw its weight behind a tax. That's only to say that there are indeed some good arguments on both sides.

In the vacuum of economic theory-land the two are, under certain conditions, even equivalent. In practice, they are clearly not. Here's the main part of a letter I just sent to the FT:

Most significantly, the US and EU cannot solve this problem alone. At the very least, the largest emerging economy emitters need to limit their pollution as well. A carbon market can make these commitments in the economic self-interest of all parties involved; a tax cannot.

Second, smart market design -- including provisions for banking and borrowing of allowances -- would dampen feared price volatility, and well-known market instruments can iron out the rest.

Third, the most important missing link in turning climate change from a problem into an unprecedented market opportunity is innovation. A cap taxes entrepreneurs to look for breakthrough technologies at any price. A tax caps innovation.

Lastly, almost all new scientific evidence over the past two years has shown that the climate problem is worse than previously feared. We do not have time to experiment with tax rates to achieve the desired results. If you want to limit emissions, do exactly that: cap them.

This, of course, is the staccato version. There's much more over at The Bulletin.

Comments

[dWj]

Of course a tax can be in the interest of developing countries, and in exactly the same way a cap can -- the rich countries pay them to go along. (You can better disguise this payment in cap-and-trade; perhaps this disguise has some political benefit?)

I don't understand point 3 at all. If you drive down the price of carbon below the comparable tax, the incentive for producing carbon-saving technology is lower than with the tax. If it's higher, it's higher.

What sells me most on the tax is that I think it's more plausible that economists and climate scientists can reasonably estimate the appropriate price of carbon than the appropriate quantity. The best argument against this is that carbon permit auctions can be done with a quantity that is a function of price, presenting an honest-to-God supply curve that is neither perfectly elastic nor perfectly inelastic; if this can be done, it may be worth the extra complications of doing an auction and having clearing agents for trades. In any case, if the price is higher than anticipated, we absolutely should back off from quantity targets, and if the price is lower than anticipated, it doesn't make sense to me that we would satisfy ourselves with our previous goals.

[odograph]

I think the hard reality is that a tax or cap would both require iterative cycles and tuning. No one is going to hit an appropriate long term GHG emission target on the first try - even if they try.

And of course I don't think they will try. The elephant in the room continues to be the required lifestyle changes developed countries, and the changed expectations of development in growing nations.

Mr. Obama's target is an 80% reduction in GHG emission by 2050, I believe. It will be interesting to see what changes he can sell to start us on that course. The standard political approach is to back-load the progress. That is, in 2010-2030 we'd maybe slow our expansion, and then count on another generation 2030-2050 to actually do the reduction.

[David Zetland]

Gerhard,

I am pro-tax (mostly b/c they are simpler and harder to corrupt), but your letter makes little sense (I agree with dWj). Your fourth point (caps are a CAP) is perhaps the best -- until you get to measurement and evasion problems.

My positive contribution to this discussion is this thought: There will NOT be some global agency to regulate and enforce a global carbon regime. This means that the "system" will have to facilitate trades between countries/individuals subject to either C&T or tax (or both, perhaps).

Solve that problem, and then let a thousand flowers bloom :)

[odograph]

My thought, before I go 52F mountain biking, is that the only way we'll really win is if the technologists save us. If solar power really does meet grid price parity then maybe we'll have the will to require electric cars and shift on over.

(And maybe that is the unstated assumption in all cap/tax plans, that by the time teeth are really needed some magic technology will be there.)

Or can anyone assuage my cynicism, convince me that we actually have the will for big changes over 10 or so years? (At > 10 years, it's another way of saying "someone else's problem".)

[Gernot Wagner]

dWj, odograph^2 and David,

Thank you for your quick responses. As I said, this is an interesting debate all around with no real slam-dunk arguments on either side -- except, I would say, for some of the questions, which I'll get to later.

It certainly doesn't help, that letters to the editor need to be extremely short, and it's tough to elaborate much with that amount of space. So here goes the longer answer, largely quoted from Nat Keohane and my entries into the debate over at The Bulletin.

I claimed in the letter that the first point around emerging economy engagement is the most important argument. So let me quote the full argument from the debate here:

A cap-and-trade system allows for the creation of a global carbon market. Such a market would provide the mechanisms and flexibility necessary to achieve the environmental goals at the lowest cost and the incentives for other countries to join. A tax does neither, while requiring much more harmonization across countries.

Since environmental integrity is the starting point in our debate, ...the United States or European Union (EU) won't be able to go it alone. Therefore, any policy solution needs to include China, India, and a cadre of other significant developing countries. Developing countries wouldn't be expected to decrease emissions as steeply as the United States and the ramp-up can be slower, but they need to be part of the solution nevertheless.

We also know that many other countries provide cheaper abatement opportunities than can be found in the United States or EU. Similarly, it will be necessary to provide financial incentives for developing countries to join because of ability to pay and the principle of "common but differentiated responsibilities" enshrined in UN documents (and agreed to by Washington) that says that industrialized countries ought to shoulder much of the burden.

How would such a system of international participation work under a carbon tax? The U.S. government collects taxes from businesses domestically. The Treasury then turns around and sends some of the collected money to its counterparts in China, India, or other developing countries, which, in turn, spend it on local abatement opportunities. That process...may be "infeasible." More directly put, it's simply not going to happen, and many economists and policy makers agree--former Treasury Secretary Lawrence Summers among them.

How would this process work in a global carbon market? As a first pass--and admittedly, we're offering a rosy picture here--it will be like any other market transaction. Instead of the U.S. Treasury, it would be a private transaction between U.S. and foreign companies. It's in the self-interest of the U.S. company to seek out least-cost compliance options. If that option can be found halfway around the world, so be it. Money will follow the market opportunity.

Concrete numbers are still hard to come by, but these financial flows would be in the low tens of billions of dollars. That alone shows that the market will be the only way to go. These sums are significantly more than current official development assistance or other nonmarket flows. Yet, they're small compared to overall market transactions. In 2007, industrialized countries sent, on net, in the order of $450 billion in foreign direct investment to developing countries. (The gross figure is closer to $1.7 trillion.)

For this reason, a cap-and-trade system could promote broad international participation. Developing countries would almost surely be net sellers in a global carbon market--both because they have ample low-cost abatement opportunities and because they're likely to receive more generous emissions targets than industrialized nations under an international agreement. As a result, emitters in the developing world could expect to earn substantial profits from abating emissions and selling allowances. Meanwhile, because advanced economies such as the United States and EU can set the terms of access to their own markets, they would have considerable leverage to persuade those other countries to take on binding emissions targets. A tax provides neither an incentive to join nor much leverage.

Moreover, if we think it would be difficult to find the right tax level domestically and regularly update it to achieve emission-reduction goals, this feat will be virtually impossible to do internationally. Yet it would be necessary to achieve a harmonized tax structure across countries. Environmental integrity quickly goes out the window.

I hope, dWj and David, this answers some of your questions and that you agree that this leads to a conclusion that a cap beats a tax on this dimension:

Of course, we cannot jump from zero to a full-fledged global carbon market. We need several intermediate steps and safeguards along the way that ensure oversight and compliance--excellent topics for another debate. For the question at hand, though, the conclusion is clear: A U.S. cap-and-trade system sets us on the path toward a global market. It enables the kind of international monetary flows necessary to attract participation, and it can more easily be harmonized internationally. A tax does neither, and would even hinder the development of a global carbon market.

David, you say that a tax would be simpler. I spare you the full quote here. Let me just say that the US tax code has 17,000 pages and refer you to the entry under "Even if simplicity is the only criterion, cap-and-trade might still be the best bet" on http://www.thebulletin.org/web-edition/roundtables/carbon-tax-vs-cap-and-trade for a longer list of arguments.

Lastly, dWj takes issue with my 3rd reason, where I say that, "A cap taxes entrepreneurs to look for break-through technologies at any price. A tax caps innovation." Yes, I admit I'm a bit proud for coming up with those phrases, but it also makes a lot of sense. As odograph says in his second comment, the real issue is innovation.

Economic models agree that the cost of climate policy as currently proposed is manageable ("pennies a day", "as rich in April of 2030 as we would otherwise be in January"; see "What Will It Cost to Protect Ourselves From Global Warming?" [PDF] for the full review of recent studies), but they are all missing one big item: new technologies. It's in the very nature of these models, that they largely extrapolate the past. Ask someone in 1900 about the biggest environmental problem facing urban areas, and it would have been horse manure. The car came along and saved us from that problem. Time and again, the story has been the same. Why shouldn't it be the same here?

Well, we simply don't know. We can't predict the future. We can look at where venture capital money is going. We can look at inspiring stories by entrepreneurs. We can ask the best scientists and tinkerers the world over. But guess what, nobody knows. That's exactly the reason why markets are better than command-and-control or any other form of mandates. We can't mandate innovation, and we don't know where it's going. We do know one thing though, and we know that for sure: Innovation will make the transition to a low-carbon economy cheaper.

Ok, now that I got that out of my system, what's the difference between a cap and a tax here? A cap says that we need to get to x tons of pollution. Businesses, entrepreneurs, etc. then go out and find ways to do that. Perhaps -- and this is to answer odograph's concern -- this target might need to get adjusted. Fine, every time you adjust the cap downward, you create larger incentives. (Just as an aside, the last time we tried such a system in the US -- for SO2 emissions in the early 1990s -- innovation ensured that pollution control was a lot cheaper to achieve than anyone had predicted at the start of the program. The result was stricter limits later because the reductions were that cheap.)

How's a tax different? If you set the tax at $30 per ton of CO2, you cap innovation at those $30. If a new technology costs $50 -- and there's no hope that the technology goes down below $30 within a reasonable amount of time to keep the business afloat -- you'd be foolish to pursue that technology. Only technologies that are cheaper than $30 get built. For anything more expensive, you'd much rather just pay the tax.

For a cap, that's simply not the case. If there's a technology that costs $50 and another one that costs $40 per ton of CO2, we'd expect these technologies to race each other to get to minimum cost.

Of course, this is a very simple view of the world of innovation. I wished I could point you to a longer argument that lays this out in more detail. (If you know of sources along these lines, please pass them along!)

In the end, as the fourth reason in the letter mentions, this is about pollution control, first and foremost. None of us would be engaging in this debate if it wasn't for the sake of finding ways to solve the climate crisis. And yes, here it's the cap, stupid. It's the simplest, most direct way. It looks like we all agree on that.

Best,
Gernot

[Roger Chittum]

The European cap and trade system for CO2 is reported as being unsuccessful (emissions continuing to rise) and plagued by evasions through use of bogus international offsets. RECLAIM for NOx and SOx in Southern California had to be suspended for major sources in 2001 and was only reinstated after they implemented the same compliance plans that had been required under the pre-existing command and control system. What's your assessment of these real cap and trade plans in the real world, and how would you close the gap between reality and theory?

[USCarbonReport.com]

In a vacuum, I agree cap and trade arguments trump a carbon tax. Moreover, the reality is that the world is going through an economic crisis that, by the most optimistic of estimates, could improve in late 2009. A "tax" on carbon would be seen as a blow to a recovering economy. I cant imagine Obama or a majority of US congressmen backing something a tax. ~ Trevor

[odograph]

I think this must be fundamentally wrong, or based on a strong non-economic motive by actors:

Economic models agree that the cost of climate policy as currently proposed is manageable ("pennies a day", "as rich in April of 2030 as we would otherwise be in January"; see "What Will It Cost to Protect Ourselves From Global Warming?" [PDF] for the full review of recent studies), but they are all missing one big item: new technologies. It's in the very nature of these models, that they largely extrapolate the past. Ask someone in 1900 about the biggest environmental problem facing urban areas, and it would have been horse manure. The car came along and saved us from that problem. Time and again, the story has been the same. Why shouldn't it be the same here?

There's just no way. We had far more than "pennies a day" fossil fuels price increase over the last 5 years, and it did not result in reduced combustion.

Now, perhaps if we were motivated and made lifestyle changes we could do those at low cost, perhaps pennies per day, or perhaps saving pennies per day in a win-win. If.

On the other hand if we hope to drive the laggards and skeptics into action, how in God's green earth is that going to work, when it hasn't in the documented past?

(And of course if we are just counting time until that technological Hail Mary, you don't really need an ineffectual plan in the meantime.)

[odograph]

(As an example of a win-win I've named here in years past: "hey folks, ride a bicycle." Displace a few trips, increase your health, save some money, help the environment ...

but at this point we probably have to engage with why we don't do that, and spend our collective energy 'proving' that the win-win is impossible.)

[John Whitehead]

Odo,

A cost of riding a bike is the additional time it takes to get there. As I've said, there are no win-wins, only benefits and costs. How about benefit-benefit-cost instead of win-win?

[odograph]

With a sufficiently jaundiced view one could say there are no "win-wins" in life, but I don't think most people approach it that way.

Yes, we've agreed that bicycle riding takes time (depending on the distance and trip, there is essentially no difference between a Trader Joe's run with car or bike for me).

The thing is, how do we expect the reader to respond to your anti-marketing? Should they stop looking for win-wins that other people feel and experience? I seem to recall from past comments threads I'm not alone in my (glass half full) view.

Ah well, I'm off to the library by bike. It might take a little longer, but I'm part of that national demographic, trying to counter the effects of Thanksgiving to New Years: meals, cookies, pies, cakes ... it's a win-win without the costs of dieting or gym memberships.

[gormk]

John,

Here and elsewhere you seem to be confusing the ECON truism "there is no such thing as a free lunch" (aka every action/decision/policy is associated with an alternative cost), with some notion that win-win situations are impossible.

Life, the economy, and even some policy scenarios are full of examples of win-win situations.

For example, if person A posts an item for sale on Ebay and person B buys it, it is a win-win situation. Yes, both incur costs. A gives up the item and B gives up money, but both are net-winners. This is called gains from trade, and I believe Adam Smith was one of the first economists to describe this phenomena.

The impossibility of win-win situation claim seems to rest on some notion of zero-sum-games, or invoking a very counter-productive argument that there will always be some obscure loser out there. What's the point?

I think Odo very well understands the notion of no-free-lunch (opportunity costs). No-free-lunch does not however mean win-win scenarios are impossible.

gormk

PS! It is also easy to create retrospective policy-scenarios that seem consistent with win-win scenarios. For example, if one had known back in the late 80's what the long-run effects of allowing/introducing SUV's into the vehicle market would be, one could easily think of policies (both command-and-control and economic ones) that would have netted benefits to consumers, producers, governments, and the environment, both domestically and internationally.

[gormk]

Quick follow up to my previous comment to John.

The economic concept of a "Pareto Improvement" is by definition a win-win (or weakly, a win-no lose) concept. John: Are you saying that Pareto Improvements for the economy is a bogus concept?

[Gernot Wagner]

Roger,

You asked about RECLAIM and EU ETS and said that:

The European cap and trade system for CO2 is reported as being unsuccessful (emissions continuing to rise) and plagued by evasions through use of bogus international offsets.

There have certainly been problems -- in particular in the 2005-2007 trial phase of the program -- but I'd refer you to a Pew Center report written by Denny Ellerman and Paul Joskow at MIT, who provide a balanced review with a rather positive conclusion (even for the initial trial phase of the program).

I have not come across any similarly comprehensive review of RECLAIM and would appreciate any pointers.

Best,
Gernot

[John Whitehead]

Gormk,

Thanks. But I'm not confused.

"Win-win" is invoked in the context of public policy. The "win-win" headline suggests that there are no costs. Hence, it is important for an economist to recognize costs.

"Gains from trade" results from private transactions and is irrelevant in this discussion.

A Pareto improvement is by definition a "win-win". Or, at least, "win-no loss." Yet, there are no Pareto improvements in public policy which is why benefit-cost analysis uses the potential Pareto improvement criterion.

So, I should back off my "there are no 'win-win' policies" a bit. How about this? "there are no 'win-win' policies without compensation of the losers"

???

[John Whitehead]

My comment is continued here:

In defense of the "there are no win-win government policies" claim

[Carlos Ferreira]

First point: a carbon cap-and-trade scheme is more economic efficient, meaning it allows for the abatement (in quantity) to be achieved where they have the lowest marginal abatement cost. It also allows for the integration of carbon offsets - the CERs (Certified Emissions Reduction).
Most of the problem with the EU ETS has been the policy of grandfathering the emissions. I suppose after the 2012 phase II starts, auctioning the permits will help. I'm not too optimistic, with all the loopholes Poland (and specific sectors) have achieved in the Poznan round.

Another idea: we won't need a worldwide authority (or agent) for a worldwide carbon market: we need a worldwide carbon stock market.

[Carlos Ferreira]

Win-win, e-bay example: doesn't that mean that both the producer of the good (that misses a sale) and the national finances of the country (because of the lack of tax collection) will lose?

[Eli Rabett]

"A cost of riding a bike is the additional time it takes to get there."

You are joking we hope. When you consider the time for parking, stopping in lines of traffic and other things, for trips under a couple of miles in a city, bikes are faster. Sometimes wetter, but faster.