Cap v Tax in FT

Here's the aforementioned letter to the Financial Times in its full glory and British spelling:

Sir, You are absolutely right to argue for prices and against too much direct government meddling within the set of "Green options for US energy policy" (editorial, January 2). You then go on to say that an explicit carbon tax would be best. Yet cap-and-trade is much more than an "implicit carbon tax".

Both sides of the debate have good arguments in favour of their positions. I myself wrote an editorial on these pages (April 26 2007) throwing the FT's support behind a tax, but I have since changed my views, for several reasons.

Most significantly, the US and the European Union 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 response to comments on the previous post elaborates on points one and three. Tim Harford summarized my argument for point three well in an email:

In other words, innovation creates real options, the cap creates an uncertain price, and real options are more valuable in the face of an uncertain price? You presumably believe the downsides of an uncertain price are less important, which I suppose is a defensible position.

Well put, Tim.