The case for cap-and-trade (or a carbon tax) in 2009

Last week Grist reported that cap-and-trade legislation to address climate change is feasible during 2009 but that the legislation may be postponed until a recession is dealt with. As a potential alternative, the Obama-Biden plan proposes (1) fiscal stimulus funds to build a green infrastructure and (2) a renewable portfolio standard that requires 25% of energy sources be renewable.

Everyone seems to want to know, "what does John think about all that? So far he has been so quiet on the issue." Ha!

My feeling is that cap-and-trade legislation should be pursued in 2009, recession be darned. Benefit-cost analyses indicate that addressing climate change, at least in a small way and then "ramping up" to something more significant over time, is a good idea. The net benefits of climate change don't change much during a recession (the benefits fall as current income falls but not by all that much since most of the benefits accrue in the future).

The economic case for cap-and-trade (or a carbon tax) is clear. Climate change and the associated negative impacts of emissions are known in economics as negative externalities. Much theoretical and empirical research supports an environmental regulation that taxes the polluting activity (or, equivalently, capping the pollution with permits and allowing polluters to trade the permits). The additional production cost of taxes or permits causes profits to be lower in the polluting industries, the supply of the polluting product falls and price of the polluting good rises. As the price of polluting goods rise consumers use less of the polluting good. As the price of nonrenewable energy rises and the price of renewable energy falls (with technological improvement) we reach the Hotelling "switch point" and the demand for renewable energy rises. The price of nonrenewable energy is, more or less, capped at the price of the renewable subsitute and the world is a greener place.

One reason why it might be difficult to enact climate legislation during 2009 is that raising broad-based taxes during a recession is not a great idea (see Keynes). However, one of the features of carbon taxes and cap-and-trade with auctioned permits is that revenue is raised for the government in addition to achieving reductions in pollution. The typical next line in this story is that these new revenues could be used to offset cuts in income, capital gains, business and other distorting taxes while keeping the government budget situation at least as sound as it was when we started. I've argued in the past that revenue recycling is a separate policy and should not be paired with a carbon tax in the minds of decision makers (since this second policy might not take shape). But during a recession we're already talking about cutting taxes. Indeed, during the 2009 recession we're talking about cutting taxes and increasing government spending so that the budget deficit is bigger than ever (as a percentage of GDP) while the budget debt is as big as ever. A new revenue source would help offset deficit risks.

My other feeling is that (1) subsidies for green energy are not as efficient as taxes on dirty energy in terms of pollution reduction and cost effectiveness and (2) forcing electric utilities and other entities that buy energy to purchase a mix of energy without appropriate price signals is not a good idea.

The case for subsidies for geen energy is less clear. In addition to the worries over the general use of environmental subsidies (e.g., subsidies reduce prices of clean energy and dirty substitutes when the goal is to increase the price and decrease the use of a bad thing; i.e., use of the bad thing and the associated pollution might not fall as much as intended), subsidies will make budget deficits bigger when deficit risks are feasible. The Obama-Biden 25% renewable energy portfolio standard would significantly increase the demand for renewables and reduce the demand for nonrenewable energy. The forced demand will increase the price of renewable energy. The decreased demand for dirty nonrenewable energy will decrease its price. The prices are moving in the opposite direction of where they need to go to provide the appropriate signals to energy consumers about the full social costs of the energy sources. Consumers will want to buy less green energy and more dirty energy. I don't know how all that would play out since it is not exactly textbook theory but there are some definite inefficiencies in that scenario.

Comments

[Roger Chittum]

"[F]orcing electric utilities and other entities that buy energy to purchase a mix of energy without appropriate price signals is not a good idea."

Why not? We've done a lot of this in the last 35 years or so, including the requirement that utilities buy electricity from co-generation projects at "avoided cost." The amazing achievements of the Clean Air Act and State analogs all resulted from command and control regulations with nary a price signal. Surely, you're not proposing to replace tried and true methods with an untested method without at least a comparative discussion. Or are you?

[John Whitehead]

Roger,

The forced demand will increase the price of renewable energy. The decreased demand for dirty nonrenewable energy will decrease its price. The prices are moving in the opposite direction of where they need to go to provide the appropriate signals to energy consumers about the full social costs of the energy sources. Consumers will want to buy less green energy and more dirty energy. I don't know how all that would play out since it is not exactly textbook theory but there are some definite inefficiencies in that scenario.

And a sarcastic answer to your question: Yes, i'm suggesting we have no discussion. I'm that sort of dick.

And that's why we started a blog (with open comments). To limit discussion!

[Matt Cox]

John,

The UK Climate Change Programme has a nice analysis on the cost-effectiveness of policies, where they conclude that regulations and taxes are much more cost effective than the subsidies at achieving the desired emission reductions.

So I think you're probably on strong ground with your hunch

[susie orman]

One reason why it might be difficult to enact climate legislation during 2009 is that raising broad-based taxes during a recession is not a great idea (see Keynes). However, one of the features of carbon taxes and cap-and-trade with auctioned permits is that revenue is raised for the government in addition to achieving reductions in pollution.

[Invisible Hand]

Most of the Carbon Tax proposals I have seen are Revenue Neutral, in that there would be offsetting tax cuts, such as lower income taxes. I think it would be much better for the Carbon Tax revenues to be used to fund proactive GHG Reduction programs such as solar power subsidies, reforestation, alternate fuels development, etc.

Using Carbon Tax revenues to directly fund GHG Reduction programs has a major advantage in that the Carbon Tax rate could be set lower to achieve the same GHG Reduction goals, since the tax would reduce the use of GHG fuels and the tax revenues would be used to reduce GHG emissions. This approach should also appeal to a lot of environmentalists, since the Carbon Tax would be providing a dedicated revenue source for GHG programs.

[Mipam Thurman]

I have a real problem with cap-and-trade policies. I do not think it is good business. Now I am NOT saying that we should do nothing about global warming, that would be suicide. I am however, thinking that creating a cap-and-trade system and setting it into law as a taxation device is trying to make something that has no value a thing which has forced value. The US economy is riddled with productive innefficiency, and this is causing the unemployment rate to rise as companies trim costs to keep their profits stable. If we introduce another commodity that has no actual value in the market place outside of a tax code, aren't we creating an even more conducive environment for productive innefficiency? (Which in turn will create more unemployment and lower demand for goods and services even further?) Not to mention the fact that all the products this country imports will become more and more expensive as the exporting countries in question are forced to charge higher prices for their merchandise (because we are buying less products from them)

The biggest problem with cap-and-trade for me is that it rewards success, and while i normally agree with this idea in principle, I think it does not address the real problem that global warming presents. We need the worst polluters to be rewarded for cleaning up their production processes. Companies that have already reduced their carbon footprint have internal reasons to do what they do, they run a tighter ship and are rewarded by a lower cost of production. We do not need to create a cap-and-trade system that rewards these environmental business pioneers. We need to reward dirty producers who take the requisite steps to clean up their operation. In terms of efficacy, you get a larger decrease in pollution by cleaning up a dirty company by 20% than you get from further cleaning up a clean company by 20%. Additionally, it is also geometrically more expensive to clean up a cleaner company than it is to clean up an already dirtier company.

[Corbett]

Invisible Hand,

The main reason that carbon tax proposals are generally revenue neutral is for distributional reasons. Carbon taxes (as with most environmental policies) are inherently regressive, and cutting pre-existing taxes can alleviate some of the adverse distributional effects of a GHG policy. Moreover, there is a "double dividend" argument at play: by cutting pre-existing (distortionary) taxes, we can cut GHG emissions AND get rid of some inefficiencies in the labor market. This would not be the case if we used the revenues in the way you propose.

It should also be noted that a cap-and-trade scheme can be revenue-raising if some (or all) of the permits are auctioned off by the government. We can begin by giving them out gratis for political reasons, but eventually we could move to an auctioned system.