Friday, August 14, 2009

Why carbon taxes may be a superior alternative?

It is now widely acknowledged that market-based mechanisms (like cap-and-trade or carbon tax) score over conventional command and control approaches (like technology or uniform performance standard) as the least distortionary, cheapest, most effective and equitable approach to controlling greenhouse gas emissions.

While market-based mechanisms are doubtless superior to command and control policies, at least in containing emissions among the larger industrial polluters, there is also a raging debate on which type of market-based mechanism is superior.

The biggest obstacle in the way of effective implementation of cap-and-trade measures are the transaction costs associated with such trades and the difficulty with efficiently allocating permissble emission allowances among emitters.

Prof Robert Stavins identifies three transaction costs of exchange - matching of potential buyers and sellers; contracting (brokerage, legal and insurance service expenses etc); and monitoring and enforcing emission control. These transaction costs not only eat into the savings (or profits) from the exchange, they also suppress mutually beneficial exchanges that would otherwise have happened.

In a 1995 article, he had claimed that "if the incremental transaction costs are independent of the size of individual transactions (between emitters and buyers of permits), the initial allocation of permits (among emitters) has no effect on the post-trading allocation of control responsibility (among sources of emissions) and aggregate (emission) control costs. But if incremental transaction costs decrease with the size of individual trades, then the initial allocation will affect the post-trading outcome." In other words, "in the presence of transaction costs, the initial distribution of permits can matter not only in terms of distributional equity, but in terms of cost-effectiveness or efficiency". However, evidence from existing cap-and-trade programs across the world point to minimal transaction costs.

Prof Stavins is one of the most prominent supporters of the cap-and-trade arrangement and makes a superbly argued case in favor of cap-and-trade here and here. He has outlined his model thus, "Initially, half of the program’s allowances would be allocated through auctioning and half through free distribution, primarily to those entities most burdened by the policy. This arrangement should help limit potential inequities while bolstering political support. The share distributed for free would phase out gradually over twenty-five years. The auctioned allowances would generate revenue that could be used for a variety of worthwhile public purposes. To increase the program’s short-term cost-effectiveness and create long-term incentives for technological development, entities that successfully implement carbon sequestration (biological or underground if feasible) would be eligible for offsets."

I have already argued here about the superiority of carbon taxes over cap-and-trade system. Greg Mankiw, one of the most vocal advocates of carbon taxes, makes an excellent case here and here. I can think of four reasons why among market-based mechanisms, carbon taxes trumps cap-and-trade

1. The monitoring and enforcement transaction costs associated with cap-and-trade arrangements become considerable when dealing with large numbers of smaller emitters like small scale industries, whose combined emissions are too large to be ignored. The fact that these enforcement mechanisms kick-in post-facto increases the incentives to evade and thereby makes the transaction costs considerable. Further, transportation sector is completely left out of the cap-and-trade mechanism, which concentrates only on the upstream side of the emission chain. Even in case of the larger emitters, the difficulties associated with collecting accurate information on actual emissions is well documented.

In contrast, carbon taxes are incurred ex-ante by the emitter, and therefore pre-empts the transaction cost of monitoring and enforcement. Further, since they are imposed on the emission source (say, fuel), it is indifferent to the size, numbers and nature of emitters. In other words, there is no need to monitor the end-use application that generates the carbon emissions.

2. Another big challenge with cap-and-trade lies in the allocation of emission permits. If the emission allowances are allocated in excess, there will be limited demand for such tradeable permits, which in turn depresses their market values and makes these trades unattractive for sellers. On the contrary, lower than required allocation of emission allowances increases the demand for tradeable allowances and pushes up their market prices, thereby increasing the cost of production for firms. The big challenge is whether it is possible to insulate the emission allowance allocation process from getting politicized (if not in developed countries, atleast in developing economies).

In the absence of a market-based mechanism for the determination of optimal quantity of emission allowances, government agencies end up performing this allocation role. The result most often, as the example of the EU ETS demonstrates, is liberal allocation of allowances, which defeats the purpose of controlling emissions. Besides, the reduced demand for tradeable emission permits decreases the market liquidity and spawns all attendant market distortions. Even the price discovery by auctioning of emission permits is constrained by the lack of information about the quantity of permits to be put on auction.

3. Cap-and-trade contains provisions for off-setting their emissions by emitters who are able to sequestrate (capture) carbon through biological means like developing forests and green sinks and even agriculture. These off-sets provide a big challenge, not only in their monitoring but also in the estimation of the potential emission reductions from such sequestration activities.

4. In an increasingly globalized world and given the "global commons" nature of climate change issues, cap-and-trade poses problems of the sort highlighted by the "border adjustment" tariffs proposed under the US Climate Change Waxman-Markey Bill, on countries that fail to cap their greenhouse gas emissions by 2020. Even between countries following cap-and-trade policies, like say EU ETS and US (when the Bill is passed into law), harmonization is likely to become a potentially controversial issue (given the differences in the way permits were allocated).

Carbon taxes, by being uniform in their application across all categories of carbon emitting products from across the world, avoids the aforementioned problems in cross-country trade. It can be easily integrated with the existing global trade policies under the WTO, without generating any market distortions.

In fact, on trade grounds alone carbon taxes is a superior alternative. Even if the transaction costs are minimal in developed economies, with their more effective monitoring and enforcement mechanisms and smaller numbers of emission sources, they are likely to be large in developing economies for exactly the opposite reasons.

In summary, while both the major market-based mechanisms - cap-and-trade and carbon taxes - are better than command and control based approaches to controlling carbon emissions, I am inclined towards the view that carbon taxes may be slightly superior of the two. It enjoys minimal transaction costs and more importantly provides an easier-to-implement framework for a global climate change policy.

Update 1
Michael Roberts has this explanation of the leakages associated with carbon offsets.

Update 2
NYT summarizes the debate between cap-and-trade and carbon taxes as that between trying to control emissions by imposing quantity restrictions and price floors respectively.

Update 3
Times reports that carbon taxes may be finding favor in Europe too in the wake of modest progress with cap-and-trade experiments. France has taken the lead in carbon taxes with a proposal that would raise the cost of driving a car or heating a home, all with the aim of encouraging conservation and thus reducing France’s overall emissions.

Sweden has had such a tax in place since 1991, when the government imposed a tax equivalent to €28, or $41, for each ton of CO2 emitted. Denmark instituted its carbon tax a year after Sweden, while Finland, Norway, Switzerland and parts of Canada impose similar taxes. The Swedes currently levy a tax of €128 for each ton of CO2, although industries that are exposed to international competition are permitted to pay the tax at a lower rate. It is estimated that emissions in Sweden would be 20 percent higher without the tax, yet the economy has still grown by 44 percent since it was put in place.

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