Wednesday, October 21, 2009

The cap and trade Vs carbon taxes debate revisited

Outside the mainstream of economic policy making, dominated as it is by the more glamorous issues like financial market regulation and macroeconomic policy making, one of the biggest areas of ideological and academic divide is over policies on greenhouse gas emissions reductions to address the climate change challenge. While everyone agrees that fundamental to addressing this issue is raising the price of carbon and ensuring universal participation, there is a sharp divide over which of the two alternatives - cap-and-trade and carbon taxes - is superior.

One group of environmental economists, led by the likes of Robert Stavins of Harvard, favor cap-and-trade, while the other group, led by William Nordhaus of Yale, pump for globally harmonized carbon taxes to combat carbon emissions. While conceding the relative superiority of cap-and-trade on grounds of economic efficiency, this blog has consistently argued in favor of carbon taxes as a superior alternative, only on the basis of its ease of administration and implementation. The fact that any meaningful emission reduction plan has to involve all the countries of the world, gives added importance to harmonization of policies across nations. Carbon content based taxes may be easier to harmonize than cap-and-trade.

This debate also carries relevance on a deeper public policy making canvas, on the issue of trade-off between policies which generate the greatest economic efficiency but face implementation challenges on the one hand, and those that are slightly less efficient but are easier to implement on the other hand. Cap-and-trade appears to be belonging to the former camp while carbon taxes to the latter.

Cap-and-trade permits those who can reduce their emissions at the least cost to sell their saved carbon credits (or certified emission reductions, CERs) to those facing higher marginal costs, and thereby achieves economic efficiency - lowest cost and least distortions. Unlike any other form of emission reduction policy, as Robert Stavins points out, cap-and-trade differentiates among emission sources and confers a compliance flexibility which can be used to cut emissions at the lowest cost.

The economics of both are captured in the two graphs below. First, Paul Krugman models the deadweight loss to emitting businesses and the economic benefits to both emitters and consumers of their products.

The carbon tax imposes a deadweight loss indicated by the red triangle.

Here is a list of possible implementation problems associated with cap-and-trade that can come in the way of achieving the desirable objectives.

1. Difficulty in selection of projects eligible for issuance of carbon credits by the UNFCC. Projects which use clean technologies or those which reduce greenhouse gas emissions cannot become the sole criterion, since there are many such projects which would in any case have come up because of their lower life-cycle costs. Even these projects now become eligible for carbon credits and the resultant subsidy.

To take just one example, all solid waste management projects or lighting energy saving projects, which would have come up in any case, are now eligible for carbon credits. These CERs are a straight subsidy to these projects. The only reason why there has not bee a flood of such projects from developing countries is lack of awareness and the bureaucratic barriers to entry (hiring of consultant, host government certification, and then approval by the UNFCC, and then finding a buyer).

2. In developing countries, where adherence to even basic and visible environmental safeguards are at a premium, it may be extremely difficult, well-neigh impossible, to monitor greenhouse gas emissions. Therefore, it will be difficult to monitor the compliance of projects eligible to sell carbon credits. And enforcement will be an even bigger challenge.

3. National governments, especially from developing countries, have a greater incentive in imposing carbon taxes, in view of its assured revenue stream, whereas the cap-and-trade regime, will provide any substantial revenues only many years latter.

4. Increasingly, CER sales have become an important source of financing such projects. In fact, they have become a sort of viability gap funding source for these projects. In other words, project promoters see CERs as part of a project financing option and less part of an emission reduction plan. This results in incentive distortions by way of efforts to game the achievement of emission targets.

Further, the market volatility associated with the prices of CERs leads to uncertainty in revenue streams for these projects and increases the risks associated with them.

5. National governments in many developing countries cannot be relied upon to effectively administer a cap-and-trade regime. Such regulatory interventions are likely to spawn corruption and defeat the purpose. An international bureaucracy can be of limited utility in monitoring adherence to standards which require invasive inspections.

6. The politics of formulating an internationally acceptable cap-and-trade regime may make it a non-starter. How do we harmonize cap-and-trade policies across nations states - the emission reduction targets, initial allocations of emission allowances and the details of tightening standards? Will the old bogey of "why should we pay for the costs of your pollution with our economic prospects" not derail any effort to impose meaningful emission caps?

7. Cap-and-trade does not address emissions from sectors like transportation and usage of electronic devices. Transportation in particular is an increasingly dominant source of greenhouse gas emissions and cannot be kept out of the ambit of any serious policy proposal to reduce greenhouse gas emissions.

8. In developing countries, the politics and lobbying surrounding the issue will ensure that the initial allocations will be very liberal and the standards will be kept deliberately loose to minimize the costs on the domestic industries.

Prof Stavins may be right in claiming that "the best (and most likely) approach for the short to medium term in the United States is a cap-and-trade system", where the monitoring and enforcement costs may be manageable. However, if we are looking at an internationally applicable uniform policy for lowering emissions, then carbon tax looks more attractive for all the aforementioned issues of the real world.

It may also be possible to have an international climate change policy that draws both approaches and standardizes them to arrive at an acceptable mix of emission reduction policies. And as this Hamilton Project paper, pointed out by Prof Stavins, indicates, governments should be presented with both alternatives, and left to choose that policy option which generates the least political opposition and which imposes the least short and medium-term costs on the economy (or that which has the least painful transition costs).

Update 1
See this graphical analysis of the Waxman Markey Bill's cap and trade proposals.

Update 2
See this chronological sequence of the evolution of the concept of cap-and-trade.

Update 3 (18/6/2010)

Report on the success of the 1990 Clean Air Act Amendments in the US to contain sulphur-di-oxide emissions from coal-fired power plants that caused acid rain. See also this video on cap-and-trade and this article on the Climate Change Bill before US Congress.

Update 4 (22/6/2010)

Free Exchange lays out the case here and here for carbon taxes over cap-and-trade.

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