09/11/2008 - 08:02

The case for cap-and-trade: There's certainty in the environmental outcome

Cap and trade sometimes seems like the Rodney Dangerfield of environmental policies: It's popular with the masses (or in this case both presidential candidates, members of Congress, major environmental advocacy groups, and the private sector) but gets no respect from most academic economists and other high-minded policy wonks. That's true despite the fact that cap and trade is a proven policy: The emissions trading program for sulfur dioxide from electric power plants, established by the 1990 amendments to the Clean Air Act, has cut emissions by 40 percent since 1990 at a fraction of the expected cost.

A cap-and-trade system differs from a tax in two basic ways. The essential distinction is that a tax fixes the price of pollution, while a cap controls the quantity. From the perspective of the planet, this makes all the difference. Based on what the science tells us, we have to reduce greenhouse gas emissions dramatically in the next several decades--by roughly 80 percent in the United States relative to current levels. The only way to guarantee those cuts is to put a cap on emissions.

A tax only achieves emissions reductions indirectly, through the price. The problem is that we don't really know the appropriate level of the tax that will induce the changes in energy demand and consumption that are needed to bring emissions down far enough and fast enough to avoid dangerous climate change. And we don't have the time (or the political attention span) to try out different taxes in a search for the "right" level. Moreover, as the economy grows, so will emissions, meaning that the tax would need to be raised over time to ensure that emissions continue to fall, as they must. Finally, political pressures will be omnipresent to set the tax low to begin with and to lower it thereafter; just witness the recent calls for a gas tax holiday. All of these factors suggest that we neither know what the right tax is, nor have the political will to set it at that level.

In contrast, a cap controls quantity directly. Congress, not the market, would determine the allowable quantity of emissions--while the market, not Congress, would determine the price. In this way, science can determine the policy goal--while the market figures out the cheapest and fastest way to achieve it. That seems like the right division of labor.

Setting a cap on emissions is especially important given the growing body of scientific evidence suggesting that climate change is likely to be abrupt and nonlinear, characterized by "tipping points" such as the melting of the Greenland or West Antarctic Ice Sheet, which would slowly but inexorably raise sea level by several meters. A hard cap is the best way to ensure that we cut greenhouse gas emissions enough to avoid exceeding dangerous thresholds in the climate system.

A second (and less fundamental) difference between a tax and cap and trade concerns whether firms pay for every ton of pollution they emit, or receive some tons for free. A carbon tax would likely be applied to all emissions. In contrast, under a cap-and-trade system, once the cap on allowable emissions is set, government could give away some portion of the allowances for free to regulated firms--without affecting the efficiency of the program in terms of achieving emissions reduction. This strikes some people as an unfair break for polluters. But it does offer an important political advantage: Politicians can distribute allowances as they see fit, without affecting the basic performance of the program.

Now, it's worth pointing out that raising revenue does matter for efficiency in the economy at large. That's because government can use the revenue to cut income taxes, which represent a drag on the economy. Moreover, if those tax cuts are targeted wisely, they can also help ensure distributional equity, offsetting the impact of higher energy costs on low-income households.

But if raising revenue is our goal, a cap-and-trade system can be designed to do it just as well as a tax can. Congress could decide to auction off most or all of the allowances, rather than giving them away for free. Whether we use a tax or cap and trade, we will have to negotiate how to divide up the "pie" created by placing a value on the right to pollute. Will we allocate those allowances to polluters or to consumers at large? The key point is that a cap-and-trade system doesn't require doing one thing or the other. Rather, it provides the political flexibility to make those divisions while still accomplishing the ultimate goal, which is reducing greenhouse gas emissions.