10/27/2008 - 12:38

Reframing the cap-and-trade dialogue

As we wrap up the second round of our discussion, it might be useful to provide a way of framing our dialogue. Each of us has offered observations about the relative advantages and disadvantages of taxes versus cap-and-trade. But how do these differences relate to the (often implicit) goals in choosing a strategy for a climate change program?

When contemplating policy implementation issues, as we are here, it can be helpful to think of the problem as a "constrained cost-minimization problem"--i.e., we are trying to minimize the cost of the environmental program, but our choice of strategy is also subject to practical constraints. So what are the costs? And what are the constraints?

The costs include, of course, the actual costs of lowering emissions (i.e., the abatement costs), the negative effects--if any--of the program on our system of public finance, and the costs of implementing and maintaining the programs. But our choice of programs might be constrained by any number of factors--including politics, law, and the need to meet a specific environmental goal.

The abatement costs include, for example, the costs of adding carbon capture and storage onto coal-fueled power plants, substituting renewable energy sources for fossil fuel, and aggressively pursuing energy efficiency. The good news is that by presenting all parties with the same price for carbon, both taxes and marketable allowances can minimize the costs of abatement, as long as Congress doesn't toy with the price signal.

Generally when Congress imposes taxes to raise revenue, it creates what economists call "deadweight loss," inefficiencies (read social costs) that result from changing prices in the markets. But in the case of carbon taxes and auctioned marketable allowances, these distortions are minimized, at least in theory, because Congress is raising revenue by pushing parties to do something that needs to be done anyway--reduce emissions. As David Weisbach points outs, the key question is whether Congress is less apt to screw up one approach or the other? Certainly, the leading bills in the Senate suggest that legislators can't resist giving away a major portion of the allowances. However, there's no obvious reason to expect them to do better when it comes to resisting tax breaks.

The third area of costs--implementation and maintenance--includes the costs of establishing the program, setting up the bureaucracy, educating covered parties, monitoring emissions and compliance, and taking enforcement action against violators. It also includes the government's costs of making credible commitments to maintain the system so that long-term investments are protected. Janet Milne has argued that by taking advantage of the existing IRS infrastructure, carbon taxes will minimize implementation costs. I find Janet's argument compelling, but as I mentioned in my previous note, I worry that taxes are less stable than emissions caps. Thus, under a tax system, decision makers may be more reluctant to invest in energy-efficient capital if they think that Congress is more likely to change the system.

The primary constraint that we face in our choice of implementation strategy is that the system needs to provide some assurance of meeting the environmental goal, assuming that there is a clear environmental goal. The Intergovernmental Panel on Climate Change has provided us with a target--a 50 to 80 percent reduction in emissions relative to 2000 levels by 2050. On this count, the cap-and-trade system dominates. It isn't that the tax approach cannot reach any given target, only that we don't have a clear map of which carbon tax rates achieve a particular level of emissions reduction. And if we get it wrong on the first pass, it will be extremely difficult to get Congress to adjust the tax again.

While there are no clear legal obstacles to either the tax or cap-and-trade approach, the two do differ with respect to their political feasibility. For better or worse, there seems to be much more resistance to the tax approach than to a cap-and-trade system. This largely may be due to a misunderstanding by the public, but the impact on political feasibility is almost certainly real.