An international cap-and-trade system has flaws

It’s good to see the discussion turning to international issues, where it seems we have some disagreements and the most difficult issues arise. So far, the discussion has been noteworthy more for consensus than anything else. Although we learn from consensus, focusing on where we disagree is a better way to make progress. I suspect that part of the reason for our broad agreement is that none of us represents the major effected industries. In the political arena where these ideas ultimately have to pass muster, things won’t be so easy. I also suspect that we do have some deep disagreements about the design of a carbon price even purely within the domestic arena. In particular, if we’re to have a cap-and-trade system, I don’t think we agree on whether a cap-and-trade system should have a pricing ceiling and price floor. I believe it must. Perhaps if we have space in another round of discussion, we can address this issue.

But back to the point at hand, which system would work better internationally–a carbon tax or a cap-and-trade system? As Gernot Wagner and Nathaniel Keohane point out, a key issue is finding a way to engage developing countries while still ensuring that developed countries participate. They suggest that we would be willing to buy off developing countries through permit allocations when we wouldn’t be willing to make the same size direct cash transfers within a tax system. Under a permit system, U.S. businesses would have to purchase permits from developing countries, giving the developing countries the same cash that they would get through a tax-and-transfer system, except implicitly through the permit allocation rather than explicitly through cash transfers.

There are two possibilities for such a system. The first is that nobody is fooled: People would understand that a generous permit allocation would result in large transfers to various countries, transfers that vastly exceed our current foreign aid budget. In this case, if we would be unwilling to transfer those sums to developing countries explicitly, we would be unwilling to do so through permit allocations. The second is that people are fooled: Somehow because of the complexity of the system, people don’t understand that we have increased our transfers to foreign countries by an order of magnitude through permit allocations. This seems to be what Gernot and Nathaniel hope for. But this is neither stable nor democratic. It isn’t stable because you can only fool people for so long. Once U.S. businesses have to start paying foreign governments for permission to operate, people will quickly figure out what has happened. It isn’t democratic: If people understood the size of the transfers, they wouldn’t agree. If we’re to enter into a long-term path toward a climate solution, people must understand and agree with the mechanism. Hiding the ball isn’t a good strategy for a policy that must endure for decades to centuries.

The other major problem with an international cap-and-trade regime that includes developing countries is enforcement. Countries have an incentive to sell their permit allocations for foreign entities to generate cash and then not enforce the resulting emission reductions in their local industries. A permit allocation to a corrupt government is like free money, something we try not to do in the development context. The alternative is to only allow sales of permits by countries with good enforcement records, but if permit buyers are held hostage to local enforcement by governments of various sorts around the world, the permit market will lose many of its benefits and possibly even fail.

Would a tax work any better? International participation in a climate treaty is one of the thorniest issues in climate change policy, so I can’t argue that it would be easy or simple. But yes, I believe a tax would work better than permits. Countries have an incentive to enforce taxes, so the enforcement problem is much smaller with a tax than with permits. To some extent, developing countries could be induced to participate through lower initial taxes plus transfers in the form of technology assistance. Harmonization would be imperfect but it wouldn’t be hard to have the same basic components of the tax across countries. After all, international trading of permits effectively requires perfect harmonization while taxes would do reasonably well with less than perfect harmonization. Most countries now have value added taxes that operate in a roughly similar manner. There is no reason this couldn’t work with a carbon tax.

Let me close by turning to the issue of environmental integrity, which is something people use to argue for permits over taxes. There’s no difference in terms of environmental integrity. Taxes would be able to provide the same emission reductions and the same ultimate carbon concentrations as permits. Just as the number of permits would decline over time to reflect some target, tax rates would go up over time to achieve the target. Just as the number of permits actually issued in any time period would ultimately have to be adjusted to reflect current conditions and new learning about the climate, tax rates would be adjusted. The potential to lower taxes in response to political pressures is no greater than the potential to increase the number of permits. And permits would, in their actual implementation, likely provide flexibility about when to reduce emissions, so to the extent that people believe that their inflexibility is a virtue, it is unlikely to be realized. Moreover, the effect of any remaining uncertainty about final carbon concentrations with a tax as compared to a permit system are swamped by the uncertainty concerning the ultimate effects of carbon concentrations on the climate.

Ultimately, I go back to where I started: It’s all about design. If we are to have a carbon pricing system, the critical issues are about designing it to work well–broad coverage, auctions in the case of permits (or no grandfathering of taxes), flexibility, and broad international participation should be the central goals. A tax can achieve these goals more easily than a permit system. But assuming the underlying policy goals are met, it may not matter much what we call it.