Carbon Taxes vs. Cap and Trade

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Apologies for being a bit behind the eight ball. Still under the weather, so forgive me if my posts for the next little while are a bit light on my own commentary.

This op-ed piece, “Getting on a low-carbon diet,” by Ronald Brownstein in the LA Times gives an even-handed treatment of the merits of carbon taxes versus cap and trade as means for combating CO2 emissions. My quibble is that he understates the degree to which the permits trading regime in the EU has failed. The price for CO2 emissions has varied widely, and as the Financial Times pointed out in an editorial, a clear price for carbon (which a tax would provide) is essential for investing, both in conservation programs and in cleaner energy sources. Volatile prices make it impossible to estimate the level of future cost savings.

From Brownstein:

….Scientists, economists and political leaders who support action against global warming all construct their proposals on a simple foundation: attaching a cost to carbon emissions. Since the U.S. (and most other big polluters, like China and Russia) does not regulate greenhouse gas emissions, factories and power plants and cars can pump carbon into the atmosphere for free; to the polluter, carbon today has no cost. This despite all the costs global warming could impose on the world, from lower crop yields to destabilizing migrations and the greater international conflict that a group of retired generals and admirals warned about in testimony before the Senate Foreign Relations Committee Wednesday.

Since none of those costs are internalized to fossil fuels like coal and oil, the effect is to artificially lower their price. That distortion encourages overuse of fossil fuels and discourages investment in clean energy alternatives (such as wind, solar, and above all, greater efficiency) that don’t produce greenhouse gases…. So for almost every political leader at home and abroad who accepts the need to pursue mandatory reductions in greenhouse emissions—a group from which the dead-ender at 1600 Pennsylvania Avenue remains conspicuously absent—the first priority is to create a cost for carbon. The question now sharpening in Congress and the 2008 presidential race is how best to do that.

To the extent American politicians in recent years have talked about controlling carbon emissions, they have almost entirely focused on a system known as “cap and trade” that attempts to harness market forces to drive reductions….

But now a group of skeptics is questioning whether that approach by itself will achieve the reductions in emissions necessary over the next several decades to stabilize global temperatures at a sustainable level. Their alternative has a sharper edge: a tax directly on the carbon emissions of fossil fuels.

The most prominent supporter of a carbon tax is former Vice President Al Gore, who touted the idea in his high-profile global warming testimony before the House and Senate earlier this year. Sen. Christopher Dodd (D-Conn.) is promoting a carbon tax in his campaign for the 2008 Democratic presidential race….

But Dodd is the only prominent presidential candidate talking about a carbon tax. And he’s not surprised to be standing under that banner alone. “Why I suspect the other candidates are not talking about this, is all their pollsters and handlers have said ‘you are looking for trouble here,'” Dodd says. “I think…there is a larger constituency for [this] than people believe today.”

Both a carbon tax and a cap-and-trade system are designed to place a cost on carbon emissions. A carbon tax does so directly: It would tax each fossil fuel based on the amount of carbon it emits when burned. Under that system, coal would be taxed the most, oil less and natural gas least. Dodd’s staff estimates that setting the carbon tax at around $30 to $37 per ton of carbon pollution would provide the right incentives for polluters to control emissions and shift to cleaner fuels—and also raise the federal government about $50 billion annually. A carbon tax set at that level would raise the price of gas about 10 cents a gallon.

A cap-and-trade system operates very differently. The cap part works like this: The government would set an overall limit on the amount of carbon the country will emit each year, and then allocate “credits” that establish emission limits for individual companies. At that point, the trade component would kick in. The credits would create a right to emit carbon; firms that can reduce their emissions more efficiently could sell some of their credits to other companies (say utilities heavily reliant on coal-fired plants) that find it more expensive to control carbon. A trading system would develop that establishes a market price for carbon pollution.

There are some other fine points under debate, particularly whether the credits should be provided free to polluters or auctioned off (by all indications, a better option.) But the bottom line is that when a cap-and-trade system works well, it leverages the power of the market to encourage innovation and efficiency. Because firms can directly profit from achieving the maximum reduction in pollution at the minimum cost, the opportunity to do well reinforces the desire to do good. The cap-and-trade system Congress approved in 1990 to fight acid rain has produced greater reductions in sulfur dioxide pollution at less cost than initially expected and minimal economic disruption….

Skeptics, though, point to the troubles of the cap-and-trade system the European Union has used since 2005 to reduce carbon emissions. Under pressure from industry, European governments gave away too many credits to polluters; the result was that the price of the credits collapsed, undermining the incentive to cut emissions or use cleaner fuels. (Some analysts say the cost fell so far it was cheaper for European utilities to buy credits and burn coal than to burn cleaner natural gas.) A second round of mandated emission reductions scheduled for next year could ameliorate the problem, but at the least, the European experience suggests that designing a successful cap and trade is an enormously complex undertaking which may require some trial and error before it works.

That prospect is at the heart of Dodd’s argument for a carbon tax. A cap-and-trade system, he says, “is confusing, it’s complicated and it takes forever.” Enforcement could also be a challenge, he says, as “people move stuff around” and perhaps try to generate phantom reductions. By contrast, he argues, a carbon tax sends an instant, unambiguous signal discouraging the use of the fuels that contribute the most to global warming.

For all his doubts about a cap-and-trade system, Dodd says he supports one, but as a complement to a carbon tax, not an alternative. And in fact linking these two ideas may be the best long-term answer in this debate.

Jennifer Layke, deputy director of the climate program at the World Resources Institute, an economic-oriented environmental think tank, correctly points out that the two policies have complementary strengths. While the cost to industry of carbon emissions fluctuates under a cap-and-trade system, she notes that a carbon tax would establish “price certainty” by telling companies exactly how much it will cost them to emit a ton of carbon. That would help firms make rational long-term decisions on whether to invest in less polluting sources of energy.

Conversely, a carbon tax does not guarantee any specific reduction in greenhouse emissions; it only attempts to drive down emissions by driving up their price. That’s where a cap-and-trade system could provide what Layke calls “environmental certainty” by establishing specific reduction mandates. Al Gore, in his Congressional testimony, reached a similar conclusion about the two ideas, testifying that he believed “the most effective approach is to do both.”

This discussion may seem wildly premature. In today’s political climate, weighing the relative virtues of a cap and a tax is a little like the Tampa Bay Devil Rays deciding whether they would rather face the Dodgers or the Mets in the World Series. At the moment there’s no sign Congress is ready to approve even a cap-and-trade system; the last time the Senate voted on the McCain-Lieberman plan, in 2005, it attracted only 38 votes. And a carbon tax proposal—because it includes that three letter word—is a much more incendiary proposition than a cap-and-trade proposal (which would also raise electricity and gasoline prices, though in a more muffled and indirect way).

But the political climate on these issues could change as abruptly as some experts fear the global climate might change in a warmer future. More leaders from different segments of American society—from utility and auto executives to the retired military officials who testified before the Senate this week—are endorsing meaningful, mandatory action against global warming. A path-breaking business/environmentalist coalition that supports compulsory reductions in greenhouse emissions this week doubled its membership from 14 to 28 by adding, among others, General Motors and Shell. With a new president committed to crystallizing that consensus, rather than resisting it, decisive change could come much faster than now appears possible.

When Washington is ready to act, the real lesson it should take from this brewing debate over the best way to discourage carbon pollution is that there is no best way. Progress against a challenge as vast as global warming will require us to use all the tools available to us: direct regulation (tougher fuel economy standards for cars, requirements on utilities to generate more of their electricity from renewable sources); economic carrots and sticks (a carbon tax that helps fund tax breaks for investment in greater energy efficiency and alternative energy sources); a cap-and-trade system that sets a hard limit on emissions; federal procurement that nurtures clean new technologies; and steps beyond all of these that we can’t yet imagine.

“The reality is we are going to spend most of this century trying to figure out how to crank down our global warming emissions,” says Dan Becker, the director of the Sierra Club’s global warming program. “We are going to need everything we know how to do and probably a whole lot more.”

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