Why revenue-neutral carbon taxes are superior to "cap and trade" schemes

To stabilize carbon emissions we need to choose effective policies to incent investors and consumers to make low-carbon choices immediately — not twenty years in the future. The most critical investment decisions are those of the power generation utilities — who are rapidly constructing inexpensive coal-fired plants around the world. To stop that impending train wreck the electric utility boards of directors need certainty of the future costs of carbon emissions. I.e., we need to establish a “price on carbon” that produces immediate results.

Fortunately, the requirements for efficient taxation and regulatory policies have been thoroughly studied — we do not need to create new “Bi-partisan Commissions” to recommend structural options. The following summarizes some of the relevant research demonstrating that a revenue-neutral carbon tax scheme is far superior to the politically popular “cap and trade” schemes such as Kyoto or the European “Emissions Trading Scheme” (ETS).

A revenue-neutral carbon tax scheme can be implemented with nearly zero administrative cost — existing tax collection and auditing channels are almost all that is required to implement a new tax schedule. The price mechanism allows each investor to confidently plan for her future cost of emissions. The carbon tax option gives us certainty of future costs, transparency, and low transaction costs associated with the carbon pricing.

The opposite of certain is what we get with the quantity mechanism of cap-and-trade. The investor faces a volatile, uncertain profile of future emissions costs. The ETS experience has demonstrated great volatility. Volatility is the enemy of what we urgently need — that is fast decisions to stop building dirty coal power generation, substituting the larger capital investments required for low- or zero- carbon plants.

The cap and trade scheme creates a new administrative monster that will be impossible to kill off once it gets going. Envision an apparatus ten times bigger than the Dept of Agriculture. Do not forget that cap and trade requires measuring and auditing reported quantities of emissions. Cap and trade will create a rich growth medium for rent seeking — which leads inevitably to corruption.

In “Bootleggers, Baptists, and Global Warming” Bruce Yandle looks at the post-Kyoto negotiations in the light of the “bootleggers and Baptists” theory of regulation. Yandle points out that in the South, Sunday closing laws make it illegal to sell alcohol on Sunday. These laws are maintained by an inadvertent coalition of bootleggers and Baptists. The Baptists (and other religious denominations) provide the public outcry against liquor on Sunday, while the bootleggers (who actually sell liquor on Sunday) quietly persuade legislatures and town councils to maintain the closing laws. In this paper, Yandle explains that something similar is happening with the treaty negotiations over climate change. Baptists are the environmental groups, and bootleggers are the companies, trade associations, and nations that are seeking favors through the global warming negotiations.

In the previous post Life After Kyoto: Alternative Approaches to Global Warming Policies I reviewed the 2005 Nordhaus study of the same name — which I think very compactly demonstrates the real-world advantages of harmonized carbon taxes vs. cap-and-trade.

Non-economists will probably always be uncomfortable with using indirect instruments like prices, just as patients may wonder how little yellow pills can cure their disease. Nonetheless, the fact that prices are more indirect than quantity restraints should not prevent us from recognizing their superior power as a coordinator and motivator for global warming.

For an in-depth exposition of the superiority of the carbon tax strategy, see The Challenge of Global Warming- Economic Models and Environmental Policy by Yale’s William Nordhaus. You can read a clear discussion of the above issues by searching the PDF for this section The Many Advantages of Carbon Taxes [A. Prices versus Quantities for Global Public Goods].

Nordhaus has probably done the best work demonstrating the many efficiencies of price schemes over quantity schemes. As just one example, a key requirement of any scheme is that it be adaptive. In Nature, 8 May 2008: among the 4 letters responding to the Nature PWG commentary is this letter from Richels, Tol and Yohe, which makes the point on the adaptive requirement better than I have:

In their Commentary ‘Dangerous assumptions’ (Nature 452, 531-531; 2008), Pielke et al. show that the 2000 Special Report on Emissions Scenarios (SRES) reflects unrealistic progress on both the supply and demand sides of the energy sector. These unduly optimistic baselines cause serious underestimation of the costs of policy-induced mitigation required to achieve a given stabilization level.

This is well known among experts but perhaps not to the public, which may explain why some politicians overstate the impact of their (plans for) climate policy, and why others argue incorrectly that ‘available’ off-the-shelf technologies can reduce emissions at very little or no cost.

The numbers presented by Pielke et al. are revealing, but they divert attention from a more serious problem underlying the SRES approach to calculating mitigation costs: a failure to incorporate the dynamic nature of the decision problem into climate-policy analysis. Until we can keep adjusting the analysis by continually incorporating uncertainty, correction and learning, we shall continue to offer policy-makers an incomplete guide to decision-making.

The focus of policy analysis should not be on what to do over the next 100 years, but on what to do today in the face of many important long-term uncertainties. The minute details of any particular scenario for 2100 are then not that important. This can be achieved through an iterative risk management approach in which uncertain long-term goals are used to develop short-term emission targets. As new information arises, emission scenarios, long-term goals and short-term targets are adjusted as necessary. Analyses would be conducted periodically (every 5-10 years), making it easier to distinguish autonomous trends from policy-induced developments — a major concern of Pielke and colleagues. If actual emissions are carefully monitored and analysed, the true efficacy and costs of past policies would be revealed and estimates of the impact of future policy interventions would be less uncertain.

Such an approach would incorporate recent actions by developed and developing countries. In an ‘act then learn’ framework, climate policy is altered in response to how businesses change their behavior in reaction to existing climate policies and in anticipation of future ones. This differs from SRES-like analyses, which ignore the dynamic nature of the decision process and opportunities for mid-course corrections as they compare scenarios without policy with global, century-long plans.

For a recent study of the costly, messy world of trading permits and offsets see the April 2008 working paper [PDF] by reliable sources Michael Wara and David Victor. Excerpt:

This article reviews the actual experience in the world’s largest offset market–the Kyoto Protocol Clean Development Mechanism (CDM)–and finds an urgent need for reform. Well- designed offsets markets can play a role in engaging developing countries and encouraging sound investment in low-cost strategies for controlling emissions. However, in practice, much of the current CDM market does not reflect actual reductions in emissions, and that trend is poised to get worse. Nor are CDM-like offsets likely to be effective cost control mechanisms.

This is excellent work — and compelling results. I hope that all the politicians pushing “son of Kyoto” deals will read it and think carefully about what they are proposing.