Carbon Tax versus Cap and Trade

15 Jun 2016

I’m curious to figure out which of these is the better option for trying to reduce emissions. My instinct is to support a carbon tax over cap and trade because I have a vague recollection of hearing a talk make this point. However, Paul Krugman actually favors cap and trade over a carbon tax, which seems like a good reason to take cap and trade seriously.

Before getting started, we want to reduce emissions but we also want to somehow grow, or at least maintain, the world economy and help developing countries. There’s some thorny moral issues here, since developing countries won’t be able to emit as much as developed countries have already emitted, but I’m going to ignore the question of which option is fairer. Also, many people think both of these are bad options since neither will do enough to limit emissions. That’s true, but they seem to be the most likely options to be implemented in the near future and so I want to have an opinion on which is better.

Externalities

I think the arguments for and against each option can be divided into those that focus on the more abstracts merits of each option and those that have to do with actually implementing either system. Let’s start with the abstract arguments.

From an economist’s perspective, climate change is an example of a negative externality. As far as I can tell, externalities were first discussed in Arthur Pigou’s 1920 book The Economics of Welfare. According to Wikipedia, Pigou was a good friend of Keynes, though they often disagreed, and a great economist -- he’s not as well remembered as he should be. Pigou is also a bit of a strawman in Keynes’ General Theory.

Externalities are basically the spillover from an activity. An example of a negative externality is a chemical plant that releases its wastewater into a nearby river. There can also be positive externalities: if you have work done on your house to make it more attractive you increase the value of your neighbours’ houses as well as your own. Either way, an externality affects people not directly participating in the activity, like the people downstream of the chemical plant.

Carbon taxes and cap and trade are both ways of reducing emissions by implementing a Pigouvian tax, which is a tax on an economic activity that generates a negative externality. The theory behind Pigouvian taxes is quite neat.

Marginal Benefit

To take a concrete example, suppose we draw a graph of the marginal benefit you get each month from driving your car versus how many hours per month you spend driving your car. The diagonal line in the figure gives an example in which these are linearly related (it seems like a linear relationship is always assumed, at least in textbook examples). Intuitively, it makes sense that driving two hours a month gives you a lot more benefit than not driving at all, but driving 16 hours a month doesn’t get you much more than driving 14 hours a month. So the marginal benefit is much bigger going from 0 hours to 2 hours than going from 14 hours to 16 hours.

Eventually driving for a little longer actually reduces the benefit you get from the car (because you spend too much on gas, waste too much time in the car, etc.) and the marginal benefit is negative. Conventional economic thinking is that economic actors increase their usage until the marginal benefit is zero.

The idea of a Pigouvian tax is to make an economic activity more expensive so that the marginal benefit goes to zero faster. This effectively moves the x-axis on the graph further up the y-axis (dashed line). The tax revenue (shaded) helps pay for the negative impacts of driving your car. In a cap and trade system the “tax” comes from businesses paying for the emission permits. The area between the shaded rectangle and the marginal benefit line is “lost benefit”, which has to be taken into account when setting the tax rate.

Krugman’s Arguments

Krugman points out that with cap and trade the x-axis is emissions, whereas with a carbon tax the x-axis is cost. So with cap and trade we can directly control the emissions but with a carbon tax we only control the cost of emitting. For this reason cap and trade is a more direct way of reducing emissions, which is what we want to do. In both cases the tax revenue can be used to help people deal with the consequences of climate change.

An important thing to note is that Krugman cites some studies which show that the lost benefit is actually quite small under most cap and trade proposals (presumably this doesn’t change with a carbon tax). These calculations don’t even include estimates of the positive benefits of reducing emissions, so the lost benefit really doesn’t seem to be something we have to worry about.

A caveat which Krugman doesn’t mention is the uncertainty generated by implementing one of these options. Over the short-term the thinking is that it is better to have uncertainty over emissions (which over, say, a year are a small fraction of the total carbon budget) than to have uncertainty over the cost of emissions (which could be a huge shock to an economy if it quickly jumps up or down). This points to a carbon tax being a better option, at least on a shorter timeframe. Of course in the long run we want to have as little uncertainty over the total emissions as possible, which makes cap and trade more appealing.

Issues with Implementation

From a big picture, economic point of view then, cap and trade seems like a better option, though perhaps the market price of carbon would have to be monitored or controlled in some way. However, there are a number of issues with actually implementing a cap and trade system which could potentially be avoided with a carbon tax. Before getting into these issues, people sometimes claim that cap and trade would create a market for emission permits which could then be exploited by clever finance-types. But emission permits ideally would be fairly straight-forward and so wouldn’t be susceptible to scams and other ways of exploiting knowledge asymmetries. Let's assume this would be a minor issue.

My first concern is the shear complexity of implementing cap and trade. Although cap and trade has already been effective in reducing sulfur dioxide emissions, carbon dioxide emissions are a completely different scale. There are so many questions which would have to be addressed: what the total cap is, how big the individual permits are, whether permits come in different sizes, how to regulate trading, etc. Every part of the economy would be affected and would have to be considered, which makes cap and trade seem like a formidable legislative task. We would also almost surely have to have a hybrid system, since cap and trade is basically impossible to implement on small scales (individual people or households). If we want to implement something as soon, and as fairly, as possible, a carbon tax seems like the way to go.

The second issue is “grandfathering” in emission permits: giving free, or very cheap, emission permits to existing companies. This is often used as an incentive for businesses to support cap and trade, but it would be a significant loss of revenue for governments. And again, the legislative task of determining who to give permits to and how many permits to give them, would be very tricky.

Grandfathering also favors well established companies, which can devote more resources to lobbying for permits, over newer ones. I don't think this is the only way in which cap and trade would hurt start-ups and small businesses more than well-established companies. Analogously, developing countries might be impacted more than industrialized countries.

This might seem counter-intuitive, since big companies/wealthy countries are the worst polluters. But they also have more cash reserves and better credit ratings, making it easier to get loans. Suppose a start-up comes along that has a way of making Coca-Cola with half the emissions of actual Coca-Cola plants. Before it can even make one bottle, it has to acquire the permits for the carbon it will emit, on top of all its other costs. I don’t know much about how start-ups work, but this seems like a significant impediment. On the other hand, with a carbon tax small businesses or developing countries would at least be able to get the benefit from their emissions before paying the tax.

Similarly, since we don’t control the cost of carbon under cap and trade it’s possible that less established companies or countries would be priced out of getting new permits. It might actually be in the interest of big companies/wealthy countries to drive up the price of carbon to discourage competition. Less established companies would also be more susceptible to swings in the price of carbon -- the issue of uncertainty in emissions versus uncertainty in the price of emitting again. Either way, competition/innovation/development seems to be discouraged.

Wrap-up

It would be great if either of these proposals was implemented on a large scale. As Krugman writes, they both provide good incentives to reduce emissions and at least a somewhat morally fair way of reducing the effects of negative externalities. Right now, I tentatively lean on the side of carbon tax. Implementing cap and trade seems overwhelming from a legislative perspective and I suspect some things would fall through the cracks. And, while I don’t worry about permits being used dishonestly, I do worry that they would benefit larger companies more than smaller ones and developed countries more than developing countries. I’m not an economist though, so I’m happy to change my mind.

There are some other related and interesting concepts and questions. For instance, the “social cost of carbon” can be used to price carbon, say for a carbon tax. Calculating this cost is probably quite an interesting exercise. I’m also curious how exactly the emissions of a given company/person/etc. are measured. I’d imagine that this is typically quite opaque, and expect it to be pretty inaccurate.