Because misconceptions are commonplace a basic tutorial on the logic and implications of regulation, carbon taxes, and tradable carbon emission permits is useful. Hopefully this will correct some common misunderstandings about what different policies do, and do not do, and help leftists and environmentalists who are not professional economists avoid being brow beaten when debating environmental policy with mainstream economists who often do not share their values and priorities.
Suppose the US government decides to reduce carbon dioxide emissions by 10% next year. The concept of equivalent pollution policies is very useful. "Equivalent" means that the policies result in the same overall reduction in emissions. What this "tutorial" explores are possible equivalent policies to reduce carbon dioxide emissions: A regulation approach mandating a 10% reduction in emissions from every source, a carbon tax set at a level that achieves a 10% overall reduction in emissions, and a cap and trade program where the number of permits printed allows for only 90% of last year’s total emissions are equivalent policies – they all achieve the same 10% overall reduction in emissions. However, while these three policies all achieve the same overall emission reduction, we will discover that they differ in other important respects.
The regulatory approach would be to order every source inside the US emitting carbon dioxide to reduce its own emissions by 10%. Many economists object to this approach for two sensible reasons: (1) This policy fails to minimize the cost to society of achieving a 10% reduction in overall emissions if there are differences in "abatement costs" among sources. For example, suppose one source emitting carbon dioxide can reduce emissions for half what it costs another source to reduce its emissions. It is inefficient to require the second source, for whom abatement costs are higher, to reduce emissions by the same percentage as the first source, for whom abatement costs are lower. Because there are significant differences in abatement costs among different sources emitting carbon dioxide this criticism of the regulatory approach to reducing carbon dioxide emissions is well taken. (2) Ordering all sources to reduce emissions by 10% provides no incentive for any source to search for new technologies that could reduce its emissions by more than 10% — no matter how cheap it might be.
There is an additional problem with the regulatory approach mainstream economists seldom point out, but which should be of concern to those of us on the left. The regulatory approach does not make sources who, in our example, continue to emit 90% of the carbon dioxide they emitted the previous year, pay for the cost their emissions continue to impose on the rest of us. In other words, the regulatory approach does not implement the "polluter pays" principle environmentalists champion with good reason. In effect the regulatory approach draws an arbitrary line. It says that the last 10% of emissions from each source is so damaging that it must be outlawed completely, whereas the first 90% of emissions costs society nothing, and therefore sources should be free to emit 90% of their previous levels without payment or apology. But this is not consistent with the facts. The fact is that as long as sources wish to emit more carbon dioxide in the aggregate than is consistent with climate stability, whenever anyone emits any carbon dioxide it imposes a cost on society. In effect the regulatory policy excuses 90% of socially costly emissions. Another way to look at the issue is that the regulatory approach implicitly grants sources a legal property right to emit 90% of what they were emitting previously, but cancels what had been their de facto property right to emit the last 10%. In other words, regulation creates a valuable new legal property right, gives 90% of this property right to those emitting carbon dioxide, reserves only 10% of the new property right for the rest of us, and bars everyone from selling their new property right no matter how beneficial a deal they might be offered.
A second kind of regulation mandates use of particular technologies and outlaws use of other technologies. For example, all new coal burning power plants could be required to include a new process that sequesters and stores all carbon emissions, and existing plants might be given a specified time to acquire the new carbon storing capacity. Or buildings could be required to include more insulation or sealants for energy conservation. When the best response takes a particular form which the government can easily determine, or when businesses are failing to make changes even though they will prove profitable over time, this kind of regulation can be very effective. And one can reasonably argue that many of the most successful environmental policies to date have been of this kind.
However, the fact that those who claim technological expertise with regard to alternative technologies for producing and consuming energy often disagree on what they recommend — or at least disagree on which changes should be prioritized and mandated first — suggests that technological regulation with regard to energy production and consumption may not be as obvious as its supporters often assume. Since there are many different ways to produce and conserve energy, since least cost means are often different for different sources, and difficult for outsiders to identify, and since businesses often do respond more or less sensibly to price signals, using a price mechanism to induce businesses to find their own least cost means of compliance has obvious advantages.
An alternative way to achieve a 10% reduction is to impose a tax on carbon dioxide emissions. The government would have to use trial and error to find the level to set a carbon tax to achieve an overall reduction in emissions of 10%. However, there is a carbon tax – some number of dollars per ton of carbon dioxide emitted — that would achieve a 10% overall reduction in carbon dioxide emissions in the US.
The logic of a carbon tax is to force producers to take into account the cost to society of their carbon dioxide emissions, just as they have to take into account the cost of using labor and scarce raw materials. Labor and resource markets make producers pay for the labor and raw materials they use, but unless the government levies a carbon tax nobody has to pay for the damage their emissions cause. Consequently, in absence of a carbon tax producers ignore the social cost of their emissions in order to maximize their profits. A carbon tax seeks to "internalize" this otherwise neglected, negative "external" effect so producers will take it into account.
When all who emit carbon dioxide pay the same tax per unit of emission those with lower abatement costs will find it in their interest to reduce emissions by more than those with higher abatement costs. This means a carbon tax distributes reductions among emitters in a way that minimizes the cost of achieving the overall 10% reduction. It also means all sources have an incentive to develop new technologies to further reductions no matter how much they have already abated.
A carbon tax explicitly makes "polluters pay." It forces those who wish to emit greenhouse gases to pay the rest of us (in the form of a carbon tax) for using a scarce, valuable resource – space in the upper atmosphere where too much carbon is already stored. At least in theory, each citizen of the United States has an equal claim on the tax revenues of the federal government. So implicitly a carbon tax awards 100% of what was formerly an ambiguous property right that was habitually appropriated by polluters without asking permission – the right to release carbon dioxide into the atmosphere — to all citizens on an equal basis.
Tradable Carbon Emission Permits
While commonly misunderstood, each half of this policy is quite simple. Permit: Anyone emitting carbon dioxide is required by law to own permits to do so. If I am emitting 246 tons, and if a permit allows me to emit one ton, then I must own 246 permits. If I own 246 permits but emit more than 246 tons I am in violation of the law — just as I would be if I caught 6 trout when my fishing permit only allowed me to catch 5 trout — and I am subject to whatever punishment for violation is established as part of the carbon permit law. Tradable: Anyone who owns a permit is free to sell it to anyone they choose, and anyone who wants to buy a permit is free to buy it from anyone who is willing to sell it to them. In other words, there is a "free market" for the permits to emit carbon where everyone is "free" to strike any mutually agreeable deals they wish.
So if the United States government wants to reduce carbon emissions by 10% all it has to do is print up 10% fewer permits than the number of tons of carbon emitted in the United States last year. However, declaring these permits to be "tradable" in a "free market" is not the same as deciding how to distribute the permits in the first place. Many assume that when the government says there will be a market for emission permits it means the government will sell the permits at an auction where all are free to come to buy. But this is not the only possibility, and unfortunately has seldom been the case.
Prior to 2008 the bulk of pollution permits were always given away free of charge to firms emitting the pollutant. The procedure used is called the "grandfather system" which awards permits for free to polluters based on their share of past emissions. For example, under the grandfather system if a company was responsible for 28% of all carbon emissions last year it would receive without charge 28% of all the permits printed. Another way to think about how the grandfather system works is that every source of carbon emissions in our example would receive, without charge, permits sufficient to cover 90% of whatever amount they had emitted the previous year. That would be their windfall wealth gain which they are free to use as they please. They could use all their permits themselves, sell some of them on the permit market if they decide to reduce emissions by more than 10%, or add to the permits they received free of charge in the initial grandfather distribution through purchases in the permit market if they decide to emit more than 90% of what they emitted last year.
The first exception to using the grandfather system to distribute permits was the North East Regional Greenhouse Gas Initiative where virtually all permits were recently sold at auction. But selling permits at auction instead of giving away permits free of charge is unfortunately not the new norm. In its current draft the Western Climate Initiative still calls for giving a large percentage of permits away free of charge to major carbon users in Western states. Europe still gives away most carbon permits free of charge to sources. And even though candidate Obama called for a 100% auction and President Obama continues to speak in favor of auctioning permits, current drafts of the Waxman-Markey climate bill under consideration in Congress call for giving away 85% of permits free of charge to major sellers and users of fossil fuels. Clearly we are far from winning the battle to stop giving permits away free of charge.
In many respects tradable carbon permits will lead sources to behave in the same way a carbon tax does. If I want to emit more carbon dioxide I need to have more permits. If I don’t own enough permits, I have to buy more in the permit market — which is costly. But even if I own enough permits to pollute as much as I want, it is still costly for me to emit carbon dioxide because the more I emit the fewer carbon permits I can sell for a profit to others in the permit market. Under both a carbon tax and cap and trade permit program there is an "opportunity cost" when sources emit more carbon dioxide. And if the price of a permit to emit one ton of carbon dioxide is the same as the tax on a ton of carbon dioxide, the opportunity cost of emitting more carbon dioxide is the same in both cases. In other words, in theory, tradable carbon permits yield the same efficiency advantages as carbon taxes – they minimize the overall cost of achieving a 10% reduction in carbon dioxide emissions and provide incentives to develop cleaner technologies to reduce one’s carbon footprint since lower emissions leaves fewer carbon permits to buy, or more permits to sell. (1)
However, there is a major implicit assumption mainstream economists make when they claim that a tradable permit program is just as efficient as a tax: They assume the actual permit market will function like the ideal market in mainstream economic text books. In the likely event that the permit market will not be perfectly competitive and/or will fail to always reach its equilibrium price instantaneously, a tax policy is superior to an equivalent cap and trade policy on efficiency grounds. Moreover, if an unregulated financial sector makes carbon emission permits part of its speculative games, there is every reason to fear that the carbon market would be subject to bubbles and crashes, and therefore be much less efficient than an equivalent carbon tax because it would fail to send a consistent and accurate price signal. Moreover, from society’s perspective the profits made by traders in the carbon market are an additional "administrative cost" beyond those of a tax policy.
For these reasons many political economists, including me, generally prefer a tax to an equivalent permit program. Unfortunately, those seeking to avert climate change were not able to win political support for carbon taxes nearly high enough to yield equivalent reductions in carbon emissions as scientists were able to win in support of a program that caps emissions. Therefore, regrettably we are now faced with a choice between a more efficient carbon tax that will reduce emissions far less because it will be way too low, and a less efficient cap and trade policy that will reduce emissions much more because scientists have moved much lower caps into the middle of the bargaining table.
Like a carbon tax, a cap and trade permit programs where all permits are auctioned implements the "polluter pays" principle and distributes new property rights on an equal basis to all citizens. Anyone who wants to emit carbon dioxide must pay for that privilege by purchasing a permit to do so at a government auction. A carbon cap and trade program takes an ambiguous property right – the right to release carbon dioxide into the atmosphere – and explicitly transforms it into a legal property right. Whereas this "right" was formerly appropriated by any who wished because nobody objected, under a cap and trade program the property right is encapsulated in carbon permits. If 100% of the permits are sold at auction the property right is explicitly awarded to all citizens on an equal basis since all citizens, at least in theory, have an equal claim on the revenues of the federal government. However, if permits are given away free of charge – as they always have been with the single exception of the recent North East Regional Greenhouse Gas Initiative — the new, legal property right is awarded to whomever receives them. Under the grandfather system the new property rights are awarded to those who are emitting carbon in proportion to their share of past emissions. The fact that those who receive the permits under the grandfather system may choose to sell them or buy more of them on the permit market simply means that those who have been explicitly awarded this new wealth are legally free to do with it as they please.
All three policies – regulation, tax, and tradable permits – will increase energy costs, and much of those cost will be passed onto energy users, including households. While we want to provide strong incentives to reduce energy consumption, we do not want households, and particularly low income households to bear the burden of averting climate change. The idea of a "dividend" is to "rebate" at least part of any revenues the government receives back to households to defray these increased costs. It is important to realize that neither regulation nor a grandfather permit program generate any new government revenues to rebate. On the other hand, both a carbon tax and a tradable permit program where 100% of permits are sold at auction generate the same amount of new revenues that can be used for this and other purposes.
(1) There is one version of tradable carbon permits that, at least in theory, yields exactly the same results as an equivalent carbon tax. If the government auctioned off 100% of the carbon permits, and if the permit market were perfectly competitive and immediately reached its equilibrium price, the results of the two policies would not only be "equivalent" they would be identical. In both cases every source would reduce its emissions by exactly the same amount because the opportunity cost of failing to reduce emissions would be the same – pay a tax or buy a permit for the same amount as the tax. In both cases every source would pay the government exactly the same amount – in one case in taxes and in the other case by purchasing permits at the auction. And in both cases the government would collect the same amount of total revenue – in one case as tax revenue and in the other case as proceeds from a permit auction.