The Economist, surprisingly, and disappointingly, has come out in
favor of carbon taxes over a cap-and-trade regime. (Thanks to Greg
Mankiw for the link.)
As is typical of Economist leaders, the argument seems reverse-engineered from
the conclusion. So, as a public service, let me fill in some of the blanks that
the Economist doesn’t see fit to include.
Most economists agree that carbon taxes are a better way to reduce greenhouse
gases than cap-and-trade schemes.
This is a stretch: I’d love to see what kind of evidence the Economist could
adduce for it. While carbon taxes might make sense in a specific case such as
gasoline taxation, there’s an enormous number of economists working very hard
on cap-and-trade systems who have come to the conclusion that they make much
more sense than trying to cover all carbon emissions with a tax.
In the neat world of economic theory, carbon reduction makes sense until
the marginal cost of cutting carbon emissions is equal to the marginal benefit
of cutting carbon emissions.
Well, maybe. But in the real world, carbon reductin makes sense until –
well, until global carbon emissions start going down rather than up, for starters.
People vary on the amount that they think carbon emissions need to be reduced.
But since "the marginal benefit of cutting carbon emissions" is something
that no one is ever going to be able to calculate with any accuracy, there’s
very little point in trying to use it to develop optimal levels either for a
carbon tax or for a cap-and-trade scheme. The best we can do is simply set a
target for carbon emissions, and try to meet it as best we can.
Clearly, trying to reduce carbon emissions by taxing carbon is much harder
than trying to reduce carbon emissions by simply regulating the amount of carbon
that can be emitted.
If policymakers set a carbon tax too low, too much carbon will be emitted.
But since the environmental effect of greenhouse gases builds up over time,
a temporary excess will make little difference to the overall path of global
warming. Before much damage is done to the environment, the carbon tax can be
raised.
Which will raise carbon prices – and which will also mean an end to the
much-vaunted predictability of carbon taxes. But it won’t, with any certainty,
reduce carbon emissions.
Misjudging the number of permits, in contrast, could send permit prices
either skywards or through the floor, with immediate, and costly, economic consequences.
I certainly can’t see "costly economic consequences" to falling permit
prices. And if permit prices rise a lot, then that would just demonstrate the
high level at which a carbon tax would need to be set in order to effectively
reduce emissions. A level, by the way, which might well be politically unfeasible.
Worse, a fixed allotment of permits makes no adjustment for the business
cycle (firms produce and pollute less during a recession).
This is exactly the wrong way around. It’s the carbon tax which makes no adjustment
for the business cycle. If firms produce and pollute less during a recession,
then they’ll need fewer permits, and the price of permits will come down.
America has had tradable permits for SO2 since the mid-1990s. Their price
has varied, on average, by more than 40% a year.
This is very misleading. The price of SO2 has varied a lot mainly because it’s
come down a lot. It turns out that reducing sulfur emissions is much cheaper
than people thought it would be. That’s good news.
Extreme price volatility might also deter people from investing in green
technology.
Even without the volatility, some economists reckon that a cap-and-trade system
produces fewer incentives than a carbon tax for climate-friendly innovation.
A tax provides a clear price floor for carbon and hence a minimum return for
any innovation.
Price volatility does not deter investments, necessarily. Let’s say that a
green technology only becomes cost-effective when the price of carbon reaches
$35 per ton. Then if a carbon tax is set at less than that (and any carbon tax
would be set at less than that), no one will ever invest in that technology.
On the other hand, if permits traded at less than that, there’s still a case
to be made to invest, on the grounds that the price of the permits might rise
to more than $35 in the future.
Indeed, a carbon tax provides a clear price ceiling for carbon, and hence a
maximum return for any innovation. That’s hardly an incentive for climate-friendly
innovation.
Ultimately, the argument is simple. A cap-and-trade system caps carbon emissions;
a carbon tax doesn’t. If you want to reduce carbon emissions, then you need
to cap them. A carbon tax, on the other hand, is very unlikely to ever reduce
emissions to 1990 levels, let alone anything lower. Auction off most of the
permits, and don’t allow a "safety valve". Then you get all of the
benefits of a carbon tax (government revenues), and none of the uncertainty
about whether or not emissions will actually, in the end, be reduced.