Why current cap-and-trade proposals are more tax than trade

A great frustration for those who (a) really care about reducing CO2, and (b) believe in the power of well-structured market mechanisms is that the current discussion around carbon policy has bastardized the language of environmental economics. There are tremendous economic and environmental benefits to be gained by a true cap-and-trade CO2 system. Unfortunately, all the plans that are currently being bandied about as cap-and-trade structures are really carbon taxes.

To understand why, we need to review a couple basic environmental economic concepts. There are essentially three ways that government can induce environmentally responsible behavior: mandates, taxes, and tradeable permits.

Mandates

The best example of a mandate is the Clean Air Act, and since we first started crafting environmental regulation, this has been the dominant approach. Thou shalt unlead thy gasoline. Thou shalt install a baghouse. Thou shalt comply with Best Available Control Technologies. In all cases, these are top-down, proscriptive approaches that mandate technologies and/or pollution limits. Their great advantage is that their environmental impacts can be known with some degree of certainty. (e.g., if you mandate a phase-out of leaded gasoline in five years, you can be certain that there will be no more lead emissions from tailpipes five years hence.) The disadvantage of these approaches are two-fold:

1. They are economically ignorant. If the mandate does not direct the lowest-cost pollution control solution, the lowest-cost pollution control solution will not be deployed.
2. They are strictly pass-fail, and encourage a nation of D students, environmentally speaking. If a mandate compels my factory to achieve no more than 10 ppm NOx emissions as a prerequisite of operation, I’ll make sure I can achieve 9.9 ppm NOx; but since there’s no incentive to make deeper cuts, I won’t reduce any further. This adds to the economic problem with mandates, since it does not differentiate between the individual who can make deep cuts cheaply and the one who faces huge costs for shallow cuts — and in so doing, fails to maximize pollution reduction.

Pollution taxes

A better tool is a tax. Such models simply price the externality, so that one can still pollute, but only at a price. Relative to mandates, their great disadvantage is that they do not lead to certain reductions. I can mandate the elimination of leaded gasoline and know that leaded gasoline will go away, but if I instead place an added tax on leaded gasoline, I cannot be certain that the tax will be sufficiently high to eliminate its use.

On the other hand, pollution taxes do solve the two problems with mandates. By placing a fixed and known price on pollution, markets are encouraged to use the lowest-cost means of pollution control to minimize their net pollution payment. Moreover, since the tax is paid per unit of pollution emitted, deeper pollution reductions afford greater economic savings. On balance, this gives pollution taxes (in my opinion, at least) a net benefit against mandates. But they still have a couple glaring weaknesses:

1. Most obviously, they include the word “tax,” which is often a political non-starter.
2. They are sticks without carrots. Like income taxes, they constitute a great source of government revenue and, on the margin, do compel markets to factor the price of pollution into their math, but they don’t provide any more direct incentive to invest in pollution reducing technology than an income tax provides an incentive to quit your job.
3. As noted above, they do not guarantee pollution reductions.
4. Finally, they are politically uncertain. Governments are always tempted to fiddle with tax policy, but are unable to fiddle with existing contracts. A factory that installs a scrubber to comply with sulfur pollution regulations will cry foul (and have ample legal protection) if the regulator comes back and tries to rescind their permit five years hence. On the other hand, if sulfur emissions are taxed at$20/ton and government decides to lower or raise the tax five years hence, the same factory cannot readily complain that they invested in their scrubber in anticipation of a permanent tax regime. As a result, it is considerably harder to deploy capital in response to a pollution tax than in other, contractual approaches.

Tradeable permits

In theory, tradeable permits are the ne plus ultra of pollution regulation, correcting all the failures of the above mechanisms. The model is that the government sets an allowed level of overall pollution (thereby ensuring that future pollution levels are known) and then allows pollution sources and sinks to trade among themselves for the rights to emit their pollution levels within that cap. Government’s role is to set the cap and ensure that sufficient measurement and verification is in place between pollution buyers and sellers, but not to stipulate technologies nor price.

These models ensure that markets are always pursuing the lowest-cost pollution-reduction measures, while still ensuring that pollution is reduced to environmentally acceptable levels. The political consequences of a tax are avoided and sticks are perfectly balanced with carrots (since every buyer is matched to a seller at the same price per unit of pollution).

Applying to modern GHG policy

This didactic review is necessary because if you only read the headlines, you might be tempted to conclude that current GHG policy is actually based on the idea of tradeable permits. After all, we talked about carbon taxes and decided we’d do cap-and-trade instead. Since the phrase “cap-and-trade” includes the words “cap” and “trade,” it must include both, right?

Sadly, no.

Every GHG policy out there today — from RGGI to Kyoto — is really a tax masquerading as a cap-and-trade. Notice why:

1. A pollution tax requires polluters to pay money to a regulatory body, who then distributes the proceeds as they see fit. A tradeable permit approach is based on bilateral trading of pollution credits without any government intermediary. Every existing GHG policy has a government intermediary and is therefore structured as a tax rather than a tradeable permit.
2. A tradeable permit model provides an incentive to reduce pollution that is exactly the same as the cost it stipulates for those who choose to pollute. If you want to release 50 units of pollution and I want to reduce pollution by 50 units and I agree to sell you my reduction for $200, you’ve paid $4/unit and I have been paid $4/unit. By contrast, a pollution tax places a cost on pollution, but the only benefit that accrues to those who are reducing pollution is the avoidance of a tax. Which, as noted above, is the same benefit that accrues to those who don’t have any income. All of our current GHG policies are structured more like taxes than tradeable permits since regulatory agencies use the proceeds of their GHG auctions to provide a variety of social goods, not all of which lead to GHG reductions; ergo, less than 100 percent of the proceeds go to GHG reduction, and the value of reduction is less than the cost of pollution.

If the issue were merely semantic, this wouldn’t be worth making a big deal about, but the problems with carbon taxes are real, and they don’t go away simply because we choose to relabel a tax as a tradeable permit. As we go into the next political season and get serious about GHG policy, let’s hope that we don’t lose sight of these realities.