Putting a price on carbon is probably an unavoidable part of phasing out fossil fuels to fight global warming and air pollution. For years, Peter Barnes has advocated a brilliant means of mitigating many of the harmful economic side effects: take the revenue from carbon taxes or auctions and rebate it back to the people, dividing it equally among each citizen.

Barnes advocates doing this via an auctioned permit system. However,the same thing could be done with a carbon tax. Instead of auctioning permits, simply tax those same embedded emissions and rebate that revenue to consumers. Raise the tax periodically to lower emissions.

Inevitably, with either a tax or auctioned permits, the price charged for carbon will be passed down the supply chain to consumers. By rebating the revenue back to consumers, you minimize the impact of those price increases. They have to pay more, but they have more money to pay with. You get the price signals to affect behavior, without lowering consumer net income.

What are the policy differences between a tax and a permit system? The usual claim is that with a tax system you get price certainty, but can’t know for sure what level of carbon reduction you will achieve. With a 100 percent auctioned permit system, you have certainty in reductions, but don’t know what the price will be. (This argument assumes no loopholes and good enforcement in both cases. To keep the length of this post manageable, we won’t question the assumption today, but let’s note that the assumption is there, and not necessarily correct.)

But there is a way a carbon tax can meet an emissions target. The taxing agency could start with a year-by-year target and set a schedule of carbon tax increases it believes will meet the target. Included in that schedule would be automatic adjustments upwards if emissions don’t fall as fast as desired.

How fast demand for carbon falls in response to price increases is unknown. But we do know that response is slower in the long run than the short run. Some worry that a system of automatic price adjustments could cause overshoot. As long-term response kicked in, we might see use fall faster than targeted. Given the seriousness of the emergency, I don’t see this as a bug, but as a feature.

Peter Barnes recently praised a study of permit auctioning systems that suggested putting a minimum price on permits when auctioning them. This was done for a number of reasons, including avoiding price fixing conspiracies. But it also brings permit auctioning closer to a carbon tax, including allowing the possibility of reducing carbon use faster than whatever minimum is set.

From a pure policy standpoint, auctioned permits and a carbon tax are so close to one another that it is hard to understand why there would be a strong preference between them. Auctioned permits with a minimum price do have a belt-and-suspenders advantage. You get both a (theoretically) fixed cap, and a minimum price that could reduce emissions by more than that cap. However, in practice, implementation will much more important than these minimums. Avoiding loopholes, exemptions, permit giveaways, offsets, poor enforcement, and selective enforcement will take priority over getting the theoretically best system.

The two proposals do have different politics. In the U.S. one obvious point is that “permit fee” has obvious advantages over the word “tax.” In addition, Barnes remarks that once a cap-and-rebate system is agreed to, the main political argument becomes how far to cut emissions. He prefers that to a carbon tax, where the argument will be over carbon price.

But in passing a cap-and-rebate system, you face arguments over permit giveaways. A carbon tax avoids that fight.

With a cap-and-rebate system, it is critical to avoid creation of a large carbon market. This means not only avoiding giving permits away, but keeping secondary markets (where people resell permits they bought at auction) as small as possible.

The reason for minimizing any secondary market is political, but critical. A carbon market produces carbon traders, and carbon traders as a whole tend to oppose reductions in total numbers of permits, whatever honorable individual exceptions might exist. In Europe, carbon traders are lobbying to expand the fraud-ridden Clean Development Mechanism (CDM), weakening additionality requirements, and weakening enforcement of all CDM. Carbon traders are among those lobbying to continue permit giveaways, and oppose auctioning increases.

If we take people like James Hansen seriously and decide we need to phase out 90-percent-plus of fossil fuel use over twenty years, and the remainder over the course of another decade, then avoiding a secondary carbon market becomes even more important. Brokers who buy and sell carbon for a living, holders of big portfolios, offset consultants, certifiers, and providers will all try to find ways to delay such a phaseout. We have enough problems with the existing carbon lobby. There is no reason for global warming opponents to grow our own mini carbon lobby.

In the abstract, I lean towards cap-and-auction over a carbon tax. I like the belt-and-suspenders approach of having a minimum price and maximum emissions. I like the fact that it may be easier to sell. But the possibility of permit giveaways, along with other ways it could help build a secondary market, worry me. Part of the politics of supporting a proposal is what its proponents are and are not willing to fight for. I’d like to know that cap-and-rebate proponents will not only oppose permit giveaways, but will stand firm against them. Equally important, I’d like some assurance that they understand the more general question of avoiding a significant secondary carbon market.

For example, one proposal is to auction permits quarterly, and let carbon-brokers server demand between auctions. I’d much rather see a large portion of permits auctioned quarterly, with the rest auctioned daily or weekly (possibly online), so that most users of permits bought them directly at auction. I’d like to see restrictions on resale. Let someone who finds they can’t use a permit have the option of returning their permit for a refund (so long as there is a reasonable expiration period — six months or more) left on it. Allow some permit resale for the sake of flexibility, but limit the percent of total permits that can be sold on the secondary market, and put other restrictions on as well.

This may seem wonkish, and technical, but the consequences are huge. Avoiding permit giveaways under a cap-and-rebate system is only part of the larger fight to avoid the creation of a European style carbon broker lobby. Are cap-and-auction proponents part of this fight as well?