Carbon Tax versus Cap-and-Trade

11/17/2012 06:50:00 PM
Carbon Taxes and Cap-and-Trade constitute two alternative policy proposals for limiting carbon emissions in the United States, in an effort to limit the harmful effects of global climate change due to carbon dioxide. Which one should we prefer?

Both plans suffer from many of the same problems: how do we accurately measure carbon emissions? This is certainly not straight forward due to the large variety of ways inwhich people can cause emissions. On top of that, there will be enormous incentive for companies to lie about their emissions, and that can prove difficult to prevent. Furthermore, what about carbon emissions from the production of goods and services overseas purchased by americans? If we only apply these policies to domestic emissions, as much of Europe has, then we will merely see companies relocate production overseas to developing countries not bound by the same rules. And while it might be easy enough to impose a tariff on manufactured goods, what about, for example, telemarketing services? Each phone call from india involves carbon emissions, so should we mandate that all foreigners pay US taxes or purchase carbon credits each time they call an american?

Setting aside those issues for the moment, which policy should we favor? Economics tells us that the carbon tax is definitely the better of the two options.

Ultimately, we'd like to not just limit carbon emissions, but actually eliminate them. Cap-and-trade provides no incentive to ever reduce aggregate carbon emissions to less than the cap set by congress. Suppose, for example, we had set the cap equal to the level of emissions in 2008, as many European countries tried. That means that the cost of a carbon credit today would be virtually zero, because, believe it or not, carbon emissions have steadily fallen since then--there would be more carbon credits in circulation than anyone even wants. If we had a carbon tax, there would still be an incentive to reduce emissions further, while with a cap-and-trade system there would not be any incentive to limit emissions at all.

This gets at the basic problem with cap-and-trade, which is that the optimal level of carbon emissions fluctuates year-to-year, while the cap mandated by congress would not. Consider, for example, a nuclear powerplant or a hydroelectric dam. These are both examples of projects that involve enormous carbon emissions during construction, but dramatically reduce carbon emissions over their lifetimes. Both are constructed primarily of concrete. The production of concrete causes a massive release of CO2 during the chemical reaction when we convert limestone (calcium carbonate) into lime (calcium oxide). But when we mix the concrete with water, a chemical reaction follows that results in a slow re-absorption of all that CO2 over the next 3 to 10 years. So the result is that in the year in which we construct the plant, the price of carbon credits would spike, even though this process does not increase the long-run levels of CO2 in the atmosphere.

More to the point, consider all the CO2 emissions from construction that aren't re-absorbed later--the coal that was burnt to make the steal and reduce the limestone to lime. Cap-and-trade would unnecessarily discourage these types of large-scale investments that are carbon intensive at the beginning but cause long-term reductions of CO2 emissions, because the price of carbon credits would skyrocket during the construction phase.

The result is that everyday necessary CO2 emissions, like driving to get to work, will crowd out the investments that would reduce long-term emissions, because there is no short-run flexibility in cap-and-trade, and therefore no way, in the aggregate, to trade off between future and current carbon emissions. By contrast, a carbon tax would allow us to both drive to work and build carbon-free energy sources upfront, allowing for a long-term reduction in CO2 emissions.

To put this differently, both cap-and-trade and carbon taxes can be structured to provide exactly the same incentives to reduce carbon emissions. The difference is that cap-and-trade limits the number of feasible ways of achieving a long-run reduction in emissions (in economic terms it constricts the aggregate resource constraint), while carbon taxes do not.