The Carbon Tax Debate: Why a Cap-and-Trade System is Better

I spent more three hours this morning at a debate

hosted by the New York City Bar Association which was narrowly focused on a

single issue: whether the US government should implement a carbon tax or whether

it should go with a cap-and-trade system. I went into the debate on the side

of the cap-and-traders, but alive to the fact that a lot of very

smart people have put their weight behind a carbon tax. So I was willing

to change my mind if I heard some good arguments in favor of the tax. I didn’t.

That said, however, the two debaters on the side of the carbon tax, Dan Rosenblum

and Jim Barrett, were very impressive and made some great points. Barrett, in

particular, seemed to be very plugged in to political considerations, and was

compelling on the question of the impact of climate change, and climate change

legislation, on America’s poorest. Environmental groups, he pointed out, tend

to lead with pictures of windmills and polar bears, not the 700 diesel trucks

per hour which drive directly in front of an elementary school in Trenton, New

Jersey. It’s in places like that – and of course New Orleans – that

the ill effects of our carbon-spewing lifestyle are most keenly felt, and they’re

felt disproportionately by poor, black Americans. Yet it’s also the case that

poor black Americans have significantly larger carbon footprints than their

poor white counterparts, which means that unless legislation is designed very

carefully indeed, they will also bear the regressive brunt of any carbon tax

or cap-and-trade system.

And there’s no doubt that either system, if it is to work in its avowed aim

of reducing carbon emissions, will raise prices for consumers. Cap-and-trade

might not have the word "tax" in its name, but it has the same effect.

In fact, as Billy Pizer noted in the debate, one of the huge advantages that

a cap-and-trade system has over a carbon tax is that, tweaked enough, you could

use a cap-and-trade system to exactly replicate a carbon tax. (Auction

everything, put in a safety valve, measure as far upstream as you like, etc.)

In other words, anything you can achieve with a carbon tax you can achieve with

a cap-and-trade system – but the opposite is most emphatically not

the case.

Specifically, both sides agreed that given the way that the US government is

constructed, one can’t expect much in the way of innovative ongoing legislation

on this front. One a system is set up, that system is going to remain for decades.

A carbon tax might be raised or lowered, but it will remain a carbon tax. A

cap-and-trade system, by contrast, would be much more flexible. At the outset,

it might behave quite similarly to a carbon tax, targeting carbon prices rather

than emissions reductions. But if you used a cap-and-trade system to do that,

it would me much, much easier to move over time to a system which targeted emission

reductions rather than carbon prices.

This was one of Jon Anda’s main points. Any successful policy, he said, has

to at least keep open the possibility that we will choose in future

to restrict global warming to 2 degrees celsius more than pre-industrial levels.

It’s entirely possible that scientists investigating feedback loops will discover

that any warming above that level would be catastrophic. We don’t know. But

only a cap-and-trade system would create a mechanism which would make that possibility

achievable. "I don’t want to tell my grandchildren that we tried taxing

CO2 and it didn’t do much good, and sorry," he said.

Anda even came prepared with a (not very catchy) slogan: a successful policy,

he said, "has to be a dynamic hedge of fat-tail CO2 risk". If it turns

out that our carbon emissions are rising too far, too fast – or not falling

fast enough – then the system has to be able to dymaically adjust to that,

and that’s something a carbon tax finds pretty much impossible to do.

What’s more, most of the most exciting carbon-reduction technologies only become

economically efficient when carbon-emission prices get very high indeed: around

$75 per ton or so. Now Anda isn’t advocating a cap-and-trade system where prices

start off that high. But the genius of any cap-and-trade system is that even

if prices aren’t there today, there’s a non-zero chance that they will be there

in the future. So it can make economic sense to invest in those technologies,

after discounting for the likelihood that they will be profitable in the future.

If a carbon tax, by contrast, is never slated to reach $75 per ton, then no

research on those technologies will ever get market funding.

The best argument for a carbon tax, by contrast, was that it is less legislative

work: it could be built in to a big 2009 tax bill. But given the number of cap-and-trade

proposals already in front of Congress, and the fact that there seems to be

very little real Congressional support for a carbon tax, that argument is pretty

weak. It might also be easier to slap import tariffs on high-carbon-footprint

goods from the likes of China if the US was operating a carbon tax system rather

than a cap-and-trade system. But that’s a question of the way that WTO regulations

are worded, and I’m pretty sure that no one thinks the wording of WTO regulations

should drive a question as important as this one.

Ultimately, the most compelling argument is the flexibility/optionality argument.

Think of a cap-and-trade system, Pizer says, as a big machine with a whole bunch

of dials. "You can dial certainty on the cap versus certainty on the cost,

and you can dial free allocations versus auctioned allocations," he says.

By fiddling with the controls, you can basically get anything you want –

which is a crucial feature given that we really don’t know exactly what problems

the cap-and-trade system is going to be asked to solve in the future. If Congress

is worried about the price uncertainty inherent in a cap-and-trade system, they

should be much more worried about the cost-of-environmental-damage uncertainty

inherent in global warming mechanisms – something which demands flexibility

in terms of our response.

It’s also worth noting that Pizer’s dials can be adjusted to match other cap-and-trade

systems globally, creating a worldwide liquid and fungible market in carbon


In the wake of my

visit to Carnegie Hall last night, I’m reminded of the case of Zankel Hall,

its new underground venue with flexible seating. Rather than simply construct

an old-fashioned shoebox, the architects of Zankel Hall ensured that all manner

of different performance and seating configurations would be possible. Now in

practice the hall opened with the old-fashioned shoebox configuration, and has

stubbornly stayed that way ever since, despite many performers and performances

which might have been better served with different seating arrangements. (I

suspect the reason for this has something to do with the stagehands’ union;

I’m not sure, though.) But this doesn’t mean that building a flexible hall was

a bad idea. The hall might not get changed at the moment, but it’s likely to

achieve its potential in the future. And that possibility alone justifies the

architects’ decision to build in that flexibility.

Similarly, if you want to impose a carbon tax, do it using a cap-and-trade

mechanism, and then turn the dials as much as you need to in order to replicate

the tax. In a couple of decades’ time, you’ll be thankful.

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