Economics focus

Tax or trade
Feb 14th 2002
From The Economist print edition

A novel approach to tackling climate change could satisfy economists and environmentalists alike

Get article background

WHAT should America's policy on climate change look like? As The Economist went to press, George Bush was delivering his answer (see article). When he rejected the UN's Kyoto Protocol as “fatally flawed” last year, he insisted that he regarded the problem as real, and promised a credible domestic alternative. Unfortunately, his proposal does not include either of the two things that would commend it as a serious effort: taxes on carbon emissions, or mandatory limits on them.

In principle, taxes and targets are equally efficient ways to reduce a given pollutant, although, as The Economist has long argued, the tax approach has the advantage of simplicity. An economy-wide carbon tax could be implemented with little of the red tape likely to surround a regulatory approach. It would send a powerful signal to all parts of the economy, unlike measures aimed only, say, at power plants. However, as Bill Clinton discovered in the early 1990s, energy taxes do not get far in Congress.

That is one reason why most American environmentalists prefer the second approach: binding targets for greenhouse-gas emissions. Once, this method might have precluded the economic flexibility of a tax—namely, that the abatement effort can vary from polluter to polluter, according to cost. Nowadays, though, even many green groups acknowledge that such flexibility makes sense, and that you can duplicate it in a target regime by issuing tradable emissions permits.

Under this approach, the government would cap total emissions and give firms allowances, by auction or grant. Since firms must pay a price if they exceed their allowances, they have an incentive to cut emissions. Since the permits are tradable, those with low marginal costs of abatement will make extra cuts and sell credits to firms that find it more costly to cut emissions.

The result is a target achieved at least cost, both to firms and to the whole economy. This is no free-market fantasy: America's scheme to trade sulphur dioxide emissions, in order to reduce acid rain, has done better than its initial target, at less than half the anticipated cost. Various proposals in Washington, DC, now suggest some form of “cap-and-trade” regime for carbon. The Congressional Budget Office has produced a good review* of the leading contenders.

One interesting proposal comes from Resources for the Future (RFF), an American think-tank. The theoretical notion that price instruments (carbon taxes) and quantity instruments (emissions targets) are equivalent, RFF researchers argue, is true only if the costs and benefits of reducing emissions are pretty certain. In the case of greenhouse gases, that is not the case: estimates of both vary enormously. A rigid target runs a risk, however small, of imposing ruinous costs. This could be true even with cap-and-trade.

This looks like another reason why a carbon tax is better. But RFF makes the case for a hybrid: combine cap-and-trade with a “safety valve”. The environmental discipline of the rigid target would prevail, unless the cost of meeting it rose sharply, to an agreed trigger price. If that happened, the straitjacket would be loosened, and extra permits would be sold until the end of the compliance period. This proposal suggests an initial trigger of $25 per tonne of carbon (adding six cents a gallon to the price of petrol); others would set it much higher. The key is that the level should rise gradually over time, encouraging individuals and companies to prepare for a low-carbon world.

Most American conservatives hate this idea. They call it a carbon tax by stealth—and since a carbon tax is a tax, it must be bad. Once the safety valve is triggered, they are right that the system works like a tax—but so what? (It need not be a tax rise in the aggregate, obviously: the revenues could be used to finance income-tax cuts.) Most greens, even those sympathetic to market approaches, are equally ferocious in their opposition. Their chief worry is that “environmental integrity” will be compromised—that is, the emissions target might not be achieved with certainty.

They are right—but, again, so what? If the cost of achieving the target turns out to be painfully high, then popular opinion would anyway doom their ambitions to failure. If abatement costs are high, this scheme still delivers the green goals of a cap-and-trade scheme until the safety valve is hit. If the costs are low (as many greens predict), the safety valve will never actually be triggered.

Economists at MIT** point out that a cap-and-trade regime might be designed to do what the safety valve does without sacrificing fixed targets. They point to “banking” provisions that let firms borrow or store allowances from adjacent compliance periods as an equivalent method. The RFF researchers reply that, for greenhouse-gas banking to work well, firms must bank lots of credits—and that raises the chances that dubious ones slip through.

The RFF approach seems best. It forces politicians to say what price society should be willing to pay to address global warming—and offers a pragmatic way to make that cost explicit.

* “An Evaluation of Cap-and-Trade Programs for Reduction of US Carbon Emissions”, by Terry Dinan, et al. Congressional Budget Office, June 2001.

† “Reducing Carbon Emissions and Limiting Costs”, by Richard Morgenstern, et al. Resources for the Future, January 2002.

** “The Safety Valve and Climate Policy, by Henry Jacoby and Denny Ellerman. MIT Joint Program Report #83, February 2002.

Copyright © 2002 The Economist Newspaper and The Economist Group. All rights reserved.