Efficient Carbon Policy: Taxes vs. Cap & Trade

1. Efficient Carbon Policy:Taxes vs. Cap & Trade CRAIG PIRRONG JANUARY, 2009

2. Externalities • An externality exists when one individual’s (or firm’s) actions confer a cost or a benefit on another • “Bads”—pollution • “Goods”—Bees • Externalities can exist when transactions costs preclude negotiation of mutually beneficial deals between affected parties • If government can lower transactions costs (e.g., through regulation), state intervention to “correct” externalities can be justified

3. Transactions Costs • Collective action problems—an externality may affect large numbers of people, and coordinating their actions may be prohibitively costly, especially due to “free rider” problems • Informational asymmetries—information about costs and benefits likely to be private. Private information can create negotiation costs

4. Carbon Externalities • Carbon is a “bad” to the extent that it causes costly changes to climate • Transactions costs likely to be very high—if anthropogenic global warming is indeed a threat, it affects everybody • Private information, especially about abatement and adjustment costs, is likely to be pervasive • Thus, there is a potential justification for gov’t intervention

5. Types of Intervention • Command & Control • Tax • Cap & Trade • Hybrid (C&T, with a tax paid on emissions over the cap)

6. Command & Control • Tell everybody what to do • EG, every power plant must cut emissions by X percent • This is likely to be very inefficient—some plants can cut emissions more cheaply than others • “Sophisticated” command and control is very informationally demanding and almost certainly encourages high transactions costs and rent seeking

7. Taxes • Classical “Pigouvian” solution—levy a tax on every unit of carbon emitted • Given the right information, possible to choose a tax that gives the appropriate incentives and leads individuals to choose the efficient level of emissions

8. Cap & Trade • Cap & trade works by (a) imposing a ceiling on the total amount of carbon released, (b) allocating the rights to emit carbon, and (c) permitting the rights holders to trade them • Given the appropriate information, it is possible to choose the ceiling to equal the “efficient” amount of carbon • Trading of rights mitigates private information problems, and ensures that carbon reduction achieved in the most cost-effective way

9. The Big Caveat • The the foregoing arguments that either a cap & trade or a tax system can achieve an “efficient” outcome were predicated on the assumption “given the right information” • Problem: In the real world—information is costly, widely dispersed, and hence almost certainly unavailable to the policy maker • This raises the question—which mechanism is most robust to uncertainty about the costs and benefits of carbon reduction?

10. The Weitzman Analysis • Weitzman (1974) addressed this question in detail • His conclusion was that the relative advantage of taxes vs. quantity controls depends on the slopes of the marginal benefit and marginal cost of abatement • “Flat” marginal benefits favor taxes • “Flat” marginal costs favor quantity control • Uncertainty about costs matters—uncertainty about benefits doesn’t

11. Implications • Best available evidence (predicated on climate models) is that marginal benefits of CO2 abatement are virtually constant—this favors the use of taxes rather that C&T • Hybrid schemes may in fact be the most efficient • Learning about costs & benefits over time + policy flexibility + good political incentives tends to diminish uncertainty and reduce differences between tax and cap systems

12. Political Economy Considerations • “Political Economy” considerations are also relevant • Since taxes generate revenues, politicians may be motivated to choose the tax not on efficiency grounds, but on revenue maximization grounds • Carbon taxes likely to be “silent” taxes—their costs are hidden in the prices of goods • Lobbying and rent seeking to choose discriminatory taxes that favor one group over others • C&T can also generate rent seeking, especially at the beginning of the process when tradeable rights are initially assigned (grants vs. auctions)

13. Enforcement • Enforcement costs can also differ across regimes • Tax collection mechanism already in place, and it is relatively easy to tax point emissions (importance of latter point probably overestimated) • Governments have an incentive to collect taxes—i.e., an incentive to ensure people play for emissions • Government incentives to enforce quotas may be weaker (e.g., Europe, 2006)

14. Enforcement (con’t) • Proposed C&T schemes are often very complicated (e.g., offsets) • Complexity raises enforcement costs • But . . . A tax scheme that encourages investments that absorb carbon would be similarly complex • Corruption—present in both systems

15. Volatility • Carbon prices in a C&T scheme are likely to be quite volatile, especially in the early years of the scheme • Contract design (expiration of credits) will contribute to this volatility • Taxes may be more predictable (though this depends on credibility of government commitments) • Volatility tends to discourage carbon sensitive investments • Hybrid scheme could mitigate this problem

16. Verdict • Political economy considerations most likely favor C&T • It is widely argued that enforcement considerations favor taxes, but this advantage likely overstated • Information costs favor taxes • Volatility favors taxes • So, if forced to choose. . . . I would probably opt for taxes, or a hybrid scheme which effectively caps the carbon price • But. . . Politicians in their infinite wisdom have chosen otherwise . . . Hence our focus on cap & trade