Climate Control: What Works Best?

As we move toward doing something about climate change, we need to make sure whatever we adopt will actually work. the two major proposals are "cap and trade" (which is used now in the European Union) and a carbon tax (which is used no where for obvious political reasons). Libertarian Ronald Baily has an excellent essay making the case that the carbon tax is the best option. Here are some highlights:

Cap-and-trade schemes for reducing pollutants have a lot going for them. First, many businesses favor them. Second, we already have an American example of a similar market that works. Third, carbon markets are accepted under international treaties and already exist abroad. Fourth, most environmental groups like cap-and-trade systems because they set firm limits on actual emissions. And, fifth, in theory at least, the flexibility of carbon markets enables businesses to figure out the least expensive way to reduce overall emissions.

The United States currently maintains a robust cap-and-trade market in sulfur dioxide permits which advocates of a GHG market hold up as a shining example. Sulfur dioxide (SO2) is emitted by power producers when they burn coal that contains sulfur. Since SO2 is noxious to breathe and contributes to acid rain, Congress in 1990 enacted legislation requiring emissions from electric utilities to be reduced to 8.95 million tons by 2010 (emissions were 17.5 million tons in 1980). Each year, the Environmental Protection Agency issues permits that allow a smaller and smaller amount of SO2 emissions.

So far, those emissions are down to about 10.5 million tons annually. According to one estimate by the EPA, by 2010, the annual cost of the reductions to electric utility companies, their customers, and shareholders will be about $3 billion, while the annual benefits—including lower mortality and fewer hospital admissions from respiratory illnesses; improved visibility; cleaner soil, lakes, and streams; and reduced damage to buildings—will exceed $100 billion. Even if these figures are exaggerated, the SO2 cap-and-trade system appears to be a major success.

The American SO2 market served as the model for the European Union’s Emissions Trading Scheme (ETS), established two years ago to meet the EU’s commitment to reduce GHG emissions under the Kyoto Protocol. Countries set a limit on how much carbon dioxide businesses and participating enterprises will emit and then allocate permits to them. The permits can be bought and sold on an open market. Manufacturers, for example, that can cheaply abate their emissions will have some permits left over. The cheap abaters can then sell their extra permits to other emitters that find it more expensive to reduce emission. In this way, a market in pollution permits finds the cheapest way to cut emissions. “Innovators can invest in technology to produce and sell excess credits,” said Jonathan Lash of the World Resources Institute (WRI). “Cap-and-trade creates a market that chooses the best options.”

From the point of view of environmental activists, the greatest strength of a carbon market is that it sets an overall specific limit on carbon emissions. As Craig Hanson, deputy director of the People and Ecosystems program at WRI, notes, “What the environment cares about is the amount of emissions and the concentration of greenhouse gases in the atmosphere. Setting limits on emissions is a policy that addresses that problem directly.” Matthias Duwe, the director of the Climate Action Network in Europe, explained his group’s support for carbon markets by saying, “Environmental effectiveness is what counts. What we want is absolute reductions in emissions. Sending signals to business is secondary.”

Despite this enthusiasm, after more than two years of operation, the EU’s carbon trading market is not working. The ETS covers the output of about 12,000 big emitters, whose CO2 amounts to roughly half of the European Union’s total emissions. While the EU’s 25 governments individually determine the number of permits they will issue, the ETS system directs the handing out of allowances, based on historical emissions, for each factory or other enterprise. Initially, allowances to emit CO2 traded for around 10 euros per ton. A year later, the price for allowances had risen to 30 euros per ton. At that price the market was being widely hailed a success, as higher prices would be an incentive for companies to work seriously at cutting their emissions. Then, in May 2006, an audit showed that several EU governments had issued permits for 66 million tons more CO2 than was actually being emitted. Everyone realized that the supply of permits was not scarce, so the price of carbon promptly collapsed to less than 9 euros per ton. By February 2007, an allowance to emit a ton of CO2 could be had for less than a euro.

. . .

The other option is to tax all kinds of carbon at the wholesale stage, as far upstream as possible. Utilities and refiners who take raw coal and oil as inputs would pay a tax on these fuels. The extra cost would get passed downstream to all subsequent consumers. Like prices for permits set in carbon markets, carbon taxes would encourage conservation and innovation. Since the tax is levied on how much carbon a fuel contains, it would make fuels like coal less attractive compared with low-carbon fuels like natural gas or even renewable energy like solar and wind power.

Carbon taxes also avoid the baseline quandary that bedevils carbon markets. For example, signatories to the Kyoto Protocol are supposed to cut their emissions of greenhouse gases by 7 percent below what they emitted in 1990. Why? That goal has no relationship to any specific environmental policy objective. In fact, achieving the cuts specified by the Kyoto Protocol goals would reduce projected average global temperatures by only about 0.07 degrees Celsius by 2050. And, as the stalled international negotiations about what to do after the Kyoto Protocol expires in 2012 show, it is very difficult to set new baselines. Also, where should baselines be established for rapidly growing economies like China and India, whose energy use and emissions are expected to more than double by 2030? Under the Kyoto Protocol, the natural baseline is what emissions would be without any restraints. However, calculating or predicting what a country’s emissions will be 20 to 30 years in the future is impossible to do with accuracy.

Under a pollution tax scheme, says William Nordhaus, the Yale economist who has been the leading advocate of this approach, “The natural baseline is a zero-carbon-tax level of emissions, which is a straightforward calculation for old and new countries. Countries’ efforts are then judged relative to that baseline.”

Another advantage is that the tax could be phased in to poor countries once average incomes reach a certain threshold. For example, carbon taxes might start to kick in when national income reaches $5,000 per capita, slightly higher than China’s current level. More generally, having a defined tax rate makes it easy for firms in developed and developing economies alike to predict the future impact of climate policy on their bottom line—something that is considerably harder to do when the government is handing out permits every year.

A tax avoids the messy and contentious process of allocating allowances to countries internationally and among companies domestically. Nordhaus says that carbon markets are “much more susceptible to corruption” than are tax schemes. “An emissions-trading system creates valuable tradable assets in the form of tradable emissions permits and allocates these to different countries,” writes Nordhaus. “Limiting emissions creates a scarcity where none previously existed and in essence prints money for those in control of the permits.”

Read it all. This is a rich essay that deserves a careful read. the point he makes is an important one--the EU cap and trade is not working because it is so easy to manipulate. Sadly, the carbon tax is also politically difficult at best. One way to ameriorate the political difficulties from a carbon tax would be to use it to reduce the taxes we otherwise would pay.


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