Download Efficient Carbon Policy: Taxes vs. Cap & Trade

Efficient Carbon Policy:
Taxes vs. Cap & Trade
CRAIG PIRRONG
JANUARY, 2009
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
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
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
Types of Intervention
 Command & Control
 Tax
 Cap & Trade
 Hybrid (C&T, with a tax paid on emissions over the
cap)
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
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
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
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?
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
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
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)
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)
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
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
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