Equity, efficiency, and (long run) equivalence

You knew, dear readers, that the econoblogosphere has been arguing vociferously the last few days about carbon taxes versus cap and trade and to what degree they are equivalent, didn’t you? It seems Robert Samuelson started the entire thing with a grumpy tirade about cap and trade on the editorial pages of the Washington Post. Ryan Avent criticized it, and then things blew up. Here is Tyler Cowen, Mark Thoma, and Brad DeLong with more, another response from Ryan, and there are many further links at these posts if you want more. The short story is that only Tyler comes to Samuelson’s defense; everyone else agrees that while there are differences they are not the ones Samuelson “identifies” since he actually spends his time whinging about regulation of any kind at all. (Brad DeLong makes this point most clearly.)

I have been on the sidelines the entire time, partially because I have been very busy with my actual life, partially because I already covered this, and partially because I am consciously trying to avoid this malady. But I could not let this statement from Arnold Kling pass without comment:

In theory, you can make cap-and-trade equivalent to a tax. What I worry about is that under cap-and-trade Congress is very unlikely to have a pure auction of permits. Instead, permits will be given to favored industries. The equivalent under a carbon tax would be to set different tax rates for different industries, with favored industries getting anywhere from a partial exemption to a full exemption to a negative carbon tax, or a carbon subsidy.

Wrong.

Giving allowances away for free in a cap-and-trade system and giving (full or partial) exemptions in a carbon tax system are not the same thing. But why not? They seem so similar, don’t they? Some particular industry or firm gets favorable treatment — either free permits or lower tax rates — and this makes them more profitable, right? Why aren’t they equivalent? Briefly, because one system (cap-and-trade with free allowances) equalizes the marginal cost of emissions, while the other (carbon taxes with exemptions) does not.

Once you establish a cap-and-trade system, every regulated entity within that system will have an identical incentive to reduce emissions. The incentive will be the market price for allowances. And this incentive will be the same for all firms regardless of how allowances are initially distributed. Even if firms get allowances for free, they will still face an opportunity cost for emissions.

If you establish a carbon tax system with different tax rates for different sectors, however, firms will face varying incentives to reduce emissions. This will end up making some firms or sectors work much harder to reduce emissions (those with the higher tax rates) and others work less hard. This will have (at least) two unfortunate effects: one is that society will get less bang for its buck now — fewer emissions reductions for the money it spends than it could have done if marginal tax rates were equal. The second problem is that over time the existence of differing marginal tax rates will tend to push economic activities into sectors with low tax rates and away from those with high tax rates. Both these effects mean that the system is less efficient than it would have been if marginal carbon tax rates were equal across the entire economy.

Economics students will recognize this as the classic distinction between equity and efficiency. How allowances get handed out matters a lot for the distributional (equity) effects of the policy, but doesn’t affect the efficiency. Exemptions and carve-outs in a tax system, however, make the program less efficient. (The actual carbon tax policy equivalent to free allowances would be lump sum rebates of tax revenues, while leaving marginal tax rates equivalent.)

In my mind this difference is important, and constitutes a public choice argument for cap and trade. In order to get any climate policy passed you are realistically going to have to make a lot of political side deals. With cap and trade the natural side deal is to give away allowances. This may not be fair, and it may be ugly, but it at least leaves us with a system that is efficient, and this is very important when thinking about policies that will likely be in places for several decades. With taxes, however, the natural side deal is exemptions. And once full or partial exemptions get established in a carbon tax code I doubt they will go away. That might not look too problematic today but the inefficiency will just get larger and larger over time and by 2020 or 2040 we will be very unhappy we have a system that has inefficiently squeezed economic activity into certain sectors. Better to give up some equity now in exchange for a system that is built for the long haul.

Where’s your network?

Ryan Avent wants to know if carbon and congestion pricing will boost the case for regional rail:

I’m of the opinion that a carbon pricing scheme would give a boost to rail travel over both driving and short-haul flying. But a potentially more important factor in some regions might be the runway congestion charges under consideration. I suspect that auctioned spots would tend to go toward long-distance flights, for which there are few good substitutes (question to the gallery: what are the high margin flights–where do airlines make their money?). Were that the case, demand for regional rail should significantly increase.

Aviation policy wonk Evan Sparks replies that short hop flights are a valuable underpinning of the airline industry:

An airline hub offers positive network effects up to the point of congestion, which varies by airport. Without the network effects of hubbing, few cities could support much air service on their own — especially long-haul international service. Sure, New York, Chicago, Los Angeles, Boston, and Miami might be OK, but even they would see cuts. Without sufficient short hops to feed the hub, marginal international destinations would face the axe. Therefore, you can’t discourage simply limit short-hops without seeing network effects. … policymakers must be cautious when tampering with the ability of airlines to take advantage of network effects in offering air service widely and efficiently. (emphasis added)

Evan knows more about the practical in-and-outs of the airline industry than I do about any subject whatsoever, so I want to be careful with my reply. But I think he is assuming that the existence of network effects implies that there are positive externalities, and it’s unclear to me that this is the case here. The examples Evan cites in his post involve private benefits that are being captured in market prices, e.g., Delta decides to use a hub-and-spoke service model because that is how it is most profitable. Network effects sometimes do have associated positive externalities. For example, if many different actors own or operate the network then each may have insufficient incentive to invest in it — the free rider problem — and so there is a case for regulatory intervention to encourage the socially optimal level of investment. But in this case it sounds like a single actor (i.e., the airline firm) operates the network.

Congestion, on the other hand, generally involves an unpriced negative externality — Delta’s use of runway space doesn’t only delay Delta’s other planes but also those of competitors — and hence there is a case for regulatory intervention.

The original question concerned which flights were high margin and if you read Evan’s response it does indeed sound like it is long-haul international flights that are most profitable. This seems intuitive to me since there are just not any good substitutes available. So I’d expect to see these flights to continue even once we price carbon and congestion. It’s also reasonable to think that pricing these externalities will decrease demand for short flights. This worries Evan:

Airlines have gradually centered themselves around hubs. … This tends to be more efficient, even if some individual flights defy logic. A couple personal examples: whenever I go to New York, I take surface transportation. But last year I flew through JFK from DC (thirty minutes) to catch a flight to London. On a trip to New Orleans last month, I flew first from Baltimore to Philadelphia — a fifteen minute flight. Such options maximized efficiency and provided me with much cheaper options than had I relied on nonstops.

Two things about this: First, I suspect that neither Evan nor any of you really care that much which mode you take to reach your nearby intermediate destination. If a flight is better — faster, cheaper, more convenient — then you’ll fly Baltimore to Philly, but if a train is better you’ll hop on board. Right now flying is cheap because it involves lots of things that neither you nor the airline pay for, like a warmer world, or other delayed passengers. If you have to pay the price for those things, however, rail might look a lot better. Second, what are these 15 and 30 minute flights Evan is talking about? I can’t imagine that these are the actual marginal increment of travel time that his short flights added to his trip. Let’s talk about boarding, taxiing, etc.

But these brings me to my final point, which is that as much as airline travel can be a hassle, it is very often even more inconvenient — or even downright impossible — to switch modes within a single trip. One of Evan’s commenters makes a very smart observation about this point:

What we really need is more of what Continental does with Amtrak - intermodal codesharing. You’ll notice that Continental doesn’t fly EWR-PHL. You have to take an Amtrak train with a Continental code on it. …

Of course, that requires a convenient plane to train connection and not many hub airports offer that. Sure, US Airways could do it in Philly if we could get a station built near PHL. That’s a long ways away and it will require a lot of money, but it’s ideal.

Which goes right back to a point which you can read Ryan making nearly every day on his blog: once we start pricing carbon and congestion, it will be much less painful if we have transportation options that are not carbon- and congestion-intensive. Rail is one of those options. This means that rail would be a smart infrastructure investment, and it also means we should get the institutional structure right to allow travelers to transfer between modes.

Some motherly advice on deficit reduction

Over on EconomistMom, Diane Lim Rogers notes that economists of all political and ideological stripes appear to support pricing carbon, which, by itself, amounts to increasing taxes. She then muses that part of the appeal comes from the fact that a carbon tax is an efficient tax, and the revenue could go towards alleviating other less efficient taxes. In particular, Rogers’ main interest is in deficit reduction. Now as I noted in the comments, it seems pretty unlikely (at least in my reading of the current political climate) that deficit reduction will garner much, if any, of America’s newly created carbon permit pie. My guess is that it’ll be eaten up by some combination of giveaways to industry (a la McCain), giveaways to the people (a la Boyce and Riddle), and spending on R&D (a la Joseph Romm). These three spending options all have obvious political constituencies, but it wasn’t obvious to me who the deficit reduction constituency is (except the unborn, who, for obvious reasons, don’t seem to carry much political clout). Nevertheless, deficit reduction is obviously a reasonable option, so I decided to check out the Brookings Paper Rogers links to.

Here’s is the comment I left for Diane after reading her paper, in which I show my ignorance of public finance,

I’m curious about the distributional implications of using this revenue to pay down our national debt. In your paper, you say, “Even if one interprets the benefits of deficit reduction as distributed broadly across the current population, i.e., as a fixed dollar amount of benefit to each American, this benefit will be progressive relative to income (a higher percentage of a lower income).”

But why would one interpret the benefits this way? Wouldn’t the benefit be proportional to each person’s share of future taxation? And given that wealthier Americans have higher average tax rates and pay taxes on a much larger ammount of income, it seems to me that reducing future tax burdens would be really regressive.

Diane replied,

Rich, there are debates on this—what is the burden of budget deficits across the income distribution? (It’s easy to figure out the intergenerational burden, not so easy to speculate on the inTRAgenerational burden among rich vs. poor.) Obviously it depends on what we think the form of the future burden will take–higher taxes or reduced government services, or some combination of both. The more it’s higher taxes, the more it depends on how we think taxes would be raised. If taxes would be raised proportionate to the current (progressive) federal tax distribution, then you’re right, that would be a more progressive change, so reducing the deficit and avoiding such future tax increases would be a regressive change. In my paper I was making the assumption that the future tax increases and/or benefit decreases associated with deficits would be distributed fairly evenly across the population, which would mean that relative to income, avoiding deficits would be a progressive change

So there you have it. I’m not surprised to hear that the distributional implications of deficit reduction are highly dependent on how you assume future tax increases were going to be financed. Given this, the real question I have is not “Under what assumptions is deficit reduction progressive?”, but instead, “What are the most realistic assumptions we can make about where future deficit driven tax increases/ decreases are likely to come from?” I know this is basically unanswerable, but any evidence (even anecdotal) or hypotheses would be welcome. I’m currently working on a paper analyzing the incidence of US climate policy, and it seems to me that this is the million dollar question when it comes to deficit reduction.

Today’s best person in the world: Peter Orszag

Today the Director of the CBO is testifying before the Senate Finance Committee on the implications of a cap and trade program. In addition to the full testimony, you can read Orszag’s summary comments on the CBO blog. As I read them, two points stood out.

First, Orszag says that the CBO believes a tax is generally more efficient than a cap because of its flexibility. We’ve already debated this issue too much. I’m merely pointing this out to chalk Orszag up in the pro-tax column on the proverbial scoreboard.

The real bombshell comes in the final paragraph:

CBO has concluded that the federal budget should record the value of allowances that are given away by the government if the recipients of the allowances could readily convert them into cash. In particular, the budget should record the value of those allowances, when they are distributed, as both revenues and outlays. That procedure, which CBO has already applied in its estimates for S. 2191, underscores that giving away allowances is economically equivalent to auctioning the allowances and then dedicating the proceeds to the recipients.

It’s one thing for economists and eco-bloggers to point out the reality of pass-through. It’s quite another for the CBO to recommend codifying it in the calculation of the federal budget. This is going to be controversial on the Hill, but if anyone can explain it simply and convincingly to Congress its Orszag.

Today’s best person in the world: Peter Orszag.

Fun with statistics: the regressivity of gasoline taxes

Yesterday on Grist, Joseph Romm responded to a reader who argued that he should care more about incidence when talking about gas taxes. His response was a litany of citations suggesting that gas taxes were not in fact regressive, partially because the poor don’t own cars/ drive as much. Romm’s supporting evidence is pretty compelling. He cites a recent study by Don Fullerton (who used to be at RFF) which finds that a gas tax would only be regressive across the top half of the income distribution (BTW, Fullerton’s paper is one of the best I’ve seen on the public finance options for curbing vehicle emissions if you’re interested in that issue). Yet despite all of the evidence Romm put forth, I was still skeptical of his claim. I’m working on an incidence paper myself right now, and do see regressivity in the data. It just depends on how you define it. Below is a table with gas expenditure by income quintile from the 2007 BLS Consumer Expenditure Survey (which, btw, is the same source Fullerton uses):

Notice how different the story looks depending on whether you put income or consumption in the denominator. Both measures have their faults, and, in the policy world, people tend to flip back and forth between them depending what point is being made. Ideally economists would like to put lifetime income in the denominator, assuming that people incorporate their future welfare/ wealth into their current decision making (ie college student go into debt with the expectation that they’ll make much more money later on). For a more detailed discussion on defining incidence see this working paper by Gilbert Metcalf.

For those who don’t have time to check out the Fullerton paper, I’d also just like to point out something about the table Romm presented in his post.

However, he omitted the third column. To be fair, his point was about average effects across all people. Yet one can imagine how the second statistic might be relevant to policymakers. While poorer people are less likely to own cars/ drive, the ones that do are likely to be significantly impacted by an increase in the price of gasoline. If a household making under $20,000 a year does own a car, it’s probably because they live in an area where there aren’t any other options for getting to school, work, etc. This means that their demand response in the face of a price increase would probably be negligible, and a gas tax would simply crowd out other consumption. Thus you could imagine framing incidence in terms of rural vs. urban households, as well as simply rich vs. poor.

None of this is to say that one way is best. And I definitely support a gas tax, although I think we should be smart about implementing it. I just thought I’d point out that on this issue, like just about every other issue in DC, different people can use the same data to make different points.

Fifty dollars per ton of carbon dioxide

That is what Marty Weitzman thinks we should do about climate change.

This came up at the World Bank event I wrote about yesterday. During the Q&A session a World Bank employee came to the mic and said that the Bank would likely soon adopt a social cost of carbon (SCC) to use when evaluating its projects, and what SCC would Weitzman recommend?

Weitzman hemmed and hawed and noted that the whole point of his paper was that there are these big uncertainties, and that previous attempts to calculate the socially optimal price on carbon haven’t accounted for these and thus are wrong, and that you couldn’t even really do the calculation with the current tools we have. But he finally acknowledged that if you made him philosopher-king and demanded an answer he would say that the price on emissions (i.e. a carbon tax or the price of a cap-and-trade permit) should be $50 per ton of CO₂, rising at rate of a few percent over inflation.

A few thoughts:

1. Muse about uncertainty all you want, but ultimately you have to name your price.

2. This is higher than a lot of mainstream economists who work on this issue. Bill Nordhaus thinks the right value today is around $10 per ton of CO₂ (see Table 5-4 of this publication); Billy Pizer at RFF thinks it is close to double this (ungated version here, see Table 5 (3 in gated version) suggesting the correct valuation is 82% higher). On the other hand Nic Stern estimates it should be $80 per ton of CO₂.

3. Carbon prices in Europe are currently about 70% of this level (thanks partially to the weak dollar).

4. Carbon prices in the U.S. are short of this mark by about… oh, that’s right, $50.

Who vets NYTimes op-eds?

Today’s piece on carbon taxes by Monica Prasad was pretty weak. Her argument is that we should tax carbon but recycle 100% of the revenue back to industry. While this is not necessarily a bad idea, the evidence she sights from Denmark’s experience is pretty JV. How much of Denmark’s comparatively strong clean energy growth came from R&D investment vs. simple resource availability? Who knows. European carbon emissions have gone up since a carbon tax was imposed, but how much higher would they have been without the tax? Not relevant. And oh yeah, just ignore all of the petty equity and distributional implications.

Also, this sentence didn’t make any sense: “But unless steps are taken to lock the tax revenue away from policymakers and invest in substitutes, a carbon tax could lead to more revenue rather than to less pollution.”

Sorry for the random rant. Read and form your own opinion, of course

UPDATE: Apparently the Environmental Econ guys got to this before I did, pointing out that demand for gasoline is not perfectly inelastic. Although, surprisingly, they forgot to hyperlink their first behavioral response. You guys are slipping!

Another Update: Over on Grist, David Roberts adds to the Prasad critique by pointing out (as I weakly alluded above) that the US aint Denmark, and that distribution and ease of transition matter a lot. My favorite line: “Far as I can tell, though, what Prasad calls not spending looks a lot like what the rest of us call spending.”

Pork barrel term of the day

Comitological hypothecation.

Hypothecation is eurospeak for earmarking. Not sure if comitological is a word, but this is supposed to mean that it takes place in a governmental committee.

If we ever get around to capping or taxing carbon, there’s gonna be a whole lotta comitological hypothecation goin on in Congress.

H/T Dallas.

Assorted links

1. British Columbia is implementing a revenue-neutral carbon tax. Mike Moffatt is a fan.

2. Oil closed above $100 per barrel for the first time ever yesterday (in nominal terms). The WSJ Environmental Capital guys immediately called it speculation rather than fundamentals.

3. In the face of high fuel prices, residents in the Northeast U.S. are switching back to wood-burning stoves, but this move carries its own costs, particularly to local air quality.

4. Cameroon wants to rent a forest — preferably to conservationists — but doesn’t seem to have any takers. The article points out that they may be above the market-clearing price.

5. Ezra Klein praises density.

6. George Monbiot, writing about climate change policy, is offended that economists place a monetary value on human life, and that hence there is a chance “we would then find that it makes economic sense to kill people.” One of the Free Exchange bloggers defends the use of benefit-cost analysis, while Tim Haab provides a straightforward explanation and able defense of why economists place a value on life. (Hint: it’s because we all do — they’re called trade-offs.)

Why the CBO likes a carbon tax

The Congressional Budget Office released a report yesterday examining greenhouse gas emissions mitigation policy. Terry Dinan at the CBO authored the report, Policy Option for Reducing CO₂ Emissions. The report looks at using 3 forms of incentive-based regulation: a carbon tax, and two variants on a cap-and-trade program, referred to as “inflexible” and “flexible” cap and trade. The report concludes that a carbon tax will be the most efficient policy instrument.

The reported has ignited a series of blog entries: the CBO director’s blog summarized the report, and Mankiw promptly excerpted the key result. Environmental Economics has already put out a series of posts this morning. For my money the most interesting conversation is happening over at Felix Salmon, where you must read the comments as well.

I want to use the discussion as a springboard to explain why the CBO says a carbon tax is more efficient, and I’m going to try to do so in a way that delves into the economics literature but remains grounded in relatively plain language. I’m also going to explain at the end why I still think cap-and-trade is the way to go.

First, Felix highlights a relevant excerpt from the report:

The case for carbon consumption caps

Judith Chevalier lays out the case for carbon consumption caps in Sunday’s NYTimes. Carbon consumption caps would solve the international leakage problem as well as insulate American workers from competition from countries without climate policy. Such an approach would also provide producers in developing nations with the incentive to become greener now, even though their governments may be decades away from enacting economy wide carbon restrictions. For these reasons, I agree a carbon consumption cap is an “elegant” solution - in theory. But I do have a couple questions about how, and if, it could work in practice.

1. Is this possible under the current WTO rules? Chevalier mentions but glosses over this point at the end. My guess is that many LDCs would consider this an unfair tariff. It’s also a slippery slope to use trade policy to achieve political goals. What’s next, linking imports to labor standards?
2. Is this type of regulation economically and informationally feasible? It seems like this would involve a substantial amount of regulatory oversight and a very costly labeling, monitoring and tariffing bureaucracy. Also, many imported goods are made of components from several countries. When would the tariff be applied?
3. Finally, would such an approach even significantly curb net Chinese emissions? By taxing exports only, it seems just as possible that the effects of domestic leakage, from exporting to non-exporting sectors, could dominate.

The interplay between an emission price and technology policy

I think we have been fairly clear here at CT about our thoughts on the role of technology policy within climate policy. It’s a somewhat nuanced position; I’d summarize it thusly:

The government should support energy technology R&D, and particularly fundamental research (i.e., basic and applied research as compared to development and deployment activities). The principal rationale for such support is that there are spillovers — large, broadly-dispersed societal benefits — associated with research that cannot be captured privately by firms; thus, there are large under-incentives for firms to invest in the socially optimal level of R&D. At the same time, the core feature of any approach to reducing greenhouse gas emissions should be an emissions pricing policy: a carbon tax or a cap-and-trade program. Such a policy is the most cost-effective approach when fundamental change must be made to complex and disaggregated systems such as the energy infrastructure. Further, a pricing policy will itself boost private sector R&D by increasing the returns to innovation, particularly in areas such as development and deployment where there are fewer market failures. Thus, R&D policy is a necessary complement, but not a substitute, for an emissions pricing policy.

Although those are my words, I think my co-bloggers would broadly agree with the sentiments. There are certainly other thinkers out there, however, who put much more emphasis on the role of technology R&D — they feel that it should be the core of climate policy and that emissions pricing policies are peripheral, unnecessary, or perhaps even counter-productive. In general I feel that these thinkers are underestimating the innovation that will occur under a pricing policy and overestimating its transaction costs. However, there are certainly better arguments for such an emphasis than others. Paul Klemperer gives one of the best I have read at VoxEU:

Developing countries are not going to give up the immediate aspirations of their (often growing) populations for climate-change benefits that are largely in the future. Worrying about preserving the environment for our great-grandchildren is a luxury developing nations do not have. …

[M]ore R&D into clean energy is probably the highest priority of all. Finding a clean energy source that is cheaper than those currently available is the only politically-plausible way of curbing continuing growth in developing nations’ emissions.

Further, he makes two insightful comments about why the rich world should develop new nuclear and CCS power facilities:

First, whether we like it or not, China (and India and others) are going to continue to develop nuclear energy. So unless the West continues to develop it too, the safety and storage and handling issues will be resolved in environments with less democratic accountability than in Europe and the US, and with more pressure to take shortcuts than in richer countries.

Second, China (and India and others) will continue to exploit their enormous coal reserves. So we urgently need research and development on lower cost Carbon Capture and Storage (CCS) technologies to remove coal plants’ emissions. The UK government is right to subsidise a demonstration CCS plant. It should probably subsidise several. It is also right to insist that the technology chosen is one that can be retrofitted to traditional plants. China is building one such plant every five days.

I agree that the rich world’s governments should be researching technologies now that the developing world can use tomorrow. But I wish he would have been more clear that an emissions pricing policy still has an important role to play, and technology policy cannot go it alone. For example, there are practical limits to how quickly R&D investment can be ramped up: an immediate doubling of energy R&D dollars might do less to stimulate new innovation than serve to push up salaries in a field that requires long training. Further, the reality is that private sector R&D investment is always going to be far larger than government R&D; Professor Klemperer, however, is quick to see private disincentives for R&D at every turn:

Businesses know that when an innovation is sufficiently important, the innovator gets little of the benefit: the developers of drugs for AIDS, and of vaccines for Anthrax and bird flu were threatened with compulsory licenses in many countries (including in the United States) until they “voluntarily” licensed their innovations cheaply.

An emissions pricing policy, however, is exactly the opposite of government appropriation of private research! Rather, it signals to businesses that emissions reductions are genuinely valuable, and there is profit to be made if they can find better ways to reduce.

I think it’s perfectly reasonable to increase government support for R&D out of a desire to subsidize long-term reductions in the developing world. But such reasoning should strengthen, not diminish, our resolve to have an emissions price as the central feature of climate policy.

Bloomberg is audaciously hopeful

In his speech at the Bali conference, Michael Bloomberg described a cap-and-trade system as vulnerable to “special interests, corruption, and inefficiencies,” and called for a tax in its stead. There have been numerous posts here at CT weighing the merits and deficiencies of taxes against those of a cap-and-trade system, so I’m not going to try to expand or improve upon those.

However, a major argument raised against a carbon tax is that of political intractability. Bloomberg attempted to address this major weakness of his policy:

He said most experts would agree that carbon taxes are “a very difficult political lift,” since they would probably boost costs for energy consumers. “But that’s what leadership is all about, and we need leaders around the world who get things done,” the New York City mayor said.

First off, a cap-and-trade, unless full auctioning occurs, is also likely to raise costs for energy consumers. Second, is it just me, or do politicians put far too much stock in their own ability to lead America to greatness? Obviously we need to elect people who have vision on important issues, but choosing realistic policies is also a big part of being an effective leader. Regardless, with Chris Dodd largely out of contention, it would be interesting to see Bloomberg jump in the Presidential race. He could inject the cap-and-trade vs. carbon tax debate into national politics. Jumping right to that dicussion in a general election (especially one in which two major candidates are discussing it) might cast mandatory carbon mitigation as an inevitability.

H/T: Mankiw.

What’s the point?

As we move from debating if we should restrict carbon emissions to discussing how we should restrict carbon emissions, one of the more contentious battles is going to be over point of compliance. This is the question of at what point in the supply chain should you regulate carbon. Like much much of the climate policy debate in the US, the issue is currently being hashed out in California. Assembly Bill 32 requires the state to reduce aggregate GHG emissions to 1990 levels by 2020, and the California Public Utilities Commission (PUC) and California Energy Commission (CEC) have been holding meetings for the past year in order to prepare for compliance. These bodies are now knee deep in the debate over point-of-compliance, and the recent arguments of Dallas Burtraw, from RFF, and Richard Cowart, director of the Regulatory Assistance Project, provide a useful insight into issues at hand.****

*** In the interest of full disclosure, I should mention that I currently work for Dallas at RFF. Nevertheless the comments in this piece are entirely my own.

The Hayek club

There’s an interesting discussion going on in the blogosphere about what might constitute a conservative response to climate change. This got started by Jim Manzi’s argument at the American Scene against a carbon tax (actually any emissions pricing policy, whether a carbon tax or cap and trade), and in favor instead of a surge in technology development funding. Ryan Avent has responded at Gristmill (and on his own blog) that we can and should price carbon, and notes that it is odd that Manzi, a conservative, is arguing for an “approach to emissions reduction that favors the wisdom of central planning over market allocations,” (i.e., technology development over an emissions pricing policy).

Manzi has written a subsequent post that clarifies his reasons for opposing a carbon tax, and they essentially boil down to this: “It’s complicated! We won’t get it right!” To defend his opposition to a Pigouvian carbon tax he invokes Ronald Coase:

Ronald Coase’s lecture upon receiving the Nobel Prize in economics is very instructive. When discussing one of the two papers for which he won the award, The Problem of Social Cost, he had this to say:

I was exposing the weaknesses of Pigou’s analysis of the divergence between private and social products, an analysis generally accepted by economists, and that was all. … Pigou’s conclusion and that of most economists using standard economic theory was, and perhaps still is, that some kind of government action (usually the imposition of taxes) was required to restrain those whose actions had harmful effects on others, often termed negative externalities. What I showed in that article, as I thought, was that in a regime of zero transaction costs, an assumption of standard economic theory, negotiations between the parties would lead to those arrangements being made which would maximise wealth and this irrespective of the initial assignment of rights. … I tend to regard the Coase Theorem as a stepping stone on the way to an analysis of an economy with positive transaction costs. The significance to me of the Coase Theorem is that it undermines the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances. Of course, it does not imply, when transaction costs are positive, that government actions (such as government operation, regulation or taxation, including subsidies) could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My conclusion; let us study the world of positive transaction costs.

Manzi goes on then to claim that what with transaction costs being so large an emissions pricing policy just won’t work. I think he overplays many of of the practical difficulties, but since Ryan’s post anticipated many of these arguments I’ll leave you to read it.

I want to object rather to Manzi’s disingenuous intellectual sophistry in ignoring the actual message of Coase’s quote.

Expected value

There was a comment at last week’s rollout event for RFF’s new report on U.S. climate policy that I found very interesting.* It concerned the role that expectations will play in determining allowance prices within a greenhouse gas cap-and-trade system, and why this may make cap and trade a more attractive option than a carbon tax for reducing emissions.

The comment came up during a discussion of one of the fundamental tensions in designing market-based climate policy: the value, on the one hand, of a stable, credible, and predictable policy that sends a consistent price signal about the value of emissions reductions, and the need, on the other hand, to update the policy as better scientific information becomes available about what the value of emissions reductions actually is.

The comment concerned the fact that given the present uncertainties about how costly climate change is going to be, we are surely going to have to update our climate policy regardless of whether it is a tax or cap-and-trade system. Further, there’s going to be a regulatory lag in response to new information. This lag will be inefficient — it means there will be a period where the carbon price of our current system is different than our current estimate of the marginal benefit of emissions reductions.

The comment was that in this situation a cap-and-trade system would be more efficient than a tax, because the prices within the system would change immediately based on the expectation that the government would, in the near future, intervene to update the policy.

Thus imagine that in 2015 we get some bad news from the scientific community about climate change: the risk of truly damaging climate change are higher than previously thought. Although it would likely take Congress a few years to act on this info and revisit the question of what the cap should now be, firms would start banking more allowances today in anticipation of the government intervening to tighten the cap, and thus prices would rise immediately. Conversely, if new scientific info suggests the risks from climate change are lower than previously estimated, firms would start borrowing against future allocations (assuming borrowing is allowed) and prices could slacken in response to new info.

Is this a solution to a real problem? It partially depends on how you think a tax or cap-and-trade system is set up. If Congress is the authority that sets the tax or cap, and is solely responsible for changing it, then I think the regulatory lag issue could be quite real. If, on the other hand, a regulatory agency such as EPA had discretion to adjust the policy in response to new information then the lag would get smaller, perhaps just a year or two.

Either way, however, the uncertainties about the costs of climate change are very real. This is one of the emerging themes in the thinking about climate change, attempting to move away from analyses based the “most likely” outcome, towards thinking about the distribution of risks, and attempting to incorporate long-tail risks into policy. Since these uncertainties can dominate the benefit-cost analysis of taking action on climate change, having a policy which responds dynamically to the latest scientific information about these risks may prove very valuable. Another reason I’ll add to my list of the advantages of a cap-and-trade system.

*Video of the first hour of the event is up at the website, but I think this comment was made during session 3 in the afternoon, so unfortunately there’s not video.

On hoarders, speculators and do-gooders

Over the past few weeks there’s been a lot of debate on this page and others about the relative merits of a carbon tax versus a cap-and-trade system. Increasingly I’ve come to feel like this is all much ado about nothing, as practically speaking a cap-and-trade system with full auctions and a safety valve is essentially the same thing as a carbon tax. Yet with that being said, there is one difference between the two that has a lot of insiders/bureaucrats worried, but that hasn’t been discussed all that much in the blogosphere to date: the potential for manipulation of carbon permits. I’ll discuss some of the potential threats, real and imagined, below the fold.

* Disclaimer - this post mainly applies to the electricity sector

** Thanks to Anthony Paul for explaining most of this stuff to me.

Conflict of interest?

Presumably the long-term goal of a carbon tax is for emissions — and hence revenues — to decline to zero.  Will the government be willing to cut off the hand that feeds it?

Institutional “stickiness” argues for cap and trade

Felix Salmon has a great summary of the carbon taxes versus cap-and-trade debate that we mentioned last week. I encourage readers to go read Felix’s post in its entirety before continuing.

It sounds as if one of the most-discussed issues in the debate concerned systemic political realities — as separate from economic or policy design issues — and what these implied for the preferred policy instrument. Here is Felix:

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.

…

Ultimately, the most compelling argument is the flexibility/optionality argument. Think of a cap-and-trade system, [Billy] 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.

[Full disclosure: I work for Billy Pizer at Resources for the Future.]

The excerpt, particularly the first two sentences, highlights a concept that is not discussed frequently by economists (probably because it doesn’t fit neatly into analytical language), but which I think most policy wonks would concede is a reality: Institutions, once created, become entrenched and will be “sticky.” It is generally possible to adjust the specific features of a program, but the larger meta-architecture — in this case, whether you are using a tax or cap-and-trade system as your policy instrument — will likely be very stable once established. This implies we need to account for path dependencies in deciding whether to use taxes or cap and trade.

Here, like Felix and Billy, is where I put in my vote for cap and trade. In the long run a cap-and-trade program best lends itself to achieving specific emissions reductions, the very type of specific targets, indeed, that we are likely to have to agree on globally if we are ever going “solve” the climate commons problem.

Having said that, however, I think that price-based instruments are the preferable approach in the near term. I think a domestic cap-and-trade program in the U.S. should incorporate a safety valve, set at a level — say, around $15–20 per metric ton CO₂ — where it would be triggered. Combined with extensive (although not total) auctioning of permits, this would effectively equate to an emissions tax in the near term.

Why do I prefer this approach?

Carbon taxes versus cap and trade: debate in New York City

There will be a debate on taxes versus permits next week in New York City. From the website:

A PUBLIC DEBATE: Should Climate Change Legislation be in the Form of Emissions Cap and Trade or a Carbon Tax?

Tuesday, November 13, 2007 9:30 am – 12:30 pm

New York City Bar Association Great Hall, 42 West 44th Street, New York, NY

They request registration by November 7, but I would encourage interested readers in NYC to try to RSVP and attend.