Common Tragedies

Thoughts on Environmental Economics

Prices versus quantities for addressing climate change

Posted by Daniel Hall on September 24, 2007

Econospeak points out several problems with carbon taxes, and comes down in favor of cap-and-trade.

I have several comments to make on this post, but first I want to address one narrow issue. Econospeak says that:

From a conventional benefit-cost perspective, Weitzman showed long ago that there were important differences depending on the slope of the marginal benefit and cost functions. Translated into common English, if we are uncertain about the long run relationship between the price of carbon emissions and the amount of emission – and we very much are – and if the risk of allowing too much climate change is greater than the risk of economic indigestion from trying to be too green – which seems pretty clear to me – then permits are the right choice.

Econospeak summarizes Weitzman, but then comes to exactly the opposite conclusion that Weitzman originally did.

To (correctly) summarize Weitzman, the marginal benefit curve for reducing emissions is very shallow in the near-term (i.e., it makes little difference to the global atmosphere whether emissions are 27 GTCO2 or 26.9 GTCO2 next year). Meanwhile, the marginal cost curve for reductions is likely much steeper in the near-term (i.e., it makes a big difference to our economy whether we cut emissions by 1% or 2% next year — costs rise exponentially with bigger cuts). (Billy Pizer of RFF summarizes this point in the introduction to this paper.)

To put this in plain English, the important long-term issue for the environment is the total loading of CO2 (and other GHGs) into the atmosphere, because GHGs are stock pollutants. Year-to-year variability doesn’t make any real difference to the environmental outcome. On the other hand, it can matter very much to the economy what the short-term allocation of permits is. Even annual weather variability can cause ~1% changes in CO2 emissions (weather was a big part of US CO2 emissions falling 1.3% from 2005 to 2006), which can then lead to short-term spikes in permit prices.

Permit systems (mis)place a high value on near-term emissions certainty at the expense of costly short-term economic volatility. Permit systems can be designed to mitigate these problems, by incorporating banking and borrowing, or being equipped with a safety valve price that will sell additional permits once prices rise to a set level. (And of course financial market instruments would evolve to help manage volatility.) But these are all features that make permits — a quantity-based instrument — look more like a price-based instrument.

Unless you don’t believe that demand curves slope downward, price-based instruments are the preferable long-term approach for addressing greenhouse gas externalities.

This doesn’t mean that I wouldn’t support a cap-and-trade approach — I think it is the best policy we are likely to get. But I do think that it should incorporate as many features as possible that make it look more like a price-based instrument (read: tax), including the auctioning of permits, the banking (and perhaps borrowing) of allowances, and a safety valve provision.

I hope to return later today with broader thoughts on Econospeak’s post. In the meantime, there is more discussion and commentary from Tyler Cowen and Megan McArdle.

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