Common Tragedies

Thoughts on Environmental Economics

Institutional “stickiness” argues for cap and trade

Posted by Daniel Hall on November 14, 2007

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? Many environmental advocates dislike a safety valve because it breaks the cap. If the U.S. were the only emitter I would be more sympathetic to this argument. But the reality is that in view of what it is going to take to actually stabilize emissions in the atmosphere — slow emissions growth globally, then reverse growth and reduce emissions to very low levels — what the U.S. does in the next ~20 years is just not that important. It’s what the world does in the next 50–100 that really matters. For America in the near term, the key thing is to get a well-designed program up and running which can make modest reductions now and — this is key — create credible expectations that much larger reductions are coming.

So why support cap and trade instead of an emissions tax? A tax could be designed to start at a modest level and increase dramatically over time. This places us back into the realm of opinions about what is politically likely. My guess is that the Congressional finance committees that are going to have jurisdiction over a carbon tax are not going to want to be constantly revisiting the tax level in order to ratchet down emissions.

My proposal is for Congress to set up a cap-and-trade system that explicitly allows a safety valve for a set period of time, say 10–20 years (or until an international agreement makes such an arrangement obsolete). There would be a set of annual caps over that beginning period, and there would be a starting safety valve price along with an expected price trajectory. This program would be managed by a federal agency — presumably the EPA — that potentially could also be given authority to make adjustments to the safety valve price. Such a structure could mirror the “climate Fed” proposal in the current Lieberman-Warner bill, except they would be targeting prices explicitly and emissions implicitly rather than the other way around. The price trajectory would need to move significantly above the rate of inflation in order to produce real increases in prices that would “bite”. The goal would be for the prices to eventually rise (towards the end of the initial period) to the point where the safety valve price was above the market price for permits and you were left with a traditional cap-and-trade system. (Although keeping an “over-the-top” safety valve in place for awhile as an additional hedge against a bout of particularly nasty unforeseen short-term volatility seems valuable in its own right to me.) When combined with a set of annual caps that involved aggressive future reductions, this would create clear expectations that emissions will have a high future price — hence technology R&D will be very worthwhile — while avoiding the effects of unnecessary and unproductive volatility in the next few years.

My preference for such a proposal ultimately reduces to how I think about risk: I view the economic risks of a poorly designed system as being much more important in the near term, and the environmental risks being the deciding factor down the road. The cap-and-trade proposal I outline here seems robust to both set of risks, accounts for (even takes advantage of) institutional stickiness, and seems relatively feasible politically (to the degree than any program is). Those who have different opinions about either risk or political realities will likely come to different conclusions.

Comments are open.

Update: Matt Zeitlin is terrified by the thought of Congress thumbing all the dials on the cap-and-trade box. In addition to Matt’s (valid) concerns there are thoughtful responses from Felix Salmon, Dan Rosenblum (of the Carbon Tax Center, and one of the debaters), and myself.

2 Responses to “Institutional “stickiness” argues for cap and trade”

  1. Rich Sweeney said

    Felix’s post was good, except for the part about a “dynamic hedge of fat-tail CO2 risk”. I don’t see how a cap-and-trade system significantly alters economic actors’ internalization of fat tail risks compared to a tax.

    On the broader point about institutional considerations, you’re starting to sway me, although I feel like we’re moving well outside the realm of economics. When I advocate taxing carbon emissions, I’m taking for granted that such a tax would be set intelligently, aiming to reduce emissions by some amount or, at some point down the line, set equal to the estimated cost to society of emitting. I’m also assuming that such a tax could be adjusted dynamically due to changes in behavior or the environment. Just because many of the ideas being floated by politicians involve arbitrary tax amounts and preset pricing paths doesn’t mean that we researchers can’t advocate something better. With that being said, political factors and bureaucratic idiosyncrasies surely need to be considered.

    Finally, I agree with Dan Rosenblum’s point over on Matt Zeitlin’s blog. Ex ante, I don’t see why people think taxes are more susceptible to political exemption than caps. If anything my undergrad poli sci background would have lead me to the opposite conclusion, as the tax approach is more transparent. Anyways, on this particular issue, I’m just speculating (much like most of the econobloggers, I fear). Maybe it’s time to bring more policy/ politically experienced voices into the discussion.

  2. Dan said

    Rich – most economists commenting on the EU ETS believe you are right – tax systems are more transparent. The main reason is that cap and trade schemes require allocation plans that are administered by local officials, who are susceptible to corruption. There is no hard and fast reduction that a participant in the scheme must achieve – and there are channels that the participant can use to influence the allocation plan. With a tax, on the other hand, everyone knows exactly what everyone must pay per unit of emissions.

    Given that climate change is a new issue, is it fair to impose the same tax on different companies? One power generator might have invested in coal before knowing that its future carbon emissions are a liability, while another investing in large hydro gains a financial advantage.

    As an aside, cap and trade schemes already have an inbuilt ‘safety value’ in the fine for emissions that cannot be covered by credits. $15-20 would be a low fine, on the experience of the prices in the EU (which is around EUR22/t – and the fine is EUR40/t).

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