Common Tragedies

Thoughts on Environmental Economics

Expected value

Posted by Daniel Hall on December 3, 2007

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.

2 Responses to “Expected value”

  1. […] and trade or carbon tax? Common tragedies has a good post on the importance of expectations to the cap and trade system, and how a cap and trade system could […]

  2. Idetrorce said

    very interesting, but I don’t agree with you

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