U.S. cap-and-trade choice inferior to carbon tax: John Kemp

Fri Feb 27, 2009 9:02am EST

-- John Kemp is a Reuters columnist. The views expressed are his own --

By John Kemp

LONDON (Reuters) - President Barack Obama's first budget puts climate change at the heart of the administration's long-term economic plan. But despite the clear theoretical advantages of a simple carbon tax, he seems set to follow the EU and California in opting for a cap-and-trade system.

The budget plan commits the administration to work with Congress on an economy-wide emissions reductions program, based around cap-and-trade.

It also anticipates almost $650 billion in revenues over 10 years from selling these yet-to-be-agreed pollution permits, and proceeds to spend it on investment in clean technologies ($120 billion) and rebates for vulnerable families, businesses and communities ($525.7 billion).

In a sense the budget is a "wish list." While federal law requires the president to submit a unified budget, there is no obligation for Congress to consider it line by line, or even use it as a starting point in the annual tax-writing and spending process.

Prudently, the administration has been careful not to rely on permit auction revenues it may never be able to collect. The projections do not anticipate spending any money raised from the permit program until October 2012.

Revenues from permit sales have also been earmarked to fund clean technology and new tax offsets. If auctions do not occur, or raise less money than expected, these spending commitments can be canceled without affecting the rest of the budget.

Nonetheless, by putting a cap-and-trade into the budget document, and anticipating how the revenues could be spent, Obama has given a strong personal commitment to seeking comprehensive climate change legislation this year.

Legislation will need to be sent to Congress within the next few months to stand any chance of being enacted in time for regulators to draw up scheme details and arrange an auction before the end of 2012.

TAXES OR CAPS

The budget confirms the president's campaign commitment to achieve reductions via cap-and-trade rather than a carbon tax.

Most commentators agree it is cheaper to reduce carbon emissions through an "incentive-based" system (establishing a market price for greenhouse gas emissions) rather than old-fashioned "command-and-control" administrative regulations.

But there is much less agreement about whether to implement incentives through a carbon tax or cap-and-trade scheme.

The non-partisan Congressional Budget Office (CBO) published a comprehensive assessment of the alternatives last year, and concluded that in most cases a straightforward carbon tax would achieve the same emissions reductions at lower cost (here).

In an analytical sense, carbon taxes and fixed caps are very similar. Both raise energy prices and discourage consumption of goods and services made by burning fossil fuels in favor of less energy-intensive items made with cleaner ones.

The principal difference lies in a trade-off between two types of uncertainty: uncertainty about the quantity of emissions reduction versus uncertainty about the cost.

A carbon tax establishes a single, transparent and certain price for burning fossil fuels, and therefore the ultimate cost of emissions reduction.

Households and firms have an incentive to take steps which increase energy efficiency and reduce fossil fuel use if the cost is less than the tax rate, but not if the costs exceed it. If the rate is set at a level which reflects the benefits to society of avoiding potentially catastrophic climate change, a tax would encourage households and firms to take only those mitigation actions which yield a net benefit.

The great advantage of a tax is that it gives households and firms certainty about how much reduction will cost. It also ensures there is no compulsion to undertake very expensive mitigation strategies for which costs far outweigh benefits.

But the disadvantage, especially in the eyes of climate-change activists, is there is no guarantee it will reduce emissions by a specified volume in any given year. Over a multi-year period, this is less of a problem. The rate can be varied if the volume of emissions reduction turns out to be smaller or greater than originally anticipated. Presumably it would also rise over time to force progressive improvements.

Cap-and-trade has the virtue of creating greater certainty about the volume of emissions reductions -- but the disadvantage of huge uncertainty over the cost for households and businesses.

In a binding cap-and-trade system, permit prices can rise to any level to ensure the cap is achieved, even if the marginal cost of reductions proves very high, and far outweighs the benefits.

Massive volatility in permit prices is a major drawback of the cap-and trade-system.

Experience with other pollution trading programs in the United States such as California's RECLAIM nitrous oxide program, as well as the EU's Emissions Trading Scheme (ETS), suggests permit prices would be far more volatile than equities, making long-term planning very difficult.

The problem, as CBO notes, is that "the cost of cutting emissions by a given amount could vary from year to year depending such factors as the weather, the level of economic activity, and the availability of low carbon technologies."

In fact, cap-and-trade risks exacerbating the already high volatility in energy prices. Trading programs are dangerously "pro-cyclical." In a cold winter or a hot summer, when air conditioners are on full, rising fuel consumption pushes up the price of energy directly. But in a cap-and-trade system, it would also send the cost of permits soaring, pushing up the price of fuel even further.

In the 2000 heatwave, California power generators' demand for extra trading credits under the state's RECLAIM program sent the cost of permits up ten-fold from $4,000 per tonne to almost $45,000, contributing to high wholesale electricity prices during the period and the state's energy crisis.

Conversely, in a downturn, slumping consumption would depress the cost of permits, and risks removing any incentive to invest in energy efficient technologies such as hybrid cars. Permit prices in the EU's ETS have fallen from 30 euros per tonne last summer to a low of just 8 euros earlier this month, largely removing efficiency incentives.

Trading schemes can be designed to limit the acceptable range of prices. By auctioning permits rather than giving them away free, the scheme administrator can set a minimum price floor. The administrator can avert sharp spikes by setting a price ceiling and offering to auction an unlimited number of permits at that price to satisfy excess demand.

Some schemes try to limit short-term volatility by allowing surplus permits to be carried forward ("banking") to meet demand in future years (when caps are likely to be tighter); or brought forward from the future to the present ("borrowing") to relieve temporary shortages.

At the limit, if the price cap is brought low enough, and the floor is raised sufficiently, the trading scheme is identical to a tax.

Most real trading schemes allow far more volatility than this. The EU's ETS is progressively moving to an auction system, but imposes no real upward limit on volatility. California's proposed Western Climate Initiative (WCI) would auction allowances, and set a minimum reserve price for them to help establish an effective floor, but again there is no upper limit.

Despite clear economic drawbacks compared with a simple carbon tax, the obvious attraction of cap-and-trade is political. It avoids the need for the government to set an explicit and unpopular price on carbon dioxide emissions; policymakers can hide behind a price determined by the inscrutable magic of the market.

In practice, by picking a quantitative level of emissions, federal regulators will also be setting a price, albeit indirectly and one subject to enormous volatility. But advocates of trading hope the lower transparency will reduce its political visibility and make it easier to implement.

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