Choosing among Climate Policy Instruments:

The climate policy debate is rapidly moving away from the question of whether action should be taken and toward the question of what sort of policy should be implemented. In this context, many advocate market-based emission control strategies as a means of reducing the inevitable costs of controlling carbon emissions, but what sorts of market-based policies are truly desirable?

In theory, there is not much difference between a pollution tax and a tradeable emission credit regime. In theory this is correct because a supply limitation can operate as a tax, and vice-versa. In practice, of course, the two programs are not equivalent. Among other things, policy makers lack the necessary information to know what tax level would be equivalent to what supply restraint, but this is hardly the only difference.

As is so often the case, transactions costs are important in choosing between available environmental policy instruments. There are significant transaction costs to creating either a pollution tax or an emission trading scheme, but the costs are unlikely to be the same. As the economist Ronald Coase pointed out in his work on firms, hierarchical command structures are sometimes less costly than competitive market transactions due to transaction costs. This is why we see non-market firm structures in the marketplace. The prevalence of these firm structures will diminish (or shift) as entrepreneurs find ways of reducing transaction costs. In the meantime, however, we should expect to see many successful firms with hierarchical command structures.

In the environmental context, the persistence of transaction costs means that market-mechanisms are not always more efficient or cost-effective than their command-and-control alternatives. This is particularly true when one is dealing with pollution problems that are highly dispersed and involve a wide range of different types of pollution sources. It may be relatively easy to design and implement a trading regime for sulfur emissions from utilities or the lead content of gasoline. It is much more difficult to have a reliable and enforceable trading regime for carbon dioxide emissions from non-industrial activities. The upshot is that a trading regime will not always be more cost-effective than a more traditional regulatory regime if it is more costly to monitor and enforce (see, e.g., carbon offsets). Pollution taxes have their own problems, to be sure, but in my experience the drawbacks of a new tax are more readily apparent, and more quickly seized upon, than the potential drawbacks of trading schemes.

Another consideration in choosing between various emission control strategies is that there is reason to believe that cap-and-trade programs are more vulnerable to rent seeking than are emission taxes designed to achieve equivalent reduction levels. Implementation of a cap-and-trade regime requires many more decisions about regulatory design than a tax regime, and that each decision presents the opportunity for rent-seeking behavior. While a tax can be designed to be relatively uniform, implementing a trading scheme necessarily requires many decisions about how to allocate and value allowances -- e.g. are the allowances to be allocated by auction, lottery, or past behavior? If by lottery, how is participation determined? If by past behavior, what behavior counts? What is the relevant time period? Is it purely retrospective, or partially prospective? What metric is to be used to evaluate comparable, but not identical, activities? Must some allowances be discounted in certain sectors to account for monitoring or enforcement problems? And so on. Users of allowances are not the only with something to gain through rent-seeking, those who seek to trade or broker allowances can also capture rents by influencing program design. (This was one of the reasons Enron fought so hard to get the Bush Administration to endorse carbon trading.) Insofar as rent-seeking involves a socially wasteful (and at times, even destructive) use of resources, the vulnerability of a system to rent-seeking should be a relevant consideration when choosing between various policy instruments.

The bottom line for me is that there is no one-size-fits-all answer to how to control harmful emissions. I like markets more than most, and readily advocate property rights solutions to environmental problems where they are viable (see here and here). Among other things, property rights approaches appear to create more powerful incentives to reduce transaction costs over time than do regulatory interventions. Lacking enforceable property rights in the relevant resources, or a ready means to move in that direction, we are inevitably forced to choose between a variety of imperfect policies. What sort of policy makes the most sense in a given context will depend upon a wide range of context-specific factors. In some cases cap-and-trade will work best. In others, traditional command-and-control or a pollution tax is the least bad option. In still others, we are best off adopting some sort of liability scheme or even doing little or nothing until other alternatives become more cost-effective.

In the climate context, at present, I would be inclined to support a carbon tax over a cap-and-trade scheme. If I had my way, a carbon tax would replace some other tax(es), such as the corporate income tax, and would be designed to be revenue neutral. But before implementing such a tax, I would do other things, such as replacing all energy subsidies, including those for renewable energy, with "">prizes" for meaningful technological breakthroughs. For more of my recent thoughts on climate policy, see here and here.

Related Posts (on one page):

  1. "Capitalism Against Climate Change":
  2. Choosing among Climate Policy Instruments:
BobNSF (mail):
Aren't all the materials which contribute most to CO2 emissions already taxed? Raising energy taxes from X to Y doesn't seem to me to require much of a transaction cost.

Well, aside from the political cost, of course.
4.26.2007 3:56pm
Dick King:
One big problem with a carbon tax is that it would be hard to scale up to international.

It's not trivial to go international with a trading regime, either, because of initial allocation issues, but at least we're not creating a world government with a taxing authority of trillions of dollars per year, which I can't imagine very many important nations accepting.

4.26.2007 4:04pm
Thales (mail) (www):
Cap and trade is a decent idea with some pollutants but:

(1) The cap needs to be monitored to make sure it is meaningfully scaled to the harm caused by the pollutant, and not subject to regulatory capture by the industry

(2) Exceptions such as grandfathering out the worst polluting plants need to stop. Period. I am told this is one reason air pollution in Texas remains pretty bad despite some historic clean air legislation signed by (no joke) then-Governor Bush.

The NYT has a decent editorial today on why this isn't a good scheme with mercury emissions, because cap and trade schemes will tend to concentrate the pollution in places that can ill afford to bear more of it.

So in that case, as with carbon, a Pigouvian tax or outright emissions control/product substitution (a reminder that sometimes the most efficient level of an activity is zero) might be the most workable idea. Other scientists have pointed out that offsets or sinks to carbon may well have other bad consequences and be too difficult to manage efficiently--e.g. planting trees willy-nilly does not absorb CO2 in the right areas and by increasing dark colored planetary surface (relative to light colored grasslands) may promote more warming by decreasing the albedo effect than it offsets.
4.26.2007 4:23pm
D Palmer:
I am not a fan of cap and trade. Why should a low polluting plant in a sparcely populated area be able to sell credits to a higher polluting one in a populous area? If something is bad it is bad. We should not be trying to reduce average pollution, we should reduce all pollution.

Make sure pristine areas stay that way and require polluted ones to get cleaned up. Don't pretend that a meadow in the middle of nowhere offsets a toxic dump in the middle of the city.
4.26.2007 4:37pm
A. Zarkov (mail):
We eliminated high pollution automobiles by imposing restrictions on their manufacture. In some places they were simply taken off the road because they couldn't get a smog certificate to operate. Similarly, why don't we take private jets out of service? With very few exceptions there is no justification for private jets-- ban them. That would hardly be a burden to the nation because 99% of us never travel on a private jet.
4.26.2007 4:57pm
Matthew in Austin (mail):
Would a carbon tax on our energy bills be $0 if our local energy plant was nuclear? That would be an effective way to get local populaces to vote to allow nuclear plants. I think almost all of our country's energy and pollution problems would evaporate if we could find a way to convince enough localities to build them, and avoiding a carbon tax would be a good incentive.

A carbon tax seems like a political winner, as far as taxes go. I know these are cheap stereotypes, but Democrats liket taxes and Republicans like nuclear energy, so a tax to promote nuclear energy seems like something that could pass through Congress.
4.26.2007 6:28pm
Zarkov's envy-based proposal for the elimination of private jets reveals part of the true motivation for most greens. But it is worse than that. It's not only the rich they are after:

When folks discuss carbon taxes, do they consider the regressive effect of this? Everything we eat, drink, wear, etc (ie, consume) is brought to us via carbon belching means. Raise gas prices $1 and your next trip to Walmart (or Dean &Deluca) will give you sticker shock.

As has been noted elsewhere, we could achieve just as much carbon savings by building a couple dozen nuclear powerplants and planting a couple hundred thousand trees, thus creating cheaper electricity and more pleasant surroundings. Why are these non-regressive options not considered? The answer is surprisingly simple: The end goal is not more peace and prosperity; the end goal is the eventual impoverishment of the human race. (yea, label me nutty n' all that, but think it through.)
4.26.2007 6:29pm
Cap-n-trade mechanisms also have the benefit of a post-regulatory correction...permits can be purchased by those who value abatement more than polluters value the emissions. By retiring permits, the cap can be effectively reduced. Even (and especially!) if we suspect rent-seeking with respect to initial cap selection, this post-regulatory corrective is always welfare improving. While it is true that we should expect free-riding and transaction cost problems with the retirement side of the market and so it won't achieve full efficiency, there is simply no corresponding corrective if a tax mechanism is used. This difference between cap-n-trade and taxes can matter a lot in areas where the uncertainties associated with pollution benefits and costs are great.
4.26.2007 6:55pm
Tom Holsinger (mail):
I favor snatching cooked meat from the hands of those who contend the current warming trend is caused by humans. Forcible conversion of several million Americans to vegetarianism will do far more to reduce atmospheric carbon emissions than anything proposed to date, save possibly retroactive abortions.
4.26.2007 7:28pm
Mark Field (mail):

I favor snatching cooked meat from the hands of those who contend the current warming trend is caused by humans. Forcible conversion of several million Americans to vegetarianism will do far more to reduce atmospheric carbon emissions than anything proposed to date, save possibly retroactive abortions.

I think a purely vegetarian diet -- especially uncooked vegetables, which I infer from your suggestion -- might have significant, um, externalities which actually contribute to global warming. We could always tax those, of course. I propose that IRS be put in charge of monitoring the "impacts" and imposing this tax.
4.26.2007 7:57pm
Rich Rostrom (mail):
Anybody who thinks there will be a real solution to a real problem is a sucker. Between "cap-and-trade" mechanisms, preferences and subsidies for ethanol and other "biofuels", ditto for wind/solar, ditto for "energy efficiency", the "global warming" crisis is generating hundreds of $billions for rent-seekers. Arguably it is the biggest theft in history.
4.27.2007 4:54am
Thales (mail) (www):
It is a legitimate critique of some methods of taxation that they are regressive, e.g. a tax on sales of goods not tied to any particular harmful effect seems in some ways unfair because it will take a larger proportional chunk out of the income of a poor person than a rich person (one reason some necessities are exempt from sales tax). But if the tax is encouraging/forcing an emitter of harmful substances to internalize that externality, why should we particularly care if it is regressive? Additionally, why assume that the burden of a carbon tax would fall on the poor--I would think those hardest hit would be, say, the shareholders of utility companies with dirty-coal burning plants (yes, yes I know it will get passed in a certain amount to consumers, depending on their aggregate price elasticity of demand, but aren't they the ultimate source of the problem--after all, there's no supply without a demand for it). Those who create/consume the harm ought to be encouraged to reduce, eliminate, substitute or pay for the harm and these people are also typically those in the best position to do so. And at any rate, rich individuals and organizations (and on a global scale, countries) are undoubtedly the largest share of energy consumption (usually tied to harmful emissions, but this can be mitigated as some commenters suggest, by using cleaner forms of energy--keep in mind however that nuclear waste and the risk of accidents are not themselves costless problems). If regressivity is really the principal objection to a carbon tax, why not combine the tax with a subsidy program--an "earned carbon reduction tax credit" or a dirty muscle car buyback program that phases out as income rises. One thing we definitely should do is end energy subsidies of any kind (including agricultural tariffs)--it defies common sense to encourage oil production, and in the case of American made corn ethanol, this is an enormous scam--it is not energy efficient. We should be making (or buying) ethanol from sugar imported from Brazil but currently can't because of rent seeking from American sugar producers and corn growers (and these aren't generally your family farmers either, but giant agricorporations).
4.27.2007 12:08pm
Justin (mail):
See, that wasn't hard.
4.27.2007 12:16pm
happy lee (mail):
The comments by Thales remind me of Ronald Reagan's little quip:
Government economic policy can be summarized as
If it moves, tax it.
If it keeps moving, regulate it.
If it stops moving, subsidize it.
Happyness will not come until we realize gov't isn't the solution. It never was and never will be.

Rich is right. Large corporations don't jump on a bandwagon unless some jerk ceo sees a few percent increase in profits in it for him. Same for corporate farms that are hoping to continue to dupe us with this ethanol lie. Reminds me of conspiracies to flouridate water and eliminate chloroflourocarbons.
4.27.2007 2:37pm
TomFromMD (mail):
"Among other things, policy makers lack the necessary information to know what tax level would be equivalent to what supply restraint, but this is hardly the only difference."

That information is very easily gained. The "tax" could be set by auction. Set the supply to whatever is reasonable, and let the market determine the price. Let the "right" to pollute last for a certain period, and then the buyer would have to re-bid. If they find before then that they don't need it, they could then sell it in an open market.

Basically, this is the same thing as cap and trade, but in reverse - it doesn't presume that anybody starts with the right to pollute, just because they've polluted in the past.
4.27.2007 8:29pm