Cap-and-Trade vs. Emission Tax – Differences

Building on my previous posts in this series providing an overview of cap-and-trade and emission taxes and a discussion of their similarities, this post illustrates some of the differences between cap-and-trade and an emission tax: the trade-off between cost certainty and emissions certainty, incentives for R&D, and revenue generation.

Cost certainty versus emissions certainty. In an uncertain world, it is impossible to design a policy that simultaneously guarantees an emissions outcome at a certain cost. An emission tax provides cost certainty – the incremental increase in energy prices is transparent and fixed under a tax – while cap-and-trade provides emissions certainty by capping aggregate emissions. Under a tax, emissions in aggregate can vary depending on the realized costs of abatement (that cannot be predicted ex ante with certainty), economic growth, relative changes in energy prices unrelated to a carbon policy, etc. These factors can likewise drive the variation in costs under a cap-and-trade program.

Should we prefer cost or emissions certainty? It depends on whether “making a mistake” in setting a cap or a tax substantially changes the costs or the benefits more. Suppose that in 2007 everyone expects a $25/ton CO2 tax to cause emissions to fall to 2005 levels by 2015, and likewise that a 2005 cap in 2015 would have a $25/ton CO2 allowance price. Now suppose that in 2015, abatement costs are unexpectedly high. Under the $25/ton tax, emissions would be higher than expected but the incremental cost to energy would reflect the $25/ton tax. Under the 2005 emissions cap, allowance and energy prices would be higher than expected but emissions would reflect the cap. Under this unexpected cost shock, if the cost to society of paying higher allowance prices under the cap-and-trade program exceeds the cost to society of foregoing some emissions abatement under the $25/ton tax, then the tax would be preferred. If instead we expect climate damages to be very sensitive to the level of 2015 emissions, then a cap-and-trade program would be preferred. Most economic research, because of the stock nature of climate change, tends to find that a tax is preferred to a cap.

A variety of cap-and-trade markets have experienced substantial price volatility in recent years. EU Emissions Trading Scheme CO2 allowance prices varied between about 7 euros and 30 euros per ton CO2 in its first 16 months. In April 2006, allowance prices fell by nearly 20 euros per ton in one week, and then down to less than a euro per ton today. The U.S. sulfur dioxide tradable allowance market has been nearly as volatile as the oil market, and much more volatile than the stock market. The southern California RECLAIM cap-and-trade program witnessed a more than ten-fold increase in allowance prices in 2000 during the California electricity crisis.

There are important caveats to these claims of cost and emissions certainty under a tax and cap-and-trade, respectively. A tax does not provide certainty about the aggregate cost to the economy of the climate policy; it only provides certainty about the incremental cost of consuming carbon-based energy. Cap-and-trade may not deliver certain environmental benefits. Complying with an emissions cap may cause emissions to increase outside of the cap – so-called emissions leakage – either to uncovered sectors of the U.S. economy (more on coverage in my next post) or to countries without carbon constraints. This leakage would offset the benefits of limiting emissions under cap-and-trade. Moreover, targets are not always met because of non-participation (the United States under the Kyoto Protocol) or non-compliance (the southern California RECLAIM program).

Incentives for R&D. Price volatility can create adverse incentives for firms to invest in R&D. Firms can form more precise expectations about energy prices under a carbon tax than a cap-and-trade program. An extensive economic literature on investment shows how uncertainty in returns can discourage investment. While some have argued that the possibility of higher than expected allowance prices creates the incentive for more R&D, the possibility of lower than expected allowance prices (and thus lower returns to R&D on abatement technology) will offset this effect. Suppose that the policies described above of a $25/ton CO2 tax (yielding 2005 emissions in expectation) and a 2005 cap (yielding a $25/ton allowance price in expectation) are considered again. The $25/ton carbon tax with zero probability of higher or lower costs will induce more R&D than the $25/ton allowance price with a non-zero probability of higher or lower allowance prices.

Revenue generation. As noted in my last post, an emission tax and a 100% auction cap-and-trade program are similar because they can both raise a lot of revenues that can be used to reduce distorting taxes on income, labor, and capital. Most Congressional proposals for cap-and-trade, however, include much less than 100% auction. Giving away emission allowances for free reflects the creation of an asset with a value equal to tens to hundreds of billions of dollars annually and handing it over to the largest emitters of greenhouse gases. It is not the polluter pays principle, but a pay the polluter principle. Large CO2-emitting corporations in Europe saw their stock prices rise under the EU ETS because of the substantial value of the assets – the emission allowances – they received. Only a modest fraction of allowances need to be given away to energy-intensive firms – on the order of 10-15% – to leave them financially equivalent under a cap-and-trade program than under no regulation.

My next post in this series will address cap-and-trade and tax design issues.