Carbon taxes vs emissions trading

Now that nearly everyone is agreed on the need for a market-based policy instrument to reduce CO2 emissions, the biggest unresolved question is whether to implement carbon taxes, tradeable emissions permits or some hybrid of the two.

I support tradeable permits, but I’ve never really spelt out my reasons for doing so. It’s important before doing this to observe that the differences between the two approaches are more limited than most of the discussion suggests. Both ensure the existence of a price for CO2 emissions and both can be set up to distribute the costs of emissions in a lot of different ways.

That said, tradeable permits have some significant advantages in my view.

I have three main reasons for preferring permits, which I will list in order of significance

First, while the natural starting point for both systems is one in which the government collects the entire implied value of emissions, either as tax revenue or as the proceeds from auctioning permits, the emissions trading system allows for (but doesn’t require) free allocation of some permits. Particularly in transitional stages when not all sources are covered, this can be used to offset unanticipated distributional consequences of the scheme, and thereby increase its political feasibility.* (OIt’s important not to issue too many free permits as was done with the first round in the EU, but some limited issue might be beneficial. I don’t want to overstress this point as much the same outcome can be achieved by paying cash compensation out of tax revenue.

Second, since we are uncertain about the elasticity of demand for emissions we are faced with a choice between allowing this uncertainty to be reflected in uncertainty about reaching the targeted level of reductions in emissions, uncertainty about the price, or some mixture of the two. Given the risk that we will fail altogether if individual countries fall short of their targets, I’d prefer some uncertainty about the price

Third, and most importantly, the ultimate solution has to be an international agreement to reduce emissions in the most cost-effective way possible. The obvious way to do this is through the creation of international markets for emissions permits. Although a full-scale global market might be some way off, regional or multiregional markets linked through something like the existing Clean Development Mechanism could be set up reasonably easily. By contrast, I can’t see how, in a world of sharply varying exchange rates, it would be possible to set up a co-ordinated global system of carbon taxes. I should say, though, that Warwick McKibbin had a piece arguing for something like this in today’s Fin. I’m going to invite him to comment on the issues, or maybe write a guest post.

Whether or not these arguments are conclusive, it seems pretty certain that emissions trading (perhaps with some modest hybrid elements) is the way we are going to go. At this point, it’s more important to push for urgent action than to get hung up in disputes about the details.

* Obviously, if you’re strongly opposed to any compensation of existing emitters and are prepared to risk total failure rather than concede on point, this is a disadvantage rather than an advantage

UpdateWarwick McKibbin has kindly responded to my invitation, and kicked off the discussion with an alternative view

98 thoughts on “Carbon taxes vs emissions trading

  1. Pr Q:

    Second, since we are uncertain about the elasticity of demand for emissions we are faced with a choice between allowing this uncertainty to be reflected in uncertainty about reaching the targeted level of reductions in emissions, uncertainty about the price, or some mixture of the two. Given the risk that we will fail altogether if individual countries fall short of their targets, I’d prefer some uncertainty about the price.

    I think the significance of a probable temporary missing of targets while the price (i.e. tax) is adjusted is greatly overstated. So what if it takes a few years to get the price right? It’s taking years to set up a trading scheme anyway so that argument is defeated anyway. Using price means we have a control system with the most important economic variable under direct control which needs to be adjusted until the desired outcome (emissions level) is achieved. Without that direct control the economic consequences are much more uncertain. Emission levels will need to be reduced over many years so there is simply not the need for “instant” setting of emission levels with all the undesirable consequences of that approach.

  2. “Your car is hurtling toward a solid stone wall. Are you going to put your foot on the brake? or are you going to put your arm out the window to produce air drag to slow you down?”

    Right, the situation is urgent and needs immediate action so let’s scrap the solution we’ve spent the better part of the past twenty years on and start from scratch.

    Just because it took from 1992 to 1998 to negotiate the Kyoto Protocol and another decade to implement is no reason to assume we couldn;t have a global carbon tax in place by next Tuesday.

    Sure a few hundred thousand businesses here and there will go under but they’re “unsustainable”.

    I guess the people who currently work from them are “unsustainable” too.

  3. Oh and if the sole purpose of a carbon tax is to raise fund – why not just jack up income tax?

    The whole point of both carbon taxes and emissions trading is to make people pay for the environmental harm their activities cause.

    I’m also struck by the fact that some people who nodded sagely when it was suggested that at some point non-climate-scientists should simply accept the consensus of climate scientists see no need to accept the environmental consensus.

  4. Ian G,

    The problem itself is obsoleting long held plans. The scientists who were standing on the ice when a melt ice lake suddenly disappeared down a hole and ten minutes later a massive section of ice split off and slid away lubricated by the water that had just gone from the top of the ice sheet to the bottom, at that point realised that the ice which it was assumed would take centuries to melt could well crack up and disappear in just a few. That was a moment of altered perception. That was a point at which long held plans became instantly obsolete, and new plans had to be made. This a war. When the battle changes the strategy must change with it.

    I think that you are exagerating in the extreme the risk to business of the increases that will flow from an ETS or a carbon tax. For most businesses the energy (electricity) is a very small part of the cost spreadsheet. Businesses for which liquid fuels are significant have tolerated a tripling of that cost before the cracks have appeared. There is nothing like that projected for electricity. Further the incresed costs related to energy are proportional to the energy replacement not the tax. The new cost for electricity will not include any carbon tax (in principle).

    Ian G 78

    That is entirely my point stated further up. I believe it is possible to effect the change to alternatives without any ETS or tax at all. Much of Australia’s electricity infrastructure is up for replacement now. A clear thinking government would replace these facilities with CSP on an accelerated programme and the new coal and gas facilities would most likely be at their due replacement time by when the infrasstructure programme got to the point of replacing them with solar or geothermal. It should be realised that the world can only make this hardware at certain rate. Steam turbines take 2 years to build and there are only so many companies in the world who know how to do it. With 194 countries all needing to do massive infrastructure changes all at the same time because they have all sat on their hands over global warming action there will be a huge shortage of turbine building capacity for decades. Rud with his cute little well organised plan, his neat tidy desk is pushing Australia way down the turbine delivery order. So in short, peak oil is solving the fuel part of the equation, and natural atrition could be used to solve the other.

    And what is this
    “make people pay for the environmental harm” ?

    This is not a police action. This is not about punishing bad boys. This is about stopping the damage, and that can only be down if there is a way of stopping ie some non damaging way of doing the same things.

    “simply accept the consensus of climate scientists”

    I hate to say it Ian but you seem to be heavily into good boy bad boy stuff. All any body is asked to do is examine the information properly and see what is going on, not tow tow to what someone is “saying”.

    I have been concerned about this since I learned in high school (in the 60’s) that a family car uses 1000 times the oxygen of a human being. From that realisation I started to look at the oxygen cycle and every thing that I have learned has led me to anticipate all of the changes in the world that we are see around us. The science is only quantifying what I have suspected (and I have no doubt that this is the same as for yourself). And the bad news is accelerating.

  5. Hear, hear carbonsink.

    Let’s not feed the denialist trolls, who have shown that they care f**k all for the future of their children and grand-children. Australia spent 30% of its budget fighting the Second World War in order to defeat a threat far less serious than global warming. Anyone who quibbles about the cost of combatting global warming is either a certifiable moron or a sociopath and a complete waste of everyone’s time.

    I have my own doubts about Garnaut’s free market supposed solution to global warming. I have written of it in the article Garnaut to provide cover for privatisation of Snowy Hydro? and on Online Opinion, but at least Garnaut is right in pointing out that the problem is deadly serious.

  6. BillB, surely the solution is simply require carbon permits to be bought before any trees are chopped down?

  7. Ian, the fact that we’ve spent 20 years working on a solution isn’t in itself a logical reason to be too attached to it. The evidence regarding the effectiveness of ETS’s so far is, well, a little underwhelming. In fact I’m quite willing to predict that in 10-15 years time when we’ve failed to make much of a dint in global emissions and the climate situation is far worse than today that we’ll regret not having attempted something tougher but still palatable and relatively inexpensive when we had the chance. Certainly by 2040 I expect we’ll be looking at the problem as justifying spending the sort of amounts of money that we spent fighting WWII.

  8. Wizofaus,

    It is best not to include anything biological in the carbon formula at all as it is all already over subscribed. The only thing that we can do is try to prevent its deterioration, all but impossible. So from a carbon trading point of view that leaves to trade…well nothing actually,.. unless of course you believe in being able to make CO2 just disappear like sweeping it under the rug. I guess that you could call that carbon sequestration. A possible dream that will follow the fate of supersonic passenger air travel.

    The biological world will be used as an solar energy conversion catalyst, and shade.

  9. BilB: “This is not a police action. This is not about punishing bad boys.”

    No! No! NO!

    This is a truly specular misunderstanding on your part – and an illustration of the problems that arise when laymen, however well-intentioned and intelligent, decide to dive into what is essentially a technical discussion.

    When I spoke about making people pay for the cost of environmental harm, I wasn’t talking about punishing them, I was referring to one of the fundamental elements of environmental economics.

    To wqit: Markets tend to misprice goods which have significant environmental externalities.

    Here’s a link to start you off:

    http://en.wikipedia.org/wiki/Coase_theorem

  10. “Ian, the fact that we’ve spent 20 years working on a solution isn’t in itself a logical reason to be too attached to it.”

    No but it is a logical reason to fear that another twenty years will be wasted trying to come up with an alternative.

  11. “In a question and answer with reporters following the rally, Dion said he has not abandoned his support for a “cap and trade� system for carbon emissions in favor of a carbon tax.�

    More of that quote was:

    “But he said such a system — which would force companies to buy credits if they go above emissions quotas — is likely years away.”

    “Ian, the fact that we’ve spent 20 years working on a solution isn’t in itself a logical reason to be too attached to it.�

    No but it is a logical reason to fear that another twenty years will be wasted trying to come up with an alternative.

    i.e. it may not be the best system but so much time and effort has already been spent on it that it is now better than the alternatives. Maybe, but I’m still curious as to why the alternatives were rejected in the first place. BTW, how long does it take to set up a carbon emissions tax?

  12. Ian G,

    “no,no,no”

    I know exactly what you are trying to say. But I believe that you are getting bogged down in marginal effects. Think of the situation of a wall between a desert and a garden. It is just as flat on either side of the wall but to get to the garden requires significant effort. Once we have climbed the wall to drop into the garden average effort is the same only the garden is more comfortable. The wall is the change in energy infrastructure, the effort to climb it is the carbon tax/ETS/CAT (what ever), and is not a permanent feature. Scrambling over the wall does not have to be beautifully executed it just has to be done and done with the minimum effort.

    If you are saying that twenty years have been spent learning how to apply an emissions trading scheme then I will say that that is twenty years wasted, because it is a pointless exercise which represents a complete misunderstanding of the purpose. Certainly the intellectual content of the economic model of the ETS is very impressive, but it is conceptually flawed.

  13. I should have added, Ian, that had governments taken carbon responsibility twenty years ago then the market driven approach would have been the way to go. But the time is up. The is no room for gentle nudging. We are at the brute force stage.

  14. I see Anna Bligh is not waiting for the Rudd Govt and is moving ahead at a rapid pace with her version of an ETS-

    “AUSTRALIA’S first new coal port in 25 years could be built in central Queensland, to boost the state’s coal exports by 40 per cent.

    Premier Anna Bligh today announced a “trifecta” of proposals for the Bowen, Galilee and Surat coal basins, during a Budget estimates committee hearing.

    Ms Bligh said the Government was considering a $5.3 billion proposal by Waratah Coal, including a new mine near Alpha.

    The Galilee Coal project would produce 25 million tonnes of thermal coal a year for export.

    A new coal port would be built near Shoalwater Bay, between Rockhampton and Mackay, with a 100 million tonne a year capacity.

    A 500km rail line from the Galilee Basin to the new port would open the region to coal exports for the first time.

    Ms Bligh said the Government was in discussions about using Australian Defence Force land, so the adjacent Byfield National park was not affected.

    “The project is expected to create around 2200 jobs during construction and some 760 permanent jobs during operation,” she said.

    The second proposal, the Bowen Basin Growth project, comprises two new mines at Daunia and Caval Ridge, and the expansion of the existing Gooyella Riverside Mine, north of Moranbah.

    The BHP Billiton-Mitsubishi Alliance proposal would boost exports by about 20 million tonnes.

    Ms Bligh said both had been declared significant projects and would undergo an environmental assessment process.

    The third proposal was a 30 million tonne a year open-cut mine near Wandoan by an Xstrata Coal consortium, which was declared a significant project in December last year.

    The draft terms of reference for the environmental impact statements are expected to be released by late September”

    Shouldn’t be any problem getting that EIS through quickly with something as important as an international ETS at stake (we trade and they emit)

  15. Coal exports increasing by 40% eh, on top of that info that Macarthur are exporting over 30% of the world’s pulverised coal now. It all makes sense when you really put those thinking caps on now doesn’t it?

  16. Observa, your point is what? That politicians are hypocritical and short-sighted? Thanx for the insight.

  17. “Ian, the fact that we’ve spent 20 years working on a solution isn’t in itself a logical reason to be too attached to it.�

    No but it is a logical reason to fear that another twenty years will be wasted trying to come up with an alternative.

    Even if an alternative does take 20 years, at least that’s better than never.

  18. Acyually wilful, I would have thought this perverse action on behalf of wall to wall Labor shows quite categorically that any remaining believers in localised cap and trade policy, let alone ‘metooing’ some failed EU internationalism are delusional, to say the least. It points irrevocably to a horses for courses approach for Australia now, similar to Canada. However, given our intimate involvement with supplying much of the world with the worst posiible raw materials for CO2 emitting, we may well need a much better solution than the Canadian opposition are proposing. That’s my position and I’m calling the delusionists on it right here and now.

  19. observa, Queensland and Federal governments aren’t the same. Bligh has a sovereign right to do what she’s done. QLD isn’t Australia.

    Of course we have got to stop selling coal sometime soon. So this is a terrible decision she’s made. But to suggest this is all Kevin Rudd and Penny Wong’s fault is more than a stretch

  20. I would have thought this perverse action on behalf of wall to wall Labor shows quite categorically that any remaining believers in localised cap and trade policy, let alone ‘metooing’ some failed EU internationalism are delusional

    “Cap and trade” or any other technique is a method for reducing our own emissions and has nothing to do with the emissions of countries that Australia exports coal to. It might suit someone’s wishful thinking to believe that we could countrol the emissions of China, say, by stopping export of coal to there but such belief is delusional. I can just imagine the type of language from Chinese officials if we told them we weren’t going to export coal to them anymore because we wanted to reduce THEIR emissions. That type of action is never going to work and the only type of action that has any hope of working is Australia setting a good example from its own emission reductions.

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