An argument for emissions trading

With resurgent debate over the relative merits of carbon taxes and emissions trading, attention has turned again to Europe where the market price of emissions permits has fallen sharply as a result of the financial crisis and recession. Most commentators have seen this as a strike against emissions trading, but actually it’s a positive. The big concern about price uncertainty arises when we are very uncertain about the cost of reducing emissions. Under cost uncertainty, setting the emissions target too low could impose unexpectedly high costs on the economy.

What’s happening here is that we are uncertain about the rate of growth of the economy. An emissions target is countercyclical since it imposes a relatively high cost when the economy is strong, and a much smaller cost when the economy is weak. This is a Good Thing.

My view, for what it’s worth, is that a well-designed emissions trading scheme is the best available option. But given the weaknesses of the government’s proposed scheme, I’m prepared to consider alternatives.

Note also that different macroeconomic shocks give different outcomes. Warwick McKibbin has done some work showing that an upward shock to growth in one country will benefit other countries less (and perhaps not at all) under global emissions trading than with a price cap or hybrid policy. That’s because the growing country will demand more emissions permits, pushing up the global price.

It’s easy to see that McKibbin’s modelling result is consistent with the analysis here. By symmetry, a negative shock in one country will harm others less under emissions trading than under the price-based alternatives. And the same logic applies to sectors within countries. It’s easy enough to see then, that for any economy with a fixed aggregate target, or for the world as a whole, emissions trading will tend to reduce the benefits of booms and the cost of slumps.

26 thoughts on “An argument for emissions trading

  1. I suppose that an ETS can function like Keysnian fiscal stabilizers, in that they provide negative feedback dampening overall oscillations on the desired maximand. (Or minimand, in the case of carbon.)

    Keynsian fiscal ratings (tax and benefits) are a sort of “governmental price” which is counter-cyclically volatile. They top up income in a bust and tamp down income in a boom. Dampening oscillations in the quantity of income, although on a higher output trend line.

    Similarly an ETS is a carbon price which is counter-cyclically volatile. It cuts the carbon price in a bust and hikes the carbon price in a boom. Dampening oscillations in the quantity of carbon emitted, although on a lower output trend line.

    Always assuming that the ETS is effective. Big Ask.

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