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Cap versus Tax after Copenhagen

March 18th, 2010 by Steven Stoft, Berkeley

As the Copenhagen Accord makes emphatically clear, developing countries are not accepting emission caps. This will make passing a strong national cap more difficult. Economically cap and trade is a carbon tax with the tax rate set by the permit market to make sure the cap is met. This results in a highly volatile tax rate, which slows investment, makes it more costly, and will likely create political problems as the price of carbon increases over the years.

Any strong international agreement will now need to focus on the price of carbon, rather than on emission caps. To be compatible with a global pricing commitment, any U.S. cap‐and‐trade policy should stabilize its price with a collar. This will also minimize the political risks of a cap’s volatile tax rate. As the collar tightens cap and trade approaches a carbon tax.

Before Copenhagen, the United States lobbied hard for caps on China and India. But on the final day of the summit, “China’s representative insisted that industrialised country targets, previously agreed as an 80% cut by 2050, be taken out of the deal. ‘Why can’t we even mention our own targets?’ demanded a furious Angela Merkel.”† China was not having caps—its own or anyone else’s. India was no less staunch.

At 7pm that same evening, Obama crashed a secret meeting (discovered while trying to find a room for a final negotiation) of China, India, Brazil and South Africa.‡ At that meeting he hammered out the Copenhagen Accord. In it there is no hint of caps for developing countries. Half of all emissions, and by far the fastest growing half, will not be capped.

One urgent reason for cap and trade — “If we lead, China will follow” — is now gone, if indeed it ever existed. More devastating for the chances of a cap passing the U.S. Senate is the fact that reality runs the other direction. If China had accepted a cap, the U.S. Senate might well have followed. But since China will not, the chances of a strong cap passing the Senate are slim to nonexistent—unless a new form of international commitment is successfully pursued. Before returning to this crucial international dilemma, let us consider the question of caps or taxes in the domestic context.

Cap and trade is said to “achieve emission targets with high certainty.” Targets are built in—those are the annual caps, but certainty is not. However emission “certainty” is the primary reason environmentalists favor caps. Cap and trade is about control. In fact, I’ve even been told by environmental regulators that cap and trade is, without doubt, a form of command‐and‐control regulation. Long forgotten was the fact that economists invented cap and trade as a market‐based replacement for such heavy‐handed regulation.

Caps do control emissions more strictly than a carbon tax. A cap is simply the number of emission permits issued in a given year. Since emitting without a permit draws a heavy fine, the cap determines total emissions. But it will not determine who emits, as would be true command‐and‐control regulation. […]

Caps and taxes work on the same pricing principle. They both raise the cost of emissions. If a five‐billion‐ton cap causes permits to cost $20 per ton, then a $20 per ton tax will hold emissions to five billion tons. No one cares whether they must buy a $20 permit or pay a $20 tax, so the same carbon price has the same effect, whether the price is set by a cap or a tax.

This gives us a short‐cut way to think about caps. Cap and trade is simply a carbon tax set by the market. Since companies buy permits to avoid running short and paying a fine, the market will raise or lower the “tax rate” just enough to make sure the cap is met.

Many claim that because the market sets the tax rate, the rate will be optimal. But, the market is just doing the government’s bidding. If the government sets a tight cap, the market will set a high tax rate. The market has absolutely no idea what tax rate is best for fixing climate change.

The similarity between caps and taxes runs so deep that when economists build their huge models of cap and trade, they don’t actually include cap and trade in the model. It’s just too complicated. Instead they build in a carbon tax. If they want to test a five‐billion‐ton cap, they just try out a few tax rates until they find one that hits the cap.

As the modeler’s trick implies, caps and taxes share the same basic economics, but caps are far more complex in their operation. This complexity opens the door to political differences. In particular, the complexity of caps brings one political advantage and one disadvantage. Cap and trade makes it easier to hide the ball, but it also makes us more vulnerable to the law of unintended consequences.

Hiding the ball. As noted, free permits are a great way to hide the handouts. But people are catching on. In his February 2009 budget, Obama proposed to auction all the permits. That completely spoils the free‐handout game. Of course Waxman and Markey tossed that idea out on day one. But, they have had to be quite careful about avoiding the kind of huge excess profits seen in Europe.

A second obfuscation may be more important. Cap and trade may be so complicated that few will guess it’s a tax. However, those who dislike taxes most, call it cap and tax, while those who don’t mind taxing for a good cause more often say it’s not a tax. Unfortunately, it’s not that helpful to hide the ball from your own team.

Unintended Consequences. The permit market is extremely volatile. The best measure of this is the EU’s Emission Trading Scheme (ETS), a.k.a the EU’s cap‐and‐trade market. During the huge stock‐market swings of the past five years, the price of the EU’s carbon permits has been three times as volatile as the S&P 500 stock index.

One consequence is that investors in green technology will hesitate before responding to such a volatile price—waiting to see which way it will go next. When they do invest, they will charge a risk premium. Hence, for subtle reasons ignored above, cap‐and‐trade actually requires a somewhat higher price to get the job done than does the more predictable carbon tax. But the more worrisome consequences are political.

The political consequence is that the public is likely to respond negatively to a volatile tax set by the market. At first, when permit prices are fairly low, this will not be much noticed. But to cut emissions by, say, 50 percent, the price of permits—the effective tax rate—will have to become quite noticeable. Then when the price doubles, a political backlash seems more than likely. This problem will only be compounded by reports of speculators making a killing (quite by accident) as a permit price bubble drives up carbon taxes.[…]

Without global cooperation, either a U.S. cap or a U.S. tax will make little difference. But to achieve global cooperation we must understand why Kyoto‐style international caps were rejected by developing countries. Consider the most recent and reasonable of the capping proposals.

Todd Stern’s trend‐line caps would cap India at half the per‐capita emissions level of the US in 1880—not 1980. How should the Indian government explain to its people that because we emit so much they must emit so little? And had China accepted such a cap from Stern in 2000, China would have been buying $60 to $90 billion worth of carbon permits on the international market right now. How would they explain to their citizens, that because they are less poor, and now make glass and steel for the rich countries, that they must buy pollutions permits from abroad?

We need an international climate commitment that allows developing countries to avoid caps and allows industrial nations to use cap and trade. In other words, at the international level, the answer to the cap‐or‐tax question must be “either is fine.” Fortunately both work by pricing carbon.

So countries should commit not to a cap but to a global carbon‐price target. And U.S. domestic policy should support such a commitment. If the global price target is $20 per ton, the U.S. should make sure its cap, or tax, or some combination of the two meets that commitment. This could be done with pure cap and trade, but given the erratic nature of permit prices, a price floor and price ceiling seem highly desirable if not absolutely necessary.

Fortunately the need for more price stability to meet our commitment to a global price target coincides with the need to reduce the domestic political risks of price volatility under a pure cap. Besides curbing price volatility, the other key to long‐run political acceptability is to keep carbon pricing cheap and to make that clear. The best way to do that is to avoid spending revenues on handouts and subsidies. And nothing would make that as clear as seeing all the cap or tax revenues returned each year with an Alaskan‐style check in the mail.

Steven Stoft is Director of the Global Energy Policy Center

P.S. A longer version of this paper is availbale here.

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8 Responses to “Cap versus Tax after Copenhagen”

  1. Lance McKee Says:

    The voting majority in any nation, in my opinion, would welcome a carbon tax and/or extraction-of-non-renewable-resource tax that progressively removes the burden of the income tax on the poor and the middle classes. Hopefully, carbon taxes, pollution taxes and extraction taxes could also replace capital gains taxes. Nations that do this will outcompete nations that don’t, because work and investment will be rewarded, not punished. At the outset, the poor will need to be protected somehow from rising prices. But ultimately, all will prosper. Consider, too, that distributed ownership of distributed electricity generation and storage assets in developed countries will result in low-cost solar roofs, storage devices and microgrids replacing tin roofs in developing countries, supporting middle class growth and raising the global median income level that developing nations are sinking to. Focus on what’s good for the middle class, and you’ll abandon complex carbon trading schemes that mainly benefit big banks, big corporations and big government. These three climate action stakeholder groups could hardly be hurt by policies that improve the financial health of the poor and middle class.

  2. Chris Cook Says:

    It’s actually possible to approach carbon markets from another direction, and that is to monetise the energy content of carbon – which is intrinsically valuable – rather than attempting to monetise by administrative and political means the carbon in CO2 which is essentially worthless, or to similarly monetise tax income.

    The mechanism for such asset-based, rather than deficit-based finance is simply to create, within a suitable legal framework, Units redeemable in payment for energy, and to apply a carbon levy to any non-renewable energy.

    I outlined at last year’s All Energy Show in Aberdeen how this could work in respect of a North Sea Supergrid here…

  3. EnerGeoPolitics Says:

    Steven, The problem with all such schemes is that there is always an incentive to cheat on a tax, and cheating is more enticing the less effective the collection/enforcement agency is. And, at this stage in human political development, we can count on any global collection/enforcement mechanism to be weak. Certainly, too weak to dissuade China. The PRC holds too much Western paper to fear any credible sanctions for any violation they choose to commit. And, if a massive carbon producer like China escapes punishment, then the whole scheme falls down.

    It is time to give up the idea of such international carbon regimes. Adaptation/mitigation is the only feasible approach before us at the present time.

  4. Steven Stoft Says:

    First on cheating — no one needs to be reminded that this is always a problem. But Stiglitz and Nordhaus, who know far more than I about international agreements, disagree with you. Also, you judge this proposal based on a two line summary. You should read the paper .

    It includes inducements for poor countries like India, and other oil-addicted countries like China, which you have not begun to consider.

    It’s now popular to say — we tried, it’s too hard, give up on cooperation. It might be too hard, but we have not tried. We should. There is now a game-theory result showing that introducing cap-and-trade actually makes cooperation harder. The 15-year effort has been backwards. We should now try going forward.

    Finally you should consider the value of a slow start in the right direction. This is incredibly cheap, so cheating would just earn public scorn while saving almost no money. And it would be far better than the boondoggle that the adaption subsidies will prove to be. A slow start could put in place an efficient mechanism that could be ramped up quickly when climate change becomes more obvious. Without this the world will likely just panic and choose a highly ineffective and expensive course of action.

  5. EnerGeoPolitics Says:

    Thanks for the link, I will definitely read the paper and link it up on my site.

    that said, a protocol, a framework, does not an effective enforcement regime make. With all due respect to Stiglitz and Nordhaus, an attempt to impose meaningfully punitive trade sanctions on China would be several orders of magnitude removed from the turtle sanctions. Sanctions on this scale would be uncharted territory. Also, a recent study from the Strategic Studies Institute indicates that sanctions on petroleum producing countries tend to produce the opposite of the desired effect. IIs it a stretch to think this might be true of carbon burning nations as well?

    Of course, that doesn’t mean one shouldn’t try. If you can create an international agreement, that is great, but I don’t think China or India will sign on to any agreement. I don’t think they believe that climate change is a serious enough problem to motivate them. They pay lip service to the issue, but I think that is primarily an attempt to shackle their Western competitors while they try to catch up. Their own behavior belies their true beliefs. China will fire up a new coal building plant every week for the next 10 years, and now they are preparing to mine the environmentally problematic methane gas hydrates on the Tibetan Plateau.

  6. Steven Stoft Says:

    Thanks in advance for posting the link.

    I agree. Trade sanction on India and China are not the way to go, which is why we don’t propose them. And with Nordhaus and Stiglitz, I meant their views on monitoring carbon revenues for cheating.

    For India we recommend a small payment (Green Fund), but a payment for cooperation instead of a payment not to cooperate — the Kyoto approach. This turns out to be incredibly cheap when you do the numbers. You can find those in this shorter paper .

    For China we show first that a $30/tonne carbon price delays their growth by only 12 days as of 2020, and second we show that a global climate agreement–done right–could actually save them money when the world oil price is considered. (No delay in growth.) This effect shows up in all major climate models, MIT, DOE, EIA.

    So I think we largely agree on the principles, but you need to look at some possibilities that are always forgotten because the numbers and the energy-climate connection are ignored.

    That said, you may still prove right. Cooperation may be impossible, but it seems a shame to conclude that without actually trying to cooperate. So far we have been trying to impose environmentalists’ command and control in the guise of cap and trade. Fine if you can do it, but lets not give up without giving cooperation some thought.

  7. Farah Amro Says:

    To argue that a carbon tax provides much greater price stability than emission trading under a cap and trade system is valid only when an emission trading system is designed without banking and borrowing options which allow firms to smooth emissions over time. This in turn contributes to leveling of the price of allowances and creates certainty in the market and thus spurs investment. A well-designed cap offers superior investor certainty relative to a tax because it establishes clear, long-term abatement requirements and allows the private sector to estimate the allowance prices needed to get the job done.
    In contrast, a carbon tax would likely start too low given political pressures and it would be exposed to unpredictable adjustments, as politicians would tend to raise or lower the tax in reaction to economic conditions.
    It is true that an emission trading scheme is much more complicated than taxation. The introduction of a new tax does not require setting up a new system with additional administrative costs attached to it. However, the experience shows that having an international agreement on a global tax is highly unlikely if not impossible. This statement is supported by an example of the unsuccessful attempt to impose carbon tax in the 1990s within its multi-national European Union’s structure. Also the Clinton administration unsuccessfully tried to introduce an energy tax in the mid 1990s but encountered strong opposition in Congress.
    Under a carbon tax scheme, the price of carbon will also increase over the years if the ultimate goal to achieve is really steady emissions reductions. Political problems can occur under a cap policy as well as with a regulated tax. Moreover, a “tax” is likely to be negatively received by end users whereas the complexity of cap and trade makes it subtly difficult that few will guess it’s a tax!

  8. lida Says:

    I agree. Trade sanction on India and China are not the way to go, which is why we don’t propose them. And with Nordhaus and Stiglitz, I meant their views on monitoring carbon revenues for cheating.

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