Cap-and-trade versus a carbon tax

Here’s a debate that’s bound to play out over and over again in different jurisdictions in the coming months and years. Two top officials in the British Columbian civil service, now retired, advocate a carbon tax over a cap-and-trade system for reducing greenhouse-gas emissions:

Carbon taxes are the most effective approach because they can apply equally to consumers, businesses and industries, and serve as incentives for all those groups to reduce their energy consumption, they say.

“The market will go to work. The cost of energy will rise, which will provide businesses and households with an incentive to consume less and demand more fuel-efficient vehicles, equipment, appliances and buildings.

No argument from me on this, as far as it goes. Bruce McRae and Don Wright, who were deputy ministers and assistant deputy ministers in portfolios such as energy, forestry and education, also advocate cutting other taxes to compensate, so a carbon tax didn’t just look like a raid on people’s pockets. They’re two gentlemen after my own heart: before the last budget, I idly hoped Finance Minister Jim Flaherty would come out with something audacious like replacing the GST with a carbon tax that penalized activities with harmful external impacts, instead of, say, buying books or furniture or new shoes for the kids. I was, of course, disappointed.

Carbon taxes have two big things going for them:

  1. They’re simple, not requiring anybody to set up a trading facility the way you have to for emissions credits;
  2. They’re universal, applying equally to all burners of hydrocarbons — including you and me when we drive or buy briquettes for the barbecue — instead of just to major emitters that can be monitored.

These are significant merits. A carbon exchange isn’t very complicated if you work in the finance department of the kind of company that would compelled to participate in one, but carbon credits come in a lot of different forms and derivative instruments that aren’t necessarily easy for a non-professional to understand; survey the basic information offered by the experimental Chicago Carbon Exchange and see what I mean. That complexity leaves the concept open to criticisms like that of climate-change skeptic Richard Lindzen in the latest Newsweek, that “Enron was a leading lobbyist for Kyoto because it had hoped to capitalize on emissions trading.”

Enron used banks and had a payroll department, too, and the fact it went bust doesn’t invalidate either of those concepts, but there’s no denying that a cap-and-trade system’s complexity is a minus.

The second point is just one of obvious fairness. It’s an imperfect system that caps the emissions from a Suncor oilsands project while not penalizing me for burning the gasoline that comes from the oil Suncor digs out.

Nevertheless, I lean strongly toward cap-and-trade, for the simple reason that nobody has a bloody clue what carbon emissions ought to cost to achieve the emissions reductions we need, so nobody has a bloody clue how much a carbon tax ought to be. It’s not even clear what numbers we ought to look for. Do we try to tax carbon emissions at a rate that would bring in enough money to compensate for the damage they do? Or do we try to tax them at a rate intended to discourage emissions altogether?

Most likely, a carbon tax would end up like cigarette taxes, and be a bit of both, plus a little of the finance minister figuring out how much money he needs and guesstimating how much he can grab from where. That’s bad, but here’s something worse: given the scale of the problem we’re trying to avert, we’d need to impose a crippling tax on carbon to be sure to get the emissions cuts we think we need. You know, go way out to an extreme, just to be sure. That’s bad both as a matter of fairness and of policy — as the B.C. ex-mandarin Bruce McRae says in the Vancouver Sun piece, British Columbia can’t afford to have its taxes be too far apart from those of its economic competitors.

The Environmental Economics blog had a fairly technical comment-thread exchange about the merits of a carbon tax versus a cap-and-trade system a few days ago. I’m compelled by the argument of commenter “powderhouse”:

I don’t know what the correct number is, and neither does anyone else — that’s the point. There’s enormous uncertainty as to both the marginal benefit and cost of abatement, so it’s difficult impossible to know where the curves intersect and where the tax should be set. Granted, the same argument could lead to the conclusion that it’s impossible to know where the cap should be set.

But if we can agree that some ppm level [atmospheric greenhouse-gas level –DR.] is too high (1000? 750? 550?, take your pick), then we can map out the remaining carbon budget and a cap-and-trade system will get us to that target. A tax will bring emissions down, but there’s less certainty as to whether we’ll wind up at the desired target.

I’d add that a cap-and-trade system also stands a chance of directly rewarding people and companies that go far beyond the minimum and make radical improvements. All a carbon tax does is punish.

Update: This goes on in Part II.

One response to “Cap-and-trade versus a carbon tax

  1. I like the idea of both. Start with a modest carbon tax, collected at the point of production or import of fuels, and start the cap-and-trade scheme with a relatively generous cap. But don’t give out permits for nothing – auction them, using the proceeds to cut corporate income tax. And use at least part (say 10 – 15% of the ongoing annual revenue from the carbon tax to redeem permits in the marketplace, year by year) while reserving at least 50% if not more of the new carbon tax revenue for income tax cuts divided equally between corporate and personal income tax, with the focus on small business and the lower personal brackets. Some of the revenue should be dedicated, particularly, to raising the personal exemption. The current $ 8,839 (federal) and $ 8,858 (BC) rates I deal with for my low income clients are a national disgrace, although the first bracket marginal rate of 6.05% (in BC) is rather more reasonable than the outrageous 15.25% marginal first bracket federal rate !

    The key thing is to get started with some sort of “depletion of natural capital” tax and to get a price on carbon emissions, and to slowly move it up (relying on long-run elasticities which are greater than short-run ones) to achieve environmentally useful substitution effects, and on the short-run inelasticity to produce the revenue to sunstantially reduce wasteful, inefficient and inequitable income taxes on which we rely far too much. As we succeed, we will need new revenues, but there are other forms of unsustainable natural capital depletion that we can tax when we get to that point.

    Michael Barkusky
    (practising public accountant and unpaid ecological economist)

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