One of the problems with carbon taxes is that they’re static. Let’s say you set a tax at $20 per ton of CO-2. It’s going to stay at $20 when the economy is hot, even if the tax rate doesn’t do much to reduce emissions. Conversely, when the economy goes south, the carbon tax will persist at $20, even though emissions may be dropping fast on their own — and companies may need some breathing room.
The first scenario is bad for the climate. The second scenario is bad for the economy.
If only there were a way for carbon pricing to respond to changing economic conditions in real time without any intervention from policymakers. If only. That would be like magic.
But I have good news for you: magic exists! There is such a thing as a magical self-adjusting carbon tax. It tracks economic conditions precisely and it always ensures the right amount of reductions. It’s called “cap and trade.”
This isn’t just a theoretical point. The New York Times recently reported that carbon prices have been tumbling during the economic downturn. For some reason, commentators keep treating this as a bad thing. But it’s not. It’s a very good thing. It’s evidence that cap and trade systems are responding dynamically, exactly as they are supposed to.
A carbon allowance in the European ETS system is now selling for less than 12 euros. It’s shed about half its value over the last few months, which is precisely what we would hope for. The reason the price has fallen is because the demand for carbon emissions has also fallen preciptiously as manufacturers and others scale back to meet the recession-era realities of the marketplace.
Similary, allowances in the RGGI system in the northeast US are going for well under $4. RGGI hasn’t been around long enough for us to observe a long-term trend, but the low price of RGGI carbon likely owes a good deal to the reduced demand for electricity-sector carbon. Some of that demand reduction was due to generators taking early action before the cap took effect, but some is almost certainly due to the deteriorating economy.
When the economy is on the ropes, it’s wise to reduce the price of carbon—and as long as the price is tethered to a firm cap, there’s no environmental downside.
But there may be a potential downside to keeping the price fixed, as a tax would. During a recession, it might be hard for policymakers to justify continuing a carbon tax on struggling firms. It’s not hard to imagine a tax being stricken from the books. A cap and trade system, by contrast, is probably less vulnerable to political gaming, if only because carbon prices will mirror the economic reality.
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Update, 3:50: As commenter Barry rightly notes below, there are pros and cons to both carbon taxes and cap & trade. With this post, I was just trying to point out one commonly overlooked “pro” for cap & trade.
In the holy war that’s raging between the two carbon pricing camps, Sightline can fairly be described as something of a Carbon Unitarian. We prefer cap & trade, but we also believe there are merits to carbon taxes. In fact, we’ve spilled a lot of positive cyber-ink on carbon taxes. See here, for example.
Barry
Excellent point on flexibility of carbon price to economic conditions.However, you are being short-sighted on dismissing carbon tax as inflexible. Only a flat carbon tax is inflexible. You could design any level of economic response you wanted into a carbon tax.You rightly point out that there are bad and good cap implementations. Some would be disaster. Some would be great. Do you want people attacking cap based on one poor example of it? Ditto for carbon taxes. Many varieties have been suggested. I personally prefer a carbon floor tax on transportation fuels for example. We are learning here folks, eh?Also one of the biggest threats our economy faces is not making the correct fossil fuel infrastructure choices in time. A low carbon price will not help save our economy on this crucial issue.I don’t understand the blanket attack on certain tools like that going on between carbon-tax-only vs carbon-cap-only camps.We need well designed tools…and lots of them.We can’t afford to attack whole categories of carbon tools.
Eric de Place
Barry,You make some good points. Especially, that the blanket attacks on carbon pricing tools are kinda nuts.That’s actually not what I meant to do here. I was just pointing out one relative merit of cap & trade. In fact, I’m going to add an ammendment to the post to make that clear. Thanks.
Jesse Jenkins
Eric, excellent points. However, what are we to make of the effect this kind of price volatility has on the ability of private firms to accurately incorporate carbon prices into their business models? One of the pros of a carbon tax is that it provides long-term certainty for businesses and others to plan their investments. In the case of cap and trade, if I don’t know whether or not I’ll be paying $12 euros a ton or $40 euros a ton on the emissions from that new power plant I’m considering building, how am I supposed to decide if investing in a coal plant or a gas plant or a wind plant is a smarter choice? While the “magical” property of a cap-and-trade program you discuss here has it’s upsides for our economy, it also has it’s downsides for it’s impacts on investment decisions. Any magic solutions you know of that can combine the best properties of taxes (price certainty) and cap and trade (automatically adjustable rates)? Or are we stuck with tradeoffs like this?
Eric de Place
Jesse,Here’s one good way to reduce volatility: cap plus tax.
ray benish
Cap and trade functions much like a tax but it is not transparent to the end payer of the increased cost of carbon. Most of what I read about cap and trade makes a great to do about the cap acting as a firm limit to emissons – cast in stone – hard as steel. Even in the Governor’s HB 1819 there is a provision for delay of start or suspension for up to one year if there is an economic emergency. More importantly, the cap is set by legislation and we all know that the legislation can and probably will be changed as the politics necessitate.I find much of the language in HB 1819 to be unsupported by fact or by experience in other cap and trade programs. Does anyone claim that the EU ETS is reducing GHG emissions? Does anyone claim that CDM and JI are working as designed? Can cap and trade folks provide sources to show cap and trade to be the least cost method of reducing GHG emissions? It seems to me that there is little empirical evidence to reliably establish the claims made on behalf of cap and trade. Another example, will companies really invest large sums long term to reduce emissions if at every downturn the allowances and offset prices become dirt cheap? It is difficult to model financial returns when allowance prices may move up or down 200 to 300% over the course of a few months.
Jim Howell
The most effective way to reduce CO2 emissions from fossil fuels over the long run is tax it at a per ton rate and invest the tax revenue in enterprises that reduce demand or produce clean alternative energy.These enterprises can then make long range capital investments knowing that they will have a predictable source of income based on carbon consumption rather than on less predictable swings in price.For example, electric trains are far more energy efficient than trucks or private cars but require long-term investments in track, power distribution and other infrastructure to operate. Long-term investments require long-term and reliable funding. This, I think, is more important than providing polluting companies some breathing room.
morgan
Which tools leads to more technological investment stability? Is it the tool that leads to greater profit stability?With regard to predictability and planning, cap and trade would seem to have more certainty about the relationship between the price of carbon and a firm’s profit, hence its ability to buy allowances, offsets or invest in technological shift.On a side note, I’m looking forward to reading how the economic nose dive is affecting our carbon footprint, ridership and vmt.Yes Jim, revenue recycling is key, though this post speaks mainly to the revenue side of the system and how it effects technological investment. There’s a whole ‘nother debate about using the proceeds to move us off carbon and protect the powerless from the impacts.