Is Managed-Price Cap and Trade Different From A Carbon Tax?

When I examined the managed-price approach to cap and trade I asked: “if managed-price cap and trade is basically just a carbon tax, why go to all the trouble of developing the apparatus of a cap-and-trade system? Why not just have a plain old vanilla carbon tax instead?”

Recent testimony from Douglas Elmendorf, director of the Congressional Budget Office (CBO), considers the possible ways that managed-price differs from a carbon tax. (All inset quotes below are from this CBO testimony.) As it turns out, there are not many important differences.

According to CBO, here’s one possible way that managed-price differs from a carbon tax:

It would allow policymakers to distribute a share of theallowances to firms for free if they wished to do so. For example, they could give allowances to coal producers, electricity generators, or to dislocated workers in the coal industry.

Okay, so managed-price cap and trade would allow free allocation of permits to polluters. Fair enough. But in reality this is only a very subtle difference from a carbon tax. There’s no good reason to believe that a carbon tax would prevent policymakers from giving things away for free. It’s no small secret that federal and state tax codes are riddled with loopholes and tax exemptions for favored industries.

Here’s another possible way that managed-price differs from a carbon tax:

It would allow firms to meet a portion (specified by policymakers) of their requirement for allowances by purchasing “offsets,” which are credits for qualifying emission reductions in areas not subject to the cap. For example, individuals or firms not subject to the cap might generate offsets through biological sequestration… and then those offsets could be available for purchase by firms subject to the cap.

So managed-price would allow offsets. But, again, this is really no different from a carbon tax. A carbon tax regime could easily include an offset program: firms could choose to either pay a carbon tax or purchase certified offsets. In fact, it would be precisely the same choice that firms would have under auctioned cap and trade with offsets: purchase a permit or purchase an offset.

And here’s another way that managed-price might differ from a carbon tax, in its basic design:

Regulators would establish a path of rising prices for allowances, with the goal of complying with the cumulative cap that legislators set. That path would be adjusted periodically if new information indicated that future compliance costs were going to be higher or lower than anticipated or if progress in meeting the cumulative cap was less than expected.

Again, this is only a phantom difference. A carbon tax could be set to gradually increase over time. (In fact, virtually every carbon tax proposal I’ve heard of has a tax rate that increases over time.) What’s more, even a fixed carbon tax rate can easily be adjusted by policymakers or regulators, just as virtually every tax in existence is adjusted. If a carbon tax extends until, say, 2050 it’s almost impossible to imagine it going untouched over that period, for good reasons or for bad.

But there are a couple of real differences between managed-price and carbon tax:

Firms could sell any allowances that they were given but did not use.

Okay, fair enough. I suppose this is a legitimate difference from a carbon tax, though it’s probably a minor one. Under a managed-price system, firms could sell unused allowances to other firms. Even so, there would likely be a limited market for these permits because under managed-price the government is agreeing to sell an unlimited number of permits at the fixed price, so presumably no one would pay more on the secondary market than they could pay to get the permits directly from the government. It is, however, possible that some firms would pay less on the secondary market in the event that other firms ended up holding permits that they had purchased and found that they didn’t need. Being able to sell unused permits at a discount would help firms manage risk.

Interestingly, Congressman McDermott’s version of managed-price cap and trade actually does not differ from carbon taxes in this respect. (Bill is here.) McDermott’s plan disallows sales on the secondary market, though it does allow firms to return any unused permits to the government for a full rebate. So in this respect too, McDermott’s plan is much like a carbon tax: firms only pay when they emit; and there’s no trading.

So that’s one legitimate difference. And here’s another:

It would allow firms to reduce uncertainty about their future compliance costs by entering into futures contracts. For example, firms subject to the cap could agree to buy allowances at fixed prices in the future from traders that were willing to absorb the risk that the price of allowances would turn out to be higher or lower than anticipated.

Under managed-price, firms could use derivatives products like futures contracts to manage their exposure to price changes. I know that derivatives are supposed to be a four-letter word these days, but they do play an important role in stabilizing the economy. And managed-price will allow polluters to hedge their risk, much as they might in an ordinary cap and trade program.

What’s the final tally? Despite CBO’s claims, a managed-price approach to cap and trade is different from carbon taxes in only two important respects: 1) there will be some limited trading on a secondary market; and 2) firms can use derivatives to manage their risk. (Congressman McDermott’s managed-price legislation has only this second difference from carbon taxes.)

There is, however, one more difference that the CBO testimony doesn’t mention. Managed-price sets up a bigger and more complex policy apparatus than a carbon tax likely would. It will design a permit and auction system, as well as a published price schedule and regulatory guidelines for adjusting prices.

All things considered, I’d rather just have either ordinary cap and trade or ordinary (adjustable) carbon taxes. (Or both.) It’s hard to see how the managed-price approach to cap and trade accomplishes much that can’t be done more simply by the plain vanilla carbon pricing policies that are already in wider circulation.