Getting the Price Right: Which is Better? pt. 2

Last week, I began to compare two important programs in the realm of environmental policy: cap-and-trade and carbon tax. I first examined the political viability of both programs and came to the conclusion that although they have received relatively equal magnitude of political praise and scrutiny, the carbon tax is a bit more politically reasonable. A carbon tax has more of a potential to attract people on the right due to the fact that it can come with the condition of revenue neutrality, which takes away people’s natural loss-averse tendencies because another part of the tax system would be adjusted. Many critics say that a carbon tax “doesn’t do enough,” but with a political climate that is perversely stagnant when it comes to important issues, compromise seems to be necessary.

I will now continue my comparison by explaining the risks, ease, and scope of both systems in an attempt to figure out if one policy is more effective.

Both the carbon tax and cap-and-trade pose very different risks. Recall that a carbon pricing policy is only effective when the marginal benefits of abating equal the marginal costs. Unfortunately, in the real world, we can’t wave a magic wand and immediately find perfect Marginal Benefit and Marginal Cost curves of pollution and abatement. If this were the case, both carbon tax and cap-and-trade would be equivalent because policymakers would know exactly the effect of price and quantity polluted. Because this isn’t the reality, the issue of uncertainty is all too prominent. With a carbon tax, the price of emitting a unit of pollution is set, but the total quantity of emissions, although it can be predicted through models, isn’t certain. This means that the amount of abatement generated by a carbon tax may not be the amount required to equal the cost and benefit of abatement. On the other hand, a cap-and-trade system provides certainty about the quantity of emissions, but there is risk over the costs of achieving the proposed reductions. This means that the market price of the CO2 allowance likely won’t be equal to the estimated benefits per ton of CO2 abatement.

Cap and trade programs seem to have the upper hand in making benefits and costs more certain. Under cap-and-trade, the market price for CO2 allowances continuously adjust for changes in the market such as price of fossil fuels, the demand for electricity, and the rate of technological change. This happens because as outside forces cause the cost of polluting to change, firms will buy and sell permits accordingly, and the price will adjust naturally. A carbon tax is unable to adjust to market changes without frequently changing the tax level, which is obviously administratively and politically difficult. The reality is that the planet is in such critical condition that having certainty of the amount of pollution emitted seems like a more successful gamble.

When it comes to ease and lower costs of administering, the carbon tax has the upper hand. A cap-and-trade system must determine maximum amount of emissions for various sources and have to figure out a way to equitably and efficiently distribute permits. The simplicity of a carbon tax also makes it faster to implement. For example, British Columbia completely enacted and implemented their carbon tax in only five months. On the other hand, the United State’s cap-and-trade system in the Northeastern U.S. took five years to negotiate and implement.

Finally, one of the more important factors of the debate is the scope of industries that each system can target. Due to the permits that come with a cap-and-trade system, it usually tends to only be implemented for restraining emissions from large industrial plants. Unfortunately, cap-and-trade programs can usually only target physical industries, and their altered behaviors and innovations can only indirectly affect the energy use of people. On the other hand, due to the straightforwardness of a carbon tax, not only can it aid in cutting emissions in firms, but it is also capable of cutting emissions related to everyday acts such as transportation, heating, and cooling. For example, one study showed the effects of a carbon tax on people’s driving habits. The price elasticity of gasoline is typically -.3 in the short run and -.7 in the long run. This means that a 10% price increase that could come from a carbon tax reduces fuel consumption by 3% in a year or two, and up to 7% in about five to ten years. By reducing fuel consumption, people will either simply reduce their driving or shift toward more fuel-efficient vehicles. This wouldn’t be able to directly happen with a cap-and-trade program.

So, based on all of this information, I have concluded an answer that nobody likes to hear: it depends. It depends on the political climate, who should be targeted, and what risks are willing to be taken. This being said, either of these two policies is better than no policies at all. At this point, action must be taken as soon as possible to put a price on the negative externalities that come with frivolous polluting.

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