In the Green world, one of the hottest and most contested debates is the validity of Carbon Trading versus the validity of a Carbon Tax and I spent some time trying to dig into these two approaches to try and understand them and give you my perspective

According to Wikipidia, Carbon Trading, not to be confused with Carbon Offsetting, is where a central authority (usually a government or international body) sets a limit or cap on the amount of a pollutant that can be emitted. Companies or other groups are issued emission permits and are required to hold an equivalent number of allowances (or credits) which represent the right to emit a specific amount. The total amount of allowances and credits cannot exceed the cap, limiting total emissions to that level. Companies that need to increase their emissions must buy credits from those who pollute less. The transfer of allowances is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions by more than was needed. Thus, in theory, those that can easily reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest possible cost to society.

Also according to Wikipedia, a Carbon Tax is a tax on emissions of carbon dioxide and other greenhouse gases. It is an example of a pollution tax, which most economists favor because they tax a "bad" rather than a "good" (such as income). Carbon taxes address a negative externality, and so are classed as Pigovian taxes - named after Arthur Pigou, who first proposed targeted taxation as a corrective to externalities. Note that in the strict definition of a Pigou tax, the tax should equal the marginal damage costs.

Both solution provide very different approaches to try and solve the same problem - reducing our emissions of carbon dioxide.   However, I believe that reducing carbon emissions is only one small battle in the overall fight for the human race to learn how to live sustainability and thus is a potential bellweather for how we will handle other sustainability issues like water, food, etc. 

Take a look at the pros and cons of these systems and see what I think is going to happen as well. 

Carbon Cap and Trade 

Pros

The arguments for a CAP and Trade system of carbon emissions generally revolve around a few points.  1) CAP and Trade has worked before on acid rain reduction, 2) its an economic system build to find the cheapest possible way to reduce the most amount of of carbon dioxide and 3) CAP and Trade systems actually combine regulation with market driven solutions.

Ok. So let's look at the acid rain cap and trade system first. I met with Fred Krupp, the president of the environment defence fund and he uses the Acid Rain program as a shining example of how Cap and Trad can really work.  According to the Environment Defense Fund:

Cap and trade was designed, tested and proven here in the United States, as a program within the 1990 Clean Air Act Amendments. The success of this program led The Economist magazine to crown it "probably the greatest green success story of the past decade." (July 6, 2002).

The following points highlight some real world results of that program:

• The expected market price for SO2 allowances was in the range of $579-$1,935 per ton of SO2; the actual market price as of January 2003 was $150 per ton.

• In the 1990s, the U.S. acid rain cap and trade program achieved 100% compliance in reducing sulfur dioxide emissions. In fact, power plants participating in the program reduced SO2 emissions 22% - 7.3 million tons - below mandated levels.

• Prior to the launch of the program, cost estimates had ranged from $3-$25 billion per year. After the first 2 years of the program, the costs were around $0.8 billion per year. The long-term costs of the program are expected to be around $1.0-$1.4 billion per year, far below early projections.

Cap and Trade is market driven.  The second big pro of a Cap and Trade system is that it embodies the qualities of capitalistism and uses well established economic principles of supply and demand. According to the Environmental Defense Fund, CAP and Trade because

"markets provide greater environmental effectiveness than command-and-control regulation because they turn pollution reductions into marketable assets. In doing so, this system creates tangible financial rewards for environmental performance."

Cap and Trade systems combine regulation with market solutions.   One of the arguments in favor of Cap and Trade systems is that they actually mandate regulation with a CAP in any emissions and provide a mechanism to tighten the screws on industries if need be.  This mechanism enables the governments to actually control where the parity point is between the cost of buying a carbon credit and the cost of earning one.

Cons:

The arguments against CAP and Trade systems generally revolve around these points 1) they provide incentives for the worst polluters to keep on polluting and 2) the inefficiencies in varifying carbon credit earning systems make the entire system unreliable.

Cap and Trade Systems enable the biggest polluters to keep on polluting.  Cap and Trade systems provide the wrong incentives to the industries who need to change the most.  Those industries which are heavy polluters and have their structure build around fossil fuels, will not change because it is simply too expensive.  Rather they will simply buy credits and continue to build up their fossil fuel dependencies as long as those credits are cheap.  Once the credit become expense or approach parity with actual change they will simply apply political pressure to governments to do away with the Cap and Trade systems.

Thus, if the companies in the worst polluting industries never really plan to change, what will happen is that the Cap and Trade system will ultimately fail.  Over time the low hanging fruits will go away and it will come time for real change to occur.  When that happens the cost of Carbon Credits will soar until they are at parity with the cost of actual change. What happens at this point is that these industries then apply political pressure, claiming they can't change and can't afford the credits, to do away with a broken Cap and Trade system.  The end result is actually more dangerous than the one we are in.  We will be tricking ourselves into thinking we have a solution that is working when it reality we will be putting ourselves further behind than we already are right now.

In fact, Larry Lohman, who is one of the biggest critics of a Cap and Trade system, says, "The main cause of global warming is rapidly increasing carbon dioxide emissions -- primarily the result of burning fossil fuels. Some responses to the crisis, however, are causing new and severe problems -- and may even increase global warming. This seems to be the case with carbon trading -- the main current international response to climate change and the centrepiece of the Kyoto Protocol."

 

Inefficiencies in measure actual carbon reductions make the system unreliable.  Unlike other market based trading systems like the stock market, the cap and trade system is not buying products that can be easily verified.  For example, when a heavy polluting coal fired electricity plant buys carbon credits on a Carbon Exchange, how can the company or the public actually verify the carbon is reduced?  Already there has been numerous reports on projects that are earning carbon credits that are more harmfull than good.  An investigation done by the Financial Times of London found:

■ Widespread instances of people and organisations buying worthless credits that do not yield any reductions in carbon emissions.

■ Industrial companies profiting from doing very little - or from gaining carbon credits on the basis of efficiency gains from which they have already benefited substantially.

■ Brokers providing services of questionable or no value.

■ A shortage of verification, making it difficult for buyers to assess the true value of carbon credits.

■ Companies and individuals being charged over the odds for the private purchase of European Union carbon permits that have plummeted in value because they do not result in emissions cuts.

In one case Blue Source, a US offsetting company, invites consumers to offset carbon emissions by investing in enhanced oil recovery, which pumps carbon dioxide into depleted oil wells to bring up the remaining oil. However, Blue Source said that because of the high price of oil, this process was often profitable in itself, meaning operators were making extra revenues from selling “carbon credits” for burying the carbon.

Carbon Tax

Pros

The CTC (Carbon Tax Center) has a full write up on the benefits of Carbon Tax systems, but the biggest points, according to them are:  

1. Carbon taxes will lend predictability to energy prices, whereas cap-and-trade systems will aggravate the price volatility that historically has discouraged investments in less carbon-intensive electricity generation, carbon-reducing energy efficiency and carbon-replacing renewable energy.
2. Carbon taxes can be implemented much sooner than complex cap-and-trade systems. Because of the urgency of the climate crisis, we do not have the luxury of waiting while the myriad details of a cap-and-trade system are resolved through lengthy negotiations.
3. Carbon taxes are transparent and easily understandable, making them more likely to elicit the necessary public support than an opaque and difficult to understand cap-and-trade system.
4. Carbon taxes can be implemented with far less opportunity for manipulation by special interests, while a cap-and-trade system’s complexity opens it to exploitation by special interests and perverse incentives that can undermine public confidence and undercut its effectiveness.
5. Carbon taxes address emissions of carbon from every sector, whereas cap-and-trade systems discussed to date have only targeted the electricity industry, which accounts for less than 40% of emissions.
6. Carbon tax revenues can be returned to the public through progressive tax-shifting, while the costs of cap-and-trade systems are likely to become a hidden tax as dollars flow to market participants, lawyers and consultants.

Cons

The cons for a Carbon Tax generally fall into a few primary categories 1) Carbon Taxes simply define how much money can be raised by a government to reduce carbon emissions, but doesn nothing to actually regulate the emissions, 2) sin taxes are jut nasty and 3) a carbon tax that would actually cause real change in behaviors of consumers and companies is not realistic and would not actually ever happen.

My Take on Things 

There is no magic silver bullet and putting too much dependency on one single approach to global warming is a big mistake with big consequences.  We need to stop thinking that we can simply pass some legislation or indtroduce some new market that will solve all of our problems.  However, that being said, I just don't want to be a complainer that doesn't have a solution.  So here it goes:

I am in favor of a Cap and Trade system and not in favor of a Carbon Tax for two simple reasons - 1) I don't believe we could ever get Carbon Tax legislation passed that would ever put even the smallest dent into carbon emissions and 2) I believe that a market based approach is one in which the system starts our inefficient and drives towards efficiency and a Carbon Tax system is one that would be simple at first and would drive toward complexity and ultimately towards entropy. 

I do believe that a Cap and Trade system is not the total solution and I do believe that it will be incredibly inefficient and many people will cheat the system in the short run, but I ultimately believe it provides a stronger construct from which to build a solution.

That being said, I believe that the biggest risk of any system we put in place is that those industries that are based on fossil fuels just won't change regardless of the system because it would mean that they would loose too much money - and that scares me because I'm a realist and I do know that money does make the world go 'round and it may be money that makes our world stop. 

Posted by Steve Newcomb on April 3, 2008 10:22 AM | Permalink