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The Debate Zone: Carbon Tax V. Cap and Trade
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Ed. note: Our climate change debate engendered a lively conversation among readers that pushed the original essays well beyond their starting points.

Gregg Easterbrook

Why we need a carbon tax

It’s a three-letter word that starts with “t,” ends with “x.” Go ahead, don’t be afraid to say the word—“tax.” The simplest, most efficacious, least bureaucratic, and best-for-the-nation initial move against greenhouse gas buildup would be a carbon tax.

This is not a liberal nostrum. Economist Martin Feldstein, once President Ronald Reagan’s chief economic advisor, has been advocating a carbon tax for nearly 20 years. In 2007 N. Gregory Mankiw, former chief economic adviser to President George W. Bush, threw his weight behind the idea, saying that a carbon tax “may be the closest thing to a free lunch that economics has to offer.” Here are the main arguments for a carbon tax:

  • Such a system would be far less complex than any cap-and-trade scheme. The McCain-Lieberman greenhouse gas cap-and-trade proposal, which drew 43 votes in the Senate in 2005, was 491 sections long. And that was just the authorizing legislation, not the tens of thousands of pages of administrative orders required to put the bill into force! The Obama plan is likely to be equally complex by the time it wends its way through Congress.
  • Because carbon cap-and-trade systems are inherently super-complex, they are nearly certain to be “gamed“—defeated by gimmicks, litigation, and special-favors lobbying. Lawyers will always think of pretexts faster than regulators can repair flaws in the language of complex regulation. America’s approach to environmental regulation is already too steeped in litigation. A carbon cap-and-trade system would make this problem worse.
  • Whatever you tax, you get less of. Today America mainly taxes labor and capital—but we want more of both! We don’t want more carbon, so let’s tax that instead.
  • Owing to simplicity, enforcing a broad-based carbon tax is imaginable. Enforcing a broad-based carbon cap-and-trade scheme is hard to imagine.
  • If carbon is taxed, individuals—not government—will make the decisions about greenhouse-gas reduction strategies. Individuals have a much better track record at economic decision-making than government does.
  • Carbon taxes will offer a clear, easy-to-understand profit incentive to those who devise carbon-reduction technology—so inventors and engineers will get to work. Conversely, cap-and-trade programs will offer an incentive to game the system; so pollsters and lobbyists will get to work.
  • The only policy failure concern about a carbon tax is that individuals and firms will simply pay the tax rather than reduce emissions. This is possible, but unlikely: experience shows that individuals and firms change behavior to reduce taxation.

But isn’t it totally and utterly politically impossible to enact a tax? Perhaps in the 1990s, when the federal budget was in surplus. Today the federal government is on the worst borrowing binge in its history—the national debt has doubled in a decade! Voters are not fools; they know little twinkling fairies will not come in the night to replace all the borrowed money. Debt must be repaid, and a carbon tax, which would create net benefits to society, may look a lot better to voters than other possibilities.

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Carter F. Bales and Richard D. Duke

Carbon caps are better

There are two main contenders for constraining carbon emissions: caps and taxes. Both are market-based approaches that put a price on carbon and other greenhouse gases and provide an economy-wide signal to encourage emission reductions, beginning with the lowest-cost opportunities.

The main difference between the two is that a pure tax fixes the price of carbon (but allows the amount of carbon emissions to vary) while a pure cap places limits on carbon emissions (letting the market price of tradable carbon allowances vary). We argue that a well-designed cap with certain tax-like features is the most efficient strategy to radically reduce emissions. This approach has four advantages.

First, a well-designed cap offers superior investor certainty relative to a tax because it establishes clear, long-term abatement requirements and allows the private sector to estimate the allowance prices needed to get the job done. In contrast, a carbon tax would likely start too low given political pressures and it would be exposed to unpredictable adjustments, as politicians would tend to raise or lower the tax in reaction to economic conditions. A well-designed cap should also include specific tax-like provisions.1 Most important, the government should purchase and delete allowances if the price falls below a gradually rising floor.

Second, a cap on carbon provides more fundamental environmental certainty than a tax, because it is, by definition, a fixed limit on emissions and because the political process to define a cap is less likely to result in emissions loopholes. In particular, the political horse trading involved in defining a cap centers on distributing a fixed number of allowances—with equity and economic productivity implications but with no impact on future emissions levels. In contrast, negotiations to define a carbon tax might result in exemptions for certain sectors, which would allow higher emissions levels.

Third, once carbon caps are in place, all energy consumers share an interest in promoting complementary policies that reduce emissions. For example, all energy consumers will benefit from lower carbon allowance prices if they persuade policymakers to enact and enforce minimum energy efficiency standards for buildings, appliances, and vehicles.

Fourth, carbon caps provide a useful economic shock absorber, since allowance prices automatically soften as soon as the economy enters a recession. In principal, carbon taxes could also be adjusted frequently to make them more countercyclical, but to do this effectively would require an unlikely level of sophistication, objectivity, and alacrity on the part of policymakers.

Experience from the US cap-and-trade system for controlling the sulfur emissions that cause acid rain suggests that a well-designed approach can yield unanticipated cost-reducing innovations. If we do not take action immediately, greenhouse gas abatement costs will rise sharply.

1 See us-cap.org to download the Blueprint for Legislative Action, issued in January 2009 by 25 major corporations and 5 NGOs.

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Comment on this debate [152]

Agree? Disagree? Let us know what you think. Please include your full name with your comment. Comments may be edited.

  • Much as I like the simplicity of a Carbon Tax, at the aggregate level I prefer the Cap n Trade mechanism.

    I believe 2 principles will drive or undermine our carbon control regime – global vs local and government intervention.

    Carbon is a global issue, and as such needs a coordinated global solution. To get 200+ countries to agree to a common carbon tax that doesn’t change through the next 50 years will be impossible. As such a carbon tax doesn’t meet the need to address a global issue with a global solution.

    Similarly, governments and political parties in 200+ countries will at some point in time make carbon tax an election platform. Our politicians have an unenviable track record of taking populist positions come election time. The carbon tax will most definitely provide fodder for populist tax policies come elections. The carbon issue is real, and I would like to put it beyond our politician’s ability to meddle with solutions.

    As such, I have a distinct preference for cap and trade. Though it is unfortunately a fairly complex mechanisms that requires strict monitoring and quality implementation.

    Posted 8 March 2009, 13:34 by Oscar J.

  • The arguments, that we in the USA must(!) reduce our overall energy consumption, are frivolous. The USA population will continue to expand over time, and energy demands will inexorably increase … especially so if we restore the mighty US manufacturing base, and especially too in “Old America” (aka east coast). There is an olde set of sayings among achievers: you do more with more; you do less with less; you never do less with more — because you have a conscience. The first nugget of wisdom fuels the drive behind liberals and their socialist obsessions, however, they are so inefficient that they violate the last nugget by actually doing less with more … e.g., the inept War on Poverty. And now, their War on Energy.

    Posted 7 March 2009, 14:01 by The Streak

  • The cap and trade is clearly a superior system as it enables the least cost sources of incremental reductions to be implemented first, thereby lowering the cost of what will be a VERY expensive proposition measured in the $100s of billions per year. It also allows the use of offsets which are a very cost effective approach if properly regulated to ensure aadditionality. Finally, it ensures reductions do occur and lets policy makers set the amount and timing of reductions.

    However, without any allocation to generators as proposed by the Obama Administration, a cap and trade has become a de facto tax. Given cap and trade is inevitably more complex to administer, then being intellectuially honest with ourselves and calling it and making it a straight tax is the best path forward (economically, but not necessarily politically which is why in reality they will never make it into a tax).

    That all said, the biggest two issues to CO2 are are less about the cap/trade versus tax debate than it is about:
    1) Ensuring we do not lose competitiveness to free riders who do not regulate GHGs at the same time is currently problematic. China is clearly the biggest player here. The Chinese arguement is essentially that the OECD industrialized countries (esp USA) and put all this CO2 currently in the atmosphere so they should bear the burden of reducing it. That is not illogical but conveniently overlooks the fact that if the OECD has CO2 costs and China does not, then CO2 regs are just a massive wealth transfer to China. More importantly it will lead to higher CO2 emmissions globally as they just shift production from relatively more efficient OECD plants to less efficient Chinese facilities. The argument that the US needs to lead on GHG regs and then the rest of the worlld will follow is naive.

    2) This is a staggering and MASSIVE tax increase in macroeconomic terms no matter how it ends up being implemented. This is not a good time to be making tax increases of this magnitude.

    So the current glide path seems to be China et al become more competitive, USA loses industrial production and makes a massive tax increase in the face of a recession, and global CO2 emissions still go up.

    Posted 7 March 2009, 09:28 by David Gee

  • As an European I saw the cap and trade system, the European Trading System (ETS) favored and supported by industry lobbyists. After a 1992 EU commission proposal for an EU-wide CO2 tax industry lobbies around BP offered the “second worst” option for them to the politicians. The main advantage for the CO2-intensive industry was the possibility to get the CO2 allowances for free. A CO2 tax is always collecting money from the polluter to the state (public) the ETS does not until 2012. Then partly auctioning (about 60%) is starting but still including huge market distortions.

    Posted 6 March 2009, 15:07 by Erwin Mayer

  • Cap and Trade is failing currently as the drop in the economy means with a fixed cap means that it has led to a lower market price which is acting as a cost-incentive to pollute more.

    Carbon taxes also fail as they, on their own do not commit a limit on carbon emissions to be met.

    This is a false choice. What is needed instead is a system of limits (top down) and policies to incentivise action (bottom up). One such system is the combination of a global agreement on climate change that is both fair and sufficient (contraction and convergence), national legislation that requires sufficient action (a stronger Climate Bill) and local action that provides the freedom to choose, yet responsibility to meet limits (e.g. Tradeable Energy Quotas – see teqs.net). What is important is not whether the solution is market driven (cap and trade) or fiscally driven (taxation) but whether it has sufficient limits to stop climate change that do not flex with the market, and that this inspires and requires sufficient action by all.

    Jonathan Essex
    Chartered Civil Engineer and Sustainability Campaigner

    Posted 6 March 2009, 14:01 by Jonathan Essex

  • Neither “Carbon Tax” nor “Carbon Cap”. I believe in a third alternative: the “Positive Incentive”. I do not think we have to force anyone to follow green rules, but for sure we have to promote people going this way. The benefits of the “Carbon Cap” approach is to fix a target…but it does not explain how to meet the target. The benefits of the “Carbon Tax” is to reduce the emissions but it does not guarantee any target and it communicates a negative feeling. In both cases we do not secure the timeline to meet any target. This is my understanding. We win some miles because we travel more and more, why cannot we win some “miles” because we travel only when it is really important? Regarding the carbon tax, it is so weak that it does not influence so much the consumer choice. In France, the government put in place reduction of income tax if you buy some solar panels…the result is really important but the move is very slow, there is no mass effect. The benefit of the “Positive Incentive” is the win-win approach and the fact it concerns anyone in the world and from any social class. It creates a positive dynamic that we need to create a new society.

    Posted 6 March 2009, 11:44 by Patrick Bachet

  • Take the main inconvenients out of a cap & trade system as it is presented above:
    (a) The complexity of it and therefore its admin costs (Should not have a trading mechanism).
    (b) The lack of public revenue generated from it to reduce national debt levels (Need a tax).

    Take the main inconvenients out of a carbon tax system as it is presented above:
    (a) The constance of the tax, which is not taking into account the state of the economy (Need a “floating” tax).
    (b) The environmental uncertainty, whereby the tax may not be large enough to motivate companies toward cleaner energies (Need a cap).

    Combine all the remaining elements, and you’re left with what we really need: A floating-tax & fixed-cap system.
    In order to keep the admin costs low, the floating tax would be based on GDP growth for the previous year (Factual/past data), and would be set by the country’s own government once per year (Frequently enough to allow companies to adapt to economic activity).
    The cap would be set by one glolal independent body (e.g. IPCC) at the beginning of a longer term period (e.g. 3-4 years), and allowances would be distributed to governments proportionally to their population (No allocation based on 1990 levels of emissions as stipulated by Kyoto). These allowances should not be traded.

    Any opinions on this?

    Posted 5 March 2009, 19:34 by B. Kellner

  • The promotion and use of alternative fuels will decrease our dependence on foreign oil, however, alternative fuels will not decrease the carbon footprint of our nation unless we also work to reduce our energy demand by becoming more efficient in our usage. Throughout the world, coal is used extensively to generate electricity and process heat for industrial applications. There are significant numbers of coal-fired utility-scale power plants currently installed in some 80 countries throughout the world. For most of these countries, coal will continue to figure significantly in any future expansion of the electricity market required to meet increased consumer demand. In the industrial arena, coal is used as a source of energy for large energy intensive industries such as paper production, cement manufacture, food processing and steel manufacture. The extensive use of coal poses significant world environmental problems: CO2, which can contribute to global warning, significant emissions of acid gas species such as NOx and SO2.
    In order to optimize the usage of biofuels, the user must learn how to optimize the combustion process and the fuel quality. The combustion of the biofuel will require a system that can continuously feed the fuel to the burner system. Interruptions in fuel flow will cause spikes in the excess air needed for combustion. These spikes will impact NOx and SOx emissions. When there is a state of combustibles, NOx will drop and Sox will spike. The inverse occurs when there is more than the required excess air for combustion. Optimization of the combustion process must be determined using heat and mass balance calculation. The calculation of the Omega Factor for proposed alternative fuels will help eliminate the fuels that will not bring enough heat into the process to replace coal. Typically in pyro-processes, fuel is one of the highest process costs. Maintaining the fuel quality through sampling and test is critical. A combustion characteristic of the biofuel must be done. This includes proximate, ultimate, and Thermograviometric Analysis. In addition a higher calorific value (HCV) can be estimated from the ultimate analysis. The final requirement is the safe storage of the biofuel. There needs to be a partnership between government and industry that promotes energy conservation and the uses of alternative fuels. A champion is needed to bridge the gap. I have replaced 40% of a lime plants coal / coke fuel with cocoa shells and glycerol. I have worked with State EPA to successfully trial a number of possible fuels. If you go to my website, you will see that I have been a champion because I desired to leave less of a footprint in terms of emissions. Globally, waste derived fuels are playing an increasingly important role in the industrial fuel mix for coal-fired power plants, cement kilns, lime kilns and emerging secondary fuels power plants. The EU Landfill Directive has forced waste management policies across the member states of the European Union to reduce the amount of waste sent for landfill disposal. The directive requires that progressively increasing quantities of biologically active waste are diverted away from landfills to incineration. Once the recyclable fraction is removed, a residual fraction remains and must be treated aerobically or anerobically to fulfill the new quality demands for landfilling. Although this approach to waste management is widely practiced, it may not represent the best technical, environmental or economic solution as this landfill waste can possess significant quantities of energy after treatment. The alternative to the aerobic or anaerobic treatment step is the creation of a fuel. This material is often called “refuse derived fuel” (RFD) or “solid recovered fuel” (SRF). SRF is the term that will define compliance with emerging European technical standards. We need to develop our own directives for the removal of energy bearing waste from being landfilled. Please contact if there is interest in the promotion or development of policy on my suggestions.

    Posted 5 March 2009, 17:15 by Jeffrey C. Morrow

  • Both are needed. A cap-and-trade system works for the roughly 50% of emissions that come from large fixed sources, and a carbon tax hits the other 50% that comes from the rest of the economy (mostly you and I and the choices we make in using energy).

    But some sequencing is needed, with a cap-and-trade to precede a carbon tax, for the following reasons:

    1. The large point sources subject to a cap-and-trade deliver more cost-effective reductions in the short- to medium-term.

    2. We don’t actually know what a ton of carbon should cost, and so don’t know at which level to set the carbon tax. Set it too low and you get very little result. Set it too high and you impose an unnecessary cost to the economy. How do you get that “Goldilocks” number? Through the magic of price discovery, which only a market that actually trades carbon (as part of a cap-and-trade and offset system) can provide.

    I agree that an interesting new opportunity here is in making a virtue out of necessity, by using the revenues of either a carbon tax or a cap-and-trade auction to start to whittle down the deficit.

    Also agree with other comments that the argument about the inherent simplicity of a carbon tax is a bit naive. A tax system can’t be “gamed”?

    Kudos to McKinsey for putting together this forum.

    Posted 5 March 2009, 16:44 by Alexander Wood

  • Several replies have commented on the fact that tax versus cap and trade for carbon emissions is a meaningless debate. No peer reviewed scientific evidence that CO2 is warming our planet exists today. Let me repeat, none. There are no peer reviewed statistics that indicate that the planet is warming faster today than it has in the past with the possible exception of urban heat sinks. Let me repeat, none.

    I do know that our sun has exhibited extraordinary behavior in recent years. At this moment there has not been a storm on the sun for over one year. This length of time without storms has never been observed before in recorded history. Maybe it would be smarter to invest many more resources in studying the sun, I don’t know.

    I will welcome a two sided debate from McKinsey that asks, “is CO2 warming the planet?” Many people appear to believe this is true and it would be fascinating to read what they are basing their beliefs on.

    Posted 5 March 2009, 16:19 by Tom Concannon

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