Tax Analysts Blog

Cap-and-Trade or Carbon Tax?

Posted on Feb 26, 2013

If you saw the SOTU address earlier this month, you heard President Obama renew his plea for a 'market based' solution to our climate change crisis. That comment triggered a heated policy discussion among my environmentalist friends. What does a tax guy say when folks ask about the cap-and-trade (C&T) systems in place around the world? If you're like me, the tendency is to applaud the ambition but criticize the execution as a failure of sorts. My typical response is as follows.

Yes, I believe that (1) climate change is for real, (2) human industrialization probably contributes to it, and (3) an economic 'price' needs to be imposed on our carbon footprint. I'm not suggesting we should give up our cars and start riding skateboards to work, but there is a social cost not currently captured by the market. This is a classic externality.

That said, I am highly skeptical of cap-and-trade. A straightforward carbon tax is the better option because it will be less prone to manipulation. I don't think C&T systems will function in the real world. Industry will lobby regulators to reset where the emissions cap is set. This is to be expected. They will cite various commercial and competitiveness concerns, often involving China's and India's questionable environmental policies. I understand why industry raises those issues; it's rational self-interest. I would do the same thing if I were in their shoes.

Moreover, regulators will be influenced to issue too many carbon credits, irrespective of where the cap it set. This is the real problem that dooms C&T, in my mind at least. Excess credits will flood the market and cause prices to plummet. Thus, the market price assigned to a fixed quantity of carbon emissions will be grossly under-valued. That gives the illusion of progress in combatting climate change, without actual results.

I believe in the sanctity of efficient markets as much as the next man, but let's be honest -- C&T exchanges are a contrived market where supply and demand are artificial. By way of example, see the following chart from the pages of The Economist. It tracks the United Nation's Certified Emission Reduction (CER) credits. The number of credits issued has skyrocketed. There's been a four-fold increase in just a few years. The price per credit is trending in the exact opposite direction, given the surplus supply. Adam Smith is smiling somewhere.

The EU's Emission Trading System (ETS) has suffered a comparable collapse in the price of carbon credits. The European Commission in Brussels recently suggested withdrawing a large number of previously issued ETS credits. The idea is a bit like quantitative easing in reverse. Several EU member states beat back the idea citing local hardship. Nobody should be surprised by this outcome. Carbon emissions are grossly underpriced on both the ETS and CER markets ... precisely because they are bogus markets.

Why would any rational, profit-seeking enterprise invest in a particular asset? Because the asset is, theoretically, scarce and thus possesses inherent value. But why invest in the asset when the reality is that countless additional assets can be conjured up by bureaucrats at the drop of a hat? Market values lie in the relative scarcity of the asset in question. In the case of a C&T the notion of scarcity is rather dubious. And, no, this doesn't mean I hate Mother Earth or deny climate change.

C&T is not a tax concept; carbon taxes are. While new taxes are not a panacea to solve all of society's problems, skillfully crafted taxes can be an effective means of addressing externalities. Bottom line: One of my wishes for 2013 is that all my 'Green' friends will throw in the towel on C&T and begin to focus their attention on a carbon tax, which would better serve their interests.

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