The Real Choice Between Cap-and-Trade and Carbon-Based Taxes

Posted January 15, 2009 at 9:24am

We all have a moral imperative to get climate policy right. To achieve that, the incoming administration and Members of the 111th Congress will have to carefully weigh all the serious options being proposed to reduce carbon emissions. However, it seems that some politicians have already made up their minds before real debate has even begun.

As last Thursday’s House Energy and Commerce Committee hearing illustrated, a number of lawmakers are narrowly focused only on cap-and-trade — the same kind of futile approach that’s failed to lower emissions in Europe. [IMGCAP(1)]

While well-intentioned, cap-and-trade systems are riddled with daunting problems. These regimes may offer the path of least current, political resistance, given its support by some environmental groups and a number of European governments. But basic economics punctuated by the developments now gripping the U.S. and global financial systems clearly point in a different direction, toward a carbon-based tax program with most of the revenues recycled in forms of tax relief.

Under cap-and-trade, the government sets an annual “cap” on greenhouse gas emissions, gives away or auctions permits to produce those emissions, and lets a new market sort out the messy job of determining the prices of emissions. The core idea is that businesses that can cut their emissions targets most cheaply will do so and sell permits to those who cannot, leaving everyone better off.

This was the approach then-Vice President Al Gore proposed at the climate summit in Kyoto, Japan, in 1997, to break a deadlock and gain support from Russia and other developing nations that were effectively exempt from reducing their emissions, but still allowed to sell “excess” permits to us and Europe. Burned by the political firestorm over his proposed BTU tax in 1993, my former boss, President Bill Clinton, still pushes forcefully for a cap-and-trade scheme, arguing : “I tried [a carbon tax] once. It didn’t work for me.”

But here’s the catch. A cap-and-trade system is very unlikely to reduce global greenhouse gas emissions — and more likely to introduce new, trillion-dollar risks for the financial system.

The clearest illustration of the problems with cap-and-trade is the European Trading Scheme, based on the Kyoto protocols covering most of Europe. According to a new report by the Government Accountability Office, there’s little if any evidence that the ETS has had any effect at all on emissions in Europe. One reason is that major emitters such as Germany simply exempt many of their facilities generating greenhouse gases. Another factor is the “offset” permits that European “transition” economies, themselves exempt from caps, can sell to other ETS members. According to a recent study in Nature, once we set aside those offsets, emissions under the ETS have actually increased by 10 percent.

The system also has failed to establish a stable price for carbon — a goal widely considered a prerequisite for any effective climate change effort. To the contrary, the prices for ETS permits are highly volatile. In the first two years of the EU cap-and-trade system, for example, permits prices moved up or down by an average of 17.5 percent per month, with daily price shifts as great as 70 percent.

Since the entire global permit market only currently amounts to some $60 billion, such volatility doesn’t threaten economic stability. However, if the U.S. were to join Europe — and China as well — in cap-and-trade, it’d be a different story entirely. Volatility like the kind experienced in the ETS would translate into much more volatile energy prices, unsettling everyone’s markets and undermining investment. And the volatile prices for the permits themselves, traded on financial markets, would attract speculation and new financial derivatives, putting us at risk for another crisis.

Even more regulations cannot eliminate most of cap-and-trade’s inherent price volatility or the incentives for its participants, including governments, to evade or manipulate the system. These are the main reasons why the father of climate-change politics, Al Gore now prefers carbon-based taxes over cap-and-trade.

A carbon tax system would apply a stable price to carbon, creating direct incentives to develop and use less carbon-intensive fuels and more energy-efficient technologies.

President-elect Barack Obama is committed equally to fighting climate change and restoring economic growth. The best way to do both is to give up cap-and-trade and learn to love carbon-based taxes.

Robert Shapiro, co-founder of the U.S. Climate Task Force and head of the economic advisory firm Sonecon, was undersecretary of Commerce in the Clinton administration.