CRAIG PIRRONG JANUARY, 2009 Efficient Carbon Policy: Taxes vs. Cap & Trade

Externalities An externality exists when one individual’s (or firm’s) actions confer a cost or a benefit on another “Bads”—pollution “Goods”—Bees Externalities can exist when transactions costs preclude negotiation of mutually beneficial deals between affected parties If government can lower transactions costs (e.g., through regulation), state intervention to “correct” externalities can be justified

Transactions Costs Collective action problems—an externality may affect large numbers of people, and coordinating their actions may be prohibitively costly, especially due to “free rider” problems Informational asymmetries—information about costs and benefits likely to be private. Private information can create negotiation costs

Carbon Externalities Carbon is a “bad” to the extent that it causes costly changes to climate Transactions costs likely to be very high—if anthropogenic global warming is indeed a threat, it affects everybody Private information, especially about abatement and adjustment costs, is likely to be pervasive Thus, there is a potential justification for gov’t intervention

Types of Intervention Command & Control Tax Cap & Trade Hybrid (C&T, with a tax paid on emissions over the cap)

Command & Control Tell everybody what to do EG, every power plant must cut emissions by X percent This is likely to be very inefficient—some plants can cut emissions more cheaply than others “Sophisticated” command and control is very informationally demanding and almost certainly encourages high transactions costs and rent seeking

Taxes Classical “Pigouvian” solution—levy a tax on every unit of carbon emitted Given the right information, possible to choose a tax that gives the appropriate incentives and leads individuals to choose the efficient level of emissions

Cap & Trade Cap & trade works by (a) imposing a ceiling on the total amount of carbon released, (b) allocating the rights to emit carbon, and (c) permitting the rights holders to trade them Given the appropriate information, it is possible to choose the ceiling to equal the “efficient” amount of carbon Trading of rights mitigates private information problems, and ensures that carbon reduction achieved in the most cost-effective way

The Big Caveat The the foregoing arguments that either a cap & trade or a tax system can achieve an “efficient” outcome were predicated on the assumption “given the right information” Problem: In the real world—information is costly, widely dispersed, and hence almost certainly unavailable to the policy maker This raises the question—which mechanism is most robust to uncertainty about the costs and benefits of carbon reduction?

The Weitzman Analysis Weitzman (1974) addressed this question in detail His conclusion was that the relative advantage of taxes vs. quantity controls depends on the slopes of the marginal benefit and marginal cost of abatement “Flat” marginal benefits favor taxes “Flat” marginal costs favor quantity control Uncertainty about costs matters—uncertainty about benefits doesn’t

Implications Best available evidence (predicated on climate models) is that marginal benefits of CO2 abatement are virtually constant—this favors the use of taxes rather that C&T Hybrid schemes may in fact be the most efficient Learning about costs & benefits over time + policy flexibility + good political incentives tends to diminish uncertainty and reduce differences between tax and cap systems

Political Economy Considerations “Political Economy” considerations are also relevant Since taxes generate revenues, politicians may be motivated to choose the tax not on efficiency grounds, but on revenue maximization grounds Carbon taxes likely to be “silent” taxes—their costs are hidden in the prices of goods Lobbying and rent seeking to choose discriminatory taxes that favor one group over others C&T can also generate rent seeking, especially at the beginning of the process when tradeable rights are initially assigned (grants vs. auctions)

Enforcement Enforcement costs can also differ across regimes Tax collection mechanism already in place, and it is relatively easy to tax point emissions (importance of latter point probably overestimated) Governments have an incentive to collect taxes—i.e., an incentive to ensure people play for emissions Government incentives to enforce quotas may be weaker (e.g., Europe, 2006)

Enforcement (con’t) Proposed C&T schemes are often very complicated (e.g., offsets) Complexity raises enforcement costs But... A tax scheme that encourages investments that absorb carbon would be similarly complex Corruption—present in both systems

Volatility Carbon prices in a C&T scheme are likely to be quite volatile, especially in the early years of the scheme Contract design (expiration of credits) will contribute to this volatility Taxes may be more predictable (though this depends on credibility of government commitments) Volatility tends to discourage carbon sensitive investments Hybrid scheme could mitigate this problem

Verdict Political economy considerations most likely favor C&T It is widely argued that enforcement considerations favor taxes, but this advantage likely overstated Information costs favor taxes Volatility favors taxes So, if forced to choose.... I would probably opt for taxes, or a hybrid scheme which effectively caps the carbon price But... Politicians in their infinite wisdom have chosen otherwise... Hence our focus on cap & trade