Cap-and-trade schemes and price increases

2009-03-10

in Economics, Law, Politics, The environment

Bike and brick wall

An exciting element of the new American administration’s climate change agenda is the promised cap-and-trade scheme for greenhouse gas emissions. During the campaign, Obama pledged that the system would auction 100% of the permits. The government would issue a set number of permits each year, which firms would need to bid for competitively. That way, the price of permits would be established through a market mechanism and whatever opportunities existed to mitigate emissions for a lesser cost would be captured. The revenues from the auctions could be used in various ways.

One big rhetorical counter-argument, employed largely by those seeking to stall the regulation of greenhouse gasses, is that this will increase consumer prices. At least when it comes to greenhouse gas intensive products, this is necessarily true in the short to medium term. The whole idea behind carbon pricing is to alter the relative cost of high-carbon and low-carbon goods: encouraging people to switch from the former to the latter, and generally minimize the consumption of high-carbon goods altogether. Prices are an important mechanism through which this information is conveyed. Also, the existence of a significant and rising cost of carbon is necessary to drive the kind of investments required to produce a low-carbon society.

There are a number of important responses to the point about raising prices. Firstly, it is important to highlight how the transition to a low-carbon economy is necessary and one-off. Putting society on a sustainable footing is a huge task, but also one of humanity’s biggest opportunities. Managed properly, our response to climate change can establish key parts of the foundation for a sustainable society. Secondly, it is key to realize that energy companies will pass along the cost of permits, even if they receive them for free (this previous post explains why). This leads to the third point, about the importance of where the funds go. In a system where permits are ‘grandfathered’ and given to power plants and industrial facilities for free, the price increases will translate into profits for those polluting firms. Cap-and-trade revenues, however, go into the public coffers. They can then be used to help individuals deal with the difficulties of economic transition, reduce taxation elsewhere, and help fund green infrastructure projects.

The 100% auction plan is certain to face stiff opposition in Congress. In spite of that, it is very much worth putting through. It is far better to get a weak but decently-designed system in place, ready to be tightened up later, than introduce something that is compromised from the start. Putting a small but real price on every tonne of emissions is thus better than entrenching a system of free emissions for favoured firms, even if non-favoured firms face higher initial carbon prices. Here’s hoping the Obama administration has the resolve and skill required to really kick off America’s urgent transition towards carbon neutrality.

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{ 19 comments… read them below or add one }

R.K. March 10, 2009 at 1:56 pm

Secondly, it is key to realize that energy companies will pass along the cost of permits, even if they receive them for free

Is there any way to design a ‘grandfathered’ system that will avoid consumer price increases?

. March 10, 2009 at 2:15 pm

Federal Cap-and-Trade System: 100% Auctions

By Clark Williams-Derry

Geez, I thought we were done with the Obama blogging for the week, but apparently I just can’t help myself. Take a look at what the administration is asking Congress to send it in the way of Cap & Trade legislation (see page 21 of the main budget document, which you can get here).

To me, this has all the right ideas: steep reductions in emissions; full auctioning of carbon permits to prevent windfalls by polluters; and a good mix of investments in clean energy and rebates to consumers.

Who knows what Congress will eventually give us — but this is the exact right proposal to get the ball rolling. And let’s hope that legislators in Washington and Oregon, who are contemplating a regional cap and trade program, will consider the US proposal as a model.

. March 10, 2009 at 2:24 pm

Cap-and-trade on steroids
More perspectives on tax/auction revenue allocation
Posted by Ken Johnson

Chaz Teplin gave some approximate numbers for how much Obama’s cap-and-trade plan would raise energy prices (based on a $14.30/MT carbon price):

Effect of the Obama carbon price

* Petroleum fuel: adds 15¢/gallon
* Electricity: adds 0.8¢/kWh (compare to 7-10¢/kWh residential rates)
* Natural gas: adds 8¢/therm (compare to 85¢/therm residential rates)

Potential effect of the Obama carbon price on renewables (10% of market)

* Sustainable biofuels: subtracts $1.50/gallon
* Renewable electricity: subtracts 8¢/kWh
* Solar heat, CHP, etc.: subtracts 80¢/therm equivalent

Magictofu March 10, 2009 at 3:21 pm

Milan, I know you’ve been reading quite a bit on these topics so allow me to ask a few questions that I never took the time to scrutinize.

Given that both cap-and-trade and a carbon tax could have identical results on carbon emissions, are there differences between these two systems that should be addressed, for instance:

Which of the two options provides the greatest levels of revenue to government?

Which one is better suited to adapt to unforeseen changes in the economy between auctions or tax rate reviews? (e.g. economic slowdown, trade conflicts, surge in energy demand, etc.)

Which of these two tools is the least costly to implement and manage from the government perspective?

Milan March 10, 2009 at 3:31 pm

Given that both cap-and-trade and a carbon tax could have identical results on carbon emissions

This isn’t necessarily true, in theory or practice. A cap-and-trade scheme with a hard cap would ensure that emissions in any particular year are below a set level. A carbon tax would not do that, but it would provide certainty about the cost per tonne of carbon emissions.

The two options also differ in terms of the politics and bureaucracy of implementation.

Which of the two options provides the greatest levels of revenue to government?

Either could. Setting a low cap would make permit prices high, as would setting a high tax. If permits are given away, they won’t generate revenue. Likewise, with taxes that are refunded (as with tax-and-dividend schemes, where revenues are shared out equally among taxpayers).

Which one is better suited to adapt to unforeseen changes in the economy between auctions or tax rate reviews? (e.g. economic slowdown, trade conflicts, surge in energy demand, etc.)

I think this comes down to how each is designed. Personally, I don’t think the system should be set up to allow month-to-month tweaking in response to economic changes. The point is to set long-term incentives for mitigation. That doesn’t happen if you set up a volatile system, or one that gets manipulated for political reasons. Imagine if an unpopular government was to cut carbon taxes before an election, for instance.

Which of these two tools is the least costly to implement and manage from the government perspective?

There is a pretty big debate about this. Personally, I think a carbon tax applied at the point where fossil fuels are produced or imported would be the simplest and least expensive policy to implement. The fuel producers and importers would then pass the costs into the rest of the economy.

Milan March 10, 2009 at 3:32 pm

In the end, a well-designed cap-and-trade system is better than a poorly designed carbon tax – and a well-designed carbon tax is better than a poorly-designed cap-and-trade system.

The challenge is less in making sure one or the other approach wins out, and more in ensuring that either is implemented in an environmentally effective way.

Magictofu March 10, 2009 at 4:47 pm

Thanks for the quick reply, I do realize that, in the end, the way the instrument is designed matters much more than the type of instrument used. I am trying to understand why some people are so entrenched in one camp or the other in terms of cap-and-trade vs. carbon tax and my questions reflected that.

I have heard a lot of people arguing that a carbon tax would be simpler to implement and manage and that it would provide more flexbility in the short term given that a trully efficient carbon credit market would take time and a lot or trials and errors to establish.

On the other hand, you have other people arguing that cap-and-trade is simply an easier tool to reach emission targets and that it is generally perceived more favourably by citizens.

Milan March 10, 2009 at 5:05 pm

I think cap-and-trade might be simpler to implement, politically – at least until major emitting firms realize that you are serious about auctioning the credits (at which point they will call it a ‘stealth’ carbon tax).

There have definitely been problems with Europe’s cap-and-trade scheme. Partly on account of that, I do think there is something to the notion that cap-and-trade schemes are trickier to get up and running properly.

As for why people come down so strongly on one side or the other, I am not sure. It may be a similar phenomenon, psychologically, to the way in which people buy into an argument in the discussions on this site, then hang onto it for dear life thereafter.

Milan March 10, 2009 at 5:10 pm

Intuitively, I have a slight preference towards a carbon tax. It is simpler to relate to the ethical issues: “Your tonne of emissions is doing some level of harm to others, and this tax is a partial reflection of that.” You can make the same point about a cap-and-trade scheme, in a more roundabout way.

Another factor to remember is the possibility a ‘safety valve’ will be built into a cap-and-trade scheme. If so, it basically transitions into being a carbon tax at the point where credits rise above a set price. This removes the benefit of certainty about emissions, but reduces the economic uncertainties associated with compliance. It gives firms a predictable maximum cost.

Magictofu March 10, 2009 at 8:22 pm

From your perspective then, would you say that Canada’s proposed GHG regulations (Turning the Corner) is closer to a tax than a Cap-and-Trade system? I have trouble finding a way to characterize it.

Magictofu March 10, 2009 at 8:24 pm

“As for why people come down so strongly on one side or the other, I am not sure. It may be a similar phenomenon, psychologically, to the way in which people buy into an argument in the discussions on this site, then hang onto it for dear life thereafter.”

It hurts… but point taken.

Milan March 10, 2009 at 8:35 pm

As initially described, TTC is neither a carbon tax nor a cap-and-trade system.

It is based on emissions intensity.

That means it restricts the emission of more greenhouse gasses per dollar of output. It also includes a number of compliance mechanisms that don’t require you to restrict output, even if it is growing more quickly than revenue. For instance, you can pay into a ‘technology fund.’

Magictofu March 10, 2009 at 8:56 pm

I understand TTC well enough, but I find it hard to label what it is exactly…

It feels like a tax on the emissions in excess of what is being allowed by the regulations but a tax that can be paid in a variety of ways (I think they call it compliance options), including exchangeable credits like in a cap-and-trade system or, as you mention, through a technology fund that will benefit the firm financing it (in a way very similar to a tax-to-subsidize scheme).

R.K. March 10, 2009 at 9:00 pm

You could call it ‘a gift to the oil and gas industry.’

Neal March 11, 2009 at 11:24 am

Personally, I would have hoped that the current economic turmoil would have hurt the public perception of cap-and-trade relative to a carbon tax. I don’t understand what’s so appealing about giving the financial sector yet another opportunity to extract rents from the rest of the economy.

Milan March 11, 2009 at 11:29 am

I don’t know if there is much informed public perception on either approach to alter. I doubt whether the vast majority of people (and, probably, lawmakers) could explain how a cap-and-trade system would work. A carbon tax is more comprehensible.

. March 11, 2009 at 12:27 pm

Who Pays for Cap and Trade?
Hint: They were promised a tax cut during the Obama campaign.

MARCH 9, 2009

Cap and trade is the tax that dare not speak its name, and Democrats are hoping in particular that no one notices who would pay for their climate ambitions. With President Obama depending on vast new carbon revenues in his budget and Congress promising a bill by May, perhaps Americans would like to know the deeply unequal ways that climate costs would be distributed across regions and income groups.

Politicians love cap and trade because they can claim to be taxing “polluters,” not workers. Hardly. Once the government creates a scarce new commodity — in this case the right to emit carbon — and then mandates that businesses buy it, the costs would inevitably be passed on to all consumers in the form of higher prices. Stating the obvious, Peter Orszag — now Mr. Obama’s budget director — told Congress last year that “Those price increases are essential to the success of a cap-and-trade program.”

. March 11, 2009 at 1:08 pm

WSJ fail
Wall Street Journal editors make bone-headed mistake; get called on it; fail to correct
Posted by David Roberts at 9:45 AM on 11 Mar 2009

The Wall Street Journal editorial page has been an organ for intellectually dishonest, fanatically ideological douchebaggery for years and years. That they publish something stupid is scarcely worth noting. But recently WSJ editors made a mistake so egregious it crossed the line into malpractice — and to boot, refused to correct the mistake, or even publish a letter that pointed it out.

. March 26, 2009 at 2:09 pm

Would you pay $2,000 per ton for your carbon footprint?
Cap-and-rebate is more robust in the face of carbon high prices
Posted by Adam Stein

Americans have an average carbon footprint of 24 tons per year. As a thought experiment, imagine I offered you the following deal: every year, I’ll charge you $2,000 per ton of your personal emissions. I’ll also offer you a guaranteed $48,000 annual rebate. Would you take the deal?

I bet most Americans would. Think about the behavioral changes that would follow. Every gallon of gas now costs you about $20. Of course, you’ll be able to afford it because I’m handing you a huge check every year. But that Prius is starting to look a lot more attractive, to say nothing of your bicycle. A single cross-country flight is now going to set you back about $2,500. Again, you can swing the expense. But is there something else you’d rather spend $2,500 on? Maybe it’s really important for you to spend Christmas with your family. Or maybe you can send them an e-card.

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