One of the more interesting misunderstandings about cap and trade is the idea that cap and trade systems provide certainty about the quantity of emissions. This is true in the world of supply and demand diagrams, but it doesn’t translate to the real world without a lot of additional conditions. These conditions are pretty hard to satisfy.
Start with the wonderful supply and demand diagram we economists use for almost everything. It has two dimensions. Value goes on the vertical axis with price. On the horizontal axis we put quantity. Quantity actually stands for the amounts that people buy and sell, so the horizontal direction is really about behaviour. A cap on any product appears as a vertical line and a statement about how people are allowed to behave: no one is allowed to buy or sell beyond that line. If you can enforce this rule perfectly you can limit emissions precisely.
Of course at this stage your cap is all theory. In the real world you have to set the caps, then monitor actual behaviour, and then enforce the rules. The nice neat vertical line on the graph turns out to a blurry, thick collection of rules, behaviours, arguments, forms that have to be filled out, forms that have to be read, filed and stored, interviews with people who seem to be breaking the rules, discussion with lawyers, and then going back to revise the rules.
The cap and trade system only works if you set the caps correctly (hard to do politically when every company and every industry is in the Minister’s office begging for exceptions), if every one who should be capped is capped (nearly impossible technically), if surveillance is intensive enough to catch people who exceed their caps (definitely expensive and unpopular), and if the caps are enforced (this is surprisingly difficult especially in countries that have already cut back on environmental and heath inspections).
In practice the largest trading system to date has failed on every one of these conditions. The European system has improved, but it is still costly and full of holes. The holes are there because politicians were convinced to leave those holes. Maybe a cap and trade system will work with no politicians, but that hasn’t been tried yet.
So short-run certainly under a cap and trade system requires setting, monitoring and enforcing caps, avoiding offsets, and comprehensive caps. Long-run certainty is even harder to provide unless there is
1) a mechanism for laying out the path of of the aggregate cap for 20 years,
2) a demonstration of willingness to be tough, and
3) a way of committing future governments.
Without those there is no certainty, just an abstract principle derived from a graph.
In fact it is far cheaper to satisfy all the requirements with a Fee and Dividend system. The tax system is cheap to run. Cutting the population in on the revenues with a dividend locks the government in because it is hard to take back a transfer to the public. A dividend therefore serves as a commitment mechanism. It allows the government to make a credible commitment to raising the tax over time, reducing uncertainty about whether the government will follow through tighter controls. Overall a tax and dividend approach provides more real certainty about reducing emissions than a cap and trade system can.
Did you know that the State Grid Corporation of China is the largest power company in the world? Or that it ranks 7th on the Fortune Global 500? Did you know that SGCC is a partner in Caring for Climate, the UN’s Initiative for Business Leadership on Climate Change”? That over 300 companies have signed on with Caring for Climate asking for a price on carbon? Or that only four Canadian companies have signed on so far?
Did you know that approximately 40 countries and more than 20 cities, states and provinces use carbon pricing mechanisms or are preparing to implement them? (There is a very good map on page 27 of the Ontario discussion paper on climate change) Carbon pricing is coming, and the key question is which version.
The two main models are the carbon tax and carbon permit trading (cap and trade). The province is trying to figure out which to use.
My approach is to start with the core idea: we want to make burning fossil fuels more expensive so people gradually shift to other products and find ways to reduce their fossil fuel use. To do this, both apporaches raise the cost of using fossill fuels for consumers.
With a tax, the increase in price goes to the government collection office.
With cap and trade the increase goes to corporations. They spend quite a lot on lawyers and finacial specialists and on filling in forms to show they havn’t cheated on their permits. The goverment collects some of what is left. How much the government gets depends on how tough the government is, but it will be a lot less than is taken from consumers. Then the government has to spend a good deal on regulation and checking up on the corproation. Cap and trade always invovles high `transactions costs.’
So what happens to the money then? The large sum from taxation or the much smaller amount left over with cap and trade still has to be spent or the economy will be seriously hurt.
Who should spend it?
I think consumers should. The reason to pricing carbon is to correct a distorted price system. Taxing and giving the money back to consumers does that job without hurting them. Correctiing the price system without hurting consumers is something voters will agree to.
The problem is that with cap and trade there is so much waste in the system you cannot avoid hurting consumers. To avoid the waste you have to go back to a carbon tax. No matter how you play it a carbon tax hurts consumers less.
Using the money for other purposes adds unnecesary complications. You are asking consumers to agree to a double-barrelled question: “Can I fix the price system and at the same time spend some of your money for other things”. You are confusing the issue, you driving everyone who disagrees with either project into the same tent. You are looking for trouble.
To Tax or Cap, that is the question for Glen Murray (Ontario’s Minister of the Environment and Climate Change).
Murray is conducting a province-wide consultation on climate policy. He will be in Sudbury from 6 to 8 pm.on March 5 at the Steelworkers Hall. Citizens will get perhaps 10 minutes each to present their ideas.
I hope someone presents the new study that Pethig and Eichner presented at a recent conference on Energy, Resources and Consumer Protection. “Self-enforcing international environmental agreements and trade: taxes versus caps” shows that a carbon tax is superior to a cap and trade system because a tax regime is more able to support a system of “Self-reinforcing International Environmetal Agreements” (SR IEAs).
This one study would take more than ten minures to present, of course, but let me summarize it for you.
In 2012 Pethig and Eichner showed that, with cap-and-trade, regulation stable coalitions are very small and hence ineffective. This is a way of saying you can never get inclusive and comprehensive international agreements among countries using cap and trade. This is a theoretical result that seems to support the position that Stephen Harper took on the Kyoto Protocol.
In their current paper Pethig and Eichner turn the result upside-down. In theory, cap and trade can deliver the same result within a country as a carbon tax. Since the two systems are supposed to be equivalent, no on had looked at the international effect of using taxes instead of cap and trade.
Pethig and Eichner find that effective international coalitions are possible “if climate policy takes the form of emission taxation.” This puts Glen Murray on the spot. Economic theory now says he has to support a Carbon Fee if he wants to encourage a strong international system to control carbon emissions.
How strong are the results? The authors warn against over-generalizing. The simple fact, though, is that this is the best model we have so far.
Is it really possible to form self-enforcing international agreements even with carbon taxation? The model says that it is only possible under certain conditions. That is a bit discouraging. On the other hand, the authors don’t include one of the basic tools of international diplomacy: bullying. If a major importer like the USA were to adopt a carbon tax and say to its trading partners “You can’t trade with us unless you have an equivalent carbon price,” getting an agreement is suddenly a lot easier. Ontario could play this game within Canada.
This isn’t an easy paper to read. I pity anyone who attempts to explain it to Glen Murray in a public consultation. Even so, the new paper should be part of the discussion. Any volunteers?
One worrying feature of the result is that even with a tax the international agreements are only stable if the climate change damage is relativeley small and if the cost of producing fossil fuels is relatively high. That suggests that making progress will be hard, because the costs of climate change seem to be pretty large and fossil fuels really are cheap.
One interesting detail is that the Pethig and Eichner model returns all the revenue from the tax to consumers. This is just an analytical convenience – it simplifies the math – but it means we don’t have to do any more work if we want to apply this result to the Fee and Dividend approach supported by the Citizens’s Climate Lobby. Their previous model used the same assumption, by the way.
We are so smart it hurts!
People have so many clever ideas. They have clever reasons for thinking democracy is a failure, that voting is a waste of time, that politicians are all corrupt, that governments can’t be trusted with tax money, that only individual action is worthwhile, that individual action is hopeless.
Here is an example. Steven Cohen, Executive Director of the Earth Institute at Columbia University has a fairly recent piece arguing that no-one should waste time trying to price carbon.
Cohen believes that “The real battle — and the one we should be fighting — is not over the economics of carbon, but over public funding of the basic research needed to make the transition to a fossil fuel-free economy.”
As an economist I am tempted to say that Cohen doesn’t really understand how raising the price of carbon will promote the basic research needed to make the transition to a carbon-free economy.
I am also tempted to argue with him over whether it really is impossible to get other nations to accept a carbon pricing scheme. China is alreading exploring carbon pricing, so Cohen may simply be wrong. And I am not sure we even need to get others to accept an international pricing scheme: we could say to nations like India that want to sell to us, “You charge a carbon tax on on what we import or we will.” It is pretty obvious that the US, the world’s largest import market, has the power to impose a carbon tax on imports.
But Cohen is absolutely right about expanding basic research. I support his argument that far.
I just think he looks a bit dumb asking people to develop new low-carbon technology while we continue to subsidize competing fossil fuels. That is called trying to suck and blow at the same time. Cohen has some clever ideas, but a good part of his cleverness might be wasted saying why only his ideas will work.
And maybe I make the same mistake sometimes. Don’t you?
Another nail in the (intellectual) coffin of Cap and Trade
(spoiler alert: bad pun a the end of this note)
In a new paper, Jessica Coria and Jurate Jaraite show that the cost of running an emissions trading system is higher than the cost of a carbon tax. The paper is called Carbon Pricing: Transaction Costs of Emissions Trading vs. Carbon Taxes.
Lets start with some details about the study. Coria and Jaraite compare the Swedish CO2 tax and the European Union’s Emissions Trading System (EU ETS). The transaction costs they look at are the costs of monitoring, reporting and verification (MRV), essential parts of any emission trading system that are not needed with a tax system. Empirical evidence indicates that these costs, at least in the case of the EU ETS, are the most important costs of compliance, with a share that might exceed 70% of the total transaction costs. The study does not include implementation costs as both the CO2 tax and the EU ETS have been in place for many years.
The transaction costs they consider do not include the cost of running a trading system, by the way. They only include the costs involved in making sure that polluters are not cheating. I have not yet found an estimate of the cost of the trading systems, but they should also be included in the calculation.
The result is exactly what any economist would predict, and not really a surprise. The authors find that the average MRV cost is 2.6 €/t CO2 higher for firms under the trading system. If they include also external costs, trading costs firms 7.4 €/t CO2 more than a tax would. These costs are large compared to the actual carbon cost and ultimately are paid by consumers.
Coria and Jaraite also found that that most firms agree or strongly agree with the statement that the EU ETS is too burdensome for small emitters. This is a fairly devastating criticism, since it means that complete coverage with a trading system will be costly and will therefore be resisted. Cap and trade systems are likely to be a trap for politicians attracted to the apparent low political cost of implementation: they will be hard to improve.
The Coria and Jaraite paper matters because it provides some numbers and takes away any chance to pretend that carbon trading is efficient.
Proponents of emission trading system argue that in theory trading systems has some (still unmeasured) efficiency gains relative to a tax on carbon. They have almost always ignored the costs of running their system. Now that a subset of the transactions costs have been measured, they have to show that the theoretical gains they claim for their particular trading system are at least as large as the extra transaction costs involved.
It is also important to notice that in theory a tax (or a “fee”, as many like to call it) works as well and as cheaply when you include very small CO2 emitters, while a trading system gets more costly as you include smaller emitters. Not surprisingly, Coria and Jaraite find that cost per ton of CO2 emissions is the largest for the smallest firms. To illustrate with a slightly silly example, it isn’t worth the effort to trade an emission permit for a backyard barbeque, (“Honey, I can’t barbeque tonight. I forgot to pick up an emissions permit when I was at Canadian Tire!”) A tax automatically gets the barbeque, but transaction costs make it cheaper to ignore the barbeque, as trading systems do.
This paper is a nail in the intellectual coffin of cap and trade systems. Unfortunately, the undead are not quite ready to lay down in the box and be nailed in. Cap and trade systems are still out there eating the brains and the lunches of innocent people. ( Sorry for that – I just couldn’t resist the metaphor once I started with “nail in the intellectual coffin of Cap and trade.”)
Please pass this note on to your favorite provincial or federal politician.
So here is a question for you. For all intents and purposes I am the local expert on methods of pricing carbon. As an economist I know that a Carbon Fee and Dividend is the best way TO START to deal with the threat of massive climate change. So how do I get the message across here in Sudbury?
Kim Campbell was accused of saynig that an election is no time to discuss important issues. She didn’t say that, so I spent the last month in a by-election arguing that action on climate change has to be a priority for the government of Ontario. I’ve been explaining to everyone who would listen that the best approach is the Carbon Fee and Dividend. (It didn’t seem that the Liberal, NDP or Conservative candidates had any interest in the topic and it was clear they didn’t understand the economic issues invovled.)
Now that the election is over, how do we take the right solution a big problem to the people? Do you have an idea? Do you want to help?
Do you have a service group, club, highschool class, church group or Chapter of Muski Canada that wants a speaker? Could you set something up? I promise to entertain and inform.
How about organizing a back-yard tea party or beer session once the weather warms up? I’ll bring a six pack!. (or tea). What else coud we do?
People usually llike the idea of a Carbon Fee and Dividend once they understand it. It is simple, it is pretty nearly painless, and it is much better than the alternatives. Discussions can be lively.
This is real news: Weasels and Liars lose!
Climate scientist and Green MLA Andrew Weaver has won his lawsuit agianst the National Post. Weaver sued the Post over four articles published between December 2009 and February 2010. The articles suggested Weaver was misrepresenting facts about climate change and trying ot mislead the public about the fossil fuel industry. I saw the articles as an intentional attack on Weaver’s professional integrity.
It is well know that the National Post has attempted to discredit anyone who doesn’t agree with their loony views (Notice that I’ve given up on taking climate change deniers seriously. The alternatives descriptions for climate change deniers and weasels, in my view, are “stupid,” “ignorant” and “dishonest”. Choose one. Please sue me, National Post editors).
The judge agreed with Weaver. She concluded that “the defendants have been careless or indifferent to the accuracy of the facts. As evident from the testimony of the defendants, they were more interested in espousing a particular view than assessing the accuracy of the facts.”
Andrew Weaver is the MLA for Oak Bay-Gordon Head and deputy leader of the B.C. Green Party. He is a Lansdowne Professor at the University of Victoria and a Fellow of the Royal Society of Canada, the American Meteorological Society, the American Association for the Advancement of Science and the Canadian Meteorological and Oceanographic Society. He is the author of “Keeping our Cool: Canada in a Warming World” (Penguin Canada, 2008) and “Generation Us: The Challenge of Global Warming” (Orca Books, 2011).