The great carbon debate

In the first of a two-part series, Robert J Shapiro argues that only a carbon tax, not carbon trading, can effectively tackle climate change.

At a 2007 International Climate Change conference in Sydney, keynote speaker Robert J Shapiro argued that the current global focus on carbon trading as a means of tackling climate change is misguided. The article below is an edited extract of his paper, in Climate Change: Getting it right, published by the conference host, the Committee for Economic Development of Australia. This article was originally published on November 16, 2007.

The carbon tax - an alternative to carbon trading

A solid consensus has emerged among scientists and most public officials around the world that emissions of greenhouse gases from burning fossil fuels, especially carbon dioxide (CO2), contribute significantly to climate changes which could have very serious, adverse effects.

The two most prominent strategies for reducing greenhouse gases are a global system of national caps on the emissions and tradable permits, modelled on the Kyoto Protocol, and global, harmonised, net carbon-based taxes.

Recent economic analyses and evidence strongly suggest that carbon taxes would be a more environmentally effective and economically efficient way to address climate change than a cap-and-trade system, and provide stronger incentives to develop alternative fuels and more energy-efficient technologies.

Both of the two principal policy approaches necessarily result in higher prices for fossil fuels, but in different ways.

Carbon taxes raise the price of carbon-based energy directly, predictably and in a constant manner, imposing the greatest costs on those firms and economies that produce the most emissions. In so doing, carbon taxes create direct incentives to reduce carbon-based energy use or substitute cleaner forms of energy, until the cost of doing so is greater than the tax.

A serious cap-and-trade program applies no direct charge to emissions up to its cap, but the cap for the system is set below its current or forecast emissions.

The two approaches differ in several important ways. The critical economic distinction is that cap-and-trade directly controls the quantity of emissions, while carbon taxes directly control their price.
The result is that cap-and-trade can produce a designated quantity of emissions, but with much greater potential volatility in energy and energy-related prices, while carbon taxes will produce more certain prices for energy and energy-intensive goods, but greater uncertainty about the quantity of total emissions.

These two trade-offs are not equivalent.

By regulating the quantity of emissions, a strict cap-and-trade program will drive the price of permits to whatever level is required to bring emissions under its cap.

The price of permits and their underlying energy source will rise sharply when emissions increase, because, for example, an industry or country’s growth accelerates or the winter weather is colder than expected.

This price volatility is both evident and substantial in both the emission permits traded under the US acid rain program, the major US example of cap-and-trade, and in the first 22 months of CO2 permit trading under the European Emissions Trading Scheme (ETS).

A carbon tax does not increase or accentuate the volatility of energy prices because it raises the unit-cost of energy by a constant amount (depending on its carbon content), regardless of how fast a company, industry or nation’s emissions are growing.

While the tax will reduce emissions by raising the relative price of more carbon-intensive fuels (and lowering the relative price of less carbon-intensive alternatives), no one can predict the precise extent of those effects for any particular level of carbon tax, and consequently the tax may be set too low to achieve a particular emissions goal in a given year. However, this shortcoming is more easily offset than the price volatility of cap-and-trade.

The environmental costs of greenhouse gases occur over a long term, and in principal a government can raise or lower the carbon tax rate year by year to achieve the long-term emissions reductions it seeks.

While some proposals for cap-and-trade systems include provisions to reduce price volatility by auctioning or distributing additional permits when permit prices increase sharply, these provisions address the price volatility after it has already occurred and taken a toll on investment.

A second important difference is that global carbon taxes have generally comparable effects from country to country, while a global cap-and-trade program usually does not.

A global cap-and-trade system creates a range of effects and incentives across countries, depending on the base from which it calculates the emissions targets for each country. Once a cap-and-trade agreement determines that a country’s emissions should be reduced by a certain percentage relative to its current emissions or to its emissions in a previous base year, the country may be able to meet its target without taking any steps if its economy slows – or it could take serious measures to reduce emissions and still fail to meet its target because its economy is growing faster than normal.

The third important difference is that cap-and-trade programs are more difficult to administer and more vulnerable to evasion, corruption and manipulation than carbon taxes.

The administration of a net carbon tax is straightforward: Each country would apply a tax rate to every energy source, which, after counting the country’s current energy taxes and subsidies, would produce the global net carbon tax rate. Each country could also collect the receipts using the same mechanisms it relies on for existing energy or business taxes. Under cap-and-trade, each country first has to create a new system to distribute its national cap among its energy-related industries and their thousands of companies and plants in the form of permits; then it must set up a monitoring system to track energy production at every site before and after permits are traded.

Cheating also poses a more serious problem for cap-and-trade than carbon taxes. While some companies will try to evade their taxes, the government on the other side of the transaction has a strong interest in discovering and stopping it. Under cap-and-trade, if a company fraudulently understates its energy production and emissions so it can sell permits for some of them, the buyer on the other side of the transaction has no incentive to uncover or reveal the fraud.

As a result, Yale economist William Nordhaus has concluded that "cheating will probably be pandemic” under cap-and-trade.

Given these drawbacks, cap-and-trade’s principal attraction appears to be political feasibility. Many environmental activists assume that a global cap-and-trade program is more achievable than global carbon taxes, because much of the world agreed to Kyoto and most people resist higher taxes.

People and companies in every country resist higher taxes. Yet Sweden and Denmark have applied carbon taxes, or their equivalent, and are now among the most emission-efficient economies in the world.

On balance, if the world community intends to take serious steps to slow and ultimately reverse climate change, the evidence strongly suggests that a global carbon tax would be preferable to a global cap-and-trade system on economic, environmental and even political grounds.

Robert J Shapiro is chairman of Sonecon, a private firm that advises US and foreign businesses, governments and non-profit organisations. He has worked as senior economic advisor to, amongst others, President Bill Clinton, Al Gore and Prime Minister Tony Blair.

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