Cap and Trade vs. Carbon Tax

The argument that an effluent charge on greenhouse gasses would be economically disruptive and politically infeasible and that therefore we should prefer a cap-and-trade system is incoherent. Sauce for the goose is sauce for the gander: either one, done at the appropriate level, will lead to dramatic changes in relative prices and require political heavy lifting.

The Waxman-Markey Climate Bill sets up a so-called “cap and trade” framework to reduce greenhouse gas (GHG) emissions. The canonical alternative approach is commonly though incorrectly, called a carbon tax. In the current Grist, Joseph Romm tees up James Hansen, a distinguished climate scientist, for preferring the latter to the former.

Romm’s piece is one of the least helpful I’ve come across on this important issue and deserves some heavy rebuttal. First, though, why not “carbon tax?” Because it isn’t a revenue raising mechanism to fund government services, but a charge for using a valuable environmental resource (the ability of the earth to tolerate greenhouse gas emissions), and the word tax attracts inappropriate political hostility. Carbon charge, maybe, but climate injury charge would be much better, as it should cover release of any greenhouse gas, including (for example) N2O, which has no carbon in it, and I’m going to call it that (CIC). A CIC obliges everyone to pay the real cost (to everyone) of this valuable economic resource when he consumes some, an obligation shown again and again to wonderfully concentrate the mind on ways to consume no more of it than is worthwhile (to everyone). The best thing to do with the proceeds of a CIC is to give it right back to citizens as a sort of negative tax, though how progressive the refund should be and how it’s distributed is an interesting issue for debate.

Romm’s main points are three. First, he flatly declares a CIC to be politically impossible. But any good policy not yet enacted is tautologically politically infeasible: if it weren’t, it would have been feased already. It becomes feasible after public deliberation and analysis makes it so, so it’s vacuous to trip up that process with the political infeasibility rap. In the present case, opinion in very divers quarters is moving (from a low base) steadily toward a CIC and away from cap and trade (CAT) as people start thinking seriously about what a nightmare CAT will be and about the many ways it is likely to fail. The less ill-informed dissing of a CIC we do now, the easier it will be to replace CAT with what economists universally agree to be a superior (not perfect, not sufficient on its own; see below) way to reduce global warming when the time comes.

His second point is only half a point, in the spirit of “…and now, a partial score: Buffalo 3”: A CIC would not be simple. Right; in fact, two sentences later, he notes that Waxman-Markey’s CAT is complicated. So this is a tie; on to

Point 3: A CIC is not a complete climate strategy. Also right, but Romm’s reasons are flat wrong. In fact neither a CAT nor a CIC will suffice to control GHG properly but it’s because various market failures, of goods that are complements to doing the right thing, need other programs to correct them, not because the CAT has mysterious power to cause compliance in the face of resistance. Example: I can be motivated to the skies not to drive my car by a very high CIC (in the form of gasoline prices) or by a CAT that rations gasoline or drives its price up, but “not driving” requires things like dense urban development, public transit, or bike paths and I cannot buy any of them myself, as they are public goods. The principal weakness of Romm’s discussion, in fact, is that every criticism (except his political tea-leafery) he levels at the CIC applies, though usually with more force, to the CAT.

Romm’s main challenge to a CIC is familiar from the earliest battles between the lawyers and the economists in environmental policy making. He claims, in essence, that a CAT can force the world to a desired atmospheric GHG level, but that no CIC can be high enough to do this. His first fallacy, and it is a profound one, is that taxes impose costs and regulation somehow does not. A CAT that really bites will make things made by firms all through society cost more, on the sound principle that if wind power were cheaper than coal, we would be making electricity that way already. By cost more, I don’t just mean higher prices: I mean more real economic resources will be consumed. It is simply absurd, deeply and dangerously ignorant, to imagine that (assuming the trading part of the CAT system successfully transfers compliance actions to where they are cheapest) we will get off any cheaper from a CAT than from a CIC that both achieve the same GHG level. Romm properly fears monied interests lobbying to tilt the CIC pinball machine away from them, and voters dismayed by the hit to their pocketbooks, but what he ignores is that as sure as God made little green apples, exactly the same thing will happen when CAT starts to actually have consequences.

The importance of this point cannot be overemphasized. Romm ridicules a $1000/ton carbon tax – “talk about shock and awe”- that he claims will be needed to stabilize climate. But the shock and awe of price increases resulting from a CAT that reaches the same level will be precisely the same.

On the issue of complexity, Romm ignores something else very important. What is the target of a CAT program – the cap we should put in place? It’s the optimal level of GHG release, that is, the amount where the damage caused by an additional unit of GHG release is equal to the cost of preventing it (which usually lower for higher releases). Release any more than that, and we’re worse off; release any less, and we’re leaving net welfare on the table. To set this cap properly, we need to know the whole marginal cost and marginal benefit functions of GHG release over a wide range to see where they cross. There’s no avoiding calculating the benefits of GHG reduction (cost of emission), but the cost of reducing GHG is very hard to predict. For one thing, potential reducers will lie (intentionally or not), just as the automakers lied about the cost of making clean cars back in the 70s. For another, those costs will fall with experience and technology progress, but we don’t know how much. The optimal discharge level will almost certainly fall as we start to deal seriously with climate, so the cap will need to be adjusted.

A great advantage of a CIC is that we don’t need to know the cost of compliance, only the marginal cost of discharge at the level we’re at now, and that’s the charge per ton of emissions to impose. Industry will reduce emissions until it costs more to do so than to pay the charge, and as they learn to do that better, they will reduce them more. As emission levels fall, we will move down the cost-of-discharge curve, so the CIC can be reduced; eventually the system will stabilize at the right place with only slow and occasional adjustments needed after that. It is a good bet that a politically palatable CAT will actually end up at a higher level of GHG in the air, and further from the optimal value, than a CIC.

Romm, in the end, has a romantic and illusory view of how a CAT program will actually work, imagining that it will empower government to impose a great national mobilization, steamrolling lobbyists and special pleaders for exceptions and gimmicks, in which the public will ignore costs and put Stakhanovite shoulders to the common wheel. And he has a naïve understanding of how taxes and charges really affect the behavior of firms and people.

Once over quickly: a well-designed CAT and a properly set CIC will reduce global warming the same amount and at about the same cost. The cost will be large and painful, larger the longer we futz around not getting started on the work. The administrative complexity of both will be enormous, though the CAT will be much more bureaucratic and intrusive. Either will attract an army of lobbyists and whiners trying to get sweetheart deals that will test the resolve of Congress and citizens, and the additional complexity of the CAT will offer them more places to hide bad stuff. In the long run, the CAT will be stickier and harder to adjust as technology advances and we learn more about the costs of climate change, and will lead to an inferior result. And having either is far, far, better than having neither: if the price of getting off the dime on climate is having to do it the second best way (something that may be true, but that Romm only asserts), it’s worth paying.

Author: Michael O'Hare

Professor of Public Policy at the Goldman School of Public Policy, University of California, Berkeley, Michael O'Hare was raised in New York City and trained at Harvard as an architect and structural engineer. Diverted from an honest career designing buildings by the offer of a job in which he could think about anything he wanted to and spend his time with very smart and curious young people, he fell among economists and such like, and continues to benefit from their generosity with on-the-job social science training. He has followed the process and principles of design into "nonphysical environments" such as production processes in organizations, regulation, and information management and published a variety of research in environmental policy, government policy towards the arts, and management, with special interests in energy, facility siting, information and perceptions in public choice and work environments, and policy design. His current research is focused on transportation biofuels and their effects on global land use, food security, and international trade; regulatory policy in the face of scientific uncertainty; and, after a three-decade hiatus, on NIMBY conflicts afflicting high speed rail right-of-way and nuclear waste disposal sites. He is also a regular writer on pedagogy, especially teaching in professional education, and co-edited the "Curriculum and Case Notes" section of the Journal of Policy Analysis and Management. Between faculty appointments at the MIT Department of Urban Studies and Planning and the John F. Kennedy School of Government at Harvard, he was director of policy analysis at the Massachusetts Executive Office of Environmental Affairs. He has had visiting appointments at Università Bocconi in Milan and the National University of Singapore and teaches regularly in the Goldman School's executive (mid-career) programs. At GSPP, O'Hare has taught a studio course in Program and Policy Design, Arts and Cultural Policy, Public Management, the pedagogy course for graduate student instructors, Quantitative Methods, Environmental Policy, and the introduction to public policy for its undergraduate minor, which he supervises. Generally, he considers himself the school's resident expert in any subject in which there is no such thing as real expertise (a recent project concerned the governance and design of California county fairs), but is secure in the distinction of being the only faculty member with a metal lathe in his basement and a 4×5 Ebony view camera. At the moment, he would rather be making something with his hands than writing this blurb.