The case for a carbon tax over a cap-and-trade system

John Kemp, a former commodities analyst turned commentator at Reuters, makes the argument for a carbon tax over a cap-and-trade system.

For one thing, he says, it is likely to be cheaper according to a non-partisan Congressional Budget Office report last year.

Cap-and-trade versus tax decision represents a trade off, he writes: a tax regime means uncertainty about the amount of carbon reduction, while a trading system leaves uncertainty over the pricing of that carbon reduction.

He believes the former is the lesser of those two problems:

The great advantage of a tax is that it gives households and firms certainty about how much reduction will cost. It also ensures there is no compulsion to undertake very expensive mitigation strategies for which costs far outweigh benefits.

But the disadvantage, especially in the eyes of climate-change activists, is there is no guarantee it will reduce emissions by a specified volume in any given year. Over a multi-year period, this is less of a problem. The rate can be varied if the volume of emissions reduction turns out to be smaller or greater than originally anticipated. Presumably it would also rise over time to force progressive improvements.

Cap-and-trade has the virtue of creating greater certainty about the volume of emissions reductions — but the disadvantage of huge uncertainty over the cost for households and businesses.

In fact, Kemp says, experience suggests there would be massive price volatility in a cap-and-trade system, and this makes long term planning difficult. Trading systems are also pro-cyclical, so energy prices could become more volatile. During periods of high energy demand, prices could skyrocket.

Conversely, in a downturn, slumping consumption would depress the cost of permits, and risks removing any incentive to invest in energy efficient technologies such as hybrid cars. Permit prices in the EU’s ETS have fallen from 30 euros per tonne last summer to a low of just 8 euros earlier this month, largely removing efficiency incentives.

Our energy correspondent Fiona Harvey wrote about evidence of this problem a few weeks ago, citing analysts saying the carbon allowance price needs to far higher than its current levels – €25 (Ambrian) or €35-€45 (Icap) – to have an impact on green investment decisions.

Some of these problems in a trading system can be mitigated, Kemp writes, by setting a price floor and by auctioning all permits rather than giving some away as the EU’s trading scheme did. The Obama government says it will not give permits away for free, “to ensure the biggest polluters to not ensure windfall profits”. But criticism is already appearing from the US energy sector, which is calling for some giveaways. Merrill Lynch says to gain political support for cap and trade, as much as 70 per cent of the permits may have to be given away.

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