On June 11, I went to a presentation at the London headquarters of BP of the BP Statistical Review of World Energy, June 2008, by Tony Hayward, Group Chief Executive of BP and Christof Rühl, the Chief Economist. Nice presentations, good documents, until the Chief Executive extolled the unique virtues of Cap & Trade and the Chief Economist jumped in by asserting that Cap & Trade was, unlike the taxation of carbon emissions, an efficient way to deal with the environmental externalities of greenhouse gas emissions. This assertion deserves a one-word label: baloney.

Cap & Trade is an efficient way to deal with the environmental externalities of greenhouse gas emissions because it is equivalent to a tax on greenhouse gas emissions.

Let me state this slightly more precisely, after defining some jargon, using that flawed but wonderful fount of information, Wikipedia: carbon dioxide equivalent (CDE) and Equivalent carbon dioxide (or CO2E) are two related but distinct measures for describing how much global warming a given type and amount of greenhouse gas (e.g. CO2, methane, perfluorocarbons and nitrous oxide) may cause, using the functionally equivalent amount or concentration of carbon dioxide (CO2) as the reference. For concreteness I will assume that what is taxed or subjected to a cap & trade regime are CO2E emissions.

Statement of the bleedin’ obvious: Every cap & trade scheme with an efficient secondary market for CO2EQ emission permits and a given way of allocating these permits is, from an economic perspective, equivalent to a tax on CO2EQ emissions and a given way of allocating the revenues from that tax.

Equivalent from an economic perspective means that they have the same effect on incentives and wealth distribution and therefore supports the same allocation of resources.

The economics is blindingly simple. I’ll take the tax first. Let’s consider a uniform tax on each unit of greenhouse gas emissions (as measured by say, a metric ton (Mt) CO2E units) in a given jurisdiction during a given period, say a year. Ideally, the jurisdiction would be the entire world, but it could be a single country or the European Union). Let’s call it the uniform CO2E emissions tax or carbon tax for short. The carbon tax would, in principle, be imposed on all CO2E emissions is all activities: production, transportation, consumption and farting.

The tax would raise the marginal cost of the CO2E-emitting activities, ideally up to the point that the marginal social cost of abatement activities is equated to the marginal social benefit from these activities. Assume that the optimal tax would be US$ C per MT of CO2E per year, and that the total amount of emissions of CO2E during that year when the tax is in place would be Q MT of CO2E emissions. This uniform tax would encourage those emitters of CO2E for whom it is less costly at the margin to reduce their emissions to expand their activities relative to those for whom it is more costly at the margin to reduce their CO2E emissions. In general, we would expect all CO2E emitting activities to shrink, but those where CO2E emissions are abated relatively easily and at relatively low marginal cost, to shrink less.

The revenue raised by the carbon tax could be added to general government revenues. It could be given to the poor, to the rich, to the United Nations or to Osama bin Laden. It could also be returned to the producers of the CO2E emissions - the tax payers. If this could be done in lump-sum fashion, that is, without influencing current and future incentives to emit, this would not be inefficient, although some would consider it unfair.

Now let’s consider the cap & trade scheme. Some authority sets an overall cap on the amount of CO2E emissions that are permitted during a given period, a year, say. Assume the amount of carbon permits issued by the authorities is Q for the year, where each permit allows the owner to emit 1 MT of CO2E that year. These permits are distributed in some way or other. For the moment, assume they are distributed equally among all adults in the jurisdiction. Now assume that the boys and girls from Wall Street and the City of London have created an efficient secondary market in which these carbon permits can be traded. Those who, as a result of the initial equal-per-capita distribution have permits that are surplus to requirements will rush to sell to those whose endowment is less than their desired emission levels. The equilibrium price that will be established in this market will be US$ C per MT of CO2E, the same as the tax per MT of CO2E under the carbon tax. So the incentive to reduce CO2E emissions, and to do so efficiently, that is, where the marginal cost of abatement is lowest, is the same under the carbon tax as under the carbon cap & trade.

Just as the revenues from the tax could be distributed in lump-sum fashion to the emitters, so the carbon permits could be distributed free of charge, and in lump-sum fashion, to the emitters. They could also be given free of charge to the poor, the rich, the UN or to Osama bin Laden. Assuming they all know how to find the secondary market in CO2E permits, the same efficient allocation would be achieved. The permits could also be auctioned off. If the initial auction were efficient, a price of US$ C per MT of CO2E emissions would be established, and every emitter would acquire the efficient quantity of permits at that price. Total emissions would again be Q. If the initial auction were wonky, there would be distributional effects but, as long as there is an efficient secondary market, the necessary permits would eventually end up in the right place at the right price.

The revenues from the carbon permit auction could be disposed of in the same ways at the revenue from the carbon tax.

The equivalence of the carbon tax and the cap & trade scheme appears self-evident. Note also that the informational requirements on the authorities for the tax to work are the same: they must be able to monitor the actual emissions of CO2E. Without that, they will not know under the carbon tax scheme, how much revenue to demand from each producer or consumer, and they will not know under the cap & trade scheme whether the quantity of permits is sufficient to cover the actual emissions of the producer or consumer.

Clearly, the authorities cannot rely on truthful revelation of actual emissions by the emitters of CO2E, under either the carbon tax or the cap & trade scheme. There will be some honest ones who will own up to their true emissions, but as with all tax evasion or license fee evasion, it is the risk of being found out and the penalty conditional on being found out that will have to provide the deterrent for understating emissions. Monitoring and informed random emissions audits will be necessary under both arrangements.

Qualifications to the equivalence of a carbon tax and cap & trade

The costs of monitoring mean that many activities that emit CO2E, especially those engaged in by households and small businesses, will escape the tax or the permit net. The major emitters (public utilities, energy guzzlers like aluminium producers and other energy-intensive large-scale production, the petro-chemical industry etc.) will have to be targeted first. Some household activities can be taxed easily, e.g. those that involve the use of gas, petrol and coal, where the inputs can be taxed easily. If anything, taxes are likely to be administratively easier than permits for much household activity that produces CO2E emissions.

An argument in favour of carbon taxes over cap & trade is that cap & trade requires an efficient secondary market. As we know from recent experience, financial market efficiency cannot be taken for granted. While the instrument that is traded in the secondary market under cap& trade is relatively simple, compared to Residential Mortgage-Backed Securities based on US subprime mortgages, cap & trade does have this additional link in the chain, and is therefore vulnerable to all the familiar financial market pathologies, from market manipulation to illiquidity.

The economic equivalence of carbon taxes and cap& trade is exact only in a world without uncertainty, or in a world with uncertainty but with complete contingent claims markets for risk trading. In the real world, where there is uncertainty and markets are incomplete, the authorities in the cap & trade case cannot be certain that when they set a cap Q, the marginal valuation of the permit will be US$ C . The expected marginal valuation of the permit will be equal to something close to US$ C, but it will not be exact. When, with the carbon tax, the authorities set a tax of US$ C, they cannot be certain the quantity of emissions will actually be Q, although the expected quantity of emissions is likely to be close to Q. In a world with uncertainty but incomplete markets, the carbon tax and cap & trade are similar but not equivalent; neither one obviously dominates the other under all circumstances.

Why then do politicians and outfits like BP prefer cap & trade to a carbon tax? The politicians prefer it because the cap & trade scheme, while economically equivalent to a tax, will not count as a tax in the traditional record-keeping manuals. It does not add to the official ‘tax burden’ the opposition likes to bash you around the head with. You can present cap & trade in a way that hides/obscures the fact that for it to work, that is, for it to reduce emissions, it must be equivalent to a tax by increasing the marginal cost of emitting CO2E; however, it does not look like a tax and will not show up in conventional tax burden calculations. Lack of transparency means absence of accountability. That is why non-transparent arrangements are universally valued by politicians.

A second reason is that with cap & trade, you can distribute the shadow tax revenue associated with the cap & trade scheme (that is the amount of revenue you would be able to obtain for the permits in a transparent, competitive auction) in a non-transparent manner. Give-aways through explicit grants or subsidies are not as easy. There are parliamentary committees scrutinizing revenues and outlays; there may be institutions like the UK National Audit Office that can ask bothersome questions.

Life is easier with the initial allocation of permits. You can, for instance, hand out the permits free of charge to your friends (including the heavy historical polluters). This is also the reason, I believe, that the heavy emitters, including BP, favour cap & trade over taxes. They believe that the initial allocation of free permits will favour them. There is this crazy notion that past heavy polluters should not be hit too hard by schemes to reduce CO2E emissions, and that they should therefore be given gratis allowances of permits that are related to their recent past emissions record. I can see no efficiency reason in favour of this, and many a fairness argument against it, but the argument carries weight in the unreal real world.

When the problems associated with running an efficient secondary market for CO2E emissions permits and the political economy of the non-transparent initial allocation of the CO2E emissions permits are taken into account, I believe that, on balance, explicit carbon taxes are better than cap & trade.

June 12th, 2008 in Economics, Ethics, Financial Markets, Politics | Permalink