On Cap & Trade and the Price of Emissions

Mark Thoma featured a very interesting discussion of the lack of political will to impose either Pigou taxes or cap & trade by Jeff Frankel, which led to some commenter who must have it in for Paul Krugman who a few years ago sensibly wrote about James Hansen:

he’s now engaged in a misguided crusade against cap and trade, which is — let’s face it — the only form of action against greenhouse gas emissions we have any chance of taking before catastrophe becomes inevitable. What the basic economic analysis says is that an emissions tax of the form Hansen wants and a system of tradable emission permits, aka cap and trade, are essentially equivalent in their effects ... A tax puts a price on emissions, leading to less pollution. Cap and trade puts a quantitative limit on emissions, but from the point of view of any individual, emitting requires that you buy more permits (or forgo the sale of permits, if you have an excess), so the incentives are the same as if you faced a tax. Contrary to what Hansen seems to believe, the incentives for individual action to reduce emissions are the same under the two systems ... The only difference is the nature of uncertainty over the aggregate outcome. If you use a tax, you know what the price of emissions will be, but you don’t know the quantity of emissions; if you use a cap, you know the quantity but not the price. Yes, this means that if some people do more than expected to reduce emissions, they’ll just free up permits for others — which worries Hansen. But it also means that if some people do less to reduce emissions than expected, someone else will have to make up the shortfall. It’s symmetric; there’s no reason to emphasize only one side of the story. And as far as I can see, the question about uncertainty is secondary; the fact is that cap and trade works. Hansen admits that the sulfur dioxide cap has reduced pollution, but argues that it didn’t do enough; well, it did as much as it was designed to do. If Hansen thinks it should have done more, he should be campaigning for a lower cap, not trashing the whole program.

There is one difference between the two regimes, which we need to mention in light of some nonsense from Stanley Reed and Mark Scott:

Still, Europe’s carbon market, a pioneering effort to use markets to regulate greenhouse gases, is having a hard time staying upright. This year has been stomach-churning for the people who make their living in the arcane world of trading emissions permits. The most recent volatility comes on top of years of uncertainty during which prices have fluctuated from $40 to nearly zero for the right to emit one ton of carbon dioxide. More important, though, than lost jobs and diminished payouts for traders and bankers, the penny ante price of carbon credits means the market is not doing its job: pushing polluters to reduce carbon emissions, which most climate scientists believe contribute to global warming.

In terms of Paul’s demand curve for emissions, Reed and Scott were talking about a drop in this demand curve – likely generated by the Great Recession and reduced economic activity that would lead to pollution. Paul captured this with his:

If you use a tax, you know what the price of emissions will be, but you don’t know the quantity of emissions; if you use a cap, you know the quantity but not the price.

Now had policymakers decided to adopt the suggestion to lower the cap, which Jeff notes isn’t exactly the current thread of Tea Party politics and global warming deniers, the price of emissions would have gone back up. Or we could have had Hansen’s fee and dividend program – which is essentially Greg Mankiw’s Pigou tax – with the same effect. But consider the alternative shock to Paul’s demand for emissions curve, which did occur at least on a global basis when China and India developed so rapidly at the turn of the century. The demand for emissions went up. Under the tax proposal championed by Hansen, we would see a rise in polluting activities as the price remained constant. Had we imposed globally a cap & trade regime – the price of emissions would have risen instead.