An emerging consensus among economists, environmental organizations, and policy makers holds that policy solutions to the climate change problem must incorporate economic mechanisms so that social costs of climate change damages are reflected in prices of carbon and other greenhouse gases.

The consensus breaks down, however, regarding what mechanism is best, with a vigorous and ongoing debate between proponents of taxes and those favoring tradable permits. Reporters covering the December 3-14 United Nations Framework Convention on Climate Change in Bali, either in person or from afar, are likely to hear a lot about these options. The Bali discussions are expected to focus mostly on cap-and-trade, reflecting the path laid-out by the Kyoto Protocol precedent. It’s realistic to anticipate chatter about the benefits of tax-based mechanisms, but it’s unlikely anything will come of it.

The two competing approaches have emerged in the effort to internalize the cost of climate change in prices of greenhouse gas emissions. Under the tax-based approach, emitters of carbon dioxide would pay a fixed price for every ton of carbon they emit, and companies would reduce emissions whenever emission reductions are available for less than the cost of the carbon tax.

The second approach would cap total quantities of emissions and require companies to have permits for each unit of emission. In most proposed systems, these permits would be tradable between companies, and under some approaches bankable for use in future years. At the start of the tradable permit system, permits would be either auctioned off by the government or distributed to companies based on the emissions of a chosen baseline year, an approach some call grandfathering. Companies with relatively high emission reduction costs would choose to buy permits on the market if the price of permits were lower than the cost of emissions reduction. Likewise, companies with low emission reduction costs would reduce emissions and sell extra permits until they get to the point that the cost of further emission reductions equals the market price of permits. The approach is patterned after the highly successful acid rain control strategy under the U.S. Clean Air Act.

In an ideal world, the outcomes of taxes and tradable permit systems would be effectively identical, as both would result in emissions reductions to the point at which the price of emissions (either the price of a permit or the level of the tax) is equal to the cost of emission reductions. In a world characterized by uncertainties, however, taxes and tradable permits can result in quite different outcomes.

Sensitive to such inevitable uncertainties, economists generally acknowledge that taxes and tradable permits behave quite differently when the costs of emission reduction are uncertain. Many argue that, for the climate change issue, taxes will probably be more effective than tradable permits. Carbon dioxide is an example of a stock pollutant, where damage caused by a particular ton of carbon dioxide emitted depends on the existing concentration of CO2 in the atmosphere. Because emissions over the short term have little effect on the total stock, the marginal benefits of emission reduction would be relatively flat. The marginal costs of emission reductions, however, are generally considered to be fairly steep given that emission reduction technologies have not had much time to develop. The risk with a tradable permit system is that the emissions cap would be set too low, leading to unexpectedly and unacceptably high costs if the costs of emission reductions prove higher than expected.

A tax, on the other hand, would avoid these uncertainty-related problems by fixing costs. Proponents say fixed costs also provide a better long-term price signal to companies, since they guarantee a constant return to emission reduction investments. Many economists argue also that income from carbon taxes could be used to progressively reduce income and payroll taxes, boosting economic growth while offsetting effects of price increases on the poor.

Many environmental organizations favor tradable permit systems over taxes, saying that approach would provide carbon target certainty. If you set a cap on emissions and adequately enforce it, you can be reasonably confident under a tradable permit system that actual emissions will not exceed the cap, they argue. In a tax-based system, in contrast, they say there is no way to know in advance what exact quantity of emissions will result from the chosen price.

This approach would pose a problem in particular if one thinks that the climate system is characterized by certain thresholds that should not be crossed – the idea of tipping points. In that case, a strict limit on emissions would be needed to avoid potential non-linear outcomes. Economists often respond that taxes would lead to uncertainty only in the short-term, as taxes can be adjusted over time to move toward a desired quantity of emissions. Tradable permit systems also tend to pose problematic distribution issues, observers point out, because giving away the permits for free could create windfall profits for companies if costs are simply passed through to customers, as many expect might be the case.

U.S. politicians may well feel most at home with tradable permit systems rather than taxes for a number of reasons, certainly not the least of which is the political aversion to higher taxes. Even though a tradable permit system would have the same or potentially greater effect on energy prices for the average consumer, and even though such a system would lack a way to reduce the burden by recycling revenue, the costs of a tradable permit system would be hidden, perhaps making it an easier sell politically.

Those regulated also might lean toward a tradable permits system because they could argue for grandfathered permit allocations and tend to pressure politicians accordingly.

These are among the kinds of issues likely to be debated at the December United Nations climate change conference in Bali, where an eventual successor to the Kyoto Protocol is likely to begin taking shape, and there appears to be a growing discussion about whether the tradable permit system embodied in the Kyoto Protocol was the right way to go.

A number of prominent economists, including Greg Mankiw, Alan Greenspan, Bill Nordhaus, Martin Feldstein, and Gary Becker are members of a virtual Pigou Club advocating for tax-based approaches. Mankiw wrote a column advocating carbon taxes in The New York Times.

Also see:

Climate Policy Analysis: The Many Aspects of Tradable Permits Design (Pt. 2)

A Question Haunting Bali Conference: Silver Bullet? Or Silver Buckshot? (Pt. 3)

Zeke Hausfather

Zeke is an energy systems analyst and environmental economist with a strong interest in conservation and efficiency. He was previously the chief scientist at C3, an energy management and efficiency company,...