Blog Post

Cap and trade in the US

What’s at stake: Capitol Hill debates on the Kerry-Boxer climate change are seen as key to Copenhagen success. As the US Senate begins consideration of the climate change legislation, discussions over how to mitigate climate change’s worst effects have set off the debates to take place in Congress. It has become increasingly clear that the […]

By: Date: October 22, 2009 Topic: Digital economy and innovation

What’s at stake: Capitol Hill debates on the Kerry-Boxer climate change are seen as key to Copenhagen success. As the US Senate begins consideration of the climate change legislation, discussions over how to mitigate climate change’s worst effects have set off the debates to take place in Congress. It has become increasingly clear that the only approach that can do the job of cutting emissions is one which involves at its core putting a price on carbon. And while the US is clearly following the road of a cap and trade system, discussions around the pros and cons of such a system against a carbon tax have been revived.

Willem Buiter says that when the problems associated with running an efficient secondary market for emissions permits and the political economy of the non-transparent initial allocation of emissions permits are taken into account, an explicit carbon tax is better than a cap and trade system. The economic equivalence of carbon taxes and cap and 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 a world with uncertainty but incomplete markets, the carbon tax and cap and trade are similar but not equivalent. Cap and trade requires an efficient secondary market, but who would now take financial market efficiency for granted. Cap and trade also allows distributing the shadow tax revenue associated with the cap and trade scheme in a non-transparent manner. For the latter reason, Greg Mankiw hopes that Barack Obama refuses to sign a bill that fails to auction most of the allowances.

Robert Stavins says that the best (and most likely) approach for the short to medium term in the United States is a cap-and-trade system. Proponents of carbon taxes worry about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax is sensitive to the same political pressures, and may be expected to succumb in ways that are ultimately more harmful:  reducing environmental achievement and driving up costs. Political pressures on a cap-and-trade system lead to different allocations of allowances, which affect distribution, but not environmental effectives, and not cost-effectiveness whereas political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs.

William Nordhaus say that quantitative limits produce severe volatility in the market price of carbon under an emissions-targeting approach. The volatility arises because of the inelasticity of both supply and demand of permits. Prices show an extremely high level of volatility. The prices of U.S. SO2 emissions allowances have been approximately as volatile as oil prices while the volatility of CO2 allowances in the EU ETS is similarly large. The volatility of allowances is not due to policy errors. It is inherent in this kind of instrument. The high level of volatility is economically costly and provides inconsistent signals to private-sector decision makers. Clearly, a carbon tax would provide consistent signals and would not vary so widely from year to year, or even day to day.

Sheila Olmstead and Robert Stavins make the case for linking cap-and-trade systems internationally. Linking the US cap-and-trade system under a new international climate treaty would bring cost savings from increasing the market’s scope, greater liquidity, reduced price volatility, lessened market power, and reduced carbon leakage. Cap-and-trade systems can be linked directly, which requires harmonization, or indirectly by linking with a common emissions-reduction credit system. Kyoto’s Clean Development Mechanism allows parties in wealthy countries to purchase emissions-reduction credits in developing countries by investing in emissions-reduction projects. These credits can be used to meet emissions commitments within the EU-ETS, and other systems are likely to accept them as well.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.


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