Month: April 2007

Update:  I’ve received some criticisms of this proposal elsewhere and I hope to do up a version 2.0 in the near future.

For the purposes of this post, I shall assume that climate change is real, is undesirable and, if not wholly anthropogenic in its causes, is still able to be mitigated by a decrease in emissions of greenhouse gases. The question is how best to achieve that goal. Generally speaking, there are two broad approaches to the problem: emission trading (cap-and-trade) or taxation.

The largest cap-and-trade scheme in the world is the European Union Emission Trading Scheme (EU ETS). You can read more about it at Defra or Wikipedia. Benefits of the EU scheme are:

• It offers a “market-based” solution while still allowing control over total emission levels, which is arguably necessary to combat climate change because, in this respect, the earth is a closed system.
• It rewards innovative companies that reduce their emissions (by allowing them to sell their excess permits).

However, it suffers from several problems:

• The allocation breakdown between countries is negotiated politically rather than on the basis of need or economic efficiency.
• The allocation breakdown within countries is decided by the government, which makes it susceptible to political vagaries.
• Incumbent firms do not incur a cost for the bulk of their emissions, but only for those in excess of their allotment.
• Because allotments are decided for several years at a time, the system raises a barrier to entry in the affected industries and so stifles innovation. This is because new entrants (who don’t receive any allotment) will have to pay for all of their permits in full. Worse still, they have to buy them from the incumbents!
• In the lead-up to allocations being made, it is optimal for both firms and governments to exaggerate – or worse, actually increase – their emission levels in an attempt to capture a higher share of the total permits and thus extract rents from others.
• It would be extremely cumbersome and invasive to spread the idea of emission permits down to the level of the individual consumer for pollution that is created by acts of consumption (e.g. burning gasoline by driving your car) rather than acts of production (e.g. burning coal to produce electricity).
• The government’s sole incentive to enforce the system is environmental altruism, which may at times take a back seat to political expediency.

As an alternative, various people advocate Pigovian taxes on greenhouse gas emissions (particularly Greg Mankiw and his Pigou Club, which boasts some pretty big names). I first want to acknowledge some of the key benefits that taxes offer in this regard:

• The infrastructure for taxation and tax auditing is already well established.
• Taxation can readily be applied to all sources of pollution, both in production and consumption.
• The revenue can be used to offset taxes that are distortionary.
• The government would have two incentives for enforcing the system – environmental altruism and protection of a revenue stream – making it more likely to be done thoroughly.

Next, the downsides to using taxes to reduce greenhouse gas emissions:

• As a general rule, the government is in no position to decide which industries are best able to innovate to reduce their emissions, but this is exactly what the government would in effect be doing when it decided tax rates on a product-by-product basis. Tax rates of X% on gasoline, Y% on aviation fuel and Z% on coal-fired electricity production include an implicit government bias in which industries ought to change.
• Because the price elasticities are not known, it is impossible to know the optimal level(s) of taxation.
• Even if the optimal tax level were known, all taxes are subject to political compromise, not just when introduced but on an on-going basis in much the same way that the allocation of permits is under the EU system.

If forced to choose between them, I would personally favour Pigovian taxes over an EU-style cap-and-trade system.

But before Professor Mankiw adds me to his club, I want to stress that if given true freedom to choose, I wouldn’t go with either of them. I would choose what I (rather cumbersomely) call a rolling-auction-cap-and-trade system. Here’s how I imagine it working:

1. An independent government agency would perform the following roles:
   1. Decide on the total number of permits to be allocated to the economy as a whole.
   2. Auction permits on a rolling basis (say, monthly) on the open market.
   3. Declare the market average amount of greenhouse gases emitted by products used in acts of consumption.
   4. Enforcement, with random audits and the ability to impose (effectively) infinite penalties.
2. Permits would be freely tradable between private agents.
3. Any firm that pollutes in the act of production must possess permits for the greenhouse gases that it emits.
4. Any firm that that produces a product which will cause pollution in the act of consumption (e.g. gasoline) must possess permits for the market average amount of greenhouse gases that will be emitted.
5. Full reporting of points 3 and 4 would be required under Generally Accepted Accounting Practices (GAAP) and must be certified by an independent auditor.

So far as I can tell, this system essentially offers all the benefits of both the EU ETS and Pigovian taxes without any of the downsides of either. It effectively places a cap-and-trade system on the entire economy (consumption and production) without forcing a burden on individual consumers to purchase and keep track of their permits. It minimises government interference and with it, the chance that the system might be picked apart by well meaning but short sighted politicians in the years to come. It offers up revenue which helps encourage the government to maintain the system and allows them to offset distortionary taxes. It does not create incentives for agents to exaggerate or alter their behaviour to “game” the system. It does not try to second-guess the market in terms of where innovation might most easily occur, nor does it impose any barriers to entry or innovation. Innovative firms benefit two-fold, by lowering their costs and – by passing at least some of those savings on to their customers – increasing their market share.

I’d welcome any comments or criticism.

p.s. I have previously wondered whether the revenue raised ought to go to the Central Bank (rather than the government) so that they could then reissue the revenue raised into the money supply. I believed back then and at least suspect now (the intuition is the same, but I’m more cautious now) that this would be the ultimate sterilised environmental policy. The money supply would remain unchanged and since the money would never go near the government, there would be no change to the government’s macroeconomic position or impact on the economy. Without attempting a model to “prove” it, I think the general equilibrium result would be a redistribution from firms and individuals that were above-average polluters to those that were below-average polluters, with the market deciding who and how much at both ends of the transfer.