Pigovian taxes or rolling-auction-cap-and-trade?

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.

4 Responses to “Pigovian taxes or rolling-auction-cap-and-trade?”


  • The allocation breakdown between countries is negotiated politically rather than on the basis of need or economic efficiency.
    – No
    The final level of allocation is decided on by the EC. The EC has a clear set of quantative rules based on past emissions, economic expanision and carbon intensity of each economy by which they arrive at the level of allocation. At no point are political considerations taken into account.

    The allocation breakdown within countries is decided by the government, which makes it susceptible to political vagaries.
    Again countries have proposed allocations but so far of the 21 countries reviewed the EC has cut 19 of th proposed allocations.

    Incumbent firms do not incur a cost for the bulk of their emissions, but only for those in excess of their allotment.

    Agreed as this is the starting point of cap and trade, as it is designed to minimise costs, which at the end of the day consumers will bear.

    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!

    Again wrong their is a reserve for new entrants called the new entrants reserve.

    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.
    -whilst in terms of game theory this is true there is no evidence of an increase in emissions actually occuring. True the intital emissions records may have been inflated but they are now all verified independently in order to prevent exactly this happening.

    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 argument for individual cap and trade is an interesting one. However the example you give of a car burning petrol is easy to resolve. The petrol station should be made responsible for the emissions. Its clear at the moment of sale that the petrol is going to be combusted so why not put the cap and trade scheme in place there. Unless of course there are thousands of consumers who purchase petrol to look at it….

    The government’s sole incentive to enforce the system is environmental altruism, which may at times take a back seat to political expediency.
    Environmental altruism and European law if they fail to enforce the system properly,

  • Miles (you don’t happen to be a wide receiver by any chance?),

    Thanks for the comments.

    I’m still intending to do up a v2.0 of this, but I’ll address some of your points here:

    Allocation between countries. Yes, it’s nominally decided by the EC on the basis of some formal rules, but the reality is that those rules were negotiated politically to achieve specific levels of permits to each country.

    Allocation within countries. You say that “he EC has cut 19 of the [21] proposed allocations.” That is a statement about allocations to countries, not about allocations to individual firms *within* countries. The latter is decided by each government.

    New entrants. The New Entrants Reserve is only a UK government initiative (see: http://www.defra.gov.uk/environment/climatechange/trading/eu/nap/neca.htm) and not an aspect of the EU ETS as a whole. Even within the UK, as with incumbents, the allocations to new entrants are done on the basis of government-department rules (which are subject to political machinations) rather than through the market, which any ETS is meant to use.

    I am already in agreement with you on where to place the burden for gasoline because, as you say, obvious at the time of sale that it will be combusted. However, it’s worth noting that some cars are more environmentally friendly in their combustion than others. That is, for the same amount of fuel in, some will emit less GHGs. As such, somebody needs to decide on the “average” emission of cars on the road. This is what I explained later on in my post.

    European law is of questionable enforceability when it is breached by the bigger members of the EU. Witness the flagrant flaunting of the Stability and Growth pact by France and Germany. Rather than the Council of Ministers imposing fines on them, the pact itself was adjusted so that they were no longer in breech. Either way, my broader point is that, whatever incentives currently exist in Europe to enforce the system, changing to an auction-based ETS would add an additional one.

  • The optimal place to tax gasoline (or the carbon in gasoline) is not at the fuel station but at the oil well or refinery, or port of import as far upstream as possible. One aspect of a Pigovian tax which is often ignored is that of using all or part of the tax proceeds to compensate the victims of the externality that is being taxed. There is a huge need for this, with developing countries facing climate adaptation costs of over $50 billion a year. This forms the basis of the Kyoto proposals: http://www.kyoto2.org/.

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