Cap and Trade vs. the Carbon Tax

So I've been addressing the issue of anthropogenic climate change for some time now, and I haven't said much in the way of addressing specific policy proposals. But I was just given a delightful present by one of my fellow FEE associates: a copy of the American Institute for Economic Research's latest Economic Education Bulletin, entitled "The Global Warming Debate: Science, Economics, and Policy." I didn't read the whole thing, but my favorite part was definitely when William R. Cotton, a professor of atmospheric science at Colorado State, closed his completely science-oriented essay, "Summary View of Climate Change," with:

There are strong indications that our global climate is warming. But the question is, is the warming due to anthropogenic greenhouse gases, or is it due to some other forcing mechanisms (or their transient absence) and natural variability. As human population on Earth continues to increase, the chances of human-induced changes in climate due to greenhouse gases, aerosol pollution, or alterations in land use become increasingly likely. Thus, rather than consider climate engineering, we should devise methods of encouraging the reduction of population growth through economic and quality-of-life incentives.

Period, end of conversation. No comment on that gem anywhere else in the entire essay. Who's got two thumbs and loves it? This guy.

But anyway, that's not the point. Later in the publication was an essay by Kenneth P. Green, a resident scholar at the American Enterprise Institute, where it was argued that a carbon tax is superior to a cap-and-trade system. I bounced between frustration, amusement, and glee as I read it, and felt an immediate need to comment. Not because Green did a bad job--he did just fine--but because he was guilty of something which is very common among people who discuss climate change: he discussed the possible "solutions" to climate change without addressing the reasons that a policy was to be implemented in the first place, and how the different solutions worked to address those reasons. His argument for a tax scheme over a cap-and-trade scheme was simply that a tax scheme could achieve the same goals, but with better economic side-effects and less potential for failure. Fine, I'll even grant it. But taxes and caps are fundamentally different policies, which only make even a little sense when confronted by specific sorts of problems.

I should explain what I mean. I've discussed elsewhere the idea that in order to make any sense from an ethical point of view, pollution taxes need to be based on the idea that an individual is justified in polluting if and only if she pays compensation to her victims for any damage done to them. That idea is controversial, but for our purposes we don't need to address that controversy. The point is only that even if we accept that idea as true, there are still only certain kinds of instances in which the injustice of pollution can legitimately be dealt with through a tax on pollution. The paradigm cases are those instances in which the damage caused by pollution is directly proportional to the amount of pollution that there is, so that the tax becomes the "price" of compensating the victims of one's actions for the costs one imposes upon them.

Cap and trade schemes, on the other hand, are built for an entirely different kind of problem. In a paradigm cap and trade situation, there is a threshold level of pollution with which policymakers are concerned, and at the threshold, a certain amount of damage is anticipated. The cap and trade scheme accordingly sets the cap at the relevant amount of pollution, and then distributes "shares" of the "environmental space" below that threshold in some way (e.g., auction, grandfathering system...). Because the allocations may be economically inefficient for whatever reason, the shares can then be traded in accordance with the wishes of their owners in order to ensure that the right to pollute is distributed to those individuals who are willing to pay the most for it (note that the normal objections to the "willingness to pay" criterion are avoided by passing the buck to the distribution process, which of course must be justified separately).

The point I want to make here is that global climate change is a very different phenomenon than the sorts of phenomena for which either of these policies is built to provide a solution. As noted elsewhere, climate change is an emergent problem. That is, climate change is not the result of any individual's actions, but rather is the consequence of many individuals acting separately, so that no individual can reasonably be said to have been able to prevent climate change from occurring, and no individual could have caused climate change singlehandedly. Accordingly, it does not make sense to talk about the consequences of climate change in terms of marginal contributions. The amount of damage caused by climate change will not likely change recognizeably with an additional increment of CO2 (or any other forcing agent), so it's not reasonable to try to put a price on how much damage "a unit of climate forcing" (expressed, perhaps, in terms of GWP, or Global Warming Potential, as defined by the IPCC?) causes.

A tax on contributions to climate change, therefore, seems like a policy which would require a bit of shoehorning. Individuals paying the tax would not be paying the "social cost" of their particular contribution, taken in isolation, because that would be basically zero. They would need to be charged for their "portion" of the total amount of damage done by climate change. So what policymakers would need to do would be to determine the total amount of damage which would be done at the equilibrium price for pollution permits, and then sell the permits at that price. The problem then becomes one of economic calculation. It could be done to some degree, but it would be inherently imprecise. And remember: the end result needs to be that the victims get compensated, so the government would have to go into its own pockets (that is to say, the pockets of its treasury or, more realistically, the pockets of its Federal Reserve printing press) to take care of the balance if it aimed low. And as my wonderful economist friends would point out, there would be a considerable incentive to aim high, creating a surplus revenue stream for the government which would almost certainly not be returned. So the tax is doable, kind of, but the problem is not the kind of thing that the tax is designed for. It's just that you can use the tax to accomplish the end goal if you want.

The cap and trade system is a little harder to adapt to the task, but there are a number of ways that the idea can be useful. First, there is a level to which we could collectively exert a forcing on the climate system without producing objectionable consequences. This level of climate forcing is a threshold which could be amenable to a soft cap and trade scheme (soft like the baseball salary cap). In this kind of policy, the cap would be set at the level of forcing which would produce no negative consequences, and this "environmental space" would be allocated somehow (or, if people find this to be a bad idea, we would simply say that these shares should be allocated in proportion to one's contribution to climate change, so that the soft cap has no effect). People not receiving these shares, or polluting in excess of their shares, would be filling environmental space which represented something like "harmful social emissions". Because these emissions would not be legitimated by the soft cap, they would be the ones which would be subject to the obligation to compensate the victims (again, if the soft cap isn't being used, as mentioned above, it would just be that everyone would have to participate in compensating the victims).

Here a potential for another cap would become apparent: We might imagine that policymakers would decide on a level of pollution (corresponding to some amount of total damage) which was determined to be "socially desirable" somehow. Perhaps, using the same reasoning involved in the tax scheme discussed above, the policymakers would arrive at the level of pollution which would clear the market if everyone paid some price for it. Or perhaps the policymakers would identify a level of pollution beyond which unacceptable results would occur, and the cap would be set there. In any case, you would then have to set a cap and allocate the shares. So again, the policy could be made to work. But the problems are simply that it's difficult to identify a level of "unacceptable" pollution, it's just as difficult to identify a market clearing price in this scheme as it is with the tax (assuming that the shares are auctioned, of course), and any other way of running the scheme is sure to carry either difficulties of its own, or charges of arbitrariness which would sever the connection between the problem and the solution.

So ultimately, what we're faced with is a situation in which the only two policy suggestions that are on the table are not particularly well suited to the task of "solving" the problems arising from climate change (and I haven't even begun to address the question of how the compensation process would even work, or whether compensation could make climate change legitimate!), and the only way to make either of them work is to basically stretch and contort them until they are made to do the job acceptably. Doing so, it will be noted, requires in both cases that government decision-makers possess knowledge and foresight which they almost certainly do not have, and even then it's unclear that the policies would work properly.

Obviously, there's a lot more to say about this. I just wanted to get some preliminary thoughts down, and I think this was a good start.