Tax vs. Trade, or Attitudes in the Carbon Economy

Tax vs. Trade, or Attitudes in the Carbon Economy

On his mock-"conservative news" show, Stephen Colbert once earnestly implored an environmentalist guest who warned about the impact of unrestrained carbon emissions, "Please, tell me, what can I do to cut carbon emissions ... without inconveniencing myself in any way?"

Many businesses feel that way. Their first choice would be for no system, but by now most businesses realize that some sort of regulation is inevitable. Their biggest wish is for a clear signal from regulators about what's required of their companies. Given this reality, their clear second choice among methods to cut greenhouse gases is "cap-and-trade," also known as emissions trading.

Precedent has a lot to do with this. Emissions trading began in the 1990s for sulfur dioxide and nitrous oxide, and the system worked better than even its advocates hoped. Even though the carbon dioxide trading will be much larger and more complicated than the last decade's markets, the historical experience with emissions trading has played a large part in winning its wide acceptance. Many U.S. utilities like it, or can at least live with it. The flexibility of cap-and-trade is a huge plus for businesses -- participants choose their specific method for cutting or offsetting their emissions.

Under a cap-and-trade program, the Kyoto Protocol sets an overall emissions cap for each country. Participating governments then issue or auction allowances that grant businesses the right to emit a set amount, and these allowances can be traded. Green companies and projects with low emissions can sell their surplus allowances to others whose emissions exceed their allotment. Relying on the market, a cap-and-trade system lets a nation reach its cap at the lowest cost.

In political terms, the opacity of cap and trade does have a few cynical benefits. Governments can placate politically powerful polluters with permits, or pay developing countries to cut their emissions without any cash changing hands between governments.

Europe's cap-and-trade system, the ETS, is actually making progress. The system covers more than 10,000 sources and has spawned a dynamic emissions trading market with millions of transactions per month. Kyoto calls for more types of emissions to be brought into the system in the coming years.

Cap-and-trade readily links with other emissions trading systems around the world. In today's global economy, where companies operate in multiple countries, this kind of system reduces the incentives for companies to flee to more lax jurisdictions. Cap-and-trade could also allow the ''banking'' of emission allowances -- reducing emissions early and using the saved emission allowances later.

Not every business sector is fond of cap-and-trade. Oil companies would be obliged to buy a great many allowances, as would the most coal-intensive utilities. A number of regional carbon trading initiatives are coming in the US, including the Regional Greenhouse Gas Initiative, or RGGI, in the Northeast, usually pronounced "Reggie." Its less-evolved counterpart in the western states is struggling to come up with a name that doesn't get pronounced "Wedgie."

To Tax or Not to Tax

The most prominent alternative to emissions trading is a carbon tax, in which emitters are required to pay a tax for every ton of pollution they emit. Most economists agree that carbon taxes are a better way to reduce greenhouse gases than cap-and-trade schemes. And yet a carbon tax has virtually no political support. Taxes are poison in America, where years of propaganda have undermined their legitimacy and make them almost impossible to get through congress. Many conservatives instinctively recoil from any tax, no matter how important the goal. Businesses often dislike the one-size-fits-all nature of a tax.

Undeterred by politics, tax advocates like the Carbon Tax Center and others tout the superiority of taxes.

  • A tax would result in a predictable price -- and business likes predictability. In the current system, volatile swings of the carbon price hampers investments in renewable energy and efficiency.
  • Taxes are transparent and easily understandable.
  • Taxes can be implemented much sooner than complex cap-and-trade systems, which require the arduous negotiation of many details.
  • Carbon taxes hit every sector, while existing cap-and-trade systems have only targeted the largest emitters, which account for less than 40 percent of emissions. Small business, in particular, might never encounter the need for an offset -- but they would still pay a tax.
  • Carbon tax revenues can be returned to the public through progressive tax-shifting, while the costs of cap-and-trade systems are a hidden tax. Its biggest winners are market participants, lawyers and consultants.
  • Carbon taxes are less prone to manipulation, while a cap-and-trade system's complexity empowers special interests and creates perverse incentives that can erode its effectiveness.

Under a carbon tax, the transfers to developing countries demanded by Kyoto and its successor agreement would set off loud alarm bells in the budget. Try explaining to a laid-off autoworker that we're paying billions to China to not build coal plants.

Other supposed pluses for a tax are probably illusory. The finagling flaws of cap-and-trade would also hobble a tax. Just consider the baroque complications and special dealing that encrust the U.S. tax code. System gaming would not be confined to emissions trading -- it would just take different forms under a carbon tax.

Is There a Perfect Solution?

So what would a perfect system look like? The best set-up would closely link economic activity to the supremely important goal of cutting greenhouse gas emissions and halting climate change. That means winning the wholehearted participation of businesses. It should be simple and able to use markets to achieve its goals. Its design would eliminate most possibilities of finagling the rules for profit -- no system-gaming.

One's choice of a method hinges on attitude towards the market. "Free marketers" who subscribe to no-regulation orthodoxy favor cap-and-trade. Foes of emissions trading are offended by the idea that you can actually buy the right to pollute.

Even after hearing out the tax advocates, most businesses would favor the emissions trading system. Unless they're like Stephen Colbert, and personal comfort is the only thing that matters.

Brian Thomas, a writer who specializes in climate change and the capital markets, maintains the blog "Carbon-Based." While at Swiss Re, he managed the firm's participation in the Harvard Medical School's "Climate Change Futures" project.