How to do cap and trade

The prospects for carbon cap and trade this year are not good: the Senate has too many doubters, Democratic and Republican alike. Still, the measure in the House is interesting. In this new column for National Journal, I argue that with a nip here and a tuck there, it could be made to act like a carbon tax in all but name. A carbon tax has a lot of advantages. And not having to call it that would be even better.

Many economists would prefer a carbon tax to cap-and-trade. One reason is that it makes this kind of fiscal gaming a bit more difficult and -- saying the same thing in another way -- a bit easier for the general public to spot.

A more fundamental difference is that a carbon tax sets a price on greenhouse-gas emissions and, in effect, lets quantities fall where they may. Cap-and-trade does the opposite: It sets a quantitative ceiling, and then the price of a permit -- in effect, the tax rate on carbon, by another name -- moves up and down according to the severity of the limit and economic circumstances. If the ceiling presses down very hard at a time of rapid economic growth, the permit price will be high; set the ceiling high enough in relation to economic activity, and the permit price would fall to zero, because nobody would have to reduce their emissions to comply.

The notion of keeping the tax constant and letting quantities vary also fits with the idea that additional carbon emissions have a known environmental cost. In principle, if you set the tax rate equal to that cost, the market can be left to decide what the correct ceiling on emissions should be. Most environmental scientists, however, would prefer to set a ceiling for the sake of extra certainty in achieving cuts of a particular size. The case for this is stronger if the damage caused by carbon emissions has so-called threshold effects -- that is, if the damage rises discontinuously once a certain line is crossed, which is a distinct possibility. You set a ceiling to ensure that the threshold is not crossed.

The trouble is, using that approach, the implicit carbon tax may then fluctuate so much that it disrupts the economy and makes energy planning for the future more difficult. Moreover, the logic of threshold effects is a little dubious when you are setting limits for the U.S. economy in isolation. Global carbon emissions, not national carbon emissions, drive global warming. The United States can set a quantitative ceiling for its own emissions, but even if it complies with that target, emissions elsewhere will decide whether a critical global threshold is crossed.

The draft bill actually envisages a compromise between the two approaches. It would create a "strategic reserve" of extra permits that could be allocated to prevent "unexpected allowance-price fluctuations." If this reserve were of sufficient size, and if it were used to hold the prices of permits steady at a specific amount -- say, $20 per ton of carbon -- then the result would be akin to an outright carbon tax set at that rate. If the architects of cap-and-trade have something along these lines in mind, the case for cap-and-trade over an explicit carbon tax collapses, and vice versa: The two become one.

If cap-and-trade were administered this way, the only remaining differences would be whether you use the word "tax," and how much cover you give to Congress in creating and disbursing pork.

You can read the whole column here [link expires in ten days].