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The Argument for Cap-and-trade (Or why the IGM is wrong)

There seems to be a settled consensus among economists that carbon taxation is superior to cap-and-trade with support from Jeffery Sachs, Nobel Laureate Gary Becker, Exxonmobil CEO Rex Tillerson, Sierra Club director Carl Pope, and Pigou Club founder Greg Mankiw. Or these three IGM polls of the biggest hotshots in econ. Any frequenter of this blog would know that this has been my preferred position as well. But I’m pretty sure I was wrong – at least to the extent climate change is our primary goal. And revenue potential of carbon permits wouldn’t be that much worse, just a bit more volatile, especially on an infinite horizon.

Evan Soltas aptly states the biggest problem with taxation (albeit reaching the conclusion that  a carbon futures market is the optimal solution):

There’s just one problem. Nobody knows how big carbon’s negative externality — if any — really is. Richard Tol, an economist at the University of Sussex and an expert on carbon-tax research, has compiled 588 estimates of this number from 75 different studies. In an e-mail he tells me that the interquartile range (which excludes the most extreme estimates) is approximately -$25 to $325 per metric ton of carbon (a negative number means a positive externality).

It’s well-acknowledged that estimating externalities is not easy. But here’s what we do know: eclipsing 2º C above preindustrial levels will be disastrous. Right now, we’re on track to a 6º C world. The World Bank doubts it can fulfill it’s mandate in anything more than a 4º C world. But scientists also know, with good probability, if we stabilize carbon at 400 parts per million (ppm) 2º C world. (And we’ve recently breached this limit, for the first time in history).

In the long-run, we also know approximately how many permits we can issue to be 50% certain that we won’t breach this threshold. (Ensure carbon emissions peak no later than 2016). That is, if there existed sufficient international will, we could solve global warming today, with great certainty, under a cap-and-trade regime.

But externalities are more complicated. What is the difference between the marginal social cost and the marginal private cost of carbon? It’s extremely tough placing a dollar value on the environment. We can more effectively calculate the public health cost thereof, but this will certainly undershoot any hope of averting tail risks with regard to climate change. The Clean Air Act handles most of that, without really touching carbon. That’s why I’m actually peeved that this ever passed – it’s kind of like removing ethyl mercaptan from your propane gas. What kind of an idiot would do that? Carbon, like natural gas, is the invisible and odorless gas that’s killing us.

So naturally, because we have no idea what the hell carbon “costs”, politicians will be unable to price it highly enough. Remember, we have a Congress where a rough half (Democrats included) don’t believe in climate change. And because any suggested tax has to be arbitrary, it will fall on the conservative side. In the future, as economic growth continues increasing demand for carbon-intensive activities will be met with both increased revenue and emissions.

In microeconomics, textbooks often cite an example of two factories polluting in a common river. In this far less complex system, the per-unit social cost can be determined, and internalized. And hence taxation will not be arbitrary. This is the most important point, politically if not economically.

If Congress can commit to averting climate change, we can non-arbitrarily argue the maximum acceptable number of permits for n-degree climate change. The insight here is that what’s keeping us from significant legislation isn’t the extent of political will, but the lack of will itself. Once we “make a move” – whether it be through taxation or cap/trade – it’s likely we’ll do the best we can with reasonable exceptions. Every major reform confirms this bias.

So it’s crucial we get the fundamentals right. Now, there are certain conditions under which taxation is superior. There’s been some fascinating work in carbon capture and storage. This can either be on-site (like at a coal factory) or, more complicatedly, from atmospheric air itself. Under current regulation, plants around the world think this is too expensive, because the technology is very nascent. But if scientists develop viable carbon capturing techniques, the government can very reasonable price each ton emitted at the cost of recapturing from the air.

The not-so-obvious implication of this argument is that carbon taxation is effectively revenue-neutral. If the government has to deploy a large-scale program to recapture emissions, all earned revenue is – by accounting identity – consumed.

A few notes on the very novel solution Soltas suggests:

Nicolaus Tideman and Florenz Plassmann, economics professors at Virginia Tech and SUNY Binghamton respectively, have an ingenious solution. In a paper published in 2010, they say polluters should be made to buy a special 30-year, zero-interest bond from the government for every unit of pollution they emit. The government would set the principal at a reasonable upper-limit estimate of the per-unit cost of pollution. The bond’s redemption value, though, would be set in the future. Bondholders would receive what is left of the principal after subtracting the actual cost of the pollution as determined by an independent agency at the bond’s maturity.

Investors could trade the securities in a secondary market, creating a prediction market for the cost of emissions. Investors who think the bond market is overestimating future costs will buy the bonds. Those who think the market is underestimating the costs will sell them.

“If you’re going to deal efficiently with pollution, it’s appropriate to put an incentive on people to economize,” Tideman said in an interview. “But you’ve got to get the price right. Experience tells us that the best way to get information about the future is a futures market. Our proposal adapts a futures market to address climate change.”

Tideman’s and Plassmann’s insight is that policymakers don’t know the actual future costs of pollution and don’t need to guess. Their market would determine the actual liability of most polluters, except for those who chose to hold the bonds to maturity. This solution uses the ability of prediction markets to synthesize a price from disorganized, disconnected bits of knowledge.

It is ingenious indeed, but not ideal. The independent agency in question will have the same problem government has in pricing carbon (that is it will be underpriced, by political nature), though it benefits future correction from a prediction market. But the whole premise derives from the ability of investors to reasonably deduce what future costs might be. There’s good reason to believe climate change poses serious tail risks, which makes this a pretty futile effort. Reason is, understanding climate science requires a lot of expert knowledge. An effective futures market assumes that said experts are not so risk-averse as to avoid the market to maximize the discounted present value of their profits.

Irrationality may not be a big deal in gold futures because level of expertise isn’t as significant a barrier, and those with the most valuable information aren’t as risk-averse (they will probably be investing on behalf of a bank). The whole idea of prediction markets seems to fall apart if a select few won’t fully divulge information onto the market (that is, maximize their profits without any consideration of risk). Maybe if Al Roth put his mind to it, he’d design a market that fixes this failure. But, until he does, I must hold back my endorsement for Tideman and Plassmann, except perhaps for the most creative solution.

Or perhaps J.K. Rowling ought to write a new book on codfish and the environment…

P.S. Some interesting thoughts from the comment section. Evan Soltas says:

Ashok, something you should read — and the most convincing argument I’ve seen for cap-and-trade — comes from an old article called “Prices vs. Quantities.” http://www.jstor.org/stable/2296698. Weitzman’s reasoning is that at the point where the costs are both uncertain and highly nonlinear with quantity, you can minimize the deadweight loss with a quota rather than a tax. Note that the optimal carbon level is just as hard of a cost-benefits question as a carbon tax. And I think tax wins big points over cap-and-trade when you get into the nitty-gritty of it. If you do cap-and-trade for big firms only, that’s a distortion, and it doesn’t solve the whole issue; cap-and-trade for all firms would be a logistical nightmare. Much easier just to collect tax at the point of production!

Martin Weitzman is one of the most interesting environmental economists (you should check this scary article with a silver lining). Soltas’ point got me wondering, and I’m starting to think climate change is a fantastic real-world manifestation of the Ellsberg Paradox. Me:

Going through [Weitzman’s model] itself, climate change strikes me as the rather perfect example of uncertain costs. And it is at least ethical in the sense of accepting the social discount rate. It really seems like the real-life approximation of the Ellsberg Paradox. (And the Knightian uncertainty thereof is what makes pricing, and to a lesser extent futures, a challenging task). This suggests we should act on this sooner-than-later (even disregarding the scientific benefits of doing so).

And if we do anything at all, it seems it would be easier to legislate command by quantity than by price. I’ve thought a bit about the logistical issue, and wonder if a robust trading regime would spawn several large financial organizations that mediate allocation of permits to smaller firms. Perhaps allowing them to “borrow” a permit today and pay for it later.

The distortion then, of course, is rents earned by said organizations!

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4 comments
  1. Ashok, something you should read — and the most convincing argument I’ve seen for cap-and-trade — comes from an old article called “Prices vs. Quantities.” http://www.jstor.org/stable/2296698. Weitzman’s reasoning is that at the point where the costs are both uncertain and highly nonlinear with quantity, you can minimize the deadweight loss with a quota rather than a tax. Note that the optimal carbon level is just as hard of a cost-benefits question as a carbon tax. And I think tax wins big points over cap-and-trade when you get into the nitty-gritty of it. If you do cap-and-trade for big firms only, that’s a distortion, and it doesn’t solve the whole issue; cap-and-trade for all firms would be a logistical nightmare. Much easier just to collect tax at the point of production!

    • Thanks for the pointer – this is a paper that was cited in something I read recently. What resonates most with me is:

      “In studying such a controversial subject, the only fair way to begin must be with the tenet that there is no basic or universal rationale for having a general predisposition toward one control mode or the other If this principle is accepted, it becomes an issue of some interest to abstract away all “other” considerations in order to develop strictly “economic” criteria by which the comparative performance of price and quantity planning instruments might be objectively evaluated. Even on the abstract level, it would be useful to know how to identify a situation where employing one mode is relatively advantageous, other things being equal”.

      Going through the model itself, climate change strikes me as the rather perfect example of uncertain costs. And it is at least ethical in the sense of accepting the social discount rate. It really seems like the real-life approximation of the Ellsberg Paradox. (And the Knightian uncertainty thereof is what makes pricing, and to a lesser extent futures, a challenging task). This suggests we should act on this sooner-than-later (even disregarding the scientific benefits of doing so).

      And if we do anything at all, it seems it would be easier to legislate command by quantity than by price. I’ve thought a bit about the logistical issue, and wonder if a robust trading regime would spawn several large financial organizations that mediate allocation of permits to smaller firms. Perhaps allowing them to “borrow” a permit today and pay for it later.

      The distortion then, of course, is rents earned by said organizations!

  2. Also, for what it’s worth, when we debate any of these policies, we’re debating welfare losses at least an order of magnitude smaller than the no-action option.

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