These comments come frim Jim Kerr and his colleague, Neal Cabral, a partner with McGuireWoods in Washington, DC

This week's question asks whether a carbon tax or a cap-and-trade program is a better "fit" for addressing greenhouse gas emissions. The answer comes down to, quite simply, whether the primary objective of the legislation is cost certainty or whether it is environmental (cap) certainty.

Under a carbon tax approach, a tax is set on emissions of GHGs at some point in the economic chain, and economic actors respond to this tax by reducing emissions to avoid it. The question is, how much will emissions be reduced, and the answer is, again quite simply, emissions will be reduced to the extent that the costs of GHG emission reductions are less than the cost of the tax. As a consequence, while the costs of a carbon tax program are fixed and certain (the amount of the tax times the amount of taxable emissions), the reductions that would be obtained under the program are uncertain (the tax gets whatever reductions it gets). In contrast, a cap-and-trade program fixes as certain the level of reductions that are to be obtained by limiting the tons of permissible emissions, while the costs of meeting the cap are unknown and uncertain (meeting the cap will cost whatever it will cost).

Having reviewed the interesting arguments of my fellow contributors, I continue to believe a cap and trade approach is preferable to a carbon tax for the following reasons:

1. Evidence mounts that carbon dioxide levels in our atmosphere are increasing more rapidly than projected bringing us closer to unmanageable climate problems. U.S. action to reduce emissions is needed soon. While the obstacles to enacting cap and trade legislation are substantial, enacting a carbon tax in the current political environment seems unlikely. (Indeed, many of those who suggest it is preferable to a cap and trade approach are not clear that they themselves would support a tax.) Shifting the policy discussion from a cap to a tax could engender years of delay.
   
2. While a carbon tax might be simpler at face value, there is nothing simple about the U.S. tax code. A carbon tax would likely soon be tangled up with other tax code provisions and with revenue raising objectives not related to energy and climate change. In the process, its impact in driving carbon reductions could be lost or diluted.
   
3. Climate change is a global problem and requires a global response. U.S. cap and trade legislation can be informed by, relate to and influence cap and trade initiatives already in place in Europe and can ultimately be part of a global standard. It can catalyze greater action by and help build mitigation infrastructure in other countries – both those with caps themselves, and those that participate in offsets mechanisms, such as the Clean Development Mechanism under Kyoto.
   
   Unless our actions here in the U.S. inspire similar actions among other large emitters of carbon, our efforts to reverse climate change will be lost. It is not clear how a tax would achieve this result. Suggestions that carbon taxes could be harmonized across national borders would immediately run into long-standing opposition to tax harmonization, as well as challenges stemming from the vastly different taxation systems deployed by different countries.
   
4. A cap and trade program could credit successful efforts to reduce deforestation, as well as other mitigation opportunities in developing countries. Deforestation is contributing 20 percent of global greenhouse gas emissions, and in many developing countries it accounts for an even higher proportion. Allowing measurable and verifiable reductions in deforestation (and potentially reductions in the loss of other natural systems) against a pre-determined baseline to be credited in a U.S. cap and trade program would be a cost effective way to lower emissions. This could help reduce costs for American businesses and consumers by allowing relatively inexpensive reductions to be credited against emissions here. Such forest offsets would increase incentives for developing countries to participate in an international treaty that significantly limits global emissions.
   
5. A cap and trade system has greater potential to create partnerships and synergies among industries and across borders than an every-emitter-on their- own approach.
   
6. And finally, a recession actually emphasizes another benefit of a cap-and-trade program: It sets a price on carbon that is responsive to market conditions. Because emissions tend to decline with economic activity during a recession, the allowance price will also decline, and the cap would put less pressure on businesses to reduce emissions further. A tax offers no such flexibility: it would have to be adjusted year by year to achieve the same effect.

The primary question we should ask when comparing a carbon tax with a cap-and-trade system is which policy is best suited to reduce emissions to a level scientists conclude would allow us to avoid the worst consequences of climate change.

In principle, a carbon tax could be as effective as a cap-and-trade system. But in practice, it likely would be more difficult to reach an emissions reduction target under a tax. A carbon tax would set a price on pollution, but it would not guarantee a specific reduction level. A cap-and-trade system, on the other hand, could guarantee a reduction target while letting the market set a price on carbon.

In either case, a system beset with loopholes or giveaways to polluters would not accomplish its intended goals. President Obama and some key members of Congress support the idea of a cap-and-trade system. A well-designed system would auction the vast majority of allowances, or permits to pollute, to ensure that the market sets a realistic price on carbon early and that polluters don’t receive unfair windfall profits. A percentage of revenues from auctioning pollution allowances should be invested in projects that will cut pollution, help us adapt to unavoidable temperature increases, and improve the economy: renewable energy development, energy efficiency, a smarter electricity grid, preserving tropical forests, creating green jobs, protecting communities and natural resources and providing consumer relief, especially to those most in need.

It also is important to note that a cap-and-trade system or an economy-wide carbon tax are not substitutes for other policies and programs. Addressing the challenges before us –- curbing our dependence on fossil fuels, global warming, rebuilding our economy –- will require a multitude of policies and tools. The solution to our energy, environmental and economic problems will come from deploying a suite of strong policies, including stronger fuel economy and renewable electricity standards, that work in tandem with an economy-wide cap. A carbon tax may be one of those other policies, too. There are some industries, such as oil refining, which may be more appropriate for a carbon tax than a cap-and-trade system.

We need to be pragmatic about our approach, and we need to take concrete action as soon as possible.

Either a carbon tax or a cap-and-trade program could work to reduce greenhouse gases and provide incentives for increasing the use of renewable energy--it all depends on the details. For example, is the carbon tax high enough to provide an incentive to switch to non-carbon-based fuels? How soon would it be imposed and how quickly would it rise? How would the revenue be used—is some of it used for renewable energy? In evaluating a cap and trade system, one has to ask, What are the required emissions reductions? When are they required? Are allowances auctioned or given away? Does the renewable energy sector receive financial compensation for the emissions reductions created by this non-polluting energy source?

In addition, whatever mechanism Congress chooses in a climate bill should be based on a recognition of the value of zero-carbon technologies in reducing emissions, and should attempt to blend climate legislation with complementary policies that are needed to reduce emission, such as a Renewable Electricity Standard (RES).

At the moment, there appears to be more support for the cap and trade system—including from President Obama and, in Congress, Chairman Henry Waxman of the Energy and Commerce Committee, Chairman of the Senate Energy and Natural Resources Committee Jeff Bingaman, and Chairman of the Senate Environment and Public Works Committee Barbara Boxer.

But it’s possible that the political balance could shift toward the tax with the support from former Vice President Al Gore and others. And it is not clear at this point how the recession will change that political calculus. There are many, including the President, who argue that climate legislation can create jobs and help solve our nation’s economic troubles, not contribute to them. It’s far too early to predict the exact policy mix that will emerge, or the final details of individual components. The most important decision, in a sense, has already been made: the election of a President and majorities in Congress that are serious about attacking the climate change issue.

And there is little doubt that wind energy can play a significant role in reducing greenhouse gas emissions, including in the all-important near-term. There is no reason to wait on new technologies to implement a greenhouse gas reduction program. Based on increased use of wind energy assumed in the Department of Energy’s 20% wind vision report (released in May 2008 and available here: http://www.20percentwind.org), wind energy can reduce electric sector emissions by about 16% or 45 million tons in 5 years (by the end of 2013), by about 30% or 160 million tons in 10 years (by the end of 2018), and by about 32% or 219 million tons in 12 years (by the end of 2020). Cumulative emissions reductions attributable to wind energy under the 20% scenario are 7,600 million metric tons of CO2 by 2030, rising to over 15,000 million tons of C02 by 2050.

To see more on the wind energy industry’s climate agenda, see http://www.newwindagenda.org

While NARUC and our State utility regulatory members have not taken a position on whether a cap-and-trade program or a carbon tax is the most appropriate method for curbing climate change, we support the enactment of a workable and efficient emissions reduction program as necessary to reduce uncertainty and protect the environment. Importantly, whatever system is eventually implemented must take into account the welfare of our citizens who will be called upon to pay the cost of this effort—whether cap and trade, a tax, or a combination—through their energy bills.

We say this knowing that utility rates will increase no matter what action Congress and the Obama Administration take, but especially in these economic times, we must soften the blow on consumers as much as possible.

NARUC’s Task Force on Climate Policy is analyzing how best to protect consumers in a carbon-constrained environment, since it is our members that will be tasked with ensuring that costs related to compliance with new climate regulations are just and reasonable. As of yet, NARUC has not reached consensus on whether, in a cap-and-trade policy, for example, an “off-ramp,” “circuit breaker,” or other cost-containment measures are the best way to protect consumers. However, we do believe that some kind of mechanism is necessary. Given the current economic climate, faith in the free market system is under question, and many NARUC members remember the 2000-2001 Western energy crisis, when another complicated energy market system literally cost consumers millions.

As Congress and the Obama Administration work out the complicated details of the nation’s needed climate policy, NARUC will be outspoken in ensuring that the voice of the consumer is heard. In any climate plan, American citizens will bear the ultimate burden, but we must find ways to keep that burden manageable.

We have to act now to put a cap in place with strong near and long-term targets. A cap is more effective than a tax for two reasons. First and most important, it sets a goal for emissions reductions. A tax may limit people’s release of carbon, but it may not do it enough to change the course of global warming. A cap--especially a declining cap--gives you firm reduction targets and a system to measure when you hit them.

Second, all the current on-the-ground experience in curbing global warming pollution comes from cap programs, while the tax model remains entirely untested. Caps are already being used in the Europe Union and a cluster of 10 Northeastern states. They are underway in California and several other states. Even Congress, the long holdout, seriously debated passing a cap and trade bill last June. I am confident that the new Congress, with guidance from President-elect Obama will pass similar legislation within a year.

The crisis of global warming is so urgent that we can’t wait for lawmakers, industry, and the American people to spend years hashing out the details of an entirely new system. We have to act now.

The wisest way to proceed is to start with being candid about the policy goal that is to be achieved, and what will have to be done to achieve it. When you strip everything else away, the goal is to reduce emissions of carbon dioxide and other greenhouse gases, and to achieve it by making it more expensive to emit those gases. How expensive this will be in the aggregate depends upon how tight the cap on emissions will be, along with how fast it will have to be achieved and the form of the constraint, as different types of constraints will have markedly different transaction costs. That decision will be informed by science and shaped by international and domestic politics.

No matter the form of the carbon constraint, it must make everything that has carbon in it more expensive. That is the whole point. It cannot be pain-free, or else it will not achieve the goal. So everything that has carbon embedded in it – every item we touch or use, every activity we engage in, every transaction we are involved in, every Google search we perform – will need to include a carbon price that encourages consumers to use or favor options that have lower carbon emissions associated with them.

No matter the form of the constraint, you need to send a price signal to get people and entities to use less carbon. It would also seem that any rational policy maker would want to do this in the most economically efficient manner possible, minimizing the transaction costs and any unintended consequences.

A lot of the debate seems to be about “one size fits all” approaches that can be extended to all parts of the economy. I think that would be a mistake. For some sectors of the economy cap and trade might be the best alternative, but based on the experience in the European Union it might not be a good fit for other sectors of the economy. Cap-and-trade and carbon tax policies both pose problems to international competitiveness, and that is the most important policy criteria for any globally traded good. The solution lies in treating the part of the economy that competes with goods from other countries differently.

In the case of energy intensive manufacturers exposed to international competition, such as steel, international sectoral agreements may achieve greater overall emission reductions while keeping the global playing field level. Globally, steelmakers are working on a sectoral approach, which in essence is an agreement to lower CO2 emissions in the steel sector in each steel producing country. Agreement to such an approach means steelmakers have solved the comparability problem and have committed to verifiable CO2 reduction targets. All that needs to be resolved are offsets for the additional cost of energy in each country, as each country’s energy policy may differ. Such a ‘composite policy’ (sectoral approach for globally traded goods and a cap or tax on regional parts of the economy such as energy) also ensures much greater CO2 emissions reductions globally, by virtue of its worldwide commitments – and wasn’t that the purpose in the first place?

Faith in cap and trade as the only “right” way to achieve the policy goal is nearly absolute among many key U.S. policymakers. We are going to need to move past any faith-based solutions, acknowledge that there is going to be a cost for individuals whether we call this a tax or something else, and design a system that will achieve the policy goal at the lowest cost to society. In the end, a rational and efficient system will likely have elements of all the major approaches – tax, cap-and-trade, regulation (CAFÉ), efficiency standards (sectoral agreements) – carefully calibrated for the different circumstances in each part of our economy.

Many economists suggest that a carbon tax has substantial advantages over a cap and trade approach to emission reductions. For example, price volatility for a permit to emit CO2 can arise under a cap-and-trade program because the supply of permits is fixed by the government, but the demand for permits may vary considerably year-to-year with changes in fuel prices and the demand for energy. Price volatility for energy has negative impacts on economic growth. If a cap-and-trade policy were adopted during the current economic crisis, it could make economic recovery even more difficult.
In contrast, a tax on carbon emissions fixes the price of CO2, allowing the amount of emissions to vary with prevailing economic conditions. Many experts conclude that it makes economic sense to allow nationwide emissions to vary on a year-to-year basis because prevailing economic conditions affect the costs of emissions abatement. This flexibility occurs under a CO2 tax because firms can choose to abate less and pay more tax in periods when abatement costs are unusually high, and vice versa in periods when abatement costs are low. This flexibility could be especially helpful to industries trying to cope with an economic recession. Traditional permit systems do not provide similar flexibility because the cap on economy-wide emissions has to be met, whatever the prevailing abatement cost. “Banking” emission credits for future use could help provide flexibility under a cap-and-trade system; however uncertainty about whether new climate change policies will be maintained could undermine the desire to reduce current production in order to bank emissions for future use.
Another factor to consider as the U.S. contemplates mandatory approaches policies to reducing greenhouse gas emissions is that the European Union’s cap-and-trade system, called the Emission Trading System (ETS) has not had much success in slowing GHG growth. The latest data from the European Environmental Agency the largest industrialized countries will exceed their Kyoto Protocol target by about 4 percent in 2010 unless strong new measures to curb demand are undertaken. In addition, a recent GAO report, “Lessons Learned: An Evaluation of the European Union’s Emission Trading Scheme and the Kyoto Protocol’s Clean Development Mechanism” (November 2008) concludes that the ETS and the Clean Development Mechanism-a policy that allows companies to claim credits for emission reductions in developing countries-has not had much success so far.
Furthermore, studies have shown that a ca- and-trade program that gives away (rather than auctioning the permits) can be highly inequitable; the reason is that firms receiving allowances reap windfall profits, which ultimately accrue to individual stockholders, who are concentrated in relatively high-income group. During the current recession, our focus should be on policies to help low and middle income households cope with job loss and mortgage foreclosures rather than providing windfall gains to shareholders whose companies are granted allowances. A carbon tax could provide revenues that could be recycled to help those who need it most as well as funds for research and development for new technologies. A key component of any mandatory U.S. program should be allowing emissions to increase as both economic growth and U.S. population increase. In addition, a carbon tax could be adjusted over time if the desired emission reductions were not forthcoming,
Finally, U.S. policymakers should keep their focus on the global growth in emissions. To be effective, policies to reduce global GHG concentrations must include both developed and developing countries. Polices which enhance technology development and transfer are likely to be more widely accepted than those that require sharp, near-term reductions in per capita energy use. Extending the framework of international agreements such as the Asia-Pacific Partnership on Clean Development and Climate to other major emitters will allow developed countries to focus their efforts where they will get the largest return in terms of emission reductions for the least cost.

The right answer might be both. Cap and trade for large-source electric power and industrial, and taxes for transportation fuels. And perhaps even an EPA driven abate & trade industrial market - rather than a cap & trade financial market (it is not necessary to create, distribute, and account for the massive value of allowances just to get an emissions cap). But the level of dialogue might be raised if we turn to the tougher questions on executing either policy.

Ten Questions on Carbon Tax versus Cap and Trade

1. Can we pick a tax level, and appreciation rate, where “risk-averse” emitters will invest sufficiently in clean technologies instead of just paying the tax and continuing to emit the same amount of co2?
2. Do we have the policy agility to adjust the level of the tax sufficiently to meet national (and potentially international) goals for emission reductions?
3. What if utility regulators allow pass-through of the tax but don’t ensure a financial return on risky investments in clean technologies until they know that they work? Couldn’t this be a huge disincentive to invest in clean technology?
4. If an appreciating tax curve is below the projected cost curve under cap and trade - what if we find in a decade that we need more rapid reductions and don’t yet possess the technology?
5. At a co2 price of, say, $20 per ton the value of the first year of economy-wide cap and trade allowances is about $120 billion. Can emitters fund this amount in the capital markets if all are auctioned?
6. If all allowances are auctioned, and funding constraints make just a year at a time auctionable, how will emitters manage a potentially 40-year abatement liability with just one year (initially) of allowances outstanding? Won’t this make derivatives the dominant co2-trading instrument?
7. To the degree that allowances are auctioned, or otherwise paid for by emitters, will they be marked-to-market on emitters’ balance sheets? If emitters use futures and options, will they also be marked-to-market? Can we manage the earnings volatility created? Will mark-to-market lead to OTC derivative structures that avoid it?
8. If cost containment is deployed, can the U.S. carbon market operate without a risk premium if some “omnipotent force” can drive co2 prices down on a moment’s notice? Isn’t that a disincentive to owning U.S. allowances?
9. Could the EPA just pick a baseline year for large source electric power industrial emissions and simply require each emitter to cut their pro-rata share by, say, 2% per annum – and allow them to debit or credit their obligation by trading with other emitters? Couldn’t such a smaller industrial market for abatement be a more pragmatic approach in this environment than a huge new financial market for allowances?
10. Aren’t carbon taxes for transportation fuels (like gasoline taxes or low-carbon fuel subsidies) arguably a more efficient solution if we want new technology and emission reductions from that sector, given that most economic models indicate only modest abatement from transportation under economy wide cap and trade?

Although both would slow and eventually reverse the growth of greenhouse gas emissions by increasing the prices of fossil fuels, there are important differences between a cap-and-trade approach and a carbon tax. While these differences are not quite as stark as they sometimes are made out to be, they are real--and they favor the carbon tax.

Principal among them is the revenue raising potential of a carbon tax. True, if the permits created under a cap-and-trade system were all auctioned off, it could raise the same amount of revenue as a carbon tax. But it's simply naïve to believe that politicians will enact such a measure when, by allocating allowances free of charge to their favored constituencies, they can curry the favor that comes from giving away literally tens of billions of dollars.

Why care about these revenues? After all, at the moment aren't we giving away hundreds of billions in an effort to jump-start a nearly moribund economy? Yes, at the moment. But another moment will come soon--one in which the challenge will be to cool off an economy fueled by cheap money and whopping deficits, and in which the added burdens of growing social security and Medicare commitments will place unprecedentedly large strains on the federal budget. Before long we'll need the revenues from a carbon tax which, even at initially modest levels (say $20/ton of CO2), will yield tens of billions.

There's another reason to like a carbon tax that even many of its proponents won't discuss. Suppose--just suppose--that the "climate skeptics" are right and that the warming we have observed these last however many years is NOT due to the accumulation of CO2 and other greenhouse gases in the atmosphere. If that happens, it will be a helluva lot easier to gradually reduce the level of the carbon tax (who'd complain about that other than tax lawyers?) than it would be to print up extra carbon allowances and, in the process, devalue all the permits that are held at the time.

There are other advantages to the tax approach, as well, along with a disadvantage or two. Other contributors to this blog will no doubt identify then. But remember this: unless we identify new sources of federal revenues and soon, the climate problem won't be the only problem we'll be leaving for our grandchildren--and may not even be the biggest.

While political leaders in the European Union, Canada, Australia, Japan, and the United States (White House and Congress) move toward cap-and-trade systems as their preferred approach for achieving meaningful reductions in emissions of CO2 and other greenhouse gases, there is a debate -- often populated by my fellow economists -- regarding the choice between two market-based instruments: cap-and-trade and carbon taxes.

I am by no means opposed the notion of a carbon tax, having written about such approaches for more than twenty years. Indeed, both cap-and-trade and carbon taxes are good approaches to the problem; they have many similarities, some tradeoffs, and a few key differences. I am opposed, however, to the confused and misleading straw-man arguments that have sometimes been used against cap-and-trade by carbon-tax proponents.

While there are tradeoffs between these two principal market-based instruments targeting CO2 emissions -- a cap-and-trade system and a carbon tax – the best (and most likely) approach for the short to medium term in the United States is a cap-and-trade system. I say this based on three criteria: environmental effectiveness, cost effectiveness, and distributional equity. So, my position is not capitulation to politics. On the other hand, sound assessments of environmental effectiveness, cost effectiveness, and distributional equity should surely be made in the real-world political context. Let me explain.

Before I go further, I should acknowledge that I developed a proposal for The Hamilton Project of an up-stream, economy-wide CO2 cap-and-trade system to cost-effectively achieve meaningful greenhouse gas emissions reductions (the proposal is available at www.stavins.com or www.hamiltonproject.org), and so I can hardly claim to be a disinterested observer.

Having said that, the key merits of a well-designed cap-and-trade approach are, first, it can provide cost-effectiveness, while achieving meaningful reductions in greenhouse gas emissions levels. Second, it offers an easy means of compensating for the inevitably unequal burdens imposed by a climate policy. Third, it provides a straightforward means to harmonize with other countries’ climate policies. Fourth, it avoids the current political aversion in the United States to taxes. Fifth, it is unlikely to be degraded – in terms of its environmental performance and cost effectiveness – by political forces. And sixth, this approach has a history of successful adoption and implementation in this country over the past two decades.

There are some real differences between taxes and cap-and-trade that need to be recognized. First, environmental effectiveness: a tax does not guarantee achievement of an emissions target, but it does provides greater certainty regarding costs. This is a fundamental trade-off. Taxes provide automatic temporal flexibility, which needs to be built into a cap-and-trade system through provision for banking, borrowing, and possibly a cost-containment mechanism. On the other hand, political economy forces strongly point to less severe targets if carbon taxes are used, rather than cap-and-trade – this is not a trade-off, and this is why environmental NGOs are opposed to the carbon-tax approach.

In principle, both carbon taxes and cap-and-trade can achieve cost-effective reductions, and – depending upon design -- the distributional consequences of the two approaches can be the same. But the key difference is that political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs, as some low-cost emission reduction opportunities are left off the table. But political pressures on a cap-and-trade system lead to different allocations of allowances, which affect distribution, but not environmental effectives, and not cost-effectiveness.

In other words, proponents of carbon taxes worry about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax is sensitive to the same political pressures, and may be expected to succumb in ways that are ultimately more harmful: reducing environmental achievement and driving up costs.

The Hamilton Project staff concluded in an overview paper (which I highly recommend) that a well-designed carbon tax and a well-designed cap-and-trade system would have similar economic effects. Hence, they said, the two primary questions to use in deciding between them should be: (1) which is more politically feasible; and (2) which is more likely to be well-designed?

The answer to the first question is obvious; and I have argued here that given real-world political forces, the answer to the second question also favors cap-and-trade. In other words, it is important to identify and design policy that will be “optimal in Washington,” not just from the perspective of Cambridge, New Haven, or Berkeley.