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The Politics of Carbon

The 2008 elections portend federal regulation of greenhouse gases by 2010.

Fortnightly Magazine - June 2008

permits to pollute in an amount up to the allowance. The permits could then be traded in a marketplace. In theory, the cap-and-trade system achieves the desired level of pollution at minimum cost, as firms with low abatement costs adopt pollution controls and firms with high abatement costs purchase permits and pollute.

In general, most economists favor a carbon tax. Taxation generally is superior to cap-and-trade systems from a social welfare standpoint when there is uncertainty about the optimal level of pollution and the costs of pollution controls are increasing. Most economists believe the costs and benefits of controlling GHG emissions exhibit these characteristics. When pollution-control technologies are expensive, a cap may impose unreasonable costs on GHG producers.

Economists also favor a carbon tax because it provides cost certainty, which facilitates investment planning. In contrast, a cap-and-trade system involves considerable cost uncertainty and variability. For instance, in the European Trading System, the European Union’s carbon emissions trading market, the price per ton of CO 2 in 2006 ranged between $12.12 and $38.98.

Many economists and other policymakers find the potential for this kind of variability unacceptable. Thus, many proposals for cap-and-trade systems call for safeguards against high and variable emissions prices, popularly referred to as a safety valve. One form of safety valve is a price ceiling maintained by the government through the sale of additional permits. With a low ( i.e., binding) price ceiling, the cap-and-trade system functions much like a tax, as firms would be able to pollute as much as they like at the ceiling price. The market price is lower and emissions higher with a safety valve (see Figure 1) .

A second type of guarantee against price volatility shifts the costs of CO 2 reductions forward in time by allowing firms to borrow against their future allowances. Under such a system, firms are able to pollute more today in return for greater reductions in their emissions tomorrow. In theory, such a system would lower the costs of complying with new GHG regulations (as there would be time to develop new, low-cost pollution-control technologies) while maintaining the integrity of the cap. However, allowing firms to borrow against future allowances may create a time inconsistency problem, as producers of GHGs might pressure lawmakers later to relax limits on emissions. This would undermine the integrity of the cap.

Political Virtues and Vices

Although a carbon tax has many economic virtues, a tax-based system of controlling GHG emissions is unlikely to be instituted in the United States. Two characteristics of a cap-and-trade system give it an advantage over a tax in national politics. First, a cap-and-trade system avoids direct taxation while still relying on market principles. This makes it attractive to politicians wanting to avoid the stigma of raising taxes. Second, the cap-and-trade system gives supporters of GHG legislation a valuable bargaining chip during legislative negotiations with powerful special interest groups opposed to limits on emissions. The support of these interests and that of reluctant lawmakers may be won with agreements to distribute permits to certain industries for free on