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Carbon tax or cap and trade? Bad economics is muddling the debate

with 19 comments

There are two articles in the Globe today that perpetuate bad thoughts on carbon policy and carbon costs. The first article (see here) pegs costs way too high by assuming that every single molecule of carbon results in a uniform costs at the highest carbon price, say $50,

At $15 a tonne, if Keephills were to fail to cut 12 per cent of its emissions, or 360,000 tonnes, the price tag on the facility’s emissions would be a mere $5-million…But at $50 a tonne, the price for Keephills would rise to $18-million. For all of TransAlta’s Canadian operations, the total penalty at $50 a tonne would rise to about $170-million.

But, there will be lower cost opportunities at the facility. So they will take abatement action and make carbon reducing investments up to the point where they can either get cheaper reductions elsewhere through trading or pay some sort of fee like that enabled under the Technology Fund or a carbon tax. And if there is recycling even this cost would be reduced on remaining emissions.

As a very general rule of thumb, since the marginal cost curve is rising (that is more reductions are more expensive), the total cost of reductions is total emissions times the carbon price divided by 2 or

Total costs = ~(Qemissions * Pcarbon)/2

This is essentially the area under the marginal abatement cost curve fixed by the price (tax) or quantity (cap/allocation) constraint. So, in the example cited, the costs are more like $8 million for the facility and $85 million for all TransAlta’s operations. And most likely there is a facility target and therefore no cost for remaining emissions of if the target emissions are achieved the fee on remaining emissions is returned (as in the case of Sweden). Suppose there is a 25% reduction required from 360,000 tonnes. This then lowers actual costs of about $2.25 million. Not trivial but not nearly as high as reported.

And where to start on the second article (see here). Here are a few samples from the article,

A much better, more effective route is a cap-and-trade system with auctioned allowances, under which government sets the future target for emissions – the cap – and turns to free market mechanisms to achieve those targets… government then has to make a guess as to where to allocate all of the carbon-tax revenues, hopefully avoiding the appearance of pork barrel politics and special interests.

With auctioning of permits, the firm must buy their allocations, which transfers cash to the regulator, and thus the cap and trade behaves a lot like a taxes. Government still has to deal with the revenue.

And then this,

A tax is simply not the best way to create effective incentives to cut emissions, and it’s not the right mechanism for promoting innovation that will abate human-caused climate change.

This argues that taxes will not result in continuous improvement, that is an ongoing incentive to reduce emissions. Not likely, since the firm will continue to see the tax and thus seek ways to avoid paying it though making investments that lower emission while minimizing the tax burden.

And perhaps most challenging,

…That’s because a carbon tax puts the government into a nearly impossible Goldilocks scenario: It must set the price of carbon just right. Not too high, meaning everyone overpays and the economy is damaged. And not too low, in which case emissions reductions are not maximized. Additionally, as we move forward, we cannot afford a system where carbon prices remained static in such a dynamic environment.

But if we set a cap too high and there is no cost constraint (i.e. price cap), costs emerge that are unanticipated. Government then has to release more permits to reduce compliance costs, which dilutes the cap (more emissions) and reduces the real value of permits (like printing money and causing inflation). In practice, the regulator will have to adjust either the cap or the tax rate as new information on climate science, cost and abatement responses emerge.

Both cap and trade and a carbon tax have challenges that need to be sorted out. But we need better reporting on this stuff. Otherwise we will continue to muddled and mired in debate…but then again that suits some folks just fine.

Written by Dave Sawyer

February 11th, 2008 at 3:22 pm

19 Responses to 'Carbon tax or cap and trade? Bad economics is muddling the debate'

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