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The Speediness Criterion: Is cap-and-trade always inferior to carbon tax?

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There is an article today indicating more delays with rules for California’s cap-and-trade program (here)

California’s blueprint to address global warming won’t include details of an emissions-trading program as regulators try to build consensus on how best to organize the market-based system….”They were a long way off at approaching consensus on the major design elements.”

This outcome is hardly surprising given the administrative complexity of cap-and-trade systems. Indeed, this is a major reason why carbon taxes tend to be preferred — complexity. But, do cap-and-trade systems necessarily take more time to implement than carbon taxes?

To answer this, one can look to the differences in the decisions required to implement the two emission pricing options. Regardless of the emission pricing policy, cap-and-trade or tax, there are a series of common questions that must be addressed by decision-makers. These include questions of who is covered and what is the desired goal, be it certainty in emission reductions or containing costs. Questions of revenue need are also common to both, with a need indicating a preference for auctioning in cap and trade. Similarly, linking with other jurisdictions must be considered under both cases, wherever it is a question of the two-way linking to allow trading or simply to ensure that carbon prices align to minimize competitiveness impacts.

While carbon taxes tend to align more closely with existing institutional functions, cap-and-trade systems are not that different. Auctioning telecommunications rights is standard practice, as is emission monitoring and verification and allocating transferable rights in the fishery. But as in the fishery, it is this last function that requires time. Allocation is really the source of why cap- and-trade systems are relatively slower to implement. The source of this is uncertainty is over both economic gain and possible economic loss. Since cap and trade systems have unknown prices in advance of implementation, there is price uncertainty, and therefore more policy caution as well as constituent engagement. This engagement slows implementation through opening the door to gaming by both participants and policy makers alike. Contrasting allocation decision making to setting a common tax rate and one can readily see why cap-and-trade is less speedy to implement.

But is this necessarily a given outcome? Likely not under at least two conditions:

• First, if policy makers decide that allocations will be set on rules over discretion then these rules simply need to be established and the allocations made. But still, the rules must be contemplated and set; and,

• Second, if cost uncertainty is taken off the table through an over allocation of permits, prices will be low, and the threat of adverse cost outcomes minimized. Of course the trade-off is lower emission reductions, but really this is analogous to a low tax rate that can be ratcheted up (or the cap down) in time.

And is slow implementation necessarily bad? Likely not given that CO2 is a stock pollutant and cumulative emissions matter. We would likely be indifferent between a fast to start carbon tax system versus a slower to start cap and trade system as long as cumulative emission reductions are the same. What matters here is the cumulative emission reductions, and with a stringent future cap, perhaps speediness is not necessarily better relative to a low tax given the cumulative reductions.

So while cap and trade is is more likely a slower option to implement, it is not necessarily inferior to cap and trade when considering a stock pollutant such as CO2. And design and policy choice can blur the lines on the speediness criterion, thus making us indifferent between the two.

Written by Dave Sawyer

November 11th, 2008 at 1:40 pm