A cap-and-trade system means governments put a limit on a nation’s carbon emissions and issue licences for its businesses and maybe its citizens to produce carbon up to that cap. The licences can be bought and sold. This creates incentives for anyone wanting to expand their lifestyle or business to use more carbon-efficient methods, or buy licences from others who have devised such methods. Examples of cap and trade include Kyoto, the European Emissions Trading Scheme, and the United States acid rain program.
A carbon tax is simply a tax that would be paid whenever you buy energy created from fossil fuels.
The rate of tax is adjusted over time to create sufficient incentive for people to reduce their use of fossil fuels (possibly by seeking out more carbon-efficient methods), to the point where total carbon output stabilises around the same level as the cap in a cap-and-trade system. Governments have the option of reducing other taxes by the amount collected under a carbon tax.
In theory, cap and trade is better because it directly affects the quantity of carbon produced. A tax, in contrast, directly affects only the price, and while price will ultimately determine quantity, this relationship is less certain and will change over time. There will be lags as governments work out just what effect the current tax rate is having on the level of emissions, and then adjust the rate if it’s insufficient.
The question, though, is not how the two systems compare in theory but in practice. And there are many problems with cap and trade in the real world.
Robert Shapiro wrote the chapter on a carbon tax in Climate Change: Getting It Right… Shapiro is a consultant who has advised Bill Clinton, Tony Blair and Al Gore, among others. From 1997 to 2001 he was Under Secretary of Commerce for Economic Affairs in the US.
His first objection to cap and trade is that it introduces great and dangerous volatility into the economy. The price of licences “will rise sharply when emissions increase, because, for example, an industry or country’s growth accelerates or the winter weather is colder than expected. … this increased volatility in energy prices will affect business investment and consumption. As the public learns to associate these unexpected price movements with the cap-and-trade system, their support for the effort could erode … this price volatility is both evident and substantial in both the emission permits traded under the US acid rain program … and in the first 22 months of carbon dioxide permit trading under the European Emissions Trading Scheme”.
Another objection to cap and trade is its enormous vulnerability to evasion and cheating. Let’s consider the first step in the system, the setting of the cap. Now, any system would have to be international to make a significant difference to the rate of climate change, and here we strike problems at the start, Shapiro says, because China and India have both said they will never accept a cap on emissions. Optimists hope they will change their position, but it’s hard to see why they should: looked at from their point of view, economic growth is a wonderful thing and they’d be mad to cap it.
Those countries that do accept the need for a cap can still rort the system with guile and luck. Australia has shown this by claiming that a slow-down in land clearing means we’re meeting our Kyoto cap, even though our production of carbon has been booming. In general, the setting of national caps is a process ripe for political manipulation. In contrast, the setting of an international carbon tax, to be binding on everyone, is a transparent process.
The next problem with cap and trade lies with the allocation of licences, again a process open to political abuse, especially in undemocratic countries. Who gets the licences, and for how much? How do you judge the carbon needs of a small but accelerating industry over a big but stagnant one that employs lots of people?
And finally, how do you monitor the amount of carbon produced by all the licence holders? Expensive but possible in Australia. A bad joke in Russia. Yale economist William Nordhaus says “cheating will probably be pandemic” under cap and trade.
Why then have most governments embraced cap and trade? Maybe precisely because it is so possible to rort and evade. It makes it easy for politicians to pretend to care about climate change while doing nothing.