Should We Trade Emissions Rather Than Tax Them?

Guest Column for 16 October, 2006.

Keywords: Environment & Resources; 

There appears to be a tendency to pose carbon taxes as the only economic way to address carbon emissions. But tradeable emission permits (TEPs) are a serviceable alternative which have both strengths and weaknesses over carbon taxes. Their greatest strength may be that they are politically more feasible.

TEPs, which permit emission of carbon (and without such permits no emissions are allowed), could be started off by grandfathering in recent levels of emissions so that current emitters got permits sufficient to allow them to emit their last year’s level, say. But each year the allowance attached to each TEP decreases so that at the end of the target period we got emissions down to our international target. This would force each emitter to reduce its level of carbon emissions unless it could acquire TEPs from others that had reduced their emissions more. Since the obdurate polluters are forced to purchase the TEPs from the reducing polluters, there would be a market incentive to seek technologies to reduce emissions, together with some demand side effects as the price of the products of carbon emitters would be forced up.

The scheme requires some development, particularly
            1. How to interface with the rest of the world, and
            2. How to deal with carbon sinks (one option is for the government to reward sinks with annual TEPs which they can sell to emitters, in effect offsetting the pollution with a sink).
            3. Administrative mechanisms.

Typically there would also be an annual resource levy to cover the cost of management, enforcement and R&D in the scheme.

This proposal essentially involves a market mechanism, but it does not involve a tax. (The levy is not a tax but user-pays. However, corporate gains from the market value of TEPs may well be treated as income and thereby taxed.) So the rents do not, on the whole, go to the public purse (which many would think a pity). It is easy to show that there would be some inequities (but a tax-based system would generate them too).

The advantage of TEPs over a tax (other than one can target aggregate emissions with precision) is that the scheme is relatively politically stable. Had it been in place last year, the coalition partners would not have asked for a repeal because they would have been destroying the property rights of the holders of TEPs who, despite any doubts about the scheme, would lobby against its abolition (since the alternative might be worse).

Of course the TEP scheme is clumsy. All impure market schemes are – which is why one only advocates them when the market is failing to deliver (big time in the case of carbon emissions). But a tax-based system is also clumsy. My guess is the TEP scheme is not as clumsy as a tax-based one, although it does not have the advantage of revenue raising.

The point of this note, is that sometimes having lost a policy battle, the losers want to fight again on the same battlefield, so sure are they of the justice of their cause. Thus those concerned with global warming seem to want to return to taxation as the mechanism. But sometimes it makes sense to look around for other policy options which give a reasonable chance of the advocates winning the next bout. As TEPs may do. At worse one learns about the strengths and weaknesses of the previous policy and its resolution.

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