Another question directed to the Carbon Tax Center: Would a carbon emissions cap become an emissions minimum as well as maximum, in effect precluding reductions below the cap level?
A “cap” of the type embedded in the House-passed Waxman-Markey bill (ACESA) is a legislated number of allowances, or permits, corresponding to tons of CO2 to be emitted. If the number of allowances is less than total expected CO2 emissions for that year, the shortfall will create an allowance price sufficient to drive demand down to the cap level. A too-loose cap (where allowances exceed emissions) will cause the carbon permit price to approach zero, as has occurred in the EU’s Emissions Trading Scheme.
Now, what happens if some people “virtuously” reduce emissions for altruistic reasons? Would they simply be making room under the cap for more emissions by someone else? Prof. James Kahn at Washington & Lee University examined a similar issue: the ramifications of hypothetical new low-carbon energy technology under a cap. Using standard tools of economic analysis such as demand curves, Kahn found that the reduction in allowance prices due to the new technology would stimulate new demand that would exactly cancel out the reduction in emissions. Extrapolating from Kahn, it appears reasonable to expect that altruistic reductions under a carbon cap would similarly reduce allowance prices and create a price signal to consume more, thus canceling out those reductions.
This perverse consequence of a carbon cap makes perfect sense, unfortunately. Consider a commuter who, independent of any price signal or federal legislation, resolves to give up solo car commuting for a carpool. Under a cap system, this “exogenous” reduction in demand for carbon emitting will lead to a slightly lower emission permit price — thus stimulating some additional use of fossil fuels elsewhere. The incremental usage might be a reciprocal departure from a carpool, or cranking up the heat, or a return to buying bottled water rather than refilling at the tap … or any of a thousand other ways to burn carbon. The result, in the end, will be the same: virtue in one arena will be offset elsewhere, due to the price-equilibrium-seeking mechanism of the cap.
It gets worse: ACESA includes both a cap and a “renewable electricity standard” (RES) which mandates that electric utilities buy a gradually-increasing fraction of their energy from renewable sources. Resources for the Future studied this same policy combination in Germany. Its finding: Germany’s combination of an RES with a cap caused an increase in the use of coal to generate electricity, as the growth in renewable-energy output created room under the cap for more coal-fired generation elsewhere. In effect, the renewables displaced natural gas-generated electricity instead of coal because gas was more costly, even with coal’s much (roughly 80%) higher carbon content and allowance cost. (This perverse incentive would disappear if allowance prices rose to a level making electricity generation from coal more costly than natural gas.)
To summarize, a carbon cap would tend to cancel out emissions reductions resulting from personal choices and from new technologies. Virtuous conservation and new technologies would reduce allowance prices, stimulating more consumption by others. And, by combining renewable electricity standards with a cap, ACESA would create another perverse incentive because shifting electricity generation to renewables tends to make more room under a cap for coal emissions.
A carbon tax, in contrast, would be free of such “canceling out” mechanisms. Indeed, if anything, “my” tax-induced conservation would tend to encourage “yours” by helping move societal norms away from consumption. And a gradually increasing carbon tax would obviate the need for renewable electricity standards by increasing the cost of high-carbon fuels and stimulating demand for low-carbon alternatives.
Finally, a carbon tax would sidestep what is likely to be cap-and-trade’s biggest “toxic” side effect: a volatile new carbon market that would benefit only speculators and could crash world financial markets again.
Photo: Flickr / megabooboo.
This problem is unlikely to be substantial because of two reasons (1). The cap is continuously reducing as a function of time, so that polluters have the right incentives for future investments (2). Price volatility, that has rightly been pointed out as a problem, has a flip side as well, which is that a firm that decides to invest in a polluting technology because others have reduced emissions may quickly find that the price has risen substantially (volatility cuts both ways)
Daniel Rosenblum says
While a gradually increasing carbon tax would increase the cost of high-carbon fuels and stimulate demand for low-carbon alternatives, it would not obviate the need for renewable energy standards. Renewable energy standards are necessary to provide important economic, environmental and national security benefits in addition to those addressed by a carbon tax. Renewable energy standards will produce those benefits more rapidly than a gradually increasing carbon tax, particularly given current natural gas prices.
David Collins says
Prof Mankiw states that the axiom “Don’t let the perfect be the enemy of the good” does not apply, because the current climate bill (Waxman-Markey) is not good enough. I would go further. The Carbon Tax is far from perfect: there remains a need for “Thou-Shalt’s” and “Thou-Shalt-Not’s” (see Dan’s comment #2 above), just for starters. And I would go beyond Mankiw’s low-end assessment, that the present climate bill is worse than no good, it is just plain bad. One bad feature is that seemingly reasonable people are claiming it actually is worth something, which somewhat kneecaps efforts to bring forth something that would actually work.
James Handley says
In response to comments:
1) Volatility under cap-and-trade is projected to delay needed investment in low-carbon energy by a decade. (“CO2 Price Volatility: Consequences and Cures,” Brattle Group.) Volatility in the EU’s cap-and-trade system (with a loose cap, depressing carbon prices) are thwarting investment in alternatives. (See “Lessons Learned…,” GAO.) Volatility does have an upside — for traders (e.g., Goldman Sachs), but not for Earth’s climate. (“Could Cap and Trade Cause Another Market Meltdown?,” Mother Jones.)
2) Renewable Electricity Standards: Germany’s experience (reported by RFF) and economic theory suggest that until carbon prices (under cap or tax) reach levels that make burning coal for electricity more expensive than burning natural gas, an RES would displace relatively expensive gas with renewables but do little to reduce coal use. In contrast, a briskly-increasing carbon tax, made possible (politically and economically) by recycling the revenue directly to taxpayers, would be an efficient, fair way to phase out coal first, followed by phase-out of other less-carbon-intensive fuels while immediately opening up financing and predictably-expanding markets for renewables.
3) ACESA would lock-in and reinforce an inadequate cap and would breathe new life into the coal industry. (Rep. Boucher assures us of coal’s bright future under ACESA.) Because ACESA would also create vested interests in allowance trading and offset selling who would resist future reforms, I wholeheartedly agree, it’s worse than no legislation. (Which would leave EPA to regulate sources of GHGs — an inefficient and cumbersome prospect, but likely easier to reform than ACESA.)
I feel the anxiety of many climate policy advocates as we’re confronted with a choice between ACESA and the prospect of starting over. That’s why it’s crucial to put a more effective, fairer and more sustainable plan on the table now, before ACESA fails.
Ken Johnson says
Re Anand’s comment #1: Whether the cap is fixed or continuously reducing, it is predetermined and does not respond to changing technologies or market conditions. Any additional emission reductions from technology advances, voluntary efforts, or unanticipated conditions will free up surplus emission allowances that will be used to increase emission elsewhere. However, this would not be the case if allowances are trading at the price floor, in which case the number of issued allowances would be responsive to market conditions and the cap-and-trade system would, in effect, revert to a carbon tax.
Re Daniel Rosenblum’s comment #2: Carbon fees could potentially obviate the need for renewable energy standards if the fee revenue is used to subsidize new, low-carbon energy sources. The fees and subsidies could be determined to give new renewables an immediate $100-per-ton price advantage over fossil fuels — far higher than any of the current carbon-tax proposals — but the fees would start out at zero because there would initially be no “new” sources. As renewables gain market share, the per-unit ($/MWh) fees would increase and subsidies would decrease, but the $100-per-ton price advantage would be maintained. The fee revenue would not be recycled to taxpayers, but ratepayers would nevertheless benefit because price competition from a growing, subsidized clean-energy industry would help maintain moderate retail electricity prices.
A cap on emissions does, in effect, preclude reductions below the cap level. However, a cap on emission allowances could lead to emission reductions below the intended emissions cap.
If allowances (instead of emissions) were capped, one could purchase allowances and voluntarily retire them without using them as a permit to emit. By purchasing allowances and withholding them from emitters, total emissions would be reduced below the intended emission cap.
James Handley says
Instead of buying up carbon allowances on a market that would surely be manipulated, why not buy coal (or if you’re ambitious, a coal mine), and sit on it, keeping the CO2 out of the air? Analogous to a conservation easement where people put land into a trust to keep it away from developers?
But seriously, why should additional reductions below a politically-set and scientifically-inadequate “cap” depend on the willingness of people (like you?) to buy up allowances? We need a system that rewards innovation and conservation: a revenue-neutral carbon tax.
I respond to your comment #7. I recognize that your first paragraph may have been a bit tongue-in-cheek, but will respond anyway.
Buying a coal mine has the same problem that buying forest land to protect it from logging or conversion to agriculture has in the offset business. It is hard to ensure that the “developer” or logger won’t just go cut down or burn some other forest. The same potential “leakage” occurs if I buy a mine.
In contrast, if there are 4 billion emission allowances issued and I buy and permanently hold 100 of them, then actual emissions will be only 3,999,999,900 tonnes. There is not the same potential for leakage here as there is in the forestry example or in the coal mine example. Conservation easements on land have similar problems that I won’t go into here.
Regarding your second paragraph; both caps and taxes will be politically-set. There’s no difference on that score.
Maybe the caps in Waxman-Markey are scientifically-inadequate, but, in general, a cap does not have to be inadequate; and the adequacy of a tax is not a certainty. What happens, for example, if demand elasticities are not what is predicted? We could adjust the tax rate, but that gets us back to a politically-set situation and still no guarantee of adequacy because prices of fuel are influenced by multiple unpredictable factors.
By the way, I favor a carbon tax. I just don’t like some of your arguments on this particular matter of virtue.