Carbon taxes are fine, but a cap-and-trade program is better

Trends, The American Bar Association, Vol. 40 Issue 4

March 2009

By Kyle Danish and Megan Ceronsky

We come not to bury the carbon tax, but to praise it. We agree that a carbon tax could offer predictable costs, administrative simplicity, and an opportunity to offset other taxes. Our point is simply that a cap-and-trade program can do all these things, and more.

Price predictability

As traditionally conceived, choosing between a carbon tax and a cap-and-trade program involves a trade-off between price certainty and emissions certainty. A carbon tax establishes a transparent and predictable price-to-emit, but the resulting emissions are uncertain. By contrast, a conventional cap-and-trade approach establishes a transparent and predictable cap on emissions, but the resulting price-to-emit is uncertain.

As traditionally conceived, choosing between a carbon tax and a cap-and-trade program involves a trade-off between price certainty and emissions certainty. A carbon tax establishes a transparent and predictable price-to-emit, but the resulting emissions are uncertain. By contrast, a conventional cap-and-trade approach establishes a transparent and predictable cap on emissions, but the resulting price-to-emit is uncertain.

Why choose? One of the climate change policy approaches considered by Congress in 2008 was a hybrid cap-and-trade program providing both price and emissions certainty. Under a hybrid approach, the government uses allowance auctions to establish a minimum and a maximum price-to-emit while maintaining a long-term emissions cap. This approach was reflected in both the Boxer-Lieberman-Warner bill (S. 3036) and the Dingell-Boucher discussion draft.

To establish the minimum price, the government reserves some allowances otherwise available under the cap and auctions them at a minimum price established  in the legislation. If the reserve allowances are not sold (because emission reductions are cheaper than expected), the government withholds them, thereby tightening the cap and making the reserve price the market floor.

The government also auctions allowances taken from future year caps at a maximum price established in the legislation. Regulated entities will purchase these allowances only if market allowance prices exceed the legislated maximum. If entities buy these extra allowances, emissions can exceed that year’s cap. However, because the additional allowances are drawn from future years, the program forces correspondingly lower emissions in the later years, thereby preserving the long-term emissions cap.

Transparency and administrative simplicity

Carbon tax advocates laud the comparative transparency and simplicity of their approach. Yet in making their case, they seem to start from a Platonic ideal. We are unaware of any major tax program that is devoid of carve-outs, loopholes, or give-aways.

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Reprinted with the permission of the American Bar Association.