Tax The Carbon, Don't Trade It

Once again, Sebastian Mallaby echoes Greg Mankiw’s sentiment that a cap and trade system for carbon emissions has some externalities that prove inefficient, at least compared to a tax. Mallaby describes the Kyoto effort that many countries have volunteered to take part in.

The takeaway:

The mechanism's clunky procedures are supposed to prevent fraud, but in practice they filter out village-based projects while not preventing fraud in big ones. As Stanford's Michael Wara has demonstrated in a devastating paper, the mechanism appears to encourage industrial producers to emit extra greenhouse gases so they can capture them and pocket extra subsidies. Chinese emitters make such extraordinary profits from this system that the government has imposed a 65 percent tax on the windfall. In effect, the green budgets of the rich world subsidize the Chinese government.

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There are two snags, however. Inevitably, some voluntary carbon permits have proved fraudulent. They represent carbon reductions that have not actually happened or reductions that have been marketed as offsets to multiple purchasers. As a result, the voluntary market is periodically attacked, and would-be purchasers shy away. Voluntary purchasers buy carbon offsets to be pure. Impure scams defeat their objective.

There is a basic logic that has unfolded before us. As I have written before, one instance of our own market failure with the environment is the externality of degrading our natural habitats, as well as a host of other environmental concerns. If a natural market process can lead to such bad externalities, then why would creating another market for permits do any better? Moreover, the efficiency of cap and trade would pale in comparison to a carbon tax.

One of the possible externalities that comes from cap and trade is that if enough “good” firms trade or sell their permits to less environmentally friendly firms, there would always be a healthy, cheap supply for the less environmentally friendly firm to buy, which would lend that firm to pollute even more. Therefore, I would not be surprised if for certain regions, or locales, their pollution would actually increase. A tax on the other hand is constant, and when the proper rate is found, firms will not find it cost effective to pollute in excess. The only problem would be figuring out the tax rate.

One way to help the cap and trade system would be to consistently readjust and regulate the permit market. Decreasing the permit supply when firms are not polluting, yet making sure that there are still enough permits in the market to keep prices down, or production steady. On the other hand, regulating the cap and trade system beyond just tracking whom pollutes, but also needing oversight and regulatory forces for the market itself would be a waste considering that a tax would not need oversight for a market.

The reason why people like Mallaby, or Greg Mankiw recommend a tax structure is because if the system is made simply enough, we not only reduce overhead, but we also reduce externalities that would otherwise occur from a newly created permit market.

While many experts have stated their opinion on the matter, there is no easy solution, although the easier, more intuitive solutions seem apropos. However, maybe we could trial this within a region. In addition, each system could be reversed, adjusted, or replaced with cap and trade, or vice-versa.

In the end, the question is when will circumstances reach the point where we feel we have no other choice but to enact a tax or a cap and trade system?