Cap-and-Trade, Carbon Taxes and Cash Incentives: Getting Rich and Going Green?

This article is from the RIIB blog of June 4, 2009

Last week the Ontario government announced that, in conjunction with the government of Quebec, it would launch a cap-and-trade system for carbon emissions. The details of this plan are yet to be determined. About a year ago, the government of British Columbia instituted a system of carbon taxes to limit greenhouse gas emissions. These taxes apply to the purchase of carbon-emitting fuels such as gasoline, fuel oil, natural gas and coal. Various governments in Canada have provided cash incentives both for energy conservation – tax credits for transit passes, cash for the purchase of energy efficient appliances and for building retrofits – and for the creation of alternative energy sources such as wind and solar energy.

How should we assess the relative merits of the plans for reducing carbon emissions and is there any reason to prefer one plan over another? Cash incentives certainly seem popular with voters, especially relative to carbon taxes. Stephane Dion discovered this as his “Green Shift” shifted him right out of the leader’s job. But can we really go green and get rich at the same time? What do we make of cap-and-trade and is it better than a system of carbon taxes?

In a wide-ranging discussion on policies to combat global warming, Professor Paul Joskow of MIT and the Sloane Foundation, provides answers to these questions. (To see a video of Professor Joskow’s discussion, click on the Speakers Series link on the RIIB web page and go to the October 28, 2008 presentation.) Joskow points out that a cap-and-trade system and a system of carbon taxes are very similar. Under a cap-and-trade system, limits are placed on total CO2 emissions and emitters are allocated emission permits. A company that can cheaply limit CO2 emissions will do so and emit less than its total permit allocation. This company can sell its remaining permits to companies for whom emissions reductions are more expensive and so find themselves emitting more than their permitted allocation. The price for permits is a market price determined by supply and demand for permits. Because permits have a positive price, the cap-and-trade system not only limits emissions but also indirectly raises the cost of CO2 generating activities.

Under a carbon tax system like that in BC, prices for CO2 emissions are increased directly via the tax. The increase in costs for carbon emitting activities provides incentives for emitters to seek ways of reducing their CO2 emissions. In this way, the direct cost raising effect of the carbon tax leads indirectly to a reduction in CO2 emissions.

What’s the difference between the two systems? Joskow points to two differences. First, the cap-and-trade system leads to certainty about the level of CO2 emissions since this level is fixed by the cap. Cap-and-trade leads to uncertainty about the costs of business for CO2 emitters since this cost is ultimately determined by the market price for permits. This price is uncertain initially and can fluctuate over time. The tax system provides much more certainty on the current cost of doing business: the tax level is fixed by the policy and so CO2 emitters know how much emissions cost. The tax policy leads to uncertainty about CO2 emission levels since we have no good estimates of how much emission reduction a given price increase will induce. The tax system may create possible future cost uncertainty, though, as tax levels may need to be adjusted to achieve certain CO2 emission targets.

The second difference that Joskow points to is in the ease of policy coordination across jurisdictions. Since global warming is, by definition, a global and not regional problem, a system that coordinates policies on emission restrictions globally is preferred to a system of piecemeal regional policies. The reason is simple. Just as some companies can more cheaply reduce CO2 emissions than others, some provinces, states and countries can more cheaply reduce CO2 emissions than others. A system that takes advantage of these differences worldwide will be able to reduce global warming more cheaply. A cap-and-trade system can easily operate large regional and global markets for emissions permits and so achieve these global efficiencies. To coordinate tax policies globally, Joskow argues, is a far greater challenge.

What about cash incentives for conservation and alternative energy production? Can we really get green and get rich at the same time? The answer is, “if it sounds too good to be true, it probably is”. These policies are the political equivalent of the flim-flam or hustle. To see why, imagine a policy that provides up to $3000 per homeowner toward the purchase of energy efficient appliances, window and insulation upgrades and the like. If one million households take advantage of the program, the cost to the government is three billion dollars. Where does the government find three billion dollars? It finds it by increasing taxes elsewhere. Remember, ‘There ain’t no such thing as free lunch”.

The bottom line is that cash incentives programs operate by raising distortionary taxes on other activities, thereby raising the cost of these activities, in order to fund the cash-back scheme. By contrast, the cap-and-trade and carbon tax systems raise the prices of CO2 emitting activities so that they reflect the true social value. The revenues that these systems generate enable the government to cut distortionary taxes elsewhere in the economy.

In addition, systems that raise the price of CO2 emissions harness the creativity of the marketplace to determine the best ways to reduce global warming. The cash incentive schemes target particular activities that may or may not be most effective in lowering CO2 emissions. Wind energy may prove not to be a particularly practical alternative energy source but windmills will be built if the government provides sufficient cash to build them. Lowering the thermostat in winter time may be a better way for some households to reduce CO2 emissions than replacing the furnace all together. With no increase in heating prices but a subsidy for replacing the furnace, the household may not conserve at all and may not replace the furnace either. Even if it does replace the furnace, the wrong outcome occurs.

In the end, as Joskow notes, reductions in CO2 emissions will result in higher energy prices and so higher prices for goods that utilize energy. This is a fact of life; we need to accept it.