Thursday, June 11, 2009

Why bankable permits are so important

Kevin Drum graciously responds to my last post on cap-and-trade in the comments section, and makes an important point:
Oddly, the best argument against C&T, I think, is that it doesn't combine well with other regulatory initiatives. Adopt a local reg to increase building efficiency, for example, and energy use goes down. But that just drives the permit price down, which will drive other carbon emitting activities up. C&T is good at forcing emissions to meet a target, but it also pretty much guarantees that you'll never beat the target. For some reason, though, critics don't often use this argument.
Indeed, the is the key inefficiency of cap-and-trade. Although cap-and-trade keeps carbon emissions below a certain level, it doesn't offer any additional incentive to lower total emissions beyond that level. In fact, the implicit price it assigns to carbon goes from zero to infinity at the cap amount, which is extremely difficult to justify. Of course, the constant price offered by a carbon tax isn't perfect either—the potential damages from climate change rise nonlinearly with total emissions, and the ideal policy is a sliding price that moves up (within limits) if emissions are too high. But in the absence of specific information telling us that the climate system will collapse when the amount of carbon in the atmosphere reaches exactly X, the carbon tax is a closer approximation.

Allowing investors to save and borrow permits, however, relieves an important part of this inefficiency. Since our emissions targets in the long run are very ambitious, it's almost certain that carbon permits will be valuable at some time in the future. Even if we overshoot our targets at the beginning, and market slack sends the carbon price plummeting, it will stabilize well above zero: it's better to simply buy permits and save them until they're in higher demand. This means that if the market can cheaply reduce emissions in the current year below the cap, it will—the need to reduce total carbon emissions determines the price, not the need to meet an arbitrary cap in any particular year. Bankable permits liberate the market to achieve long-term carbon reduction in the most efficient way possible.

Fortunately, the current Waxman-Markey bill includes provisions for borrowing and saving permits. This is incredibly important. We can't let misguided appeals to environmentalist populism ("don't let polluters put off their obligations" or "don't let speculators pile up a fortune") put this policy in danger, when it has the potential to improve cap-and-trade so dramatically.


Artturi said...

C&T also "ensures" that you never fall short of the target.

It's a tradeoff between stabile carbon prices or stabile carbon emissions.

The rational for a carbon tax is that we don't really know how much we wan't to lower emissions, but we do no a price that is too high.

The rational for C&T is that we don't really know how much we can afford to pay for limiting emissions, but we know a level that's too high.

Obviously there is some truth to both of these claims and we should pick a policy that is either something in between tax and C&T (Let's say 40% tax 60% C&T) or pick either C&T or tax depending on our certainty of the claims. (In this hypotetical 40-60 casee 100 C&T)

Anonymous said...

The biggest reason I like carbon tax better than cap & trade is that it's harder for the crooks & thieves in congress to game it for their buddies. Next biggest reason, is that there is a far smaller role for Wall Street - no hugely remunerative jobs buying and selling permits. We are pretty good at collecting taxes, and it is cheap, low transaction costs.

Further, the claimed disbenefits of carbon consumption are really long-term, so if we set the tax level 'too low' or 'too high' to get what we think is the optimal level of carbon emission, we can fix the tax level the next year, no big problem.