The proviso on a carbon tax – determining the price of carbon – is a show stopper

We Europeans have settled on cap-and-trade and are about to get serious with it. In the States, it looks fairly certain federal carbon pricing law will be put in place, but whether that is a tax or cap-and-trade is still up in the air. The Congressional Budget Office came out in favour of tax earlier this week, and the American economics blogosphere has been chewing the debate over.

The key argument in favour of a tax is that reductions over a period of several decades can be made more cheaply. This is because the cost of reducing emissions is volatile and depends on a range of unpredictable factors, such the weather, credit markets and technological developments. If the carbon price is fixed, companies can make reductions in years when it is cheap to do so, and pay the tax when reductions are expensive. Because cap-and-trade schemes use fixed, time-bound limits, the emissions price could be prone to short term spikes that make reductions pricey.

The problem, of course, with a tax, is that while you do know the cost of emissions, you don’t know what level of reduction that cost will achieve. This is critical – it is not possible to accurately determine the cost of carbon necessary to achieve the targets that climate science gives us. The CBO report says that:

Provided that the tax was set equal to the expected benefit of reducing a ton of CO2, a tax could thus result in substantially greater net benefits (benefits minus costs) than a comparable cap-and-trade program.

Agreed. But the proviso is understated. We have only very rudimentary ideas about what carbon price will deliver the reductions we believe are necessary.

During some years, cap-and-trade will pinch an economy, even with flexibilities such as the facility to bank credits for use in future phases. To deliver a certain volume of emissions reductions, these costs must be accepted.

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3 Responses to “The proviso on a carbon tax – determining the price of carbon – is a show stopper”

  1. “it is not possible to accurately determine the cost of carbon necessary to achieve the targets that climate science gives us.”

    Bollocks. Here are some:
    – econometric models of commodity demand
    – econometric tax incidence models
    – “guess and check”

  2. Hi David,

    What is an econometric tax incidence model?

  3. please see this post – http://cboblog.cbo.gov/?p=72 – for clarification of the CBO’s position

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