Category: Economics

One of the main themes of the ongoing United Nations General Assembly is climate change but it is clear that the issue is receiving token attention and nothing more. The real debate on climate change is occurring outside of the four walls of the United Nations and it revolves around the effectiveness of two economic policies: carbon tax and quota. It is a question of how, not what or why anymore. The successor of the Kyoto Protocol, which is to be discussed later in December this year in Bali, Indonesia, is likely to center around the debate.

The Kyoto Protocol which is set to end in 2012 has several mechanisms aimed at reducing greenhouse gases emissions. Central to the mechanism is a method known as cap and trade; it is quota system (also known as carbon credits). Developed countries are given certain cap or amount of quotas and each divides those quotas as they see fit to entities within their boundaries. On top of that, these countries which are officially called the Annex 1 could reduce its reduction obligation by investing in clean technology in developing countries like China and Malaysia that will aid emissions reduction effort.

Alternative to carbon credit is carbon tax. While it has no sanction in the Kyoto Protocol, its end is the same as carbon credit.

The point of these two policies is to realign private cost with social cost. Under circumstances where only private cost is considered, imposition of tax will create inefficiency. When there is a divergence between social and private costs, imposition of tax however — or subsidy depending on the scenario — will create efficiency. The phenomenon of climate change is essentially the case of misalignment of social and private costs.

In a perfect world, the effects of quota and tax are the same but the methods differ. In the real world, unfortunately, it is more about politics than economics. This is reflected in the clear division of opinion between economists and politicians on the issue.^[1]

On one hand, most economists prefer carbon tax over tradable carbon permit. Politicians on the other hand prefer cap and trade method to tax. The reason for the latter’s preference is simple: the idea of direct imposition of tax on the masses is very unpopular and could cost them votes. Economists prefer carbon tax simply because the method is simpler than what a quota system will demand. Most of all, economists do not need votes to do their work but politicians do.

Under the quota system, permits have to be distributed among entities. The problem of distribution is sticky and it has to appeal to the concept of fairness whereas such concept is hard to define. Mainstream economics itself has chosen to bypass the issue of fair equity altogether and concentrate on efficiency instead. Still, that does not prevent one from questioning how does one distribute those permits fairly?

The most common method is to use past information. An authorized distributor of permits, in this case the state, gathers emissions data of various firms and offer permits to players in various industries according to past volume. For instance, if a company emitted 1 ton of carbon last year, the company would get a permit to emit a certain ton of carbon this year to accommodate growth or to encourage carbon reduction. The problem with this method is that past information is not always helpful, if not helpful at all; historical data is a bad way to project the future. Worse, such method may be biased to stable industries at the expense of expanding industries.

Another method of permit distribution is most economists’ favorite: auction. Through this, apart from all the virtues of efficient market, the government will receive income.

Despite that, the method advocates by most economists so far is carbon tax. Carbon tax is to easier to manage because it does not need all the distribution setup that the permit system requires. Furthermore, the cap and trade method might suffer what the Kyoto Protocol is suffering now. The mechanism under Kyoto Protocol as practiced by the European Union is less than perfect because of permit inflation.^[2] Participating countries have issued too much permits in the name of Kyoto Protocol. For this reason, many participants are expected to miss their reduction target. Of course, the same scenario is repeatable under carbon tax regime; too low a tax rate, we will see meager reduction.

For the successor of Kyoto Protocol however, the question of whom to collect the tax will be sticky. To have an United Nations-sanctioned entity to collect it might be tantamount to the idea of world government. That itself may receive considerable objection from various countries apart from the question of how should the money collected be spent. In order to circumvent the question, we could have a cap and trade mechanism to distribute quotas among countries. Based on the amount of quotas a country receives, the country could impose comparable tax on itself. That however may be less than desirable — it might suffer the weaknesses that Kyoto suffers — though internationally, more politically feasible.

^[1] — Too bad, then, that politicians seem set on a second-best route to a greener world. That is the path of cap-and-trade, where the quantity of emissions is limited (the cap) and the right to emit is distributed through a system of tradable permits. The original Kyoto treaty set up such a mechanism and its signatories are keen to expand it. The main market-based alternative—a carbon tax—has virtually no political support.

A pity, because most economists agree that carbon taxes are a better way to reduce greenhouse gases than cap-and-trade schemes. That is because taxes deal more efficiently than do permits with the uncertainty surrounding carbon control. In the neat world of economic theory, carbon reduction makes sense until the marginal cost of cutting carbon emissions is equal to the marginal benefit of cutting carbon emissions. If policymakers knew the exact shape of these cost and benefit curves, it would matter little whether they reached this optimal level by targeting the quantity of emissions (through a cap) or setting the price (through a tax). [Doffing the cap. The Economist. June 14 2007]

^[2] — [An] audit showed that several EU governments had issued permits for 66 million tons more CO2 than was actually being emitted. Everyone realized that the supply of permits was not scarce, so the price of carbon promptly collapsed to less than 9 euros per ton. By February 2007, an allowance to emit a ton of CO2 could be had for less than a euro.

The woes of the EU’s carbon market are not over. In October 2006, all of the European Union countries forwarded their proposed National Allocation Plans for carbon dioxide emissions to the European Commission. It turns out that all of the countries, except the U.K., allocated permits for emissions that averaged about 15 percent above actual current levels. The EC’s environment commissioner, Stavros Dimas, warned: “If member states put more allowances into the market than are needed to cover real emissions, the scheme will become pointless, and it will be difficult to meet our Kyoto targets.” In other words, if there is no scarcity of carbon permits, then the permits are worthless, and there is no carbon market.

Many commentators argue that the last two years of turmoil are just the shakeout phase of a carbon market that will soon be robust. But the travails of the ETS highlight the fact that governments have every incentive to cheat. If they issue enough permits, their electricity companies will be able to generate power without adding to their costs—or the costs of their customers. And low energy costs give a nation’s businesses a competitive advantage over businesses in other countries. [Which Carbon Diet Works Better?. TierneyLab. NYT. May 26 2007]