11/11/2009 05:12 am ET | Updated May 25, 2011

Tax or Trade to Cut Carbon?

Part of the debate over how to best tackle climate change in the US, EU and other developed countries is around the question of tax or trade. Do we up the tax on gasoline, or for that matter on electricity or heating oil, do we put big taxes on refineries and chemical plants and steel mills who are enormous energy users? Well, we can all understand taxes, even members of Congress understand taxes. And I think they all think they understand the consequences of 'carbon taxes', namely, stuff that is energy intensive becomes more expensive, people use less of it, and members of Congress who voted for it become unpopular.

But what about this cap and trade thing? First of all, the idea is pretty simple. Big energy users (to start with, like those steel mills or refineries) are told that next year they can only emit, say 90% of what they are emitting this year. That is the 'cap'. They can find ways to make the reductions themselves, or they can go out in to the marketplace (which has to be created) and buy permits to emit more. That is the 'trade'.

Now why would anyone prefer this cap and trade method to the good old fashioned tax method? I think there are a few reasons, some obvious, some more subtle. First of all, when we tax, we expect a demand response, put up prices and consumption goes down. Some of you will remember back several years when there was discussion of a five cent (about 4% at the time) a gallon tax on gasoline, which was shouted down, in order to curb demand. Instead of this, we let our friends in OPEC impose a 100% price increase on us. In effect, a tax with the revenues going to them rather than to our own government. And did that giant whack generate a dramatic fall in demand? It did not. The key problem with using carbon tax to curb demand, hence reduce emissions, is that we have very poor understanding of how the consumers will react to the higher price - in economist speak we don't understand the elasticity of demand very well, and we have proved this over and over.

But with trading the reduction is guaranteed. If we have 1,000 permits to emit greenhouse gases today, and we withdraw 100 of them from the system next year, and let users compete to buy the remaining 900 permits, either from the government or from each other, well, we just know that next year emissions will be 90% of this year, maximum. And we can do that again the following year.

And there is another advantage of trading. This was first pointed out by Michael Porter and Claas van der Linde in an article in Harvard Business Review in 1995. Trading, market mechanisms, make managers ask tough questions of their team. If I am managing a refinery and my energy manager comes to me and says we need to go buy some permits to get down to our cap, what do I do? Probably I talk to one of my friends who is managing another refinery and say 'Boy, this cap and trade thing is tough, we have to go buy permits', and if he says, 'Oh, well, my guy tells me we have excess permits because we have found ways to generate savings beyond our cap', well, I go right back and tell my energy manager he better look harder at our energy use before he goes and buys anything. Cap and Trade is a way to motivate industry to be more efficient, and more innovative. And that has to be a good thing.