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What Makes a Good Cap-and-Trade System?

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Lots of economists and analysts on both sides of the aisle prefer a carbon tax to a cap-and-trade system, but political reality is such that the former is exceedingly unlikely and the latter has become all but inevitable. So it's time to focus on doing it well.

One question that came up in the panel Q&A was this: what makes for a good cap-and-trade system? This subject is both enormously complex and enormously relevant to current politics. We need the grassroots to be engaged, pushing back against the many half-ass measures on offer, lobbying on behalf of good measures.

To engage, people need some simple guidelines. So at the panel, I chose three markers of a good cap-and-trade system. Obviously there could be others, but these seem to me to be points where pressure could create positive movement:

  1. Auction rather than give away permits. As Europe painfully discovered, when you give away emissions credits, it's a financial windfall for the biggest polluters and creates no incentive for them to change. Permits to pollute should be sold, and the market should decide their initial price. Edwards and Obama, at least, are on record supporting this approach; several bills leave it up in the air, or punt it to the EPA. It should be made explicit.
  2. Spend the revenue wisely. Auctioning credits will produce a great deal of revenue -- by some estimates, up to $50 billion. That revenue will provide a crucial tool to accomplish two goals:

    --Spur the development and deployment of clean energy: do things markets don't do well, like investing in infrastructure (e.g., public transit), basic research, and protecting carbon sinks.

    --Drum up political support: produce tangible benefit for voters, either by reducing other taxes (e.g., payroll) or by returning the revenue directly to citizens, as with Alaska oil revenue. (It's worth noting that auctioned permits with revenue returned to citizens is functionally equivalent to a revenue-neutral carbon tax.)

    There will be good-faith disagreements about what to do with the revenue, but the important thing is that it not disappear into the general fund, sinking without a ripple into entitlements and defense spending.
  3. No "safety valves." Some cap-and-trade bills (e.g. Bingaman's) contain measures that would allow unlimited selling of permits at a pre-set price per ton of CO2 (e.g., $12 for Bingaman's). The idea is to prevent the program from becoming "too expensive," but the practical effect is to sacrifice one of cap-and-trade's great benefits: predictability. The emissions cap will ratchet down in set intervals, at set times, and the price of carbon will steadily rise, allowing private actors to plan ahead. If the market is sporadically thrown open when prices get too high, businesses have incentives to hold out on needed long-term changes, or to game the system by manipulating prices. Note: this leaves open the possibility of reasonable cost-containment measures like the one contained in the Lieberman-Warner bill, which hold tight to long-term targets while allowing some short-term flexibility. There are ways to contain costs that don't screw up the whole system.

So: auction permits, spend the resulting revenue wisely, and don't short circuit the system with safety valves.

We can all remember that, right?