With a new administration and the possibility of federal climate legislation in 2009, the spotlight of public interest is suddenly shining into the esoteric world of climate change economics. Most recently, the New York Times devoted an editorial to the matter on December 26th. We find the practitioners of this dismal science in the midst of a wonky civil war. They are divided into two camps: those who favor a carbon tax and those who prefer cap and trade.
A carbon tax and cap and trade both work by raising the price of carbon emissions, which provides an incentive for businesses and households to change their behavior. The difference between a carbon tax and cap and trade is that one works through price and the other works through quantity. A carbon tax simply puts a cost on emissions, for example, $10 per ton of carbon dioxide. People who like to know how much something will cost in advance like the carbon tax. In cap and trade, the government creates permits representing emissions under the cap. The price of a permit fluctuates as the fixed number of permits in circulation (and therefore emissions) is reduced over time. People who care more about the quantity of emissions and can stomach the idea of price volatility are more inclined towards cap and trade.
As the tax versus trade debate has heated up, each side has found or recruited "climate change celebrity endorsements." Al Gore, NASA's James Hansen, the New York Times' Thomas Friedman, and New York's Mayor Bloomberg have come out in favor of a carbon tax. But most politicians favor cap and trade, including President-elect Obama, Senators Boxer, Lieberman, McCain, and Warner, Congressman Henry Waxman, and others. The carbon tax (or "fee") contingent says their proposal is the simplest, and is unburdened by the complexities of cap and trade. The cap and trade folks argue that a tax high enough to induce the needed reductions will never pass politically.
The issue gets more complex when you consider that each interest group has its own preferred version of a carbon tax or cap and trade system. Labor groups may support a carbon tax, but only if it were "revenue neutral" (reducing payroll taxes equal to the carbon tax). Business groups may only support cap and trade if permits are given away for free, while environmental groups' would support it only if permits were auctioned. Each politician has his or her own formula dividing the percentage of permits auctioned versus given away, presumably balancing the business and environmental interests in their district. This does not even touch the issue of how to spend the revenues collected (I hope to get to that in future blogs).
Everyone has his or her favorite form of carbon pricing, but it's not really an either-or question. A carbon tax and cap and trade system can co-exist. In fact, a carbon tax can be a price floor in a cap and auction system. The problem is, as Lincoln once said, "A house divided against itself cannot stand." Creating a carbon price will require almost everyone who drives or uses electricity to vote against his or her own short-term self-interest. It is difficult to see how either a carbon tax or cap and trade will pass without the full support of every person concerned about climate change and energy security. So before we divide ourselves into ever-smaller infighting factions, let's try to get the carbon taxers and the cap-and-traders to unite behind the message of "putting a price on carbon."