Friday, 23 March 2018

Cap-and-Trade better than Carbon Tax

           In my last post[1], I noted that I, personally, am a climate change sceptic[2]. I also believe that we should not take any major action to mitigate the feared implications of climate change unless our major trading partner, the U.S, does likewise. However, I then went on to argue that if we must do something, then a carbon tax should not be rejected out of hand because it provides more opportunity for the market (businesses and consumers) to freely make economic choices than government regulation. For example, if the tax is high enough, businesses will seek alternative ways to produce. I also, mentioned in passing that a cap-and-trade system as instituted by Ontario and Quebec is, in principle, better than carbon taxes as a means to harness the ability of the market to fight carbon and other forms of pollution. While seeking the same objectives as a carbon tax, it achieves its goals at a lower overall cost for society. From a stewardship perspective that is important, since we don’t want to waste any of our God-given resources. I will expand on that in this post. However, I will first add a bit to what I said about regulation in the last post.

Some regulation will remain necessary.

In the past, I noted, regulation (command-and-control) was the main tool of environmental policy. Government bureaucrats specify what companies and consumers can and cannot do. Regulation, is costly and enforcement is frequently inadequate. Past regulation has frequently been too precise or with too short a compliance deadline, so that flexibility to implement the latest, best technology is reduced. I recognize, that, in practice, carbon taxes and cap-and-trade may also be implemented with a host of regulations and exemptions and, therefore, market choice and efficiency may be reduced. We should seek to reduce such over-regulation while exemptions might be better attained through other ways which do not affect the favourable incentives intended by these two policies.

Moreover, government regulation will have to remain a significant part of environmental policy. For the most toxic pollutants, for example, outright bans are the only possibility. Bans may also be required in particularly sensitive areas. The Chinese government, for example, banned all tree cutting in the flood-prone Yangtze basin because”trees standing are worth three times as much as trees cut” because of the flood control service provided by the forests.[3] In other cases, such as mandatory minimum efficiency standards for cars or appliances or some pollutant emissions, simple regulation may prove most effective. As much as possible, such regulations should be restricted to specifying the result (the limits desired) rather than mandating how that result is to be achieved so that companies are left free to decide how best to meet these standards.

Regulation is also necessary to specify conditions for companies to operate in particularly environmentally sensitive areas e.g. drilling for oil and gas. Even then, however, the market can be used to supplement the regulations by requiring ‘environmental performance bonds’ (an insurance to be bought by companies who undertake environmentally sensitive actions such as building a pipeline through nature reserves). The market determined price of the bond will reflect the potential liability and force the companies to consider that cost. Moreover, in case of actual damage, the money can be used to rehabilitate the environment and compensate victims

            Detailed government regulation is also required when the interests of parties in the marketplace conflict. For example, in 1990, European governments were concerned with the reduction of emission of volatile organic compounds (VOCs) which escaped when cars were being refuelled. The problem could be addressed either on the cars by installing a carbon cannister that would absorb the vapour or, alternatively, by installing a vapour balancing system on the pumps. Obviously, the oil companies and the automobile manufacturers could not agree on the choice. The German government finally made the decision in favour of the pump system.[4]
            In any case, the need for regulation continues. Continual review is, however, a necessity–if only to ensure the regulations do not become obsolete. Where regulation is deemed to be necessary, we must be prepared to devote adequate resources to establish and enforce them.

The Advantage of Cap-and-Trade

            Cap-and- Trade (also referred to as a system transferable pollution permits) has the government set a cap for the total amount of carbon (or other pollution) emissions. Allowances or “rights to pollute” are then divided over all the companies either by auction or otherwise. The auctions generate revenue for the government.The key to the overall cost saving is that these allowances may be bought and sold. A simple[5] example, will, hopefully make this clear. Consider the following companies who pollute different amounts (Column 1) and differ in how much it costs them to clean up their pollutants (Column 2):

            Table 1                                   Cost of
                                    Total                    per
                                    Pollutants        pollutant
(1)                    (2)

Company  1        6,167              $100
Company  2        5,500                125
Company  3      25,000                150
Company  4      50,000                225
Company  5      30,000                300

Now consider the cost of cleanup if the government mandated a cut of 10% across the board. The cost to society of every company reducing their pollutants by 10% would be $2,530,000.

            Table 2                                   Cost of
                                                            Cleanup           10 %                Cost
                                    Total                    per               pollutants           of
                                    Pollutants        pollutant          Cleaned up      Cleanup
(1)                    (2)                   (3)                      (4)
        (2) x (3)
Company  1        6,167              $100                     617              $     61,670
Company  2        5,500                125                     550                     68,750
Company  3      25,000                150                   2,500                   375,000
Company  4      50,000                225                   5,000                1,125,000
Company  5      30,000                300                   3,000                   900,000
                                116,667                                      11,667               $2,530,000

            Now suppose we have a cap-and-trade scheme that would allow the rights to pollute to be traded. Let’s assume a market price for pollutants at $130[6]. At that price, it would pay Companies 1 and 2 to clean up all their pollutants since they would be able to sell their right to pollute. On the other hand, it would pay the other three companies to buy these rights instead of cleaning up since their cost to clean-up are higher than this market price.

Table 3                                               Cost of
                                                            Cleanup           amount            Cost
                                    Total                    per               pollutants           of
                                    Pollutants        pollutant          Cleaned up      Cleanup
(1)                    (2)                   (3)                    (4) 
                                                                     (2) x (3)
Company  1        6,167              $100                 6,167               $   616,700
Company  2        5,500                125                 5,500                    687,500
Company  3      25,000                150                      0                       0
Company  4      50,000                225                      0                       0
Company  5      30,000                300                   .  0                       0         .    
                               116,667                                      11,667              $1,304,200
By having only those companies clean up that can do so at the lowest cost, 10% of pollutants can be cleaned up for $1,304,200 rather than  $2,530,000. The same amount of pollution is cleaned up at a much lower cost under cap-an-trade than by government mandate a cut across the board. That’s the case for cap-and-trade!

Not only does every company have a financial incentive to reduce its pollution, with tradeable rights, the market will also ensure that the overall cost to society of pollution reduction will be as low as possible. Companies with more difficult problems can, in the first instance, buy up the available rights to pollute. As these rights become more expensive, the incentive to find technological solutions will increase. While the government enforces the overall permitted amounts, the market decides the most cost-effective way to reduce. In fact, the market price of the traded permits also serves as price signal. The higher the market price for the permit, the more incentive there is for innovators to devise new remedial technology or processes.  A final benefit of the system is that environmentalists or governments can speed up the clean-up process by themselves getting together and purchasing--and not using--the pollution rights. In Cleveland, for example, a group called INHALE sprung up to buy and bid up the price of sulphur-dioxide credits so that U.S. utilities would be forced to clean up their own emissions.[7] Such action reduces pollution immediately and, by raising the price of rights, increases the incentive for others to reduce pollution.

            Of course, the effectiveness of tradeable quotas will depend on the extent of the permitted emission amounts—the cap. Any cap will be an arbitrary number but can be reduced over time to get the desired result while generating the least amount of disruption (e.g. in terms of employment). As such, this policy alternative (just like green taxes), is consistent with our conditional preference for the market.  Since climate change is a global issue, it would seem reasonable that these allowances be traded over wide regions as has been done for carbon in a linked market by Ontario, Quebec and California. If you believe in the need to reduce carbon, it doesn’t matter where this reduction takes place. The problem is, however, to what extent these markets are actually harmonized e.g. are the caps equally burdensome etc? Only time will tell whether the implementation of this system will achieve the desired effect. In any case, cap-and-trade is, in principle, a useful policy tool in the fight against climate change—if you believe in the need to do something about it.

[2] That skepticism was reinforced by a recent post I read by Matt Ridley, “The Climate Wars’ Damage to Science”,
[3] Lester R. Brown, Plan B: Rescuing a Planet under Stress and a Civilization in Trouble, W.W. Norton & Co. Ltd., New York, 2003.  p.209.
[4] Lévêque and Nadaï, in Henk Folmer, H. Landis Gable and Hans Opschoor, editors; Principles of Environmental and Resource Economics: A Guide for Students and Decision-Makers, Edward Elgar, Aldershot, UK & Brookfield, US., 1995,p.317
[5] And, admittedly, simplistic.
[6] This market would come to equilibrium at a price between $126 and $149
[7] Robert Sheppard, “How much am I bid for a pair of carbon-dioxide credits?” The Globe and Mail, Jan 17, 1998.

Friday, 9 March 2018

No Carbon Tax? Let’s not be hasty!

                The Ontario Progressive Conservative(PC) Leadership race has again brought to front and centre the issue of a carbon tax. After the resignation of Patrick Brown as leader, all four candidates running to succeed him have come out against such a tax although the party had just (at Brown’s insistence) adopted a platform that included a carbon tax. Prior to this, Justin Trudeau’s Liberal federal government has mandated that provinces must adopt either a carbon tax or a cap-and-trade scheme. If not, the federal government will institute a carbon tax itself in those provinces in order to meet Trudeau’s commitment to fight climate change. Both British Columbia and Alberta have already implemented such a tax.  Ontario and Quebec have introduced cap-and-trade-plans that achieve the same goal. In the meantime, the U.S. government under Donald Trump has backpedaled on any climate change commitment. As a candidate, Trump had already made it clear that under no circumstances would he support a carbon tax.

               Obviously, a carbon tax (or cap-and-trade) will drive up energy prices, inevitably lead to higher consumers costs and reduce family incomes. Should we, therefore, jump on the conservative bandwagon to reject the carbon tax? Of course, the answer to this question depends on your belief about man-made climate change. Personally, I remain a skeptic about the necessity to take drastic steps to deal with climate change. I do not think the science on this issue is “settled”. However, if there is a good chance that we can reduce the predicted negative effect of climate change, Christians should favour maintaining God’s creation for our children and grandchildren. On the other hand, I think it is folly for Canada to take major action while the U.S., our most important trading partner refuses to do so. The uncertainty concerning the renewal of NAFTA and Trump’s overall protectionist attitude (e.g. tariff on steel and aluminum) are bad enough for us—considering how many Canadian jobs depend on exports to the U.S.

               Nevertheless, a complete rejection of a carbon tax may be a bit hasty.  After all, as government you have to get the money somewhere. For all his left-leaning platform, Brown at least recognized that his proposed spending increases have to be offset by new revenues[1]. Those vying to succeed him have not made clear how they intend to fill the financial gap left by their rejection of the carbon tax.  Economists generally recognize that we should tax the bad rather than the good.  Instead of a tax on jobs—e.g. income tax or corporate tax, a tax on cigarettes or luxury items is preferable—as are sales taxes in general. If you believe carbon is bad, it should be taxed. A carbon tax can be revenue neutral by reducing other taxes. Reducing income taxes will even increase economic growth[2]. In effect, if you accept the need to fight climate change, then a carbon tax is, in principle, not a bad idea.[3]

A market oriented policy

               In fact, a carbon tax is entirely consistent with the preference for the market that I have been advocating on this blog.[4]  Before the carbon tax (or cap-and-trade), the most prevalent government instrument to fight climate change and to curb pollution in general--has been regulation (command-and-control); government specifies what companies and consumers can and cannot do. Regulation, however, is costly and enforcement is frequently inadequate. Past regulation has frequently been too precise or with too short a compliance deadline, so that flexibility to implement the latest, best technology is reduced. Establishment of regulations is a time-consuming process and provides opportunity for companies and bureaucrats to subvert the system. Moreover, regulations are likely to become obsolete and become the norm rather than minimum standards. Thus, continued improvement is discouraged.

               A carbon tax, on the other hand—like all “green” taxes—leaves the basic decisions to the market rather than government. It follows a very important economic principle that has been accepted , in theory, by most industrialized countries since the 1970's—that is to seek to "make the polluter pay the cost” or putting it differently, to make the user pay the “full” cost.  This principal would seem to be in accordance with the biblical concept of personal responsibility. In economic terms, that means to force the producer to "internalize" the "externalities" (or neighbourhood effects). To the extent that this can be done, the cost will be reflected in production and buying decisions--the market price will reflect the full cost in the final price. Thus, consumers will be motivated to buy less of the polluting product or scarce resource. Pollution will be reduced and/or the scarce resource will be used up more slowly. 

               Consider, for example, the production of gasoline. While the actual cost of production is reflected in the price of gasoline, various indirect costs are excluded: e.g. the cost of treating respiratory illnesses and the deaths caused by breathing polluted air, the cost of repairing acid rain damage to lakes, forests, crops and buildings caused by the emissions as well as the potential costs of oil spills and of climate change–ice melting, more destructive storms and relocation of refugees from rising sea levels.  To the extent that these costs are not currently reflected in the price of gasoline through taxes, the consumer uses more gasoline than is economically warranted. If the gasoline were to fully reflect these environmental neighbourhood effects, the price would, no doubt, increase.[5] At the higher price, consumers would use less (by reducing driving, purchasing more fuel efficient cars etc.). That is, the market's mechanism for efficiently allocating resources now "counts the cost" of pollution and climate change.  

A comprehensive, “carbon tax” on the burning of all fossil fuels reflects the full costs to society of mining coal and pumping oil, of the air pollution associated with their use and climate disruption; the increased price simultaneously reduces consumption. With a carbon tax, companies are left free to innovate and choose the most cost-effective way of reducing their carbon emissions. To save on the carbon tax, they have every incentive to do so.  Better solutions can, moreover, be adopted as soon as they become available. On the other hand, if bureaucrats have to specify the solution, those who make the decision are not the ones who pay the costs and may not possess all the relevant information. The process becomes cumbersome and time-consuming as all affected parties have to be given opportunity to provide input and comment. Once specific regulations are put in place they may stay in place for a long time. There is little incentive for governments to reopen this arduous process when new technology becomes available.  The process also reduces the motivation for companies to keep searching for better solutions. Finally, carbon taxes can be introduced gradually and increased over time so that companies’ activities are not halted abruptly and their employees thrown out of work in one fell swoop. Increases according to a predetermined schedule will permit industry to adjust. 

Pollution charges, such as the carbon tax, require government only to set the amount of the charges—the “price” of carbon. The market is then free to decide how best to reduce the pollution. Competition will motivate companies to continue to improve and keep looking for improved technology. If regulation mandates the installation of certain pollution control devices, once the requirement is implemented no further improvement in pollution abatement is likely. However, if a company is taxed on its emissions, they will be motivated to continue to seek better and lower-cost abatement methods regardless of how much they have already done in this regard. The most cost-effective alternatives are, therefore, likely to be obtained using the market (leaving companies to make choices) rather than by a regulating agency[6].

While a carbon tax can be used in conjunction with regulations, in theory at least, regulation can be significantly reduced. In practice, governments will use all the tools at its disposal including subsidies. In Ontario, for example, subsidies continue for wind turbines and solar through, among others, above-market prices paid to generators of these sources of power. However, with an escalating carbon tax, at some point, companies would decide for themselves that the cost of generating electricity using coal or natural gas (including the carbon tax) is higher than the alternatives of wind or solar. They would then switch the best alternative without the incentive of subsidies. 

Now an argument can be made that a carbon tax would hit hardest on the less wealthy. That is true, since electricity and heating are larger part of their budget than it is for those who are better off and have more discretionary spending. However, the higher prices for heat and light would also motivate them to be more stewardly with the use of these resources. Instead of, for example, providing them with a discount on their power bills, this incentive should remain. Rather, they should be compensated in a way that will not affect their decisions about power use but maintain income: e.g. refundable tax credits.

In sum, the carbon tax is a market-based solution to predicted climate change problems. If you accept the need to do something about climate change, this policy tool should not be rejected out of hand. It provides companies and consumers with the incentive to do something about it while leaving them free to choose what that action will be. Ideally, a carbon tax should be revenue-neutral by reducing other taxes. The weak in society should be compensated for the extra costs but through and income-related refundable tax credit rather than subsidies related to their use of power.

[2] In 2003, prominent economist N. Gregory Mankiw wrote, “Cutting income taxes while increasing gasoline taxes would lead to more rapid economic growth, less traffic congestion, safer roads, and reduced risk of global warming–all without jeopardizing long-term fiscal solvency. This may be the closest thing to a free lunch that economics has to offer.” See Lester R. Brown, Plan B: Rescuing a Planet under Stress and a Civilization in Trouble, W.W. Norton & Co. Ltd., New York, 2003. p. 232. That is all the more true when one considers another benefit to family life that may be obtained if the increased gas taxes provide incentives for employers and employees to relocate to reduce commute times. Increasing the potential for both spouses to exercise their familial  responsibilities can only be regarded favourably by Christians--see Michael Schluter and John Ashcroft, ed. Jubilee Manifesto: A framework, agenda & strategy for social reform, Inter-Varsity Press, Leicester, 2005, p.170 ,174.
[3] Although, from an economic perspective, cap-and-trade is better.
[5] While it would be impossible to determine these costs exactly, that is not necessary. Rough approximations will suffice to justify setting relevant charges. In any case, some charge is better than no charge; charges can be increased over time.

[6] Of course, these advantages of a carbon tax do not take place instantaneously. It takes time for companies to invest in new methods of production and for consumers to change their buying habits.