As Congress considers a dozen climate change proposals, RFF Senior Fellows Ian W.H. Parry and William A. Pizer analyze the pros and cons of a cap-and-trade and CO2 tax based systems. In the article, published in the Fall 2007 issue of Regulation magazine, they suggest that features of the chosen system may be more important than which approach is taken. This is because many of the features traditionally associated with each are, in reality, interchangeable.
For example, the authors say that either system levied upstream (at the point of producers and processors) in the fossil fuel system would achieve broad coverage with higher energy prices encouraging energy saving and the use of less carbon-intensive fuels throughout the economy. Meanwhile, either system could also be levied downstream (further down the supply chain) on a smaller set of emission sources, but would fail to take advantage of the cheapest reductions wherever they occur.
Parry and Pizer believe that the revenue from a CO2 tax could be used to reduce income taxes which, at $5 - $15 per ton, could result in overall implementation costs that could be very low, or even negative. On the other hand, a cap-and-trade system in which permits were auctioned rather than given away could use revenue in the same fashion.
One of the criticisms of the cap-and-trade approach is that volatility in the permit market discourages investment in carbon-saving technologies and erodes support among the public for stricter emissions caps. However, the authors argue that by allowing firms to bank and borrow permits and incorporating a “safety valve,” (a price point where additional permits would be available) short-term price swings can be all but eliminated. |
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Meanwhile, a criticism of the tax approach—that it cannot be used to achieve a particular emission level—is less true over longer horizons where the tax rate can be adjusted. Indeed, it is the long-term cumulative emissions that truly matter for reducing the risk of climate change.
The major differences seen by Parry and Pizer, therefore, are not between taxes and permits, per se, but among the features of either system and whether they raise revenue and avoid unnecessary volatility. They also warn against “mischievous” outcomes for both systems in which revenue would be used for pork barrel projects or politically-motivated exemptions rather than tax reductions with economy-wide benefits.
While revenue-raising, safety valves, and borrowing provisions are included in a growing number of the bills before Congress, the authors advise that it still remains to be seen how judiciously funds will be used in the final legislation.
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