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Pricing Carbon in California : A Complicated Problem with No Simple Solution

In a couple of weeks, California will hold the first auction of greenhouse gas emissions permits. This auction is notable and newsworthy as it effectively sets in motion the world’s second largest greenhouse gas emissions trading program. But it represents only one small piece of a much bigger, much more complicated picture of how emissions permits will be distributed.

If you wade through the various appendices of the 2010 rulemaking, you will stumble across this graph which nicely summarizes how the 2.5 billion tradable greenhouse gas emissions allowances issued under the program will be allocated over the next eight years:

In the first compliance period (2013-2015), only 10 percent of permits will be sold at auction. The rest will be distributed for free to various stakeholders in ways that are designed to offset the costs of complying with regulation.

Needless to say, this permit allocation process has been controversial. While a coalition of industry stakeholders argues that a larger share of permits should be allocated for free, many economists and policy analysts disagree.

I was recently asked to give a talk about cap-and-trade in California to an audience of thoughtful alumnae. As we discussed the above picture (and underlying nuance), several folks raised the question:  Why not simply tax carbon and avoid all of this permit allocation complexity and controversy?

California alumnae are not the only ones who, when confronted with the messy realities of cap-and-trade, are wondering whether a “simple” carbon tax would offer a more transparent and preferred alternative. This sentiment is particularly prevalent when it comes to permit allocation.

For example, in a recent WSJ article, David Weisbach contends:

“A carbon tax doesn’t require an initial allocation of permits. Thus the temptation to give the permits to politically favored industries doesn’t present itself. I think this is a very substantial benefit of a tax.”

The Carbon Tax Center, which actively promotes carbon taxes as a preferred alternative to cap-and-trade, makes a similar argument:

“Carbon tax revenues would most likely be returned to the public through dividends or progressive tax-shifting, while the costs of cap-and-trade systems are likely to become a hidden tax as dollars flow to market participants, lawyers and consultants.”

Yesterday, in a blog post that is well worth reading,  Robert Stavins argues that “current enthusiasm about carbon taxes in the academic and broader policy-wonk community is largely a manifestation of the grass looking greener across the street”.  With respect to perceived differences in rent allocation and stakeholder compensation, I could not agree more.

In principle, a cap-and-trade program in which all permits are auctioned can be designed to generate distributional impacts equivalent to a carbon tax in which revenues are returned to the public through dividends or tax breaks. However, when cap-and-trade has been applied in practice, the free allocation of permits to industry has played an essential role in securing political support.  California offers an important case-in-point. Industry stakeholders have very serious concerns about how pricing carbon in California will affect their ability to compete in global markets. Electricity rate payers are very concerned about the impacts of policy-induced electricity price increases. Free allocation of permits and recycling of auction revenues provides  a viable means of mitigating these impacts.

It is true that the distribution of emissions permits created under California’s emissions trading program has been – and continues to be- a complicated, messy, and highly political process. However, industrial competitiveness concerns would be no less salient, and debates about how to compensate various stakeholders no less complicated, had California pursued a carbon tax.  The only difference would be that compensation would be delivered in the form of recycled tax revenues or tax exemptions (versus recycled permit auction revenues and free permit allocations).

To be sure, there are some important differences between these two market-based policy instruments.  For example, a cap-and-trade system allows policy makers to commit ex ante to a specific emissions target, letting the market determine the carbon price. In contrast, the policy maker sets the carbon price with a carbon tax, letting market forces determine how much pollution abatement will be supplied at that price.  The resurgence of interest in carbon taxes, and the increasingly animated carbon tax versus cap-and-trade debate, has an important role to play in shaping policy responses to climate change in California and beyond. Constructive policy discourse should focus on the fundamental differences between these two market-based policy approaches. Compensation paid to affected industries is not one of them.

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