The Big Stick: Cap and Trade in the Peoples Republic of Carbon

Many of us have argued that a patchwork of national or subnational climate policies is a largely pointless undertaking unless the big two (United States and China) are part of that patchwork. The US has taken some steps towards national regulation recently and there are noises coming out of China that the next five-year plan will contain a significant piece of mitigation policy.

The sooner, the better. The averaged annual growth rate of Chinese emissions over the past decade was 9.1%, which implies a doubling of emissions every eight years.

In order to get emissions under control, there are inflexible standards or price-based mechanisms like cap and trade (CAT) and carbon taxes. The US lacks a national CAT, yet has functioning markets in California and on the East Coast. The EU has the super-national emissions trading system (ETS) supplemented by a significant portfolio of energy efficiency and renewable energy policies.

China has, in the recent past, started a few experimental cap and trade systems, which may well be regarded as blueprints for a larger national market. While trade volumes on these exchanges are relatively thin, the figure below shows that prices vary between 4 and 13 dollars per ton (which is not too far from the price on the California system and the ETS).

Daily permit prices on six Chinese regional exchanges (Dollars per ton)

The big stick CDW-2

The National Development and Reform Commission, which is the arm of the Chinese government responsible for economic planning, has provided coarse outlines of a national market starting in 2016, which will cover 3-4 billion tons of CO2 with a volume of roughly 65 billion US Dollars by 2020. This is twice the volume of the European market. And some simple algebra suggests that the planners expect permits to trade at just below $20, which is higher than anywhere else in the world currently or in any of the regional markets in China. This is exciting news and will surely provide some significant momentum in the upcoming climate talks.

I am somewhat puzzled by the apparent choice of a national cap and trade system over the other price based alternative to a CAT: a carbon tax. The reason I am puzzled is deeply rooted in some simple political economy. Cap and trade generates valuable assets (permits), which are frequently handed out to carbon intensive industries, which would otherwise fight the regulation and possibly prevent it from being implemented. If the government hands out permits, it gets no revenues from these permits.

A carbon tax, on the other hand, is charged on each carbon atom and most likely charged fairly far upstream the carbon river. It generates revenues for the government (especially at ~$20 a ton). My (limited) understanding of how environmental policy works in China is that industry gets much less say in what regulations will be implemented and how.

Here are a few simple advantages of a carbon tax over cap and trade in an economy that currently does not come close to collecting a universal income tax:

  • It is relatively simple to collect far upstream.
  • It provides carbon price certainty.
  • It does not suffer from the significant design issues involved in setting up a market in one of the most highly regulated economies in the world.
  • It generates significant revenue, which may prevent one from having to set up or ramp up income taxation schedules, which are distortionary.
  • It provides the regulator with direct control of the rates.
  • China has extensive experience at the regional level with collecting effluent fees (which are essentially emissions taxes of criteria pollutants).

One argument, which is often used against a carbon tax is that it does not guarantee what emissions reductions will be in any given period, as the marginal abatement costs are not known by the regulator. While this is certainly true, Lucas Davis points out from across the hall that with GHGs we care about cumulative emissions. When the marginal benefit of abatement curve is relatively flat, you want the flexibility afforded by taxes.  If costs end up being higher than expected, emission sources can abate less. One clear disadvantage of a tax is that it is somewhat harder to exempt individual sectors/firms from the tax. What this might mean in the Chinese context is that it puts smaller (already inefficient) coal mines at a further competitive disadvantage and risks significant local employment impacts.

The problem with almost all environmental regulation of course is that there will be some winners and some losers, but overall we make the pie bigger. I am thrilled to see the Chinese government get serious about climate regulation, but would hope that serious consideration is given to a tax instead of a cap and trade system. China has significant experience with taxes and the main institutions required to put a new one in place are, well, in place. Setting up a market is hard and the devil is in the details. Just ask California.

About Maximilian Auffhammer

Maximilian Auffhammer is the George Pardee Professor of International Sustainable Development at the University of California Berkeley. His fields of expertise are environmental and energy economics, with a specific focus on the impacts and regulation of climate change and air pollution.
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3 Responses to The Big Stick: Cap and Trade in the Peoples Republic of Carbon

  1. Pingback: The Big Stick: Cap and Trade in the Peoples Republic of Carbon | Veille énergie climat

  2. Bo Chen says:

    The small coalmines have never been major local employers and there is no problem whether they are at an disadvantage due to the carbon tax. Actually, the government has long been taking taking measures to consolidate the small mines. Another problem I can think about the CAT is also related to some simple political economy. The state-owned enterprises could obtain more favorable treatments when the government initially distributes the permits which would make small and medium private business less and less competitive.

  3. Mark Trexler says:

    I’ve just peer-reviewed a paper from Chinese authors looking at some of the legal and administrative barriers to the implementation of cap and trade pilots in China. Those barriers go so far as to throw into question the entire enforceability of the programs – there may be no penalty if firms don’t comply because the programs don’t have the necessary legal framework. I hadn’t realized how substantial the barriers were (even beyond those mentioned in Maximilian’s blog) – it will be interested to see how it plays out.

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