We argue that the best carbon price signal is a cap and trade system with a price floor. The floor can be maintained by having firms pay an extra fee when they exercise their permits, based on the amount of their emissions. The carbon price then becomes equal to the sum of the permit price and the extra fee. This is similar to having emissions trading scheme combined with a carbon tax.

Stern described climate change as the greatest of market failure we have ever seen. Part of the reason for this market failure is that firms have not had to pay for the damage that they are doing to the planet. Any solution to the climate change problem must therefore involve making the polluter pay, be it through prices, quantities, other forms of regulation, or a combination of these mechanisms.

Price based mechanisms are known as carbon taxes – the regulator sets the price, leading to a reduction in emissions. The main quantity based mechanism is known as emissions trading, or cap and trade. A cap and trade scheme involves the regulator setting the amount of emissions, with the market determining the permit price. One form of cap and trade is carbon rationing, which is a pure application of the polluter pays principle – emission permits are allocated to the public, and polluters are required to buy permits from the public. There is also a form of emissions trading known as “baseline and credit”, which includes schemes like the UN Clean Development Mechanism and the NSW Greenhouse Gas Abatement Scheme. Baseline and credit schemes have problems with establishing a baseline, which means that it is difficult to prove that emissions reductions are real. For the rest of the post, when we discuss emissions trading we will be discussing cap and trade schemes. We shall also discuss hybrid approaches, which combine elements of a carbon tax and a cap and trade scheme.

A cap and trade scheme is not more or less market based than a carbon tax. The key issue is uncertainty — nobody knows how much emission reductions you will get for a given carbon tax level, and nobody knows what the carbon price will be for a given level of the cap. There are two sources of uncertainty – uncertainty in the cost of mitigation and uncertainty in the cost of climate change. It is not too hard to estimate upper bounds for the cost of mitigation (John Quiggin does it for electricity generation here, and some advocates of a very low carbon tax such as William Nordhaus also assume the existence of a “backstop technology” that plays a similiar role). The uncertainties in the costs and impacts of climate change are much greater, involve a whole lot of “long tails”, and cannot be bounded – in the words of Weitzman ( 2008 ) On Modeling and Interpreting the Economics of Catastrophic Climate Change, they have “potentially unlimited downside exposure”. There is also the issue of the discount rate, and of environmental costs, which mean that aggregating costs is also an ethical question.

When choosing a price or quantity, it will either be too high or too low (because of uncertainty), and there will be a welfare loss. Weitzman (1974) Prices vs Quantities discusses the mathematics of this issue. Weitzman argues that the slope of the marginal cost and benefit curves are what matter and that if the cost of abatement goes up faster than the cost of climate change then a tax is better, if it doesn’t (such as when climate tipping point is a risk) then a cap-and-trade system is better. Hepburn (2006) Regulation by Prices, Quantities or both: a review of instrument choice has some good discussion of these issues.

The uncertainty in the science is a very strong argument for more mitigation at a faster rate, issues where the science has not been entirely resolved but have serious impacts on risk include melting ice sheets (Greenland and West Antarctica are worth about 13 meters if they both go), carbon cycle feedbacks, albedo feedbacks affecting carbon cycle feedbacks (a recent paper suggests that melting arctic ice will increase the permafrost melting), and very low probability high impact possibilities of methane hydrates being released. All of this points to getting emissions down to as low a level as possible as quickly as possible at costs that can be managed. It is important that costs are kept as low as possible in order to ensure that the mitigation task continues (this is a political economy issue), as well as reasons of utility and human welfare. The problem with a pure cap and trade scheme is that it is very difficult to choose an emissions reduction trajectory when much of the recent science suggests that it would be prudent to reduce emissions as quickly as possible to a level somewhere around zero.

This brings us to the issue of hybrid approaches. Most hybrid approaches can be thought of as a cap and trade scheme where there is a price floor, a price cap, or both. The Australian Government’s Carbon Pollution Reduction Scheme Green Paper proposes a price cap – firms can always buy more permits at the level of the price cap, this means that the emissions cap is no longer a strict cap. Having a price cap is problematic because is there is a risk that the social cost of carbon is greater than the cap. The issue of long tails in the damage function and of potentially unlimited downside exposure make this risk more significant.

The issue of potentially unlimited downside exposure, the latest science, and the politics of mitigation all suggest that the risk of climate change damages exceeding the costs of mitigation is far more serious than the risk of the costs of mitigation exceeding the damages from climate change. For this reason we should have a price floor and not a price cap. A price floor helps us to choose an emissions reduction trajectory which would reduce emissions as quickly as possible to a level somewhere around zero. The emissions cap should be chosen so that it is sufficient to avoid dangerous climate change and the price floor should be as close as possible to the expected social cost of carbon. Having emissions caps is also useful for international cooperation – it is more likely to be consistent with negotiations under the UNFCCC.

Additional benefits of a price floor are that it manages the risk that the carbon price collapses if the amount of emissions goes below the cap, which happened with the EU Emissions Trading Scheme. A price floor also provides an extra degree of certainty for investors in low emissions technologies.

According to Hepburn (2006) a price floor can be implemented by a commitment by the regulator to buy emissions permits at the floor price. In his Draft Report, Ross Garnaut has criticised this approach. He states (page 344):

A floor price for permits would require the scheme administrator to enter the market to purchase permits whenever the permit price fell below a specified value. A floor price is incompatible with international trade in permits as it would effectively create an unlimited liability for the Australian scheme administrator.

There is another approach to a price floor that does not have this problem. A traditional cap and trade scheme works by firms being required to have purchased enough permits that cover their emissions. When a firm reports its emissions, it surrenders an equivalent amount of permits. We can introduce a price floor by requiring firms to pay an “extra fee” for each tonne of emissions when they report their emissions. The carbon price is then equal to the sum of the permit price and the extra fee. This approach is only slightly more complex than a pure cap and trade scheme. This approach is also very similar to having emissions trading scheme combined with a carbon tax.

Note: An earlier version of this post was included as a comment on John Quiggin’s blog post Carbon Taxes vs Emissions Trading, which also included a comment by Warwick McKibbin where he describes his hybrid approach (where there is a price cap).

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