May 2009

In a New York Times column, Nobel prize winning economist Paul Krugman has written some commentary on the Waxman-Markey legislation that proposes to introduce an emissions trading scheme in the United States. It is well worth reading. In his column, when Krugman discusses some of the objections to the scheme, he states:

One objection — the claim that carbon taxes are better than cap and trade — is, in my view, just wrong. In principle, emission taxes and tradable emission permits are equally effective at limiting pollution. In practice, cap and trade has some major advantages, especially for achieving effective international cooperation.

Not to put too fine a point on it, think about how hard it would be to verify whether China was really implementing a promise to tax carbon emissions, as opposed to letting factory owners with the right connections off the hook. By contrast, it would be fairly easy to determine whether China was holding its total emissions below agreed-upon levels.

I agree with Krugman that cap and trade has major advantages in terms of achieving international cooperation. This is the main reason why I support cap and trade. However, because carbon dioxide is more or less a stock pollutant, it has been argued that setting a price by introducing a carbon tax will be more likely to reduce emissions by an appropriate amount. I therefore disagree with Krugman that setting a tax is equivalent in principle to having tradable permits, because of uncertainty.

A cap and trade system with a price floor has the same advantages to emissions trading when it comes to international cooperation; it also has the same advantages of carbon taxation (and is probably superior to carbon taxation) when it comes to managing uncertainty. Unfortunately,it is very to find a serious discussion about price floors in the peer-reviewed economic literature since 1976 (but Roberts, M. J., Spence, M., 1976, ‘Effluent Charges and Licenses under Uncertainty’ is well worth reading). Most of the discussion on hybrids between cap-and-trade and carbon taxes has been about schemes with price ceilings.

See also:

Update: The Waxman-Markey bill does in fact have a price floor.

The Carbon Pollution Reduction Scheme legislation was introduced into Parliament on Thursday May 14, 2009. This legislation includes new measures that were announced on May 4, which includes a delay of a year before firms must purchase permits. Below are some of the changes to the bill compared to the Exposure Draft Legislation.

The object of the act has been changed, with the addition of 4(a) to Section 3 of the legislation:

(4) The third object of this Act is: (a) if Australia is a party to a comprehensive international agreement that is capable of stabilising atmospheric concentrations of greenhouse gases at around 450 parts per million of carbon dioxide equivalence or lower—to take action directed towards meeting Australia’s target of reducing net greenhouse gas emissions to 25% below 2000 levels by 2020;

The government’s has announced policies (not in the bill) for what it would expect of developing and developed countries before agreeing to a 25% reduction:

The Government will adopt a 25 per cent target only as part of an ambitious international agreement involving comprehensive global action capable of stabilising greenhouse gases in the atmosphere at 450 ppm CO2-e or lower. Such a comprehensive and ambitious agreement must meet following conditions:
1. comprehensive coverage of gases, sources and sectors, with inclusion of forests (e.g. Reducing Emissions from Deforestation and forest Degradation – REDD) and the land sector (including soil carbon initiatives (e.g. bio char) if scientifically demonstrated) in the agreement;
2. a clear global trajectory, where the sum of all economies’ commitments is consistent with 450 ppm CO2-e or lower, and with a nominated early deadline year for peak global emissions no later than 2020;
3. advanced economy reductions, in aggregate, of at least 25 per cent below 1990 levels by 2020;
4. major developing economy commitments to slow growth and then reduce their absolute level of emissions over time, with a collective reduction of at least 20 per cent below business-as-usual by 2020 and a nominated peak year for individual major developing economies;
5. global action which mobilises greater financial resources, including from major developing economies, and results in fully functional global carbon markets.

There has also been a very minor modification to the sections of the legislation that deal with scheme caps and gateways (which describe how Australia will set its trajectory), with the addition of sub-sections 14 (7) (relating to the caps) and 15 (6) (relating to the gateways):

14 (7) If: (a) regulations are made for the purposes of this section; and (b) on a particular day (the tabling day), a copy of the regulations is tabled before a House of the Parliament under section 38 of the Legislative Instruments Act 2003; then, on or as soon as practicable after the tabling day, the Minister must cause to be tabled before that House a written statement setting out the Minister’s reasons for making the recommendation to the Governor-General about those regulations.

Subs-section 15 (6) is identical to 14 (7) except that it applies to a different section of the legislation. This changes are extremely minor and do not address the serious problems with this aspect of the legislation that I have raised before.

The most significant changes to the legislation relate to how the price cap (fixed price permits) will work, which is in Section 89 of the legislation. In the first year of operation, 2011-2012, the price of carbon will be set at $10 per tonne CO2-e — in this year the CPRS will function like a carbon tax; between 2012-2013 and 2015-2016, the government will issue fixed price permits that will initially be at $40, and increase by 5% above the CPI in subsequent years. As well as everything being shifted back by a year, the method in which the fixed price permits is set is slightly different. Previously, the price was set precisely in the legislation, and increased by 7.5% each year.

In the ultimatum game, there are two players and a sum of money. The first player proposes how to divide up the sum of money, and the second player chooses whether to accept or reject the proposal. If the second player rejects the proposal, neither player receives anything. This game has a unique subgame perfect equilibrium where the first player receives all of the money, or almost all of the money when payoffs are discrete.

Experiments where people have played the ultimatum game have consistently found that the first player will usually offer significantly more money to the other player than the subgame perfect equilibrium, and the second player will be unlikely to accept the offer if they are offered less than 30% of the total amount.[1]

It has been argued by Fehr and Gächter that the ultimatum game provides evidence that economic agents don’t just base their decisions on pure self interest, and reciprocal considerations play an important role in people’s actions. It has been argued by Barrett that the ultimatum game also provides evidence that an international environmental agreement is more likely to be self-reinforcing if it is perceived by its parties to be fair. [2]

[1] Güth et al. (1982), An Experimental Analysis of Ultimatum Bargaining, Journal of Economic Behavior and Organization, 3, pp. 367-388

[2] Fehr and Gächter (2000), Fairness and Retaliation: The Economics of Reciprocity, The Journal of Economic Perspectives, 14 (3), pp. 159-181;  Barrett (2003), Environment and Statecraft – The Strategy of Environmental Treaty-Making, pp. 299-301.

Australia’s Prime Minister, Kevin Rudd, has announced some changes to the proposed carbon pollution reduction scheme legislation. In short, this is what is being proposed:

  1. The scheme will be delayed until July 2011;
  2. In 2011-2012 the carbon price will be set at $10/tonne and there will be an unlimited amount of permits;
  3. Emissions trading will be begin proper in July 2012 — I don’t know if there will be any price caps or floors after July 2012.
  4. There will be “recession buffer” where industries eligible for assistance at the 60% rate “would receive a 10% buffer for a finite period”, while those eligible at the 90% rate “will receive a 5% buffer for finite period”.
  5. The 5%-15% target reduction range will be kept unless an agreement consistent with 450ppm CO2-e is agreed to, in which case Australia will agree with a 25% reduction on 2000 levels.
  6. Some token measures that enable households to buy and cancel permits — something that they probably would be able to do anyway.

Some of the fine print on how the targets will work is here.

I’ll reserve my final opinion until I see whet the new legislation looks like next week, but it does seem like overall it is a slight improvement. There is stuff in the scheme that is unfortunate, such as the delay, the $10 carbon price in 2011-12, and the extra 5-10% free permits to emissions intensive industries. But the targets for 2010-11 and 2011-12 in the White Paper were so weak that I wouldn’t have been surprised if the carbon price was less that $10 in those years anyway. The 5-10% extra free permits to emissions intensive industries won’t affect the overall target, but is an equity issue and a waste of taxpayers money.

In my opinion the conditional target is more important than the unconditional target, because that is what makes the most of a difference for international cooperation. The willingness to go beyond 15% emission reductions is very good news, the government has partially fixed what was the worst problem with the CPRS. Unfortunately a 25% reduction for Australia would only consistent with 450 ppm CO2-e that was very generous to Australia, and unlikely to be acceptable to developing countries, low per-capita emitters, and countries responsible for low amounts of historical emissions — in other words Australia would be getting a “special deal”, which is similar to free-riding. What Australia should be doing is be willing to accept a reduction of at least 25% by 2020 as part of an agreement consistent with a stabilisation target of 450 ppm CO2-e or less.

One way to respond to this development would be to put on the table proposals that have not been on the agenda so far. A steadily increasing price floor should be at the top of the list, as should be overhauling the scheme caps and gateways approach for setting the target (too inflexible), and the ability of firms to buy an unlimited amount of CDM credits (which have additionality problems). Only a steadily increasing price floor will drive the investment in renewable technologies that we need.

On whether the legislation should be passed, I would be very reluctant to pass it unless something was done about the scheme caps and gateways approach to setting the trajectory. The problem with the gateway approach is that the minister can set lower (and upper) bounds on Australia’s emissions forever. It is not appropriate for the minister to set any lower bound for emissions, let alone forever.