Emissions Trading, Carbon Taxes or Fuhgetaboutit

Published January 7, 2008

Tony Soprano, the celebrated television philosopher, has it right. “Fuhgetaboutit.”

Other less distinguished policy analysts are divided between emissions trading and a carbon tax to deal with the possibility of global warming.

Emissions trading is flawed in several respects. It is subject to fraud and political manipulation. The Emissions Trading Scheme in the European Union is a notable example. The RECLAIM system in the South Coast Air Basin (SCAB) in California and even the acid rain trading nationwide are also examples.

To the policy wonks, it has other problems as well. Each source has to be benchmarked, tracked and the reduced emission claims have to be verified. The number of projects under an open ended carbon trading scheme would be many more times previous trading systems. This would greatly increase the system’s administrative costs. Accounting for the huge number of sequestration projects would be an enormous complication and vulnerable to a great deal of fraud.

Another perceived problem is that the prices of allowances and credits in previous systems are very volatile and do not reflect stable differences in abatement costs. Rather than asking why this is so, they want to cap the carbon allowance prices. This follows the renowned analytic tradition in Washington. When the data are inconsistent with the prevailing theory, then the data must be changed, not the theory.

One might reasonably ask, what is going on here? Trading is supposed to occur between emission sources with different costs of abatement. The low cost source is supposed over reduce emissions and then sell the excess to the high cost source. That does not imply a lot of volatility in allowance prices because technology of abatement does not change that much. By contrast, the allowance price volatility does track an alternative theory. During a weather related energy shock in one area, the emission source has a choice of using extra allowances to cover the operation at higher capacity, or shutting down and buying energy from sources where the crisis is less serious.

This is an attractive strategy because the rules of the trading scheme can be changed at any time. In past schemes, the allowances or credits were denied property status. This means that changes could be made by the government and the victim of a takings could not get reimbursed under the Fifth Amendment of the Constitution. Thus, the allowance price is closely related to the price of the fuel (natural gas) used at the margin to produce more energy (electricity). Energy contracts are property, unlike the allowances and credits. This means hedging will be done mainly with energy contracts rather than emission allowances. Does the emission allowance price track the price of natural gas? Yes, it does. Moreover, this reinterpretation implies that the touted savings from emissions trading are grossly inflated.

Another problem with emissions trading the policy wonks want to fix, is that the lower allocation of allowances that represents the reduction in allowed emissions are “free.” Under the latest version of carbon emissions trading, the initial endowment of credits would be taxed. The effect is to raise the costs of all the emissions, not just the reductions. This makes the analytical results of emissions trading mathematically identical to the proposed carbon tax. It also revives the quaint Soviet tradition of charging the family of an executed man for the bullets.

Notwithstanding the claims of supporters, the carbon tax is no boon to society, either. The basis would levy the carbon content of principal energy sources, such as crude oil and natural gas at the wellhead. The tax would supposedly be passed forward to the final consumer and not to employees or stockholders. The tax would supposedly be neutral, in the sense that the proceeds would be returned to the economy generally in a way that would not further disrupt relative prices. While that might sound attractive, taxpayers would be properly suspicious of whether such a rebate would actually take place. Once the government has the tax revenue, who really believes that favored constituencies will not receive the proceeds so that the politicians will better their chances of getting reelected?

A closer look at the carbon tax proposal makes me suspicious. While energy producers would be taxed, countless numbers of projects to lock up carbon, mainly in the agriculture sector, would receive tax credits. There is potential for a massive diversion of funds from energy consumers to farmers. I suspect the politicians are hoping the sequestration tax credits will come just in time to replace the failed ethanol subsidy.

Now, there is nothing inherently wrong with tax credits. They could serve to offset government expenditures on levees and other activities to mitigate the effects of global warming should it actually occur. But tax credits should be universally available. To propose that some have their taxes increased and others have their taxes reduced suggests the same old tired political redistribution is being attempted. I doubt that taxpayers will be fooled.

One might ask about what is left if both emissions trading and the carbon tax are fatally flawed? The answer might be the much maligned command and control system of regulation. After all, it exists throughout the world and has for some time. It is more difficult, but not impossible, to distort the regulations for political benefit. Regulations are subject to a judicial process where anticompetitive and counterproductive effects can be made apparent. This is not to say that remedies are automatic. But it probably retards the extent of the distortions.

There might be a solution already in place. Energy prices have grown rapidly in the last three years and are now, in nominal terms, near an all time high. Corresponding to the high prices, conservation efforts have kicked in and with them a reduction in carbon emissions. They declined 1.5% in 2006 and probably more so in 2007. Why force even more high-cost reductions with emissions trading or a carbon tax? That would be piling on an already difficult situation and probably retard economic growth worldwide without substantially reducing emissions. Moreover, there would be virtually no incremental moderation in global warming.

We should take Tony Soprano’s advice about emissions trading and the carbon tax. Fuhgetaboutit.

Jim Johnston ([email protected]) is an economist and policy advisor to The Heartland Institute.