Types of Carbon Pricing (Part 1 of 3)

This post is the first of three summarising the differing features of carbon pricing instruments – emissions trading (cap-and-trade), carbon taxes, and hybrids – and commenting on some of the implications for existing carbon pricing schemes.  The three together can be found as a pdf file under the carbon pricing pages of this site.

These posts focus on the differences between types of carbon pricing.  However there are many commonalities, and any type of well-designed carbon pricing is usually preferable to none.   Political circumstances will often play a major role when choosing the best approach in practice – a scheme which cannot be introduced for political reasons cannot be regarded as optimal in any practical sense – and a pragmatic approach to carbon pricing is likely to be the most productive.  Furthermore carbon pricing has quite a short history compared with many forms of regulation (the EUETS, the first large scale carbon pricing scheme, started less than 10 years ago).  For now there should not be undue concern about a wide diversity of approaches to carbon pricing, because this variety enables more to be learned about how different designs work in practice.

The role of uncertainty

The standard theory on the choice between a cap and trade scheme and carbon taxes(1) frames the problem as maximising total net benefits of pricing under uncertainty.  If the behaviour of the market were known in advance setting prices or quantities would yield the same result – one could set quantity knowing the price that would result, or vice versa.  However when market responses are uncertain, as they always are in practice, the two instruments have quite different properties.

When the abatement costs differ greatly depending on the amount of abatement required (high slope of the marginal abatement cost curve) a tax will tend to be preferred.  This is because setting a cap a little too high or a little too low could result in either excessively high prices for little benefit or missed opportunities if the tax is set too low.  In contrast when the damage costs are rapidly increasing as emissions rise (there is high curvature of the damage function) a cap will tend to be preferred.  This is because under a tax the price might be set too high, proving economically costly for little benefit, or too low, leading to very high damages as threshold levels of pollution are reached.

The problems caused by uncertain outcomes have been highlighted by the emergence of a large surplus of allowances under the EUETS, in which a fixed cap has led to unexpectedly low prices.

A long term cumulative cap to prevent dangerous thresholds being crossed

The prospect of rapidly increasing damages implies that globally and over the long term an emissions cap may have significant advantages for limiting greenhouse gas emissions, especially as avoiding severe damage requires deep cuts in emissions compared with business as usual.  The costs of the damages from climate change cannot be known in advance with any certainty, but seem likely to increase very rapidly (and highly non-linearly) as the concentration of greenhouse gases in the atmosphere increases and large irreversible damages, such as the melting of ice caps, are locked in.   This requires a limit on cumulative emissions (a global cumulative carbon budget) to prevent such large damages being realised, including those from natural thresholds being crossed.  There is inevitable scientific uncertainty about exactly where each threshold is, so attitudes to risk will also be important in setting the cap.

Addressing such rapidly increasing damages ideally requires a global annual cap reducing over time to be set, such that the cumulative total cap (area under the curve) corresponds to a limit on the cumulative emissions above which dangerous thresholds may begin to be crossed.  (The situation is complicated by the need to take account of sinks and other forcings such as aerosols, and further by the dependence of damage on the path of the stock over time.)   This type of approach informs the analysis of the limits of the cumulative amount of fossil fuel that can be burnt (see the recent Fifth Assessment Report from the IPCC (ref 2)).

The effect of decisions taken now on the stock of a pollutant over time is particularly relevant for climate change.  Much energy infrastructure has a very long life, so a decision now will influence emissions for decades.  Furthermore a larger proportion of CO₂ emitted stays in the atmosphere for centuries, so emissions determined by current investment decisions will affect the stock in the atmosphere over all relevant timescales.

There is no binding global agreement to establish such a cumulative cap (nor does there appear likely to be).  However an increasing number of emissions trading schemes in major economies with stringent long term emissions goals are being established, and may provide over time the best approximation to the ideal of a global emissions limit that is likely to be available.  For example the EU has cap decreasing at 1.74% p.a. with a goal of 80-95% reduction by 2050, California also has a clear 2050 goal of 80% reduction from 1990 levels, and China is increasingly expressing emissions reduction ambitions and implementing them in the form of emissions caps, regionally at present but with ambitions to move to national limits.  In contrast a series of carbon taxes would give much less certainty of staying below any threshold.

Flexibility

Emissions trading may also allow more flexibility in how and when emissions are reduced.  Banking provisions and multi-year compliance periods, which feature in most scheme designs, can allow firms to make choices about when to abate and how much, giving them flexibility in reducing costs in ways which are difficult to replicate under a tax.

Strategic signals

Emissions caps can have the further advantage of giving a stronger strategic signal that emissions will have to decrease to much lower levels in the long term.  The changes required to achieve this often fundamental and transformational rather than marginal.  The signal provided by a long term quantity limit may prove effective in stimulating investment in technology development, physical infrastructure, grid operating regimes and other longer term elements of a low carbon economy.   These will require many other policy interventions, and will not be achieved by carbon pricing alone.  However a cap can be useful in making the case for these measures by defining the scale of the challenge (although it can have the weakness of not incentivising measures that go beyond the cap, which is a point I’ll return to in looking at hybrid instruments).

In contrast a tax, even if effective in signalling marginal changes, may not signal more fundamental change to the same extent, although a defined escalator on a tax may go some limited way towards this.  For example, very high fuel taxes have played a role in incentivising improved fuel efficiency in vehicles, but fleet efficiency standards (in effect a declining cap on emissions intensity) have also played an important role, and the expectation of the need to move to very low levels of emissions seems to have been important in stimulating the world motor vehicles industry to put vast resources into developing electric vehicles.  Similarly the expectation of very substantial decarbonisation of the power sector created by quantity targets appears to be driving necessary discussions and early action on grid design, trading arrangement reform, and system operation.

Addressing competitiveness concerns

There may also be some advantage from greater administrative ease in addressing concerns about competitiveness of emissions intensive trade exposed industry through the allocation of free allowances.  In principle the same outcomes can be achieved with a tax by setting thresholds above which the tax is payable, as, for example, under the proposed South African carbon tax.  However providing such shielding under an ETS may be politically, legally or administratively simpler under an ETS.  For example, it may be politically difficult to be seen to “give tax breaks to big polluters”.

Offsets and linking

Other proposed advantages of emissions trading are less compelling relative to a carbon tax.  For example, offsets can be included under a tax, as is proposed in South Africa and Mexico, as well as under an ETS.  There may be potential to link emissions trading schemes.  However at present trading schemes remain diverse with wide dispersion of prices and limited prospects for direct linkage.  And under a tax governments can easily look to the levels of taxes elsewhere and take that into account in setting their own tax rates, with some potential for linking taxes by means of credits if this is desired.

Quantity limits as an expression of non-monetary values

Among the most compelling reason for choosing caps is that the consequences of climate change imply choices about issues that are not captured by an economic cost benefit analysis looking at maximising net benefits.  Choices are ultimately about the effects some people now impose on others, the legacy current generations leave for the future and how can this be balanced against the needs of the present.  This necessarily requires the debate to address how acceptable we find the risk of melting ice caps or the loss of the Amazon forest.  While economic analysis may inform some of these choices it cannot make them, because in the end they are not only about money.  Under this framework an emissions trading scheme is an instrument to achieve a goal that is necessarily specified outside the framework of net monetary benefits.  This is represented much more directly by limits on cumulative emission than by a carbon, even though uncertainties about the effects of a particular atmospheric concentration remain.

Drawbacks to quantity limits

However an ETS also has drawbacks.  Prices can be very volatile, because abatement is typically a small proportion of emissions making the price the result of a small difference between two numbers (the cap and business as usual emissions), one of which is rigidly fixed and the other of which is highly uncertain(3).  Such volatility is likely to persist, even with provisions to bank allowances, which are intended to smooth out price fluctuations, and with other provisions such as overlapping or rolling compliance periods.  For example, banking is a feature of the EUETS, and prices have still been volatile, although banking has helped sustain Phase 3 prices above zero.

Highly volatile prices are undesirable because they increase the risk of investments in abatement, and hence their costs, leading to decreased economic efficiency.  Volatile prices may also bias the form of abatement towards shorter term expenditure, such as fuel switching, rather than longer term investment.  They also make government finances more difficult to plan where auctions are used, and make a revenue neutral carbon pricing scheme, often an objective of policy, more difficult to sustain.

More fundamentally, an emissions trading scheme may fail to price emissions correctly in some circumstances because it fails to give any incentives to reduce emissions further below the cap.  If emissions are below the cap, allowances are not scarce, and the price drops to close to zero.  However emissions below the cap impose a cost and so should be priced(4).  This is evident under the EUETS at the moment where further abatement would clearly have value not signalled by the current price.  This problem of under-pricing damage is especially severe given the limited time horizons and incomplete commitment that are part of emissions trading schemes in practice.

Such drawbacks may carry particular weight where the advantages of an ETS seem less compelling.  My next post will look at what the alternative of carbon taxes might deliver, and the circumstances in which this might be a more appropriate policy choice.

Adam Whitmore – 28th April 2014

Notes

1 This basis of the choice between price and quantity instruments was first laid out clearly in by Martin Weitzman  in one of the most widely cited papers in the environmental economics literature (Weitzman, M.L. 1974 Prices vs. quantities, Review of Economic Studies 41 (4) 477 -491).     A good recent survey of the merits of different approaches is in Carbon Taxes vs. Cap and Trade: A critical Review, Lawrence H. Goulder Andrew Schein  Working Paper 19338 http://www.nber.org/papers/w19338

2  http://www.climatechange2013.org/images/uploads/WGI_AR5_SPM_brochure.pdf

3.  See Grubb, M. (2009). Reinforcing carbon markets under uncertainty: the role of reserve price auctions and other options for a discussion of this point.

4  This is measured by the Social Cost of Carbon.  There are large uncertainties in estimating what this is, and it is difficult to account for non-market impacts, but it nevertheless provides a useful indication of the cost of damage, at least as a lower bound – see page below in this section for a discussion of the social cost of carbon.

Failings of market failure as a guide to policy

The orthodox economic framework for analysing climate policy in terms of correcting market failures contains important insights, but is too narrow to identify a complete set of policies. 

This post is a little more abstract than usual, with no data or charts.  It looks at the framework that often underlies analysis of policies for reducing greenhouse gas emissions, though only taking a brief look at a subject that warrants much more extensive treatment.

The orthodox policy framework around emissions mitigation, especially among economists and particularly in developed English-speaking economies, consists of identifying, assessing and fixing market failures.  At the risk of slightly caricaturing this approach, essentially it stipulates that the costs of damages from greenhouse gas emissions are not normally factored into economic decisions, a major market failure which needs to be addressed by pricing emissions.  Other market failures may also need to be addressed if emissions reduction is to be achieved efficiently.  For example, there is a divergence of incentives between tenants and landlords (a principal-agent failure), which needs to be addressed by other interventions such as building standards.  Once market failures have been identified and fixed, markets can be left to do their job of making efficient production and consumption decisions.

This framework contains some valuable insights.  Carbon pricing has the potential to help reduce emissions at lowest cost, because there will be many different opportunities to reduce emissions, and a market will help reveal where the low cost abatement can be achieved, and incentivise cost effective action.  And asking what might stop energy markets from operating efficiently can provide important – though not fully comprehensive – insights into where policy interventions might be needed.

However in practice the characteristics of the energy sector imply that the necessary range of policies and activities is much broader than the framework of market failures alone would suggest.  (In other sectors, especially land use, which accounts for a substantial proportion of global greenhouse gas emissions, the limitations of the market failure framework are if anything even greater, with a diverse set of policy approaches needed – but more on this will need to await a future post).  A narrative that focusses exclusively on fixing failures so that markets can do their job is likely to lead to important dimensions of policy being missed.  At best the framework  of market failures highlights where problems may exist, but in many cases says little about how they can best be addressed.

For example, the characteristics of electricity production and delivery mean that electricity markets must be designed, and the form they take can have a major effect on the extent to which they enable a transition to a system with lower emissions.  Electricity markets may, for instance, differ in the way they deal with a preponderance of generation with very low marginal costs, increased interaction between supply and demand (enabled by smart metering and related trends), and likely greatly increased use storage.  An understanding of economic principles will surely help achieve effective market design, but labelling the need to design a market as a market failure does little to help.

Related to this, electricity and gas flow through networks with strong natural monopoly or oligopoly characteristics.  Network development, operation and pricing are inevitably subject to regulation, which may be more or less effective in stimulating low carbon investment.  Again, characterising network monopoly as a market failure, while doubtless valid, does little to tell you how networks need to be designed to enable lower carbon energy systems.

Furthermore, people’s behaviour often does not conform to the simple rational profit maximisation that much mirco-economic theory assumes.  This is more of a failure of (traditional) economic theory than of markets themselves.  This has major effects in areas such as energy efficiency, and a range of policies is typically required to address behavioural characteristics.  Behavioural economics and psychology will offer more insight here.

And, crucially, decarbonisation requires a fundamentally new energy system, including new technologies, notably for electricity storage.  The role of technology policy is too large a subject to go into here, but it is worth noting that the state and various types of institutions other than private corporations, such as universities and research institutes, have played a major role in fundamental innovation in a range of sectors.  It is likely that many such institutions have a role to play in decarbonisation, and looking at their role within a framework of market failure is unduly constraining, and risks misinterpreting their appropriate role and likely behaviour.

More broadly market based instruments such as carbon pricing are just that: instruments for achieving a goal.  The goal cannot be defined by markets, not least because choices affect those still to be born and the type of world they will inherit may differ fundamentally, not just marginally, from the present, depending on the choices made today.

Furthermore, all markets are embedded in wider society, including political and legal institutions.  These institutions and their actions must continue to have legitimacy if the transformation to a lower carbon society is to be effectively achieved.  Enormous efforts are required to retain public support for actions to address the climate change problem, and for the institutions that must implement emissions reductions policies, including carbon pricing.  Maintaining and enhancing this social and political capital and infrastructure is a task that goes far beyond fixing market failures.

It is possible to force-fit some of these issues into a framework of market failures, but doing so risks limiting the range of policy options and associated actions that are considered.  A much broader and more active approach is needed, asking what needs to be done and what tools and approaches are best suited to reaching a goal.  Markets have a major role to play in an effective policy programme.  But talking exclusively within a framework of market failures is likely to miss important dimensions of good policy design and many aspects of the activities that need to be undertaken to achieve the scale of decarbonisation needed to reduce the risks of climate change to more acceptable levels.

Adam Whitmore –  4^th April 2014