Types of carbon pricing (part 3 of 3)

This is the last of three posts 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 posts together can be found as a pdf file here.

This post looks at the benefits of hybrid schemes that include elements of both quantity and price management, and what this implies for the design of carbon pricing schemes around the world.  In practice most carbon pricing schemes are to some extent already hybrids, but here a preferred form of hybrid is suggested.

It has long been recognised there is no need to restrict policy to a pure price (carbon tax) or pure quantity (cap-and-trade) instrument, and that a hybrid of the two can have benefits[1].  In particular an emissions cap combined with a price floor can limit total emissions, and so reduce the risk of crossing cumulative thresholds where damage becomes very high, while ensuring that the price never falls below estimates of the current marginal cost of damage.  It is thus likely to form a better approximation to the cost of damages than either a tax or a cap alone, more closely conforming to the basic principle that carbon prices should approximate to the costs of damages[2].  It also allows the cap to specify a (global) social choice about the acceptable level of risk, while continuing to price emissions below that threshold so as to stimulate investment to abate emissions which, even if the worst of the risks are avoided, impose costly damage.  And it gives a clear signal about the scale of the challenge and the transformational change necessary to meet it.

A price ceiling may also make sense if it prevents unduly costly abatement that reflects only the particular circumstances of a regional ETS over a limited time horizon.  However a cap is there to prevent steeply rising damages above a particular threshold, so it is necessary that the integrity of an overall global target is maintained.  This can be supported by setting aside allowances from within the cap in a cost containment reserve, as is already done in California.

Also, the advantages of a tax may be better realised by a hybrid scheme than by a pure tax for simple pragmatic reasons.  Emissions trading schemes are already in place in many jurisdictions and it is likely to be easier to move to a hybrid scheme that at least gains some of the benefits of a tax than to abolish an ETS and replace it completely with a tax.  Indeed many ETSs already have elements of price management.

Price floors and ceilings can be stepped, creating a full price schedule, where additional emissions are considered to create different costs.  However estimates of the appropriate price levels are subject to large uncertainties.  And the stock of GHGs is the atmosphere varies relatively little with additional emissions over short time periods even in large jurisdictions.  This suggests that a stepped floor may imply a precision in the specification of desirable trade-offs which is not really justified by the precision of the available data.

There may be further advantages from introducing hybrids in enhancing stability and thus credible commitment with price containment mechanisms.  They can reduce the pressure to review a scheme because either prices or emissions levels are proving outside expected ranges.  On the other hand price containment may make linking of different emissions trading schemes more complex.

Implications for existing schemes

So what does a policy reflecting best design practice look like?  Larger jurisdictions should look to put in place an emissions trading scheme with a long term declining cap, consistent with long term goals for limiting the global stock of greenhouse gases.   This should be complemented by a lower limit on price in the form of an auction reserve price increasing over time.  For smaller jurisdictions a tax, or at least fairly tight bounds on the price under an ETS, may make more sense in the short term, probably with the eventual goal of moving towards an ETS linked (directly or indirectly) with other schemes.  Making additional allowances available at high prices (a ceiling) is likely to be beneficial if these can be drawn from a pool of allowances previously set aside.  However the quantity of additional allowances available at a higher price should be limited to protect the integrity of the overall cap, at least in larger schemes.

This rough outline gives a framework for a broad, high level assessment of current schemes.  The scheme that approximates most closely to best practice design at the moment is California.  Quebec offers an example of moving to an ETS linked to a larger scheme, in this case California, and also includes the good design features of the California scheme.  RGGI has broadly appropriate in structure, but the levels of both price floors and ceilings look much too low to adequately price the damages due to additional emissions.  Similarly the price ceiling in the Alberta scheme looks too low at present, and moves towards reform are welcome.

The EU ETS remains the world’s largest carbon pricing scheme, with a cap declining according to a long term goal, and as such is very valuable.  It would benefit greatly from a price floor, although this is unlikely to prove politically feasible.

British Columbia’s carbon tax seems appropriate to its circumstances and is at something like an appropriate level, although it could seek long term to integrate into an emissions trading scheme covering Canada and (preferably) the rest of North America.  In the meantime Mexico may be justified in choosing a tax due to its administrative simplicity, but the starting level looks much too low.  South Africa may also be right to favour a tax, at least at present, given its greater simplicity.  New Zealand would be justified in considering a carbon tax in place of its ETS, and certainly current low prices under the ETS look inappropriate.

China appears to be moving in the right direction with its preference for emissions caps including recognition of the need for price containment, though its particular approaches to price containment will take some time to become established.

So, much is being done, but there is potential for reform to improve the functioning of carbon pricing schemes.  Continuing expansion of limits on emissions in China is of enormous importance.  And the California scheme offers a model of good design which many could follow.

Adam Whitmore – 13th May 2014

[1] The original analysis in this area is Roberts M.J. and Spence M., 1976 Effluent charges and licenses under uncertainty.  Journal of Public Economics 5 193-208.

[2] Working Paper No. 48  See Climate Strategies Briefing Paper (www.climatestrategies.org) Grubb, M. (2012). Strengthening the EU ETS. Creating a stable platform for EU energy sector investment. Climate Strategies Full Report (www.climatestrategies.org) for a discussion of this issue in the specific context of the EUETS.

Types of carbon pricing (part 2 of 3)

This post is the second 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 here.

Carbon taxes define a set price for all emissions from a jurisdiction and a particular time.  For jurisdictions accounting for a small proportion of emissions and looking at limited time horizons – for example British Columbia over the next 5 years – variations in emissions will have little effect on the stock of GHGs in the atmosphere, so there is little likelihood that any incremental emissions will lead to a dangerous threshold being reached.  Consequently the cost per tonne of damage is quite constant over different levels of emissions (the marginal damage function is very flat).  In contrast, an excessively high price under a cap may prove economically damaging.  This implies a constant price set by a tax may price damage appropriately.

Indeed given the dependency of damage on the stock of emissions such arguments apply to quite large jurisdictions over quite long timescales.  The limited variation in damages per tonne as emission vary over quite large ranges compared with annual emissions from any one jurisdiction is among the main reasons that many favour taxes rather than quantity limits [1].

Price stability

A carbon tax also addresses many of the drawbacks of an ETS by providing price stability.  This may stimulate investment more efficiently than a volatile price, because it can be built into companies’ financial models with greater confidence.  It also provides governments with greater revenue stability.  It is likely to make revenue neutrality for governments,(i.e. no change in total tax burden) easier to manage.  Revenue neutrality is often stated as an objective of carbon pricing, and appears to be an important factor in continuing political support for the carbon tax in British Columbia.

Furthermore, some of the other advantages of emissions trading may also prove less compelling for smaller jurisdictions.  They are more likely to be technology takers, playing a limited role in stimulating new technology, which will frequently be deployed globally, implying any strategic signal for technology development created by a cap is less relevant.  And appropriate measures for shielding of emissions intensive trade exposed industries against carbon leakage remain entirely possible under a tax.

Administrative simplicity

A tax may also prove administratively simpler than an ETS, because an ETS requires allowances to be tracked whereas a tax simply requires emissions to be monitored.  This is intrinsically simpler than tracking allowances in any case, and may be made more so by the existence of existing systems for taxing energy use.  For large economies the administrative costs of an ETS are likely to be a small proportion of the total scheme costs, but this may not be the case in smaller economies.  Simplicity may also be an appealing feature for jurisdictions with less developed administrative capacity, which may struggle to implement an ETS.

Fit with complementary measures

A carbon tax may also fit better with complementary measures, such as those to encourage deployment of renewables.  Unanticipated increases in renewables deployment can reduce the carbon price under an ETS in a way that is not possible with a tax, and indeed this is one of the factors that has contributed to lower prices under the EUETS [2].  (A related argument that the unilateral UK carbon tax, known as carbon price support, does nothing to reduce emissions because the cap is set at the EU level is less clear-cut, for example because of current surpluses under the EUETS, the potentially endogenous nature of future caps, and the risk of lock in from investment). [3]

Drawbacks to carbon taxes

However there are also drawbacks to taxes.  Setting the price of emissions at the level of damages is sound in principle.  However there is an order of magnitude uncertainty about what that cost of damage is.  Even if the damage is fairly constant (the slope of the curve is almost flat) there is still a risk of (greatly) over-pricing or under-pricing the damage, although If taxes are primarily intended to reach a certain target level of emissions by adjusting them over time this may be less of a concern.

And for larger jurisdictions the advantages of emissions trading remain – there is, by design, no limit on emissions under a carbon tax, so there is a risk of crossing thresholds of atmospheric concentration with consequences of very high damage costs.  In principle this risk may be mitigated by the possibility of increasing taxes rapidly as the threshold is approached.  However it may not be possible for governments to signal such an increase, or to implement it, especially as there would need to be an increase across all major jurisdictions to avoid crossing a global threshold of atmospheric concentration.  Furthermore such an increase may not be anticipated by investors in infrastructure, leading to difficulties in making large, rapid reductions in emissions even in the case of very high taxes.

Similarities between taxes and quantity limits

Under both a tax and an ETS learning is possible.  If the tax is not producing sufficient abatement then it can be increased, if a cap it producing low prices it can be tightened.  A tax may have some advantages in this respect as it can be adjusted annually, but something like the five year rolling cap introduced in Australia appears to offer opportunities for an ETS to show similar flexibility, so there does not appear to be a clear cut advantage for either type of instrument.

And in both cases it may be politically difficult to set the carbon price at an adequate level.  Taxes are rarely popular, although the British Columbia carbon tax seems to have done better than most.  And there will always be concerns about setting a cap too tight, risking higher prices and distorting growth.  This will be exacerbated by the interest of both governments and companies in being optimistic about economic growth and industrial production.

Comparison of properties of price and quantity instruments

The circumstances which favour emissions trading and taxes are summarised in the table below.

Factors where higher values favour caps (and lower values favour taxes)	Because …
Share of global emissions covered	Increased proportion of atmospheric GHG stock covered
Time periods for which policy is committed (including future targets)	Increased proportion of atmospheric GHG stock covered
Length of life of investments	Increased emissions lock-in, so larger contribution to GHG stock
Importance of strategic signal for technology and infrastructure development	A cap can give clearer signals on longer term abatement
Variation in abatement costs over time	The flexibility on timing offered by an ETS may help firms abate at lower cost
Administrative capacity	Jurisdictions with higher administrative capacity will find the additional administrative burden of an ETS less onerous
Factors where higher values favour taxes (and lower values favour caps)	Because …
Rate of decay of atmospheric GHG stock	A higher decay rate of the gas in the atmosphere diminishes the effects of uncertain emissions on outcomes.
Discount rate	A higher discount rate diminishes the importance of future damage from with uncertain emissions.
Frequency of policy review	Adjustments to taxes can reduce expected deviations in emissions trajectories.
Importance of stable price signal for current investment	A tax gives a constant price signal (though subject to amendment)

 

Some of the drawbacks of both an absolute cap and a pure tax come from the rigidity of either the quantity or price that is set.  In almost all markets supply and demand both vary with price.  However under a pure ETS the supply of allowances remains constant irrespective of the price (zero elasticity of supply), whereas under a carbon tax the variation of emissions is unlimited at the same price (infinite elasticity of supply).   Very few markets function this way, and a carbon market need not.  It is perfectly possible to set a price schedule which varies with the price of allowances.  Schemes which include both price and quantity limits are referred to as hybrid schemes, and these are reviewed in the next section.

Adam Whitmore – 5^th May 2014

 

References

[1] For a detailed analysis of this issue see Newell and Pizer, Regulating Stock Externalities Under Uncertainty Resources for the Future, May 2000

[2] The recession appears to have been the main factor leading to lower prices under the EUETS.  However renewables deployment also appears to have played a a role.

[3] Separately it is also been argued that there are circumstances in which a tax may prevent capture of rents by oligopolistic fuel producers better than an ETS.  However it is not clear that the conditions in which such considerations prevail apply in practice given the current structures of gas and coal markets in particular.  See Goulder reference quoted in my previous post for a discussion of this issue.