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.

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