4. The choice of type of carbon pricing schemes

There is a long history of analysis and discussion of the merits of different types of carbon pricing, and especially about the relative merits or emissions trading, carbon taxes, and hybrids of the two.  See below for text that summarises the main arguments.  They are also addressed in a video which can be accessed via the videos tab on this website or here:

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Partially updated 24/02/16, last fully updated on 11/04/14

Carbon pricing instruments

 

1.      Introduction

This note summarise the differing features of carbon pricing instruments – emissions trading (cap-and-trade), carbon taxes, and hybrids.  The first part looks at emissions trading schemes.  The second looks at carbon taxes.  The third looks at how instruments combining management of prices and quantities (hybrid instruments) can have advantages over either on its own.  It also comments on some of the implications of the properties of each type of instrument for existing carbon pricing schemes.

This note focusses 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 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.

Much of the debate has until now largely been conducted from an economic perspective.  However there are also important political considerations, and these are covered in the latter part of this note.

The role of uncertainty

The standard economic theory on the choice between a cap and trade scheme and carbon taxes[1] frames the problem as maximising total net benefits 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.

2.     Quantity limits

 

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[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 allowance cap decreases by 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 clear 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 to some extent.

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 does not give any incentive 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.  The next section looks at what the alternative of carbon taxes might deliver, and the circumstances in which this might be a more appropriate policy choice.

3.      Carbon taxes

 

Constant signal of damage caused

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 reachedConsequently 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 more 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[5].

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 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 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[6].  (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 and the potentially endogenous nature of future caps and the risk of lock in from investment).

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 similar 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.

4.      Hybrid Instruments

This part looks at the benefits of hybrid schemes that include elements of both quantity and price management.  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 or pure quantity instrument, and that a hybrid of the two can have benefits[7].  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 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, better conforming to the basic principle that carbon prices should approximate to the costs of damages[8].  It also allows the cap to be consistent with 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 the cap is there to prevent steeply rising damages above a particular threshold, so it is necessary that the integrity of an overall target as a part of the global total is maintained.  This can be achieved by setting aside allowances from within the cap in a cost containment reserve, as is already done in California.

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/quantity schedule, where additional emissions are considered to create different costs.  However the estimates of the appropriate price levels are subject to large uncertainties.  And the the stock of GHGs is the atmosphere varies relatively little with additional emissions over short time periods even in large jurisdictions.  This suggests that the imposition of 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.

5.      Political factors

 

The perspective covered here has been based on considerations of economic efficiency.  However there are also political factors which determine which policy is considered optimal.  A flawed design that can be implemented may well be better than a well-designed scheme, so political factors will often feature in any discussion of design.

The international context

Under the UNFCCC agreements countries have signed up to national targets in the form of INDCs (Intended Nationally Determined Contributions).  These are expressed in quantity terms, rather than  in the form of a carbon price and target cost.  There is thus a natural compatibility between the international targets and quantity based schemes implemented at a national level.

This commonality derives from a more fundamental similarity between the international targets and national implementation of quantity targets. The international target seeks to limit temperature rises to below 2 degrees, essentially representing a hard threshold above which damages are deemed to be unacceptable.  The prevalence of quantity instruments among major schemes in effect represents a recognition of this threshold and the need to allocate it.

Other considerations

There may be other political considerations that affect scheme design.  For example in the EU elements of price containment are greeted with suspicion because some regard them as potentially endangering fiscal sovereignty.  In part this reflects the perception that price floors and ceilings resemble a tax.  Although these concerns are not well-founded they  have influenced the debate on EUETS reform.

6.     Implications for design of existing and future  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.

This outline, high level though it is, gives a framework for assessing 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 adequate price the damage created by emissions, and the almost unlimited quantity of extra allowances available at the ceiling price is a matter of concern.

Similarly the price ceiling in the Alberta scheme looks too low at present, and moves towards reform are welcome.   The price is due to increase to $20 per tonne on January 1, 2017 and moving to $30 per tonne on January 1, 2018, aligning the price with that in British Columbia.  Coverage will also increase over time from around 45% (those emitting over 100,000 tonnes p.a.) of emissions to 78 to 90% of provincial emissions, which is welcome.  However the apparent move away from trading around targets is less 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 remains a very valuable.  It would benefit greatly from a price floor, although this is unlikely to prove politically feasible.

It is appropriate for British Columbia to be pursuing a carbon tax 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 with recognition of the need for price containment, though its particular approaches to price containment will take some time to become fully established.  A national cap remains highly desirable.

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

[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.

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

[6] 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 consideration prevail apply in practice given the current structures of gas and coal markets in particular.  See Goulder reference quoted above for a discussion of this issue.

[7] 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.

[8] 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.