I'm not entirely sure what you mean by a "conventional cap and trade"
with a fixed price. Do you mean that the government would sell an
unlimited number of short-term permits at an escape valve price? In
that case, you would really be talking about a hybrid system, rather
than a conventional cap and trade. Also, grandfathering under any cap
and trade system is far from efficient, though it may be necessary for
political reasons.
To avoid reinventing the wheel on this, I'll quote something I wrote
on the subject a few months back. My apologies in advance for any
economic jargon:
Two competing approaches have emerged in the effort to internalize the
cost of climate change in the price of carbon emissions. The first is
a price-based approach, where emitters of carbon pay a fixed price for
every ton of carbon they emit. Under such a system, firms will choose
to reduce emissions whenever emission abatement is available at a cost
lower than the level of the carbon price. The second approach fixes
the total quantities of emissions, and is a tad more complicated. In a
quantity-based approach, the quantity of permissible carbon emissions
is capped and firms are required to possess permits for each unit of
emissions. In most modern variants, these permits are tradable between
firms, and may or may not be bankable for use in future years. At the
start of the quantity-based system, permits are either auctioned off
by the government, distributed to firms based on the emissions of a
chosen baseline year, or distributed annually based on emissions in an
updating prior period. Firms with relatively high abatement costs will
choose to buy permits on the market if the price of permits is lower
than the cost of abatement. Likewise, firms with low abatement costs
will reduce emissions and sell extra permits until the point at which
the cost of further abatement equals the market price of permits. In
an ideal world of perfect information and no transaction costs, the
equilibrium outcome of taxes and tradable permit systems would be
effectively identical, as both would result in firms abating to the
point at which price of emissions (either the price of a permit or the
marginal tax) is equal to the cost of abatement. In a world
characterized by uncertainties, however, taxes and tradable permits
can result in quite different outcomes.
In his classic 1974 article, Prices vs. Quantities, Martin Weitzman
pointed out that price-based and quantity-based approaches behave
quite differently when the costs of abatement are uncertain. The
relative effectiveness of each depends on the slope of the marginal
abatement cost and marginal benefits curve. If marginal abatement
costs are expected to be steep, e.g. each unit of emissions costs more
than the prior unit to abate, a price approach will tend to limit
potential deadweight loss that would occur under a quantity-based
mechanism by capping costs should marginal abatement costs prove
higher than expected, and allow for the optimal level of abatement
should abatement costs prove lower than expected. If the marginal
benefits curve is steep, however, a quantity-based mechanism can limit
the deadweight loss that would occur due to inefficiently high or low
abatement under a price-based mechanism. Thus steep marginal costs and
flat benefits of abatement would tend to favor a price-based
mechanisms, while flat marginal costs and steep benefits would favor a
quantity-based mechanism.
In the context of climate change issue, it is likely that price-based
mechanisms will outperform quantity-based mechanisms, at least in the
short term (Pizer 2002). Carbon dioxide is a classic example of a
stock pollutant, where the marginal damages of a unit of emissions is
solely a function of the existing concentration of CO2 in the
atmosphere and a single unit of emissions has a negligible effect on
the total stock. Hence the marginal benefits of abatement should be
relatively flat over the short term. Likewise, marginal abatement
costs are expected to be steep, as each additional unit of abatement
will be more expensive than the prior one, and there is little time
for innovation in abatement methods. If a pure quantity-based
mechanism is implemented and marginal abatement costs prove higher
than anticipated, firms could be forced to pay permit prices well in
excess of the social cost of carbon, leading to a loss of welfare. In
the long term, however, the situation changes considerably. Here,
marginal benefits of abatement are expected to be quite steep, as the
stock changes dramatically over time. Likewise, marginal costs of
abatement are expected to become more flat as both endogenous and
exogenous technological development drive down abatement costs. This
has led some to suggest that the ideal mechanism for greenhouse gas
abatement is one that acts like a price mechanism at the margin with
the flexibility to behave like a quantity-based mechanism in the long-
term by changing the price in response to changes in the slopes of the
marginal cost and benefit curves (Stern 2006).
Unfortunately, efficiency is not the only criterion that governs the
policy-making process. In reality, efficiency is but one of many
factors used in deciding which policies to adopt. Also important are
concerns about effectiveness, in terms of how much emissions are
actually reduced, concerns about equity, in terms of who has to bear
the burden of emissions reductions, and concerns about what is
political acceptable to the powerful actors. Quantity-based mechanisms
(tradable permits) and price-based mechanisms (taxes) perform
differently in their ability to satisfy these oft-competing criteria.
Tradable permits
Tradable permit systems have proven the most popular mechanism to date
in both international climate negotiations and domestic policy
proposals. They have the benefit of being more politically acceptable
to firms, as virtually all tradable permit systems for greenhouse gas
emissions implemented so far have grandfathered most permits to
existing firms based on emissions from a particular baseline year.
This reduces the compliance costs of firms vis-à-vis a tax and creates
a barrier to entry for new firms in GHG-intensive sectors, giving a
competitive advantage to those firms granted initial permit
allocations. Trading in permits helps minimize abatement costs by
allowing firms with high abatement costs to buy emission permits from
those with low abatement costs. This is particularly important on the
international level, where abatement costs differ widely between
countries.
Tradable permit systems allow the explicit separation of effectiveness
and equity. Effectiveness is solely governed by the level of the cap,
as climate change occurs based only on the total quantity of
emissions, irregardless of who actually emitted them. Equity, on the
other hand, is solely determined by the initial allocation of permits.
This separation of efficiency and equity can be a mixed blessing,
however, as equity issues tend to be highly controversial and
efficiency can suffer if no equitable distribution can be agreed upon
under a given cap. These issues are particularly important in the
context of developing an international tradable permit system.
Tradable permit systems also tend to lack a continuing incentive for
abatement. Under a permit system, firms will reduce overall emissions
to the point at which the total emissions of all firms is equal to the
cap, but there is little systemic incentive incentive to make further
reductions even if abatement costs prove lower than anticipated. The
only way to achieve additional reductions is to reduce the total
amount of permits in the system. This can be accomplished in two ways:
either the government can reduce the emission allowance of all permits
by a constant amount, or they can buy up permits from the market to
remove them from circulation. The prior option could potentially wreck
havoc on the market in the absence of a fixed schedule of reductions
decided at the time of policy formation. As the recent experience of
the European Trading System demonstrates, if people are uncertain what
the value of permits will be in the future, changes in permit
allocations can lead to dramatic spikes or drops in the market price
of permits (Sterner and Muller 2006). However, creating certainty in
the permit market limits the ability of the government to tighten
permit allocations in the future in response to new scientific
developments that clarify the social cost of carbon. The second
option, buying up permits, may result in an unacceptable transfer of
wealth from the government to firms, especially if initial permit
distributions were grandfathered rather than auctioned. Additionally,
the announcement of a large government buy up of permits could lead to
a spike in permit prices and potential windfall profits to firms and
traders.
Finally, international trade in permits poses potential compliance
issues. Countries initially allocated excess permits will have an
incentive to sell their permits at the onset and later withdraw from
the treaty when emission restrictions start to impose an economic
burden. In the absence of trade sanctions on countries that withdraw
from the treaty, which would prove problematic under international
trade law, non-compliance may pose a huge problem. One way around this
may be what David Victor calls "buyer liability" (2001: 69-74). In a
buyer liability system, a permit becomes void if the initial issuer
defaults on their treaty obligations. Thus all permits in the market
would be explicitly priced based on the perceived risk of default of
the issuing nation, and nations would have a strong incentive to take
steps to reassure potential buyers against the risk of default. A more
subtle but no less problematic form of non-compliance has been seen in
the empirical experience of the European Trading System (ETS).
Countries have had an incentive to allocate emission permits in excess
of their cap to help reduce the burden on their firms. The discovery
of widespread overallocations recently led to the collapse of permit
prices in the European market (from 30 euros to 10 euros per permit),
and has led regulators in the EU to focus more on ensuring that permit
distributions are compliant with overall country caps in the next
phase of the trading system (Sterner and Muller 2006). Given the
difficulty of uncovering permit overallocations in a trading system
with a strong central regulatory oversight, one can imagine that
preventing excessive permit allocations by a country in a truly global
trading system would be quite problematic.
Emission taxes
Taxes tend to be favored over tradable permits by most economists, as
they cap potential compliance costs while avoiding the problem of
permit distribution. Revenue from taxes can be used to reduce existing
distortionary taxes, such as income or payroll taxes. Many argue that
shifting taxes from economic goods (productive labor) to economic bads
(pollution externalities) can yield what is termed a "double
dividend": increased social welfare both through lower taxes on
earnings and decreased harm from environmental externalities (Repetto
2001). A number of European countries have already implemented some
tax-shifting policies, where revenue from taxes on landfilling, sulfur
dioxide emissions, and increasingly carbon emissions is used to reduce
other taxes (Brown 2001). Taxes also create a consistent price signal
for firms considering abatement investments, providing guaranteed
returns for abatement independent of actions taken by other firms
(Hepburn 2006).
Taxes are arguably more flexible than tradable permits, as the level
of the tax can be adjusted over time in response to the increasing
social cost of carbon without the problem of having to remove existing
emission rights from circulation. However, a system in which the level
of the tax level increased at an unpredictable rate (given that the
predicted social cost of carbon is an function of the inherently
sporadic rate of scientific discovery) would come at an economic cost,
as uncertainty about future tax levels would result in inefficient
investment decisions. Additionally, future tax increases will likely
prove politically controversial. Governments would have an incentive
to resist increasing the tax over time, which would effectively
undermine the system. An increasing, flexible carbon tax is essential
to allow a tax-based system to behave like a quantitative constraint
over time to avoid the potential large long-run inefficiencies
discussed earlier. Carbon taxes are much less effective when they lack
the flexibility to adjust the tax level based on changes in the
expected social cost of carbon and the marginal cost of abatement.
Taxes may also be more difficult to implements on an international
level than tradable permit systems. Creating an internationally
harmonized carbon tax would pose a number of practical difficulties.
Countries would have some incentive to neglect to enforce taxes as a
result of rent seeking by powerful domestic interests. A simple look
at the effectiveness of the current tax systems in countries like
India, Brazil, or China suggests that a harmonized carbon tax would,
in practice, not be uniformly enforced. Lax enforcement for export-
focused industries could be potentially remedied by border tariffs on
products based on their remaining externalized costs, though proposals
to this end have so far proven extremely controversial (Bounds 2006).
Countries may also disagree over tax levels based on equity grounds.
Because taxes do not separate efficiency and equity concerns, there is
no simple way to differentiate responsibilities without undermining
the overall efficiency of the system.
A carbon tax would likely be opposed by many firms, as they may
conclude that the increased costs of compliance (due to the taxation
of all emissions, not just up to a certain point) vis-à-vis a tradable
permit system would be larger than the potential benefits of a tax
system should short-term compliance costs prove higher than expected.
Likewise, taxes are extremely controversial in the United States for
political reasons. While a pure tax system might be ideal from an
efficiency standpoint, the political realities may require compromise.
It may be necessary to use elements of both taxes and tradable permits
to create a hybrid approach, combining the political acceptability of
a tradable permit system with the efficiency of a tax.
Hybrid systems
The current political context in many countries, especially the United
States, strongly favors tradable permit systems over tax-based systems
(Hepburn 2006). With this constraint in mind, many economists have
started looking for ways to make tradable permit systems behave more
like taxes by limiting potential short-term deadweight loss when
abatement costs are uncertain. They have built off the seminal work of
Roberts and Spence (1976), who first proposed a "mixed system" of
emission permits bounded by a penalty for excess emissions and a
subsidy should the permit price fall below a certain threshold. This
has the benefit of capping potential abatement costs at the penalty
level while creating a continuing incentive for abatement via the
subsidy should abatement costs prove lower than expected. Modern
hybrids proposed for carbon abatement tend to include the price
ceiling proposed by Roberts and Spence, but generally opt to not
include a price floor. This may be in part explained by the potential
for large monitary transfers from the government to the private sector
to should abatement costs prove substantially lower than expected, or
perhaps an implicit assumption that abatement costs will always be
relatively high.
Under the most common hybrid varient, proposed by Victor (2001),
Wilcoxin and McKibbin (2002), and others, potential compliance costs
of a tradable permit system would be capped by an "escape valve" that
would be triggered once the market price for permits exceeds a certain
pre-determined level. Once the escape valve is triggered, the
government would sell an unlimited number of annual permits for a ton
of emissions at a fixed price. The escape valve effectively acts as a
tax on the margin once permit prices reach a certain point. In
practice, the escape valve would be set at a level where it was
unlikely to be triggered unless abatement costs prove higher than
expected.
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