A few other interesting considerations when designing an "ideal"
system:
Upstream vs. downstream regulation
Abatement policy mechanisms can regulate emissions at the point where
carbon enters the economy, the point where greenhouse gases are
actually released, or somewhere in between. Under an upstream program,
producers and importers of GHG-producing fuels would be required to
hold permits for any fuel they sold, based on the GHG-potential of
those fuels. The price effect of an upstream permit system would
peculate down throughout the economy, raising the price of energy
produced proportional to carbon releases and creating an incentive for
increased energy efficiency and greater use of alternative energy
generation technologies. Upstream solutions of the benefit of greater
coverage and simpler implementation than downstream solutions, as
there may be as few as 2000 entities that would be required to hold
allowances. However, upstream solution may be less politically
palatable due to their wide coverage of sectors where price increases
may be less popular (e.g. transportation fuels in the United States).
Downstream solutions, on the other hand, will be quite expensive to
implement outside of the rather narrow power sector. Regulating
emissions at the tailpipe would be impractical for all 300 million
vehicles in the United States, as the transaction costs would prove
prohibitively high. If a downstream solution focused on a particular
sector, as the Kyoto Protocol focuses on the power sector, there would
likely be some leakage between regulated and non-regulated sectors.
For example, if only large power producers are regulated, it would
create an incentive for people to run smaller generator units that do
not meet the threshold for regulation. The cost imposed to meet a
particular overall emissions target would be higher for specific goods
in a limited downstream system, while an upstream system with broad
coverage would more effectively spread out costs.
One potential shortcoming of an upstream system is that it might
provide an inadequate incentive for carbon sequestration.
Internalizing the cost of emissions at the point of extraction or
import is only effective if the amount of carbon emitted per unit of
fuel combusted cannot be reduced. If carbon sequestration is a viable
option, however, there would be little incentive for downstream
electricity generators to capture carbon post-combustion, as it would
have no direct effect on the price they pay for fuel. There may be
some ways to get around this problem, perhaps by exempting fuel sold
to generators using carbon capture and storage from permit
requirements or creating markets for additional permits generated via
downstream abatement (similar, for example, to CDM permits in the EU
ETS). Regardless, this will still be a somewhat problematic issue for
upstream systems.
Another question, especially for upstream systems, is how to deal with
carbon feedstocks (e.g. fertilizers and plastics). An overly broad
system would raise the price of fossil-fuel derivatives, such as
plastics, that do not directly result in greenhouse gas emissions.
Fuel destined for these purposes could be exempted from permit or tax
requirements, but it would be difficult in practice to determine the
lifetime emissions of numerous products.
Finally, there is a question of how the price signal would differ if
permits or fees are disconnected from the point of emissions. For
downstream users in an upstream system, the incentive for emissions
abatement would be solely embodied in the GHG intensity-weighted price
of fuels. Price increases in fuel would create an incentive to
minimize fuel use, or minimize power purchased from generators using
expensive fuel. As long as greenhouse gas emissions from any given
fuel are independent of the method in which the fuel is used, as
discussed earlier, a price mechanism should theoretically have an
identical effect no matter where it is placed in the product "stream".
However, shifting the price signal upstream of the point of emissions
could potentially dampen the abatement incentive in practice by
shifting the focus from reducing emissions to reducing costs. As there
are potential options for reducing the greenhouse gas emissions of a
given fuel, especially for non-carbon fuels that can be converted to a
more benign form (e.g. methane incineration), pricing emissions
downstream could create a greater incentive for innovative emissions
reduction solutions rather than just energy efficiency.
Initial allocations of permits
Given the potential value of emission permits, the initial allocation
is extremely important. Permits can be allocated by grandfathering,
auctioning, or updating allocation systems. Grandfathering involves
giving firms permits based on a certain baseline year, preferably far
enough in the past so as not to influence recent investment decisions.
Grandfathered permits will often result in windfall profits for firms,
as the cost of permits can be passed through to the consumers while
the benefits of permit sales will not, at least in imperfect markets.
Permits can also be auctioned by the government at the beginning of
the system. These auctions would reduce potential barriers to entry of
new firms, as all firms would have to pay for their permits. However,
since permit price might have changed since the initial auction, the
relative burden on companies may vary by time of entry. Auctions would
also provide a revenue stream that could be used to offset the
distributional impacts and/or tax interaction effects of the system.
Auctions would prove unpopular politically, however, as they involve
fairly substantial transfers of wealth from firms to the government,
even if that revenue is subsequently recycled. Auctions also risk
inefficiently high initial permit prices, especially if the permits
involved are indefinite and firms are risk adverse and believe that
the system will become stricter over time. In theory, auctions could
be structured with a price cap, but the government would have to be
willing to provide unlimited indefinite permits at that price cap to
avoid creating scarcity conditions.
Finally, permits can be allocated based on emissions in the prior
year, with permit allocations updated regularly. This would impose the
least impact on firms, as permit allocations would best mirror their
current emissions and hence match their abatement costs better than
the other systems. However, an updating allocation would create
perverse incentives that would unduly reward investments in further
carbon-intensive generation, as those who build a new plant would be
rewarded with an increased pool of permits the following year. This
waters down the effectiveness of the tradable permit system, as the
benefit from additional permits would offset the cost of compliance.
Revenue recycling: efficiency and distribution concerns
Revenue raised via the auctioning of permits and/or the sale of annual
permits could be used to offset the effects of the system. As
increasing energy prices will tend go have a regressive effect on the
economy, given that poor people tend to spend a larger portion of
their income on energy, revenue could be used to progressively reduce
income or payroll taxes. A tradable permit or hybrid system would also
tend to create inefficiencies due to the interaction of new and
existing taxes. This "tax interaction effect" can be reduced by
recycling revenue as efficiently as possible, possibly by cutting
corporate capital gains taxes and other distorting taxes. Note that
there is, to some extent, a tradeoff between offsetting the equity and
efficiency effects of the system. A system that offsets purely
regressive tax effects might be less efficient than one focusing
purely on the most efficient revenue recycling.
Banking
Banking would allow firms to preserve unused permit with the option of
using that unit of emission in the future. Firms may choose to bank
excess permits rather than selling them as a hedge against future
permit market volatility. This might be less important, however, in a
system with a low escape valve price). As Pizer has shown, tradable
permit systems that allow banking tend to exhibit less volatility than
those without banking. If initial permit allocations proved too high,
however, banking could have the perverse effect of watering down
future compliance periods should a large number of permits be banked.
Carbon target certainty
The traditional economic analysis of climate change treats it as a
stock pollutant with the damages associated with a particular ton of
emissions rising convexly as a function of to current stock. The
relatively slow change in marginal damages, at least in the short
term, is used to argue for the superiority of fixing prices rather
than quantities in dealing with the problem. In the long term, as
Stern pointed out, marginal damages begin increasing much more
quickly, and a mechanism that fixes quantities would produce better
results. The important question, than, is where this crossover point
occurs. At what point is achieving a certain carbon target, say
atmospheric concentrations below 550 ppm, worth the risk of higher
than expected abatement costs?
The climate system is characterized by its non-linearities. The paleo-
climate record reveals a number of climate "tipping points" that have
occurred in geologic times, where the climate has shifted relatively
quickly from one stable state to another. These shifts are regulated
by positive and negative climate feedbacks, such as cloud formation,
albedo changes, methane releases, etc. If the potential for sudden
climate shifts past a certain point is high, than a tax based system
risks treading on the "tail" of probable future climate change
scenarios, where the low probability high cost impacts occur. The
merit of tradable permit systems in limiting potential damages, albeit
at the risk of incurring high costs, is rather intuitive. This has led
to the opposition of many environmental groups to both tax-based
systems and hybrids, both of which provide no "hard cap" on emissions.
This argument is often inadequately addressed, and there are potential
benefits of strict cap tradable permit systems in limiting the risk of
catastrophic outcomes.
One method that tax-based systems and hybrids can use to behave more
like a quantitative restriction is to actively adjust the tax level
and the number of permits allocated in response to changing
understanding of the marginal benefits and costs of abatement. This
active system management is especially important for pure tax systems,
as the price of carbon will have to be adjusted as better knowledge
emerges regarding the price elasticity of abatement if the system
wants to meet certain quantitative targets in the long run. As
discussed earlier, systems with either fixed term or annual permit
distributions will be better able to respond to changing degrees of
uncertainty.
National vs. international trading: linkage issues
Tradable permit and hybrid systems can be limited to intranational
trading, can include trading between similar blocks of signatory
countries, could include trading between disparate comparable systems,
or could incorporate similar to the Clean Development Mechanism (CDM)
to encourage investment in emissions abatement in non-signatory
countries. In practice, trade between a signatory and non-signatory
country under a hybrid regime may prove problematic due to the cap on
potential emission prices. If the price cap is below the international
price of permits, than firms would have an inventive to pay the price
cap level for all permits in the U.S. while selling all initially
allocated permits abroad. In this case, the U.S. system would
essentially drag down the international permit price.
To avoid this outcome, firms could be restricted from the
international trade in permits whenever the international permit price
rises above the escape valve price. However, if firms could foresee
this price increase happening in the future, they would still have an
incentive to oversell permits abroad in the present. A second option
would be to restrict the use of the price cap whenever the
international permit price is higher than the price cap, though this
would effectively render the price cap useless in most situations.
Finally, the U.S. could lobby for an international uniform price cap
on permit costs compatible with any U.S.-chosen system.
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