It just seems odd to see a hybrid system referred to as a
"conventional" cap and trade; perhaps the Bingaman bill is proving
more influential than I expected :op
Tradable permit systems do allow the seperation of efficiency and
equity, and thus permit the initial permit distribution to be chosen
based on political considerations without effecting the overall level
of abatement that occurs (though it certainly effects the equity; just
look at the windfall profits in the power sector due to grandfathering
in the first phase of the EU ETS!). Grandfathering allows the
government to soften the blow for businesses. Cap and trade systems
also make the price implicit, rather than an explicit tax, which may
be more politically palatable (after all, what we don't know can't
cost us...). Ironically, tradable permit systems involving any degree
of grandfathering will tend to be considerably more regressive than
tax systems, as there is no revenue to recycle to offset the rising
cost of energy for the poor.
>From an economic standpoint, the only real reason to prefer cap and
trade systems over emissions taxes is if the marginal damages of
climate change are so steep that it becomes essential to limit
emissions to a certain fixed target, lest we pass a threshold.
However, most modeling I have seen (see Pizer's 2002 paper, for
example) requires an unrealistically high convexity of the marginal
benefits of abatement function for permits to outperform taxes. Also,
climate change is probably not a threshold problem, tipping points of
no return notwithstanding.
As far as limiting price volatility goes, a hybrid system with an
escape valve would prevent too much volatility (especially if short-
term abatement costs prove higher than anticipated). Similarly,
allowing for the banking of permits would reduce cost volatility
between compliance periods (and thus avoid the problem currently
facing the EU ETS, where permits are effectively worthless at this
point). Banking could be problematic, however, should initial permit
allocations be higher than optimal, as it would limit the ability to
remove permits from the system. As far as I know, there are no real
benefits of short-term price volatility (other than the opportunity
for a few people to get rich arbitraging the market).
I've been doing some work recently on what I call a "phased hybrid"
system that transitions over time from a standard hybrid to a pure tax-
like system. In a phased hybrid, firms would receive an initial
portfolio of fixed-term tradable emission permits, either via
grandfathering or auctioning. As the number of permits in the system
decreases over time (as the initial allocation of permits expire), the
price of permits will converge with the price cap, which should
ideally increase over time proportional to the social cost of carbon.
After a certain period of time, none of the initial permits will
remain in the system, and all firms will have to pay for emissions at
the level of the price cap. At this point, the system will be
functionally identical to a pure price-fixing mechanism. The benefit
of this system over a traditional hybrid system is that it provides a
mechanism to eliminate initial allocations (and thus makes any
necessary grandfathering less onerous). It would over time remove the
barrier to entry posed by initial allocations, and also provide
continuing incentives for abatement due to the defacto price floor
that would develop as the number of permits in the system decreased
and the system started to resemble a pure tax.
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