Climate Policy Blog

Last week I wrote about a new fee and dividend climate policy put forward by a group of conservative policy makers (which you can download here or read about here and here). It’s a fee starting at $40 per ton of carbon dioxide that increases over time. All revenue would be returned on a per-capita basis to the American people with checks coming every three months.

The approach would provide serious climate protection, as much or more than anything anyone has tried so far. Yet past policy debates (like the Washington State initiative I wrote about here) suggest there will be criticisms of the approach that have at most a thin basis in reality. These criticisms will be important to avoid (or refute) if this new approach is to receive a fair look. So my next few posts will look at some of the most common misunderstandings likely to arise with this new approach.

One of the largest complaints of approaches like this has come from some of the strongest proponents of climate protection. They would prefer a hard cap on emissions rather than using a price that forces unspecified emission reductions. The reason is that a cap sets an upper limit on emissions and therefore seems to guarantee a specific level of climate protection. With a price, there is no such guarantee (but there is also potential for even greater emissions reductions, as I explain below).

The two approaches to compare are cap and trade and an emission fee. Here’s how each of them works in their purest forms:

In cap and trade, policy makers determine the quantity of emissions (the cap) and create a tradable permit system to achieve that cap at least cost. Anyone who wants to emit a ton of carbon dioxide must have one of the permits and people can buy and sell the permits freely in an open market. The price of these permits is determined by the transactions that occur within that market (i.e., how much people are willing to pay for them).

If permits are abundant (i.e., there are lots of permits relative to the amount people want to emit), then the price of permits will be low. This would occur, for example, if it is easy to reduce emissions or to find alternatives to emitting. However, if permits are scarce (because people really want them), then the price of permits will be high. We don’t know in advance what the price of permits will be because we don’t know how easy it will be to achieve the cap (i.e., to reduce emissions). We do know, based on a hard cap, how much emissions there will be.

So for cap and trade the price on emissions falls out from the cap. If it is hard to reduce emissions then the cost of emitting will be very high—as high as necessary for emitters to stay within the cap.

In contrast, with an emission fee policy makers set the price of emissions (the fee) and leave it to the market to freely determine the quantity of emissions that will result. Anyone who wants to emit a ton of carbon dioxide can do so as long as they pay the fee. So the quantity of emissions falls out from the price. If it is hard to find alternatives to emitting, then we could get very little reduction in emissions. However, if it is easy to find alternatives to emitting, then we could get very strong emissions reduction.

Most climate policy over the last two decades has focused on how much we are going to emit, which makes intuitive sense at first because that is a more direct measure of climate change risk management than the price of emissions. But the difference in focusing on prices or quantities is fairly subtle because a cap leads to a price and a price leads to a specific reduction. Whatever leads to the highest emission price (a cap or a fee) will result in the greatest reduction in emissions. In pure form, a quantity based approach leads to stronger climate protection if it is hard to reduce emissions but a price based approach leads to stronger climate protection if it is relatively easy to reduce emissions.

But this is where second order effects start to matter. If permit prices turn out to be higher than expected (or if permit prices jump around unpredictably) then the policy is prone to becoming unstable. People and policy makers simply aren’t likely to accept that and they will want to weaken the cap or overturn the policy altogether. So establishing a cap and trade system doesn’t equate to stabilizing the climate system. That cap must be maintained and function smoothly over several decades.

Economists and some policy makers recognize this risk and they have devised a way to protect against overly high permit prices in a cap and trade system. They set an upper limit on prices—a price at which permits are always available. This ensures that permit prices will never exceed that upper limit but it also sacrifices the hard cap—there is no longer a maximum level of emissions. Overall, that would make cap and trade less effective at climate protection than an emission fee because there would be no potential for greater climate protection if emissions reductions are easy and no upper limit on emissions if emission reductions are hard (note, I published this article on the topic several years ago if you want to take a deeper dive).

There are also a number of reasons to be wary of cap and trade including the tendency for emitters to demand (and policy makers to give away) permits that have enormous public value, the potential for permit holders to manipulate the market, and the uncertainty of permit prices.

Those who would reject a price on carbon dioxide emissions that starts at $40 per ton will have a difficult time defending that on the grounds that there is a viable alterative that could provide more climate protection. Simply put, that alternative would have to establish a higher price on emissions (whether through a fee or a cap) and then sustain it over time. So far, nothing else has come remotely close to doing that.

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