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Tax or Cap? Clear Thinking About Carbon Solutions
a report by
Industry Outlook
Steven Stoft
Director, Global Energy Policy Center
Before Copenhagen, the US lobbied hard for caps on emissions from appear to be free or nearly so. Most of these subsidies are quite
China and India. However, on the final day of the summit, “China’s transparent, but there is one very clever free permit scheme that
representative insisted that industrialised country targets, previously works as follows. The government hands out, for example, one
agreed as an 80% cut by 2050, be taken out of the deal. ‘Why can’t million free permits to a certain company, but because of its
we even mention our own targets?’ demanded a furious Angela emissions, the company is forced to hand them all back at the end of
Merkel.”
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China was not having caps – its own or anyone else’s. India the year. Environmentalists notice this and complain that the
was no less staunch. At 7pm the same evening, President Obama ‘polluter’ is not paying. However, there is more to it than that:
crashed a secret meeting (discovered while trying to find a room for a the real polluters – the end users who buy the company’s products –
final negotiation) among China, India, Brazil and South Africa.
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At that are paying. The real beauty of this scheme is that the payments from
meeting the Copenhagen Accord was hammered out. In it there is no the end users amount to a pollution tax collected and retained by the
hint of caps for developing countries. Half of all emissions, and by far company getting the free permits.
the fastest growing half, will not be capped.
Economists predicted this from the day they invented cap and trade,
One urgent reason for cap and trade – ‘if we lead, China will follow’ – but it is not just a theory. This scheme has now made headlines many
is now gone, if indeed it ever existed. More devastating for the chances times in Europe by generating billions in excess profits, mostly for
of a cap passing the US Senate is the fact that reality runs in the other utilities with coal-fired generators. The economics is too complex to
direction: if China had accepted a cap, the US Senate might well have explain in detail here; in brief, the free permits with no strings attached
followed, but since China will not, the chances of a strong cap passing are seen as a gift and not as a decrease in production costs. The permit
the Senate are slim to non-existent – unless a new form of international requirement is seen as a cost increase, which is passed on to
commitment is successfully pursued. Before returning to this crucial consumers, who pay the full cost of permits to the company even
international dilemma, let us consider the question of caps or taxes in though the latter was given all its permits for free. So, this scheme
the domestic context. works like every magic trick. We watch the government and the
lobbyists intently, suspicious of a handout as the government gives
Cap and Control away billions of free permits. We see their true value. However, the
Cap and trade is said to ‘achieve emission targets with high certainty’. company then hands them all back and we see no sleight of hand –
Targets are built in – those are the annual caps – but certainty is not. but, of course, we were watching the wrong hand. The handout did
However, emissions ‘certainty’ is the primary reason environmentalists not come from the government, it came directly out of our own
favour caps. Cap and trade is about control. In fact, I have even been pockets, as we paid more for the company’s product. Cap and trade
told by environmental regulators that cap and trade is, without doubt, is a carbon tax, and free permits implicitly grant companies the right
a form of command-and-control regulation. The fact that economists to keep the tax receipts.
invented cap and trade as a market-based replacement for such heavy-
handed regulation is long forgotten. Cap and Tax Are Twins
Caps and taxes work on the same pricing principle: they both raise the
Caps do control emissions more strictly than a carbon tax. A cap is cost of emissions. If a five billion ton cap causes permits to cost £20
simply the number of emissions permits issued in a given year. Since per ton, a £20 per ton tax will hold emissions to five billion tons.
emitting without a permit draws a heavy fine, the cap determines No-one cares whether they have to buy a £20 permit or pay a £20 tax,
total emissions; however, it will not determine who emits, which would so the same carbon price has the same effect, whether the price is set
be the case with true command-and-control regulation. by a cap or by a tax.
This gives us a short-cut way to think about caps. Cap and trade isThe Magic of Free Emissions Permits
Giving out free permits has become quite controversial – but do free simply a carbon tax set by the market. Since companies buy permits to
permits matter? Not if you only care about emissions. Once the permits avoid running short and paying a fine, the market will raise or lower the
are given out, the owners can and will sell them to whoever needs ‘tax rate’ just enough to make sure the cap is met.
them most – the ‘trade’ in cap and trade – and even if they do not, the
limited number of permits still firmly caps emissions. Many claim that because the market sets the tax rate, the rate will be
optimal. However, the market is just doing the government’s bidding.
However, ‘free’ permits are, in fact, quite valuable, and they are If the government sets a tight cap, the market will set a high tax rate.
often used to subsidise special interests. Sometimes these subsidies The market has absolutely no idea what tax rate is best for fixing
are useful, but often subsidies are wasteful, especially ones that climate change.
© TOUCH BRIEFINGS 2010
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