Stoft_mod_energy_rev_Outsourcing_book_temp.qxd 25/02/2010 13:38 Page 9
Tax or Cap? Clear Thinking About Carbon Solutions
The similarity between caps and taxes runs so deep that when Unintended Consequences
economists build their huge models of cap and trade, they do not The permit market is extremely volatile. The best measure of this is the
actually include cap and trade in the model – it is just too complicated. EU’s Emission Trading Scheme (ETS), also known as the EU’s cap-and-
Instead, they build in a carbon tax. If they want to test a five billion ton trade market. During the huge stockmarket swings of the past five
cap, they just try out a few tax rates until they find one that hits the cap. years, the price of the EU’s carbon permits has been three times as
volatile as the S&P 500 stock index.
Not Identical Twins
As the modeller’s trick implies, caps and taxes share the same One consequence is that investors in green technology will hesitate
basic economics, but caps are far more complex in their operation. before responding to such a volatile price, waiting to see which way
This complexity opens the door to political differences. In particular, the it will go next. When they do invest, they will charge a risk premium.
complexity of caps brings one political advantage and one Hence, for subtle reasons ignored above, cap and trade actually
disadvantage: cap and trade makes it easier to hide the ball, but it also
makes us more vulnerable to the law of unintended consequences.
Hiding the Ball
As noted, free permits are a great way to hide the handouts, but
One urgent reason for cap and
people are catching on. In his February 2009 budget, Obama proposed
trade – ‘if we lead, China will
to auction all the permits. That completely spoils the free handout
game. Of course, Waxman and Markey tossed that idea out on day
follow’ – is now gone.
one, but they have had to be quite careful about avoiding the kind of
huge excess profits seen in Europe.
A second obfuscation may be more important. Cap and trade may be requires a somewhat higher price to get the job done than does the
so complicated that few will guess it is a tax. However, those who more predictable carbon tax. However, the more worrisome
dislike taxes the most call it cap and tax, while those who do not mind consequences are political. The political consequence is that the
taxing for a good cause more often say it is not a tax. Unfortunately, it public is likely to respond negatively to a volatile tax set by the market.
is not that helpful to hide the ball from your own team. At first, when permit prices are fairly low, this will not be much
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