Carbon tax or cap-and-trade?

Cap-and-trade or carbon tax?

That National Post has a great survey of the different carbon pricing systems that could be used.  My vote is for cap-and-trade. 

The reason has nothing to do with the environment, or with some desire to punish successful businesses (the reason the NDP seems to use to justify their version of cap-and-trade).  There is no emotion in my decision.  There will be no mention of spotted owls or humpback whales or polar bears or Gaia.

For me, it's about boxes.

The reason I think cap-and-trade makes sense comes from packing theory.  You have to fit a bunch of items into a box.  You have large items and small items.  The correct approach is to figure out how to do the big items first.  The small items are dealt with later.  Indeed, the more effort spent on efficiently dealing with the large items, the more likely that packing the small items can be done with nearly no effort.  The small items just fill in the large gaps left over from the efficient packing of the large items.

Imagine the volume inside the box is the amount of carbon you want to emit.  You have large emitters (large items) like power plants and factories, and small emitters (small items) like family homes and private cars.

The carbon tax approach promoted by Liberal Party leader Stephane Dion, and endorsed by David Suzuki, ignores the box and the items.  It simply increases the cost of carbon and hopes that the cost will reduce carbon usage.  There is no attempt to direct or influence where the big reductions will happen.  For instance, a critical industry might just shutdown altogether with the intention of moving to the United States or Mexico in order to avoid the carbon tax.  If that is not politically acceptable (for instance, it might be a large employer in Quebec), then the Liberals, in the name of being revenue neutral, will simply return the carbon tax money paid by that industry.  Not only does that defeat the purpose of the carbon tax, it distorts the market, as the government starts playing favourites.  The only certain thing is that middle-class Canadians will never be a "favourite" and will be paying the tax in full (as happens in Sweden, where industries are given a deep discount on the carbon tax, but regular consumers pay it in full).

The cap-and-trade approach recognizes that the carbon emission limit nonsense is just a packing problem.  The carbon goals are defined.  This is the size of the box.  The large emitters (large items) have to pack themselves into this carbon emissions box.  That is done by defining emission limits for each emitter, the sum total have to fit inside the carbon emission box.  The limits are set lower than the current emission levels, so that we can see overall lowering of emissions.  So how do you get in the box if the current emissions are too high?  Not a problem.  Each emitter either drops emissions below the limit, or raises the limit by buying unused emission room from another emitter.  In effect, the government set limits do not have to be optimal.  Indeed, they ought not to be.  The cap-and-trade system is designed to move towards an optimal solution (that is, the correct emission level for each emitter given the size of the carbon emission box) regardless of the starting point.  If one emitter is below his assigned limit, he can sell that extra space to another emitter.  An emitter can decide on whether to buy space or make space.  Either way, the net effect is that of trying various packing configurations in order to get the large items into the box.

What about the little emitters?  Well, we don't have limits.  We never have to pay.  Like the packing problem, the small emitters can find space in the carbon emissions box created by efficiently packing the large emitters.

What is good about this approach?

• The government doesn't do the actual packing, the emitters do.  The government defines the size of the carbon emissions box, and defines one possible packing by defining the caps, but the emitters can adjust all they want after that through trading, naturally progressing to an optimal ordering.  Less government is good.
• Carbon emission is not defined to be a bad thing.  How novel.  Maybe that's why the environmentalists don't like it as much.  It lacks the moral judgment that comes with a carbon tax.  In particular, the emissions by small emitters are not subject to punishment at all.  As for the big emitters, they can emit up to their limit without any additional costs or criticism.  The only time carbon emissions matter is when they exceed their trade-adjusted caps.  In contrast, a carbon tax punishes you starting with the first joule of energy you use and never lets up.
• No new government taxes are needed.  The only time the government is financially involved is when a company cannot meet its cap levels by reducing emissions or by buying credits.  That's when a fine is imposed.
• The government can adjust the caps to reflect reality.  Some industries are big emitters, and it isn't a matter of efficiency, but of physics.  Others are large emitters, and for them it is a matter of efficiency.  Caps can be adjusted accordingly so as not to punish some emitters unfairly.  A carbon tax is blind and affects everyone without any rhyme or reason with regards to the levels.  Now it has to be admitted that caps can be adjusted to play favourites, but then those caps are set ahead of time and announced publicly.  A government has to justify the differing cap levels.  Returning money to a favoured industry after the fact, as would happen with a carbon tax that has punished some industry too harshly, might be less likely to be noticed, and in any case, reflects a reactive approach instead of a proactive one.  Being reactive, a tax refund might be too late to repair the damage caused by a carbon tax.
• A cap-and-trade system can be run by a private consortium, like any commodities market.  The government would provide targets and some oversight, but would not have to develop expertise in carbon trading.  Contrast this with a tax regime which is defined and administered entirely by the government.  Less government is good.

Will consumers be affected?  Sure.  If a company misses the limits, the resulting fine would likely increase the cost of the products and services it offers.  But then we can purchase from another vendor that has been able to make the limit through efficiencies.  And since my disposable income hasn't been slashed by forcing me to pay a carbon tax on my own emissions, I have the ability to make these sorts of purchasing decisions.  The market continues to work.

Like any market system, there can be abuse. Speculators can mess around, there can be hoarding of credits waiting for the price of carbon to rise, and so forth.  But then the real stock market works despite the shenanigans, so it isn't like we don't have the experience to know how to deal with these things.

As I pointed out, the stated reasons for a carbon pricing regime makes little sense to me in the first place, but assuming we have to have one (and admitting that I could be wrong and this might be a good idea after all), then the choice seems clear to me.  I'll check the box beside cap-and-trade.