2009-06-03

Cap-and-Trade vs. Carbon Tax

Question: What's the big deal with the fight between Carbon-Tax and Cap-and-Trade?

Answer: Perception, enforcement and finance.

Perception

Let's assume that two proposed policies are looking to collect $1B from the economy - Cap-and-Trade and Carbon-Tax. First off, it's easier to sell the free market aspect of a Cap-and-Trade over the tax aspect of a Carbon-Tax.
It's a matter of perception.

Convincing voters to pay "yet another tax" will hurt your chances of getting re-elected. But if you obscure the new cost in a financial construct, tax payers will (initially) blame business for increasing costs.

Don't be fooled, both systems will raise costs!

Enforcement

Under a cap-and-trade model, a central authority (a government) issues emissions licences uniformly to a sub-set of emitters at the start of a term. At the end of the term, they require these emitters to own licenses matching their output for the term. If they do not, a penalty is incurred. Picture a game of musical chairs if you will.
1) How will the government prove an emitter produced 10 tonnes of CO2 and not 5?
2) How many civil servants will be employed to audit these emitters?
3) How will this model scale from the initially small sub-set of emitters to the planned totality of the economy?

A Carbon-tax model is easy to enforce and audit as well as having the benefit of not exacerbating price shocks (explained below). Tax all sources of emissions (coal, natural gas, gasoline, diesel, etc) and no auditing is required.

It's a mentality of top-down vs. bottom-up.

Finance

The most important difference lies in financial implementation.

The free market is designed to buy and sell goods and products. Tangibles like stocks, precious metals, and frozen concentrated orange juice are amendable to securitization. Constructs like mortgage securities, collateralized debt obligations and emissions caps are the antithesis of a product. They are the lack of product.

In recent years, the world has learned that when you separate an obligation from the party who made that commitment through securitization, unforeseen consequences are inevitable (e.g. global financial crisis, illustration).

We are on track to repeat the mistakes of the U.S. financial system in our attempts to foster a new industrial economy built around environmental efficiencies.

What Might Happen?


Due to the psychological nature of trading price shocks are inevitable - cost certainty is needed for economic stability. More importantly, a cap-and-trade model can cause some high polluting producer produce goods at a lower cost than comparative low polluting producers.

A simple example would compare two farmers in California and Southern Ontario selling produce to Southern Ontario. The Californian farmer uses solar panels to run irrigation pumps, and can sell their emissions cap to the farmer in Ontario who does not have solar cells. The fact the produce is grown in an desert irrigated using power from solar panels (which were made using coal power stations in China and shipped 10,000km), and then shipped 3,000km to Ontario is not accounted for.

A contrived example, but it demonstrates what happens when the source of carbon emissions (the fuel) isn't used as the basis for emissions control.

Closing

All governments are investigating some kind of emissions control regime. Let us not repeat the obligation securitization mistakes of high-finance in the green economy we are all looking to bring us out of this mess.

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