Cap-and-Trade or a Carbon Tax for Greenhouse Reductions?

By Kennedy Maize

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Some CEOs Prefer Carbon Taxes

Some in the coal-burning utility industry have decided to oppose the cap-and-trade model. They, and allies in the oil industry, have begun mounting an argument that cap-and-trade will recreate the economic conditions that led to the current market kerfuffle over collateralized debt obligations and credit default swaps in the mortgage market, as well as the collapse of Enron’s trading empire. The CO₂ trading markets, they argue, will result in market-destroying chaos.

David Sokol, an electric industry generating veteran and chairman of MidAmerican Energy Holdings, a Warren Buffet utility, argued in a recent Washington Post op-ed, “If you liked what credit default swaps did to our economy, you’re going to love cap-and-trade. Just read Title VIII of the [Waxman-Markey] bill, which lets investment banks, hedge funds, and other speculators participate in the cap-and-trade market. They don’t have emissions to cut; they have commissions to make.”

This has become a standard argument against the cap-and-trade plan endorsed by many congressional Democrats and the Obama administration. At the most recent ELECTRIC POWER Conference, the consensus around the CEO Roundtable was that with cap-and-trade there will be market manipulation and a lack of a free and transparent market. Their clear, but not unanimous, preference was a carbon tax.

In the case of CO₂ trading, Harvard’s Hogan said, the market looks far more transparent than the trading market for mortgages and mortgage-backed derivatives. Hogan predicted “pretty standardized contracts” for CO₂ sales. “Carbon is carbon,” he said. “There isn’t much variance” likely in contract terms. Unlike mortgages, where terms were individualized and often quirky and the securitizing of the contracts was an attractive way to spread risks over a large number of diverse mortgages.

Supporters of a carbon cap-and-trade market cite the alleged successes of the U.S. SO₂-trading regime. By most accounts, that market has worked remarkably well. Emissions have fallen by half, and there has been no market manipulation by players. Costs to generators have been minimal.

MIT’s Ellerman, a longtime expert on emissions trading mechanisms, said the development of derivative markets in the SO₂ and the fledgling European carbon emissions trading market have been useful. The U.S. SO₂ market, Ellerman said, has seen some trading of derivatives, such as forward contracts, options, and loan swaps. But these have been a small part of the overall market, which is not large and not highly developed. None of these derivatives are beyond conventional market phenomena, Ellerman told MANAGING POWER, or raise any concerns about market behavior.

As for those who say a carbon cap-and-trade market will spin out of control and mimic the market for such exotic instruments as mortgage credit default swaps, Ellerman said, “That’s scaremongering.” The proponents of this line of argument “do not understand markets” and are positioning their lack of understanding into opposition to what he believes is a sensible approach to CO₂ reductions, Ellerman said.

Is a simple carbon tax preferable to a cap-and-trade regime? Not necessarily, argues Ellerman, although many economists prefer what they view as a simpler tax approach. Allocation of allowances by a public-policy procedure (through Congress and upfront political processes, such as cap-and-trade), Ellerman says, is more transparent than using the tax code to divvy up the allowances. The tax approach, he argues, is “subject to sub-rosa lobbying and lots of behind-the-scenes activity. I’d rather have it all done in public through congressionally mandated processes.”

Another view comes from former Reagan administration economic advisor Martin Feldstein, now a Harvard professor. He argues in The Washington Post against the Obama plan for allocating carbon allowances, from a different perspective. In an op-ed column, Feldstein straddles whether cap-and-trade or a carbon tax is a better policy instrument to deal with global warming. Instead, he focuses on costs of CO₂ reduction and suggests that no policy is the best policy.

Positing whether an imputed $1,600-per-family annual cost of a cap-and-trade policy is worth “the very small resulting decline in global CO₂,” Feldstein said he thinks not. “In my judgement,” Feldstein wrote, “the proposed cap-and-trade system would be a costly policy that would penalize Americans with little effect on global warming. The proposal to give away most of the permits only makes a bad idea worse. Taxpayers and legislators should keep these things in mind before enacting any cap-and-trade system.”

Feldstein argues that the U.S. should hold off on a CO₂-reduction mechanism until China and India commit to greenhouse gas reductions. Many foreign policy experts predict that China and India will never agree to any reductions.

This debate is far from concluded. Stay tuned as the discussion continues in the House and Senate.

—Kennedy Maize is MANAGING POWER’s executive editor.