Instrument Choice, Carbon Emissions, and Information

Abstract

This article examines the consequences of a previously unnoticed difference between pollutant cap-and-trade and pollution taxes. Implementation of cap-and-trade relies on a forecast of future emissions, implementation of a pollution tax does not. Realistic policy designs using either regulatory instrument almost always involve a phase-in over time to avoid economic disruption. Cap-and-trade accomplishes this phase-in via a limit on emissions that falls gradually below the forecast of future pollutant emissions. Emissions taxation accomplishes the same via a gradually increasing levy on pollution. Because of the administrative complexity of establishing an emissions trading market, cap-and-trade programs typically require between 3 and 5 years lead time before imposing obligations on emitters. I present new evidence showing that forecast error over this timeframe for United States energy related carbon dioxide emissions from the Department of Energy’s energy model – the model used for policy design by Congress and the EPA – is biased and imprecise to such a degree as to make such use impractical. Forecast emissions are insufficiently accurate to allow for creation of a reliable or predictable market signal to incentivize emission reductions. By contrast, carbon taxes, because they do not depend upon a baseline emissions forecast, create a relatively clear level of policy stringency. This difference matters because policies that end up weaker than intended face low odds for strengthening while those that end up stronger than intended are likely to be weakened. The political asymmetry combined with actual model forecast errors leads to bias in favor of suboptimal, weak, policies for cap and trade. This is a serious concern if, as is usually the case, a cap is set based on political bargaining rather than on an optimal balancing of abatement costs and avoided climate damage. By contrast, the same model bias would lead to more environmentally effective than forecast carbon taxes but without the political consequences created by price volatility, were such programs to be implemented in the US. Thus while theory tells us that cap-and-trade and carbon taxes can be equivalent, imperfect information leads to suboptimal environmental performance of emissions trading, relative to carbon taxation policies. Policy makers should weigh these practical, information related concerns when considering approaches to controlling emissions of greenhouse gases.