Cap and trade can also mesh poorly with local rules. If Colorado passes a regulation that cuts electricity use, for example, its utilities will pollute less and need fewer emission permits, which means the cost of permits goes down. But if the cost of permits goes down, then utilities in other states will increase their emissions to the point where the Colorado rule might have no net effect at all. Because of these two problems, says Dallas Burtraw, an economist at Resources for the Future, "the tax approach, on net, wins in my mind."
Except it's not so simple. As Grist's David Roberts has pointed out, "The carbon tax that economists talk about is a whiteboard tax"; in real life, things are messier. Congress loves nothing more than fiddling with the tax code to favor one interest group or another, and corporate America knows better than to assume that today's levies will be the same tomorrow.
The basic tradeoff is this: With a tax, you know exactly what the price of carbon will be, but you don't know for sure how much carbon reduction that tax will get you. You have to guess. With cap and trade, you don't know for sure how much carbon will cost, but you do know exactly how much carbon reduction you'll get. Whatever technical flaws cap and trade may have compared with taxes, this by itself is enough to convince most environmental groups that it's a superior approach.
3. Europe is already doing it. In 2005 the European Union started phase one of its Emission Trading Scheme. The initial rollout was a fizzle. Too many permits were allocated, enforcement was weak, and permit prices dropped to as low as 2 cents per ton by the end of 2007. As early as 2006, one major European environmental group was already complaining that "lax implementation of the ets is a major disappointment."
But phase two, which began in 2008, has proved more robust. At press time, CO2 permits were selling for about $17 per ton. That is still too low, but the plan is for cap levels to decrease in the future and for more industries to be brought under the ets umbrella. As that happens, the price of permits will continue to rise, and the market will work its magic.
The EU is fully committed to cap and trade. If the United States wants to be part of a global carbon reduction strategy, learning from the ets and eventually integrating with it is probably our best bet.
4. There's no such thing as a free permit. One of the key issues with any cap-and-trade system is how you allocate permits. Power plants would like to get them for free, and at first glance this seems appealing. If you set the overall carbon cap at 90 percent of current levels, and allocate only that number of permits, that should reduce carbon without raising prices for the consumer. After all, the power plants didn't have to pay for the permits, so there are no costs to pass along. Right?
Oddly enough, no. The economic theory involved is a little hairy, but those permits have a value on the open market, and that means that in many cases marginal producers can make more money selling their permits than by producing power. They'll only be willing to produce power if they can raise prices enough to make the power-producing business more profitable than the permit-selling business, and eventually everyone will jack up prices to follow suit.
This may sound abstract—even a bit fantastical—but it's absolutely real. In fact, when permits in phase one of Europe's ets system were handed out for free, electricity prices rose and power companies pocketed a windfall profit (which Britain's Department of Trade and Industry estimated at about $1.1 billion a year in the UK alone). Dale Bryk, an attorney with the Natural Resources Defense Council (nrdc), puts it bluntly: "If you ask them point-blank if they'll charge customers for free permits, they won't tell you. But they know they will."
A better way is for the government to hold an auction to set the price of permits. This has a couple of extremely salutary effects. First, it puts everyone on a level playing field (since Congress has no ability to allocate permits to favored interests). Second, and even better, the money from selling the permits goes to the federal government, not to the carbon emitters. That's a pretty useful revenue stream, one that would probably start out at about $20 to $30 billion per year and go up steadily as the cap came down and the price of carbon permits increased.
5. It matters what you do with the money. One of the problems with cap and trade, as with any energy tax, is that it's regressive. In absolute terms, poor families spend less on energy than rich families, but they spend a greater share of their income, and this means that higher energy prices hit the poor especially hard. The Congressional Budget Office, for example, estimates that the price increase from a moderate cap-and-trade plan would cost low-income families 3.3 percent of their income, compared with only 1.7 percent for better-off families. Reducing greenhouse emissions may be a global priority, but should it be done on the backs of the poor?
In a cap-and-trade system where permits are given away, there's nothing you can do about this. In fact, because the windfall profits of such a system benefit shareholders in fossil fuel firms, who are generally high earners, you really would be taxing the poor to benefit the rich.
But in a system where carbon permits are auctioned off, this imbalance can be addressed. James Boyce and Matthew Riddle of the Political Economy Research Institute favor a policy called "cap and dividend," which rebates 100 percent of the auction revenue back to the public, much the way that Alaska issues checks to its residents based on tax revenue from the oil industry. Alternatively, the Center on Budget and Policy Priorities has proposed a "climate rebate" program aimed exclusively at poor families that allocates 14 percent of permit auction revenues to replace the buying power that low-income households would lose from higher energy prices. (Families would get the money via existing, proven programs such as the earned income tax credit.) The rest of the revenue stream would be left over for investments in energy efficiency, mass transit, and green R&D.
This also might make cap and trade attractive to politicians who are wedded to congressional pay-as-you-go rules (which prevent spending on new programs unless there are new tax revenues to pay for them). "Given the fact that Democrats want to stick to paygo rules and no one wants to raise middle-class taxes," says Tony Kreindler of the Environmental Defense Fund, "an auction starts to look very attractive."