Why Carbon Pricing Is Preferable to Carbon Regulation

And, within those policies deemed "carbon pricing," a carbon tax is preferable to cap-and-trade.

A new paper from the Niskanen Center explains why "carbon pricing" is a better way to reduce greenhouse gas emissions than traditional emission control regulations. As study authors Shuting Pomerleau and Ed Dolan explain, setting a price on carbon (such as through a tax) allows for the more efficient reduction of greenhouse gas emissions because the costs of emission reductions can vary widely across sources. The result is more cost-effective emission reductions and the imposition of fewer constraints on economic dynamism. Moreover, carbon pricing regimes more readily accommodate changes in technology over time than do centralized regulations.

One common complaint about carbon pricing, and a carbon tax in particular, is the potential regressive effect of increasing energy prices. Yet as Pomerleau and Dolan note, such regressive impacts can be readily addressed by rebating carbon tax revenues.

While the potentially regressive effects of carbon pricing are widely discussed, there is relatively little attention paid to the regressive impacts of other proposed greenhouse gas policies. As Pomerleau and Dolan note:

On purely theoretical grounds, there is no reason to believe that the impacts of environmental regulations are any less regressive than those of a carbon tax. Since regulations tend to raise the cost of doing business, they can be expected to raise prices of goods, with a disproportionate impact on the purchasing power of low-income households.

While traditional regulatory measures of greenhouse gas emitters are also likely to increase energy prices, such measures do not generate a revenue stream that could be rebated to offset the potentially regressive effects. Thus it is a mistake to assume that carbon pricing is more regressive than regulatory alternatives.

Another reason to prefer carbon pricing to traditional regulations is that carbon pricing is easier to adopt and less vulnerable to legal challenge and delay. As I explain in this paper (originally published by the Niskanen Center as well), traditional regulatory approaches to greenhouse gas emission control face substantial legal and administrative obstacles, even if expressly authorized by Congress.

Where I differ with Pomerleau and Dolan is with the extent to which they characterize carbon taxes and cap-and-trade systems as largely equivalent approaches. This is common in the economic and political science literature, but I believe it is a mistake. While price and quantity instruments can be modeled as equivalents, they are quite different in operation and in terms of political economy. While Pomerlau and Dolan acknowledge some of the differences, I think they understate the reasons why one approach (a carbon tax) is vastly preferable to the other (emission trading).

Supply constraints, such as those that are created for tradeable permit systems, tend to produce significant price volatility, which can discourage investment in low-carbon technologies. Further, cap-and-trade systems, in practice, often require regulators to engage in many of the same quantification and assessment measures required under traditional regulations. This is why even a relatively simple cap-and-trade system imposed on a limited number of sources, such as that which was used for acid rain-causing emissions under the 1990 Clean Air Act Amendments, required years to put in place. By comparison, British Columbia adopted and imposed its carbon tax system in a matter of months.

The political incentives created by the two approaches are also quite different, as are the rent-seeking vulnerabilities. Imposing a supply constraint creates the sort of fixed-pie allocation problem that accentuates the demand for rent-seeking. Further (as a I discuss briefly in my paper linked above), implementing a cap-and-trade system requires far more of the administrative process than does imposing a simple price or tax, and greater complexity creates greater vulnerability to rent-seeking. In short, each discreet determination regulators must make is an opportunity for rent-seeking, and the implementation and adoption of cap-and-trade systems require far more such determinations than does the adoption of a tax or price system.

The problem, of course, is that a carbon tax or other carbon pricing system would almost certainly require action by Congress, and that seems quite unlikely. This could change with the election of a conservation-minded Republican, or a sudden Democratic willingness to consider the adoption of a carbon tax through reconciliation, but neither seems all that likely right now. Thus for the moment, the best greenhouse gas emission policies are those the United States seems least likely to adopt.