Comments

1. #1 TokyoTom

   February 19, 2009

   Do these physical variations impact upon the effectiveness of a cap and trade strategy?

   Yes, Bernard, of course they do. In order for any market to function, what’s being bought and sold has to have a discernable value, and where that is not so easily dtermined or where trades are not immediate, parties need to be able to judge counterparty risk to be able to use institutions to enforce the trades. It’s much easier to run any market within a smallish community of well-acquainted users; as the size of the market grows, sophisticated insitutions and services are needed for smooth functioning.

   As a practical matter, it is far easier to run a market for SO2 permits in a particular affected air shed like LA, than it is to create an international market for GHGs that effectively binds the whole world. It’s too hard to monitor & too easy to cheat. E.g., the EU can have ETS, but if US, China, India, Australia, S Korea, Brazil etc. remain free riders, there’s little incentive for them to have strict limits or actually comply, and it’s too easy for the “Clean Development Mechanism” that allows offsets (to permit limits) with developing countries to devolve into funding of unproductive/counterproductive activities (like the scam of having the Chinese produce CFCs that western countries pay them to destroy).

   For the time being, agreeing on and monitoring common tax policies (and emissions) is much easier.

2. #2 Sortition

   February 19, 2009

   Gaz,

   > It seems that big oil and coal businesses tend to favour a carbon tax rather than cap and trade. I wonder why?

   The reason seems straightforward. As I already pointed out, C&T exposes energy companies to huge risks due to the considerable uncertainties in the elasticity of demand for emissions, which translate to considerable uncertainties in the value of the emission allowances.

   These same uncertainties would be a bonanza for financial companies who will offer various “risk management schemes” (similar to the schemes used in the subprime mortgage market) at great profit to themselves, as long as things work out, and at great loss to society when they do not.

3. #3 Gaz

   February 19, 2009

   Sortition (#102)
   “..considerable uncertainties in the elasticity of demand for emissions..”

   Glad we got that one sorted out. Your solution is to subject the environment, rather than polluters, to the uncertainty.

4. #4 Sortition

   February 19, 2009

   Gaz,

   > Glad we got that one sorted out. Your solution is to subject the environment, rather than polluters, to the uncertainty.

   That’s unfair. You asked a question, I gave you an answer. If you don’t like the answer, don’t blame me.

   As for “my solution” – I described it above. By gradually adjusting the tax rate, the same reduction can be achieved without creating artificial risks.

5. #5 Gaz

   February 19, 2009

   Sorition:

   1) “By gradually adjusting the tax rate, the same
   reduction can be achieved without creating
   artificial risks.”

   a) You don’t know how gradually or rapidly you will have to adjust it.

   b) An unknown future tax rate is an artifical risk. That uncertainty will be reflected in, for example, the share prices of energy companies. Uncertainty will create the potential for windfall gains or losses in financial markets. There’s no getting around it.
   You just have to choose which version is most consistent with achieving a reduction in GHGs with certainty. That certainty applies to a cap and trade, even if it is made inefficient by allowances for special intersts. It doesn’t apply to a carbon tax unless you accept the potential for large and unpredictable changes in the tax rate and all the economic disruption that would cause.

   2) “If you don’t like the answer, don’t blame me.”

   I’m not blaming you, I just don’t agree with your answer. Nothing personal.

6. #6 Sortition

   February 19, 2009

   > a) You don’t know how gradually or rapidly you will have to adjust it.

   The scheme I already suggested (tax is increased by 20% per year until emissions targets are achieved) is quite predictable.

   > b) An unknown future tax rate is an artifical risk. That uncertainty will be reflected in, for example, the share prices of energy companies. Uncertainty will create the potential for windfall gains or losses in financial markets. There’s no getting around it.

   This is grasping at straws. There is a big difference between energy companies having to stake their economic viability on guessing how the public is going to react to significant price changes and people having to make a (very educated) guess whether a year from now energy will cost 20% more.

   I don’t think, for example, that anyone can estimate with any reliability how much would energy prices have to go up before energy consumption per capita drops to, say, 90% of what it is now. Would 100% price increase be enough?

   > That certainty applies to a cap and trade, even if it is made inefficient by allowances for special intersts. It doesn’t apply to a carbon tax unless you accept the potential for large and unpredictable changes in the tax rate and all the economic disruption that would cause.

   This is wrong on both sides. First, there is no complete certainty in C&T (or any scheme) unless you go to the length of implementing the draconian measure of allowing utility companies to change prices at very short notice and disconnect customers who are behind on their payments at very short notice. Second, on the tax side, you can achieve approximate goals reliably – which is all that matters since 10% difference, say, between emission goals and achieved emissions matters very little.

7. #7 F=Gaz

   February 19, 2009

   Sortition: “I don’t think, for example, that anyone can estimate with any reliability how much would energy prices have to go up before energy consumption per capita drops to, say, 90% of what it is now.”

   I couldn’t have put it better myself.

8. #8 Sortition

   February 19, 2009

   >> Sortition: “I don’t think, for example, that anyone can estimate with any reliability how much would energy prices have to go up before energy consumption per capita drops to, say, 90% of what it is now.”

   > I couldn’t have put it better myself.

   Ok, so if we agree on that, please tell me what are the poor energy companies to do, when the government sells off allowances that toal 90% of the current total. Should they bid 3 cents per kWh worth of emissions, or 10 cents or 30 cents? With a 10x worth of uncertainty, any choice is likely to result either in windfall profits or in devastating losses.

   Of course, this huge uncertainty is also translated directly into similar uncertainty in the cost of energy, subjecting consumers to much higher uncertainty than my suggested adjustable rate tax scheme.

9. #9 TokyoTom

   February 19, 2009

   An unknown future tax rate is an artifical risk. That uncertainty will be reflected in, for example, the share prices of energy companies.

   Gaz, this is a feature of carbon taxes, not a bug. Just implementing a carbon tax, regardless of what the tax rate is, will – via uncertainty about future tax rates – send a strong signal to markets.

   Of course the same is true for cap and trade, but it`s much more difficult to adjust the cap. Further, the short-term price volatility of permit prices bears no relation to the long-term goal of lowering emissions.

10. #10 Gaz

    February 20, 2009

    Sortition:

    “Ok, so if we agree on that, please tell
    me what are the poor energy companies to
    do, when the government sells off allowances
    that toal 90% of the current total. Should
    they bid 3 cents per kWh worth of emissions,
    or 10 cents or 30 cents?”

    Why do you have such a lack of confidence in the ability of energy companies to estimate the demand for their product?

    These “poor energy companies” operate in energy markets. That’s what they do. Volatility is their middle name. These businesses have been operating in markets where they have had to bid for scarce resources for centuries. Our society is based on this idea.

    The possibility of some volatility in the price of emissions permits is not an argument against an ETS, any more than it is an argument against markets for bananas or foreign exchange or pork bellies or shares or whatever.

    TokyoTom:

    “Just implementing a carbon tax, regardless
    of what the tax rate is, will – via uncertainty
    about future tax rates – send a strong signal
    to markets.”

    What signal – that the tax rate is subject to uncertainty?

    “Of course the same is true for cap and trade,
    but it’s much more difficult to adjust the cap.”

    Oh really? What basis do you have for that assertion? Do you mean politically difficult or administratively difficult?

    “Further, the short-term price volatility of
    permit prices bears no relation to the long-term
    goal of lowering emissions.”

    You think so? I’d disagree, but if so, so what?

    Energy prices have been volatile for centuries yet trends in the price level have still informed producers. Oil still got drilled, coal still got dug up.

    Under an ETS the average price level will send a signal to energy producers that permits are becoming scarcer and that other approaches are becoming relatively more profitable.

11. #11 Sortition

    February 20, 2009

    > Why do you have such a lack of confidence in the ability of energy companies to estimate the demand for their product?

    Just one comment ago you enthusiastically agreed that no one can know what price raise would be sufficient to cause even a 10% reduction in demand. Yet, now you accuse me of being of little faith when I point out the consequence of this statement.

    > These “poor energy companies” operate in energy markets. That’s what they do. Volatility is their middle name. These businesses have been operating in markets where they have had to bid for scarce resources for centuries.

    The cost of energy has been variable, but [demand has been stable](http://probonostats.wordpress.com/2008/03/19/us-energy-consumption-per-capita/). If energy companies face rising costs, they simply pass on those added costs to the consumers. So stability in demand used to work for the companies. Under C&T, the same stability in demand is working against them. This is a completely new situation.

    Of course, as I pointed above, any uncertainties that are being faced by the energy companies will be translated into uncertainties for the consumers who may face wildly unpredictable and possibly fluctuating energy prices.

    > The possibility of some volatility in the price of emissions permits is not an argument against an ETS, any more than it is an argument against markets for bananas or foreign exchange or pork bellies or shares or whatever.

    A person can live without bananas or pork bellies or even foreign currency, but a person cannot live without energy. That is why elasticity of demand for energy is so low and that is why introducing volatility into the cost of energy is dangerous. Furthermore, it is a risk with no benefit – you have yet to point at a single real advantage of C&T over tax.

12. #12 John Mashey

    February 20, 2009

    re: #99 Gaz

    “It seems that big oil and coal businesses tend to favour a carbon tax rather than cap and trade.”

    Without implying any position whatsoever on carbon tax vs cap-and-trade:

    1) Businesses like favorable tax treatment, preferably 0% , or even better, subsidies.

    2) If unable to get that, everyone likes *predictable* tax treatment so that one can plan. In particular, oil companies especially have to plan long-term investments.

    3) BUT, it is also possible that someone who wants 1) might argue *for* a carbon tax, hoping either that

    a) People will propose high-enough carbon taxes to be meaningful, but the political flak will make them impossible for legislatures.

    OR

    b) They will pass a carbon tax, but it will be too low to be a bother … think of paying a traffic ticket once in a hundred illegal parkings…

    Such misdirection arguments were described in discussion of Lomborg.

    4) SUGGESTION: from outside, if the only bit of data is “supports a carbon tax”, then you really don’t know much. What you need to know is:

    a) What’s the starting rate, and when does it start?

    b) What’s the shape of the rate curve, is it fixed by time, or otherwise computed?

    There are corresponding, but different, questions about cap-and-trade, like free-versus-auction, escape hatches, etc.

    Anyway, on either side, the devil is in the details, so it’s hard to know offhand the actual wishes.

13. #13 Gaz

    February 21, 2009

    Sortition: “Just one comment ago you enthusiastically agreed that no one can know what price raise would be sufficient to cause even a 10% reduction in demand. Yet, now you accuse me of being of little faith when I point out the consequence of this statement.”

    Nice comeback, but actually I didn’t say they’d get it right all the time, just like anyone operating in any commodity market. They have to forecast demand for their product under conditions of changing price and supply now, they will in the future, under whatever scheme we have

    Actually I think this is a bit of a red herring – there’s actually no reason to suppose carbon-based energy prices will be much more volatile under a cap’n'trade system than the are now.

    The supply of fossil fuels is already limited. Look at how oil prices behave. All that a cap’n'trade setup does is tighten the limit to a perfectly predictable timetable.

    Anyway, the objective of either scheme surely is not to guarantee price stability for energy companies but to reduce the output of GHGs. I suspect this is why the energy companies seem to prefer a carbon tax.

    As you said, “If energy companies face rising costs, they simply pass on those added costs to the consumers.”

    Under a carbon tax regime this creates an enormous incentive for energy companies to engage in anti-competitive behaviour, eg gas distribution company buying wind farm company to freeze out the competition, that sort of thing.

    If they succeed in that effort, then they can continue to pass the cost of the tax on to consumers in conditions of the low price elasticity of demand for their product that you have identified.

    Under a C&T, eliminating the competition won’t help so much – you can still only produce so much carbon energy.

    Re volatility: you are of the view that the price of carbon-based energy would be much more stable under a carbon tax versus a cap’n'trade.

    I don’t think this is necessarily true.

    I think your view is based on the assumption that the plan to raise the tax in step-wise fashion, say 20% at a time (I assume you mean 20% in year one, 40% in year 2, 60% in year 3, but correct me if I misunderstood you) would do the trick.

    But what if you did this and after 5 years it turned out that emissions were reduced at only a third of the rate you expected?

    Do you double the tax rate in the next year? Triple it?

    Do you try and catch up and risk a recession or just resign yourself to being 5 years behind schedule.

    There is clearly potential for a lot of volatility there. I am not saying it would happen, but I just don’t think you can be so sure that it won’t.

    Another way of looking at the price voaltility question.

    In either case, the price of caerbon based energy could be seen as consisting of the raw material (eg oil) which is already very price volatile, production costs which are fairly stable, and the additional cost of a tax or the permit prices.

    If it turns out that the amount of tax or the price of a permit is less volatile than the current price of oil or coal, then either of these schemes could make energy prices more predictable rather than less predictable.

    But my point is that there’s a great potential for simply missing the emmissions target by a big margin if you get the tax rate wrong.

    That’s what I think is the main advantage of a C&T.

    There are others – eg Garnaut thinks it would be better for international trade in emissions rights, which is more economically efficient, if you believe in that sort of thing.

    I also think a permit system is more transparent, in that you know how many permits there are and the price of a permit is known (which is important both to fossil fuelers and aternative producers).

    With a carbon tax, I suppose the tax commissioner might publish how much carbon tax he collected.

14. #14 Sortition

    February 21, 2009

    > Nice comeback [...]

    It’s not a comeback, that was my point all along.

    > there’s actually no reason to suppose carbon-based energy prices will be much more volatile under a cap’n'trade system than the are now.

    As I already pointed out, the reason is the inelasticity of demand for energy.

    > I think your view is based on the assumption that the plan to raise the tax in step-wise fashion, say 20% at a time (I assume you mean 20% in year one, 40% in year 2, 60% in year 3, but correct me if I misunderstood you) would do the trick.

    20% per year means the price for the consumer after n years of increases would be p0 * 1.2^n, where p0 is the price before the tax is introduced. The tax rate is therefore 1.2^n – 1. Thus, as long as the emission targets are not met, the price grows exponentially.

    > But what if you did this and after 5 years it turned out that emissions were reduced at only a third of the rate you expected?

    The price will continue going up at the 20% per year steps until the targets are achieved. Of course, the targets have to be adjusted depending on how long it takes to get there, but the rate of increase of energy price is limited to 20% per year. Note that after 5 years, if the targets were not met, the price will have gone up by 150%, after 10 years the price will have gone up by over 500%, and by 15 year by over 1400%.

    > But my point is that there’s a great potential for simply missing the emmissions target by a big margin if you get the tax rate wrong.

    As I already wrote multiple times, by adjusting the tax rate over time, that possibility is eliminated. It may take a few years, but the targets (properly adjusted to account for the time that has elapsed) will be achieved.

15. #15 Gaz

    February 22, 2009

    Thanks for the response, Sortition.

    I just want to make sure I understand your preferred carbon tax mechanism as you explained it in the previous post.

    Please correct me if I have misinterpreted your formula.

    The amount of tax paid is a fraction of the price prior to the introduction of the tax, yes?

    In that case the tax would be more like what the Australian tax system refers to as an excise, like we pay for petrol – so many cents per litre. The tax amount per tonne paid would not vary according to changes in the market price of fossil fuels.

    Let’s say as an example, the pre-tax price of emissions starts off at $40/tonne.

    Then in the first year the tax would be 20% of that, which would be $8, right?

    So the final price would be $48.

    In the second year, the tax rate would be (1.2^2 – 1) = 0.44.

    And 0.44 or 44% times $40 = $17.60, so the final price of emissions is whatever the pre-tax cost is plus $17.60.

    So far so good?

    If that’s right, then in year three we get 1.2^3-1 = 0.728 ir 72.8% and the price of emissions is pre-tax cost plus $29.12.

    Now if we follow that through, and take 2010 as year 1, then by 2020 the tax per tonne would be $40 times (1.2^11-1) = $257.20, ie more than six times the pre-2009 price.

    By 2050 by my calculations we’d have a tax per tonne of $70,509.

    Yes I can see how you have confidence that a carbon tax would be effective, but the exponential formula means your choice of an initial rate is important.

    If you took 10% as the tax rate, you have $1951/tonne by 2050. A rate of 15% would mean $12,282/tonne in 2050.

    Am I barking up the wrong tree?

16. #16 MattB

    February 23, 2009

    This is the great thing about the economics debate… at least with the climate there is science to fall back on. But they were all interesting comments Gaz and Sort. Cheers.

17. #17 Sortition

    February 23, 2009

    Gaz,

    Yes – that is what I am proposing. Just to be clear, in your example, the 2020 price will be $257.20 per ton only if emission targets were not met by then. When the emission targets are met, the price increases stop.

    And, yes, the yearly rate of increase matters a lot. I suggested 20% because I believe that 20% yearly increase is both high enough to reduce demand in the time frame needed, and gradual enough so people can adjust to it without unnecessary hardship. (Of course, reducing carbon consumption will not be easy, but there is no need to make things more difficult than they have to be.)

    I emphasize again that the tax revenue must be refunded to the residents by being divided between them equally.