Monday, April 26, 2010

Collars on caps

The great virtue of cap and trade over taxes is that the former gives you determinate levels of carbon output. Taxes, as Paul Krugman put it in the NYT a few weeks ago, give you determinate price but indeterminate carbon output. If you are worried about climate, the former wins out over the latter hands down unless you have a mechanism for adjusting taxes to adjust carbon output. But such a mechanism forces legislators to revote and pay the price of such votes – for one big difference between permits and taxes is that the former can be handled administratively unlike the latter. When it comes to cap and trade, there is another trade off – how smooth you want to make market adjustments. One way to achieve that is by gradually tightening caps. Another way is by introducing a price collar that provides both a floor and a ceiling on the traded price of permits. The problem with such a ceiling is that it simply acts to bust the cap unless it is implemented very judiciously. The problem is that once the mechanism is in place, there will always be a temptation to invoke it in response to howls of pain as the caps are tightened. The only way to avoid that, is to tightly specify how and when such a collar kicks in. The current bill under design in the Senate has worrisome features in its collar provisions that should raise alarms – the worst thing would be to have cap and trade with a collar that is so tight that you have no real determinate limits on carbon at all. Indeed that might be worse that a tax!

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