Climate change news has been recently dominated by the rift between developed and developing nations over the amount of money the former should give the latter to move to a low carbon economy. Yet this issue, while vitally important, is not all that’s at stake. Beyond climate friendly funding lie the questions of how the goals will be reached and what will happen if a country snubs its nose at the rest.
Three proposed approaches to reduce carbon emissions have been taken seriously at one point or another: cap and trade, cap and dividend, and a carbon tax. Cap and trade, the favored approach, would have nations issued permits for emitting greenhouse gases. These permits could be traded on an open market so the emissions cuts can occur where they are most cost effective. Over time, the number of permits is ratcheted down to meet the desired reduction in emissions. Cap and dividend follows a similar approach, but sells the permits on the market much like the Federal Communications Commission auctions wireless spectrum. The money from the permits would then be remitted to taxpayers, alleviating the burden of increased costs due to emissions reductions. The last, the carbon tax, is the simplest of the three—a tax on carbon emissions.
“Most economists would recommend a tax,” said Bard Harstad, professor of managerial economics and decision sciences. “All the firms would know what the tax is going to be, it would give revenues to the governments—which can be useful—and it’s very easy to administer.”
But a carbon tax has not even been debated at international summits. Harstad said there’s a good reason for that. “The problem with a tax is that it is called a ‘tax.’ People—particularly Americans—hate taxes. It involves a payment from the private sector to the public sector and many people don’t trust the public sector to use the money appropriately.”
A pure cap and dividend approach is a spin on the carbon tax, but unlike the tax, “the total level of pollution is known,” Harstad said. But unlike the tax, the equilibrium price of carbon in a cap and dividend scheme is unknown. Furthermore, businesses would be strongly against a pure cap and dividend for many the same reasons as a carbon tax—they would have to forfeit money to comply.
The frontrunner couples binding caps on emissions with trading of permits that allow a certain amount of pollution. Such a scheme has worked successfully in the past on a more limited scale with the sulfur dioxide market in the United States. Sulfur dioxide emissions have dropped over 40 percent since the cap and trade scheme was enacted in the 1990 Clean Air Act amendments while electricity generation has increased. The success of the sulfur dioxide permit market gave weight to the current carbon cap and trade proposals.
“The good thing with a trading program is the reduction will take place where it costs the least”, much like the carbon tax and cap and dividend, Harstad said, but without the stigma. Nations that can trim emissions easily can sell their permits to those that find it more difficult to comply with their cap. As long as global emissions drop below the agreed target, the program will be a success. Some question the fairness of rich nations being able to buy compliance. Such arguments are not bulletproof, Harstad said, as the end result should be reduced emissions not a painful atonement.
“On the other hand if we minimize the pain, the companies in the U.S., for example, don’t have the same incentives to develop new technologies if they can easily buy a reduction elsewhere,” Harstad said. So while buying permits on the open market may be advantageous in the short term, it may hinder a nation’s prospects for long term economic growth.
The carrot or the stick? Or both?
Despite the potential pitfalls, cap and trade is likely to win out. But any cap and trade scheme will be for naught if there is no way to punish noncompliant nations. How to do so has been a sticking point for years. The Kyoto Protocol, for example, had a particularly anemic enforcement mechanism, calling for noncompliant nations to fulfill their missed target plus an additional 30 percent cut while suspended from the permit trading market.
One intriguing if not controversial solution Harstad supports involves international trade. In a Financial Times opinion piece, he argues that climate agreements should be linked with favored trading status. If a nation were to pull out of a treaty, their trading status with the other nations would fall. The same would happen if a country failed to meet an emissions target.
“There are only so many sticks and carrots that we have,” Harstad told me. “There’s not enough [carbon] quotas in the world to offer everyone that they would all participate without making the outcome too lax. We have to offer something other than that. Being a favored trading partner is one of the few options.”
Tying trading status to emissions compliance may be key. Indeed, trade-reliant China announced their opposition to such an approach just yesterday. Their opposition is telling and suggests that favored trading status may be the carrot-and-stick a successful treaty needs.