Economic Incentives for Controlling Greenhouse Gases

Limiting emissions of carbon dioxide and other greenhouse gases could be very expensive. If control measures are to be taken, serious thought should be given to so-called incentive-based (or IB) policies because of their cost-saving potential. Two such IB policies are particularly attractive—emissions taxes and transferable emissions permits.

Either approach could be used at the national or international level. For instance, nations might jointly negotiate worldwide limits on greenhouse gas emissions, then introduce taxes or marketable permits to meet their individual obligations. Alternatively, nations might agree to use economic instruments at an international level—a global emissions tax or a worldwide market for emissions permits. Unlike a command-and-control (or CAC) approach to limiting emissions, in which a national or international authority establishes very detailed pollution-control measures for each of a large number of sources, IB policies harness the power of self-interest to protect the environment. In so doing, they can reduce emissions at least cost to society, thus freeing up resources for other pressing problems.

The cost-saving capacity of IB approaches has both a short-run and a long-run dimension. In the short run, when technology is more or less fixed, emissions taxes or marketable permits would confront sources of greenhouse gases with a price for their pollution—either they would pay a tax for each ton discharged or they would have to acquire a permit (a costly permit). In either case, sources that could reduce a ton of emissions at a cost less than the per-ton tax or permit price would elect to do so since they would save money as a result. Sources finding emissions control more expensive on a per-ton basis than the tax or permit price would not reduce emissions. Thus, without any direction from a central authority, emissions control would automatically be concentrated at the sources where it is least expensive.

Over the longer term, IB policies would provide powerful incentives for research on and development of new technologies to limit greenhouse gases. Polluters could reduce the taxes they pay—or the amount they spend on permits—by finding cheaper and more effective ways to reduce their levels of emissions. Thus taxes or marketable permits would effectively harness the profit motive, both in the short run and the long run, to work on behalf of pollution control. Several studies have found very large cost advantages for IB policies, with savings amounting to as much as 90 percent of the cost of a CAC approach that produces the same emissions reduction.

Despite the fact that emissions taxes and marketable permits both confront sources with a price for their emissions (and, in so doing, result in cost-minimizing outcomes), these two approaches have some important differences in a policy setting. These differences explain why legislators and environmental regulators in the United States have favored marketable emissions permits over emissions taxes. Under the Clean Air Act Amendments of 1990, for example, reductions in sulfur dioxide emissions from coal-fired power plants will be achieved through a system of marketable permits. And under the U.S. Environmental Protection Agency's Emissions Trading Program, attacks on urban smog and other traditional air pollution problems have included limited use of tradeable emissions permits.

One advantage of the permit approach is that it gives regulators direct control over the quantity of emissions. This is important since environmental laws typically call for specified levels of pollutant emissions or ambient concentrations. In addition, the permit approach can offer a way around one of the political obstacles to emissions taxes—namely, that if all emissions are taxed, sources could face very large tax liabilities for emissions that in the past have been free. Of course, this would also be true if the government decided to "confiscate" all heretofore permitted emissions and chose to auction them off to the highest bidder. But there is another way a permit system could be set in motion. The regulator could distribute the desired number of permits free of charge to existing sources in proportion to their previous emissions and then allow free trade in the permits between any buyer or seller. The granting of valuable assets like permits to existing sources would obviously engender much less opposition from emitters than would the levying of a tax.

When the benefits and costs of emissions control are uncertain, as they are sure to be, the choice between emissions taxes and transferable emissions permits is more difficult to make. Errors in setting the rate at which emissions are taxed or in determining the quantity of permits to be issued can have very different consequences.

Consider a setting in which disastrous environmental consequences would ensue if pollutant concentrations were to exceed some threshold level. If the environmental authority set an emissions tax too low, emissions might exceed the threshold level. In this case it would be better for the environmental authority to employ a permit system under which it could ensure that emissions stay below the danger level.

Under an alternative setting, however, environmental damage from additional emissions does not increase significantly, but control costs do. In fact, most studies indicate that—regardless of the pollutant in question—beyond a relatively constant range the marginal cost of additional control begins to increase sharply. Here, setting an emissions limit that is too tough (allowing too few permits) could impose high control costs on most sources. With an emissions tax, this danger is avoided because sources could always opt to pay the tax and avoid the more costly control measures.

Which, then, is the better policy instrument—an emissions tax or a system of transferable emissions permits? The choice would be clearer if we had a better fix on the damages associated with greenhouse gases and the costs of controlling them. With respect to damages, most projections seem to suggest that they would increase gradually as greenhouse gases accumulate in the atmosphere. However, there are fears that, beyond some threshold, global warming could suddenly become self-reinforcing and increase rapidly. If so, the preferred policy instrument clearly would be one that allows firmer control over the level of emissions—namely, a permit system.

On the other hand, there are good reasons to believe that the marginal costs of reducing emissions of carbon dioxide and other greenhouse gases will rise—and probably rapidly after some point. In setting purely quantitative targets for emissions reductions, as in a permit system, there may be a danger of incurring much higher costs than envisioned at the outset. This danger could be avoided by levying an emissions tax. A substantial tax could induce all the control activities that are reasonably affordable. Although the exact size of the emissions reduction would be uncertain, a tax would protect against the huge costs that would be incurred to achieve some (perhaps quite small) additional reductions in carbon emissions.

Given the certainty of rising emissions control costs, the use of an emissions tax appears preferable, at least for the present. If, however, scientists find that there are critical threshold levels of atmospheric CO2 and other gases, a system of transferable emissions permits would look more attractive.

On an international scale, the choice of policy instruments for limiting emissions of greenhouse gases becomes more complicated. A realistic appraisal must address two problems. First, effective use of emissions taxes or transferable emissions permits requires a certain minimum level of administrative and technical sophistication (with regard to monitoring, for instance), which may be lacking in some of the developing countries. Second, there currently exists no international agency with the power to ensure compliance with global policies. This presents a particular problem in the global trading of emissions permits, for which an entity like a domestic court system is needed to enforce property rights over the permits and compel adherence to contracts to trade these rights.

An additional problem must be addressed to make emissions trading feasible on a global scale. It is difficult to envision a competitive international market in permits because so many participants would come from nonmarket economies and because some participants from market economies, such as regulated or nationalized electric power companies, could have distorted incentives. To make a global market for carbon dioxide permits competitive, Michael Grubb of London's Royal Institute of International Affairs proposes that permits be initially vested in governments for use by their national emitters, rather than in private hands. The primary purpose of Grubb's proposal is to address the distribution of the responsibility and cost for emissions control among nations, not (as with the domestic permit market) to achieve an internationally cost-effective allocation of control efforts. Grubb further suggests allocating permits to each country in proportion to its adult population; industrial countries finding themselves with fewer permits than current CO2 emissions could then "rent" permits from any developing countries finding themselves with a surplus, provided the proceeds were used by the latter to mitigate global warming. Domestic control policies (permit trading, taxation, or CAC measures) would be needed in the industrial countries to satisfy their national obligations for greenhouse gas limitations.

International exchange would establish market prices for permits that developed countries would be willing to pay when their own mitigation costs were higher. However, there is no reason to believe that the resulting distribution of emissions control efforts would be cost-effective, because governments lack the information possessed by individual emitters to exhaust all gains from trade. Instead, the main accomplishment of Grubb's program would be to provide an economic incentive for developing countries to participate in mitigation efforts, since their failure to do so would cost them revenue from permit sales. However, Grubb's formula for the initial distribution of permits may place an intolerably high cost burden on the industrialized world (see "Resolving equity issues in greenhouse gas negotiations" in this issue).

Another proposal for international emissions control—one that favors a tax approach—has been offered by Darius Gaskins of Harvard University and Bruce Stram of the Enron Corporation. Their proposal calls for agreement on a tax rate applicable to carbon emissions from member nations of the Organization for Economic Cooperation and Development. The proceeds of the tax would be earmarked for developing countries to use in limiting greenhouse gas emissions. The intent and focus of this proposal are similar to Grubb's. The main differences are in the choice of instrument and in the intensity of control—Gaskins and Stram would start out with much more modest incentives for greenhouse gas limits.

Grubb contends that tax systems vary widely among nations and often include subsidies (some hidden), making it hard to harmonize tax policy on an international scale. On the other hand, a tax is a highly visible sign of the cost of emissions control programs—and a flexible one. The tax rate could presumably be adjusted over time if either more or less effort were required to contain carbon emissions. Moreover, the tax approach provides protection against decisions that could prove overly costly, since emissions sources have the option of paying the tax rather than introducing further control measures. Once permits are issued and traded, on the other hand, the cost of curtailing carbon emissions becomes hidden in product prices and is less apparent to the public and its representatives. This may bias the policy process in favor of excessive controls.

Entitlements granted by permits also tend to generate vested interests, making adjustments in the supply of permits difficult to bring about. For example, if new research convinces us that climate change is not the serious problem it is now believed to be, we would want to increase the number of permits. But existing permit holders (like those owning taxi medallions in New York City) would object, since this would devalue the permits for which they may have paid a sizable sum. Conversely, buyer resistance could scuttle reductions in the number of permits. For these reasons, some contend that the political economy of the situation favors taxes over permits.

A final point bears mention. Any truly cost-effective approach to preventing global climate change must encompass all radiatively active gases, not just carbon dioxide. In this regard, neither taxes nor marketable permits have a distinct advantage, either as unilateral or multilateral instruments. Under a tax regime, the tax on carbon emissions could be set first, with appropriate tax rates established for the other greenhouse gases on the basis of their relative contribution to warming. If a gas were ten times more harmful than CO2 on a per-ton basis, the tax rate would be ten times that for CO2. Under a permit system, the terms of trade could be made to depend on radiative potential. For example, to emit one ton of the more potent gas, 10 carbon permits would have to be acquired. As scientific information accumulated about relative potencies, tax rates or trading ratios could be adjusted.

This need to account for other radiatively active gases represents an added complication to any regulatory approach. But it should be considered because it is likely that the optimal preventive strategy will include a number of measures directed at greenhouse gases other than carbon dioxide. This observation heightens the importance, and the challenge, of harnessing economic incentives to limit global warming.