Which is a better policy for reducing greenhouse gases: a tax on carbon or a cap-and-trade approach?

Given today’s gridlocked politics, I realize that’s a little bit like asking: Do you like your unicorns to be striped or polka-dotted? But as the Times pointed out:

This week, the top executives of six large European oil and gas companies called for a tax on carbon emissions. These companies — the BG Group, BP, Eni, Royal Dutch Shell, Statoil and Total — are not taking a bold environmental stand. They are being pragmatic. They want an efficient and predictable policy to limit greenhouse gas emissions because they realize something must be done.

Good for them, and while U.S. energy producers such as Exxon Mobil are conspicuously absent, some have apparently said they could live with a carbon tax if it could be offset by lowering other taxes they face. On the other hand, the fact that the politically powerful Koch Industries opposes any new price on carbon takes us pretty quickly back to the unicorn discussion.

But let’s put the politics aside for a moment and get our wonk on around this question of if — I’d say “when,” though probably not for a long while — we eventually make a move in this direction, what’s the best way to do so?

The Times editorial interprets the European companies as calling for a carbon tax, but as I read their statement, they broadly endorse “carbon pricing systems.”

Two approaches to such systems typically involve either a tax on carbon production and/or use, or a system of permits, in which fossil-fuel-based energy producers are either given or sold (at auction) numerical allowances of greenhouse gas emissions that they can buy or sell to one another. (Since we’re talking taxes, I don’t discuss a third approach: regulatory restrictions such as requiring a certain share of energy production to come from renewable sources by a future date.)

A primary advantage of the capped approach is that at least on paper, it limits carbon pollution to an established level, one that can be adjusted down over time as energy producers implement the required efficiencies. And while both approaches provide monetary incentives to conserve, under cap-and-trade, producers who’ve moved early to adopt carbon-capture technologies can make serious money selling permits to laggards.

Conversely, under the carbon tax, as Peter Barnes points out in his excellent new book (a must read that recommends a “cap-and-dividend” program, where the revenue is distributed equally to the public), we can’t know what we’ll end up with in terms of carbon reduction. If (after-tax) energy prices fall, as gas prices have in recent months, or technology achieves significant efficiency increases (e.g., if cars and trucks improve their mpg), even in the presence of a new tax, consumers may demand more energy and carbon-based energy consumption could increase.

So cap-and-trade is the way to go, right?

Not so fast. It’s no slam dunk, and I’d ecstatically take either one. But while in theory the cap is attractive, in the real world, I like the tax better. The problem is the interaction of complexity and political, and thus carbon, leakage.

There are a couple of design issues around capped plans that, given the sway of energy producers, could easily bounce the wrong way. First, initial permits can be either sold or given to polluters. Obviously, they’d like to get them for free, but that’s a huge giveaway — more corporate welfare to an already highly profitable industry. As Barnes puts it, selling the permits “should be a no-brainer, but there’s a political disadvantage: if permits are sold, they can’t be used as political bargaining chips. Hence the congressional bias to hand out permits in exchange for support from powerful industries.”

Second, and this problem is more pernicious, there are “offsets.” That’s where an energy producer can get a credit against their cap because they’ve allegedly reduced carbon-based emissions somewhere else in their operations. Again, this sounds reasonable on paper, but it can be easily gamed. For example, firm A, facing a carbon cap, can pay firm B to create a pollutant. Firm A then buys and destroys the newly created pollutant, getting credit for an offset and, thus, increasing, on net, carbon in the atmosphere.

So caps can be leaky and given away as political quid pro quos. What, other than the absence of a cap, can go wrong with a simple tax on carbon?

Well, one problem right in front of our faces is that Congress can set it too low, rendering it ineffective in a “Pigouvian” sense (a Pigouvian tax is a tax on activities with negative effects on society not reflected in the producer’s costs; it’s thus a tax designed to internalize a negative externality). The federal gas tax is very much a tax on carbon, and it’s been ridiculously stuck at about 18 cents/gallon since 1993.

Another problem, alluded to above, is that while industries may be making some better noises about taxing carbon, at least the American corporations are likely to insist on “revenue neutrality,” meaning cutting some other taxes in return for the new tax on carbon.

The problem with that idea, beside the fact that we need more revenue, is that we’d probably be trading a progressive tax — like the federal income or corporate tax — for a regressive one. Since low-income households spend a larger share of their income on energy, carbon taxes are regressive.

That’s why smart plans would both set the tax at a level that bites and include a rebate mechanism for the least well off (or, in Barnes world, for everyone).

I’m congenitally against complexity in the tax code and admit that it’s not optimal to have to create ways to offset this aspect of either approach. But as economist Chad Stone documents, this rebate mechanism is well worked out and has even found its way into various bills.

None of which have gone anywhere, which brings us back to the unicorn showroom. Figuring out which is a better way to tax GHG emissions is what we call a high-level problem, and I reiterate that I and many others, including apparently some large European energy producers, would be okay with either cap-and-trade or a carbon tax.

In other words, the barrier here is not the fine points of tax wonkery. It’s politics, and that’s a much higher bar to clear.