CBO Report: The Real Story

This post is by Nat Keohane, Ph.D., Director of Economic Policy and Analysis at Environmental Defense.

The Congressional Budget Office (CBO) released a report this month on Policy Options for Reducing CO₂ Emissions [PDF]. It concludes that a carbon tax reduces emissions more efficiently than cap-and-trade.

But a careful reading reveals the report to be a theoretical exercise with no real-world relevance. It highlights the drawbacks of a version of cap-and-trade that no one advocates, and bases its efficiency analysis on a faulty premise.

The CBO report compares four scenarios:

• carbon tax
• cap-and-trade with banking and a "safety valve"
• cap-and-trade with banking and a "circuit breaker"
• cap and trade with no flexibility

These scenarios are unrealistic. No one is suggesting inflexibly capping emissions in every individual year – this is a straw man. Plus they make the mistake of coupling a sound strategy like permit banking with cap-breaking safety valves and circuit breakers.

Banking, Safety Valves, and Circuit Breakers

Banking permits for use in different years is widely accepted as good strategy. With permit banking, a total "emissions budget" is set over a long period. For example, current legislation before Congress would determine total emissions between 2012 and mid-century. Banking and borrowing permits lets the market determine when emissions cuts can be made at least cost.

Permit banking was a key reason for the wild success of the cap-and-trade system that reduced acid rain. Banking also is a feature of the legislation currently before Congress, and indeed of every serious legislative proposal that’s been made.

A safety valve, in contrast, seriously undermines the main advantages of a cap. With a safety valve, when prices reach a predetermined dollar value, businesses no longer have to rely on the established supply of allowances available in the market. Instead, the federal government makes new allowances available for sale at a specified price – potentially in an unlimited quantity. This creates two serious problems:

1. It destroys the cap, and the hard limit on emissions is critical. A safety valve gives the illusion that we are controlling emissions while allowing more greenhouse gas pollution into the atmosphere.
2. It limits the economic opportunity of those who develop cleaner technology. Higher permit prices signal the market to invest more in innovative low-carbon technologies – happy news if you’re in the business of inventing and selling ways to cut pollution. A safety valve would sharply curtail incentive for innovation, driving costs up in the long run.

A circuit breaker has all the same problems as a safety valve. With a circuit breaker, the cap is loosened if the price of permits rises above a certain level.

The Key Premise is Wrong

Let’s forget for a moment that the report’s scenarios make no sense. The CBO report says that even when compared to the most flexible cap-and-trade system, a carbon tax is a more efficient way to reduce emissions. They reach this conclusion from a faulty premise.

At the heart of the CBO analysis is the notion that the cost of greenhouse gas emissions (i.e. the damage from climate change) is relatively flat and predictable, so the cost of each additional ton of emissions (the "marginal cost") is roughly constant. If this were true, they’d be right – the most economically efficient approach would be a tax equal to the marginal damage.

But this premise is false! Far from being constant and predictable, the damage from climate change is nonlinear and uncertain.

Scientists tell us that climate change is subject to "tipping points" – that after a certain threshold is reached, climate can change in qualitative and discontinuous ways. For example, at 32°F ice changes to water. The best known climate tipping point affects the Greenland Ice Sheet, which could begin a slow, irreversible meltdown if global temperature passes a certain threshold. (For more on tipping points, see our post on "9 Dangerous Tipping Elements".)

A carbon cap sets a quantity target – the amount of emissions is certain, the price is uncertain. A carbon tax sets a price target – the price is certain, and the amount of emissions is uncertain. If the amount of emissions has a predictable cost, then it makes sense to base policy on price. But this is not the case in a climate system subject to tipping points. If we exceed our "carbon budget", the costs could become astronomical. Scientists may differ on exactly what our carbon budget should be, but there’s no question that a quantity target is what’s required.

When the central problem is setting the right quantity – how much we can safely emit in total – then the arguments that support a carbon tax flip in favor of cap-and-trade. The CBO report actually acknowledges this. Almost as an aside, the report points out that the existence of a threshold or "tipping point" for the consequences of climate change "could make a cap more efficient than a tax." The CBO report treats this as a merely hypothetical concern, but scientists tell us that it is, in fact, the case.

So don’t be too impressed by the conclusions in the CBO report. It might be useful reading for undergraduate economics classes, but it has little relevance for real-world policy debates.