Review of Environmental Economics and Policy Advance Access originally published online on January 6, 2009
Review of Environmental Economics and Policy 2009 3(1):42-62; doi:10.1093/reep/ren021
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Cap and Trade, Rehabilitated: Using Tradable Permits to Control U.S. Greenhouse Gases
* Environmental Defense Fund, 257 Park Ave. South, New York, NY 10010, USA; e-mail: nkeohane{at}edf.org
This article presents the case for using a cap and trade program (i.e., tradable permits) to control U.S. greenhouse gas emissions. The analysis draws two basic distinctions between such an approach and a carbon tax (the alternative favored by many economists). The first concerns how the value of emissions is allocated. Under cap and trade, the government can capture the value of emissions by auctioning permits or by freely distributing allowances to emitters. A carbon tax would generally capture the entire value as revenue. While free distribution has efficiency costs, it gives policy-makers important flexibility to resolve distributional issues. The second distinction is that a tradable permit system sets the quantity of allowable emissions, while a tax sets the price. In the context of international policy, cap and trade promotes cost-effective abatement and broad participation. A quantity approach may also be preferred on efficiency grounds. Although the prevailing view among economists is that uncertainty about marginal costs favors taxes, that view ignores the possibility of allowance banking and borrowing, and overlooks growing scientific evidence that climate change will be highly nonlinear and characterized by "tipping points." A simple thought experiment illustrates how a prices-versus-quantities argument might favour cap and trade.
JEL Classification: Q54, Q58, H23, L51
I am grateful to Suzanne Leonard and an anonymous referee for exceptionally detailed and helpful comments, as well as to Simon Dietz, Britt Groosman, John Mimikakis, Lisa Moore, Rob Stavins, Gernot Wagner, and James Wang. All remaining errors are my own.
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