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Review of Environmental Economics and Policy Advance Access published online on January 6, 2009
Review of Environmental Economics and Policy, doi:10.1093/reep/ren016
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© The Author 2008. Published by Oxford University Press on behalf of the Association of Environmental and Resource Economists. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org

Balancing Cost and Emissions Certainty: An Allowance Reserve for Cap-and-Trade

Brian C. Murray*, Richard G. Newell{dagger} and William A. Pizer{ddagger}

* Director for Economic Analysis, Nicholas Institute, and Research Professor, Nicholas School of the Environment, Duke University.
{dagger} Gendell Associate Professor of Energy and Environmental Economics, Nicholas School of the Environment, Duke University, a University Fellow at Resources for the Future, and a Research Associate at the National Bureau of Economic Research. E-mail: richard.newell@duke.edu.
{ddagger} Senior Fellow at Resources for the Future. Senior authorship is not assigned.

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   Introduction
 
The economic debate over using taxes versus cap-and-trade to control pollution emissions revolves around the relative merits of using prices versus quantities as the policy instrument. A cap-and-trade system fixes the quantity of emissions allowed but leaves the market price of emissions rights uncertain. In contrast, a tax fixes the price of emissions at the tax rate but leaves the quantity of emissions uncertain. This trade-off raises essential questions for policy design: which form of uncertainty is a greater burden to society? What can be done to minimize that burden or maximize net benefits? A sizable economics literature has addressed these questions, dating back to Weitzman (1974) and others.

Taxes and cap-and-trade are, in some sense, extreme examples of the alternative market-based approaches that are available to correct an emissions externality. The government stipulates that emitters must obtain the "right to emit." These rights (typically called allowances or . . . [Full Text of this Article]


   Market-based Emissions Regulation and the Reserve-based Approach
 

   Advantages of an Allowance Reserve
 
Representing Marginal Damages across Cumulative Emissions
Expanding Political-Economic Flexibility
Addressing Concerns over Ability to Achieve Long-Term Targets

   Optimal Policy in a Dynamic Setting
 
Performance of a Tax Program
Performance of a Cap-and-Trade System
Why Dynamic Cap-and-Trade Can Deliver a Better Outcome
How Can an Allowance Reserve Enhance Efficiency?

   Implementation Issues
 
Ceiling Price and Reserve Size
Maintaining the Cumulative Cap versus Establishing a Range
Introducing Reserve Allowances to the Market
An Allowance Reserve Board or Legislative Specification?

   Conclusions
 

   Technical Appendix
 

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