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  • 27th Sep 2019

Designing emissions markets carefully

Marty Weitzman in memoriam

Professor Marty Weitzman, a giant in the field of environmental economics, passed away exactly one month ago. On his ‘month’s mind’, we reflect on Marty’s work on pricing carbon emissions. 

I never met Marty in person, but he and I had been discussing his work over email during the past five years. His work helped answer the question: what is the best way to increase the price of carbon? The two main competitors are as follows:

  • Cap and trade systems set an emissions quantity ‘cap’. Market participants then bid up or down the price of emissions allowances (the ‘shadow’ carbon price).
  • Carbon taxes set a price on emissions directly. It is then the quantity of emissions that is determined by market participants, based on that price and their own costs and revenues. 

At university, while studying economics, I became obsessed with the question of which system was superior. I entered college in the US just before Barack Obama was elected President amidst large Democratic majorities in the House of Representatives and Senate. This Democratic trifecta meant comprehensive climate policy was squarely on the agenda, and the question of whether that policy should be based on cap and trade or a carbon tax was a topic of intense interest amongst economists and policymakers. In this intellectual milieu, I worked with Professor Larry Goulder to create a review of the relative attractions of the two systems. 

We found they were equivalent in many ways. A cap and trade system that results in allowance prices of £25 looks a lot like a carbon tax of £25/tonne. 

But one difference that we noted came from early work by Marty. Marty showed that the systems may perform very differently once we acknowledge that policymakers may be uncertain about firms’ costs and revenues. For example, if the cap ends up being more difficult for businesses to achieve than expected, it can lead to unexpected spikes in allowance prices. 25 years later, a real-world illustration of this problem happened in California, where prices for permits for NOx (a pollutant involved in industrial production and electricity generation, subject to a type of cap and trade system) rose far above expected levels in the summer of 2000, contributing to a state electricity crisis. 

After Larry and I published our review, Marty and I developed a friendship over email. In many ways, Marty was a ‘pure theorist’ in the classic model-building economist frame. But as a theorist, Marty was also deeply invested in understanding the implementation of emissions pricing systems. Today, many cap and trade systems have price ceilings and/or price floors, indeed partly to avoid the problems Marty had warned could arise when cap-based systems lack any mechanism to stabilise prices. For example, the UK has a carbon price floor complementing the EU’s cap and trade programme. 

My last emails with Marty discussed his concerns about how countries’ emissions pricing systems would interact with each other. He was working on a paper pointing out the ways cap and trade systems’ price ceilings and floors make it more difficult to link cap and trade programmes across borders because of uncertainties about which country enforces the price floor or ceiling. For example, if the UK and EU have a linked cap and trade program, each with a price ceiling, and allowance prices approach that ceiling, power plants would be able to pay a fee for their emissions at the ceiling price (instead of buying allowances). But it would be unclear who would enforce the fee – and collect the revenue. This uncertainty indicates another way that carbon taxes may be superior to cap and trade systems, once we consider the complexities of linking programmes between countries. 

When I first started studying environmental economics, my view was that the ‘cap and trade versus carbon tax’ debate was overheated. But Marty’s work began to change the way I thought about the debate. One further point in favour of carbon taxes, or cap and trade systems with price floors and ceilings, is how the system interacts with other regulation. It turns out that pure cap and trade programmes (ones with no price ceiling or floor) neuter the emissions-reducing effects of other regulations. 

I remember noting this to Marty. He wrote back: ‘I am not sure how potent this nested-leakage effect is, empirically. It would be a real contribution if someone tried to measure the strength of this effect empirically.’ Marty was constantly challenging his own instincts and models, searching for places where the models might rely on excessively simplifying assumptions, and looking for empirical corroboration. BIT is increasingly considering questions of ‘market design’ – for example, in tackling online harms, improving employment policies and programmes in labour markets, and regulating utility markets. We stand on the shoulders of giants like Marty in carefully considering the second- and third-order effects of regulation and policy. 

In the area of climate action, BIT’s view is that the optimal ‘market design’ includes changes to choice architecture that cause more efficient behaviour by consumers and producers, but also a higher price on carbon. The UN Climate Action summit earlier this week has only reinforced the urgency of tackling climate change. Behavioural insights tell us that human beings are ill-suited to addressing climate change without decisive government action. Our view is that governments should pursue pro-sustainability nudges and regulation directly increasing the price of carbon. 

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