CO2 needs a price but taxes are the best way

The Kyoto protocol to fight climate change expires in 2012. The shape of a successor treaty is still in doubt, but one aspect seems certain: carbon trading will play a major role. A Financial Times investigation today reveals that carbon markets leave much room for unverifiable manipulation. Taxes are better, partly because they are less vulnerable to such improprieties.

Climate change poses a classic spill-over problem: individuals do not suffer the full burden of producing carbon dioxide, but society does. To equate the private cost to the higher social cost, governments can create markets for carbon, by using tradeable permits, or impose a tax.

So far, the preferred method has been tradeable permits. Creating markets for carbon has political advantages. They are easy to sign into law and even easier to execute. Instead of the optimal method of auctioning permits, governments have given them away. It is no wonder that energy producers are keen to participate in these schemes.

While short-term politics favour markets, taxes would be better in the long term, because industry needs certainty for investments years hence. A government committing to painful taxes signals the seriousness of its intentions.

Carbon taxes, offset by cuts in other taxes, are more difficult to eliminate than artificial markets.

Carbon markets have other problems. Above all, they fix the amount of carbon abated, not its price. Getting the amount of emissions a little bit wrong in any year would hardly upset the global climate. But excessive volatility or unduly high prices of quotas on carbon emissions might disrupt the economy severely. Taxes create needed certainty about prices, while markets in emission quotas create unnecessary certainty about the short-term quantity of emissions.

Both carbon taxes and markets put undue burden on the poor. Governments should counter such regressive carbon taxes by lowering taxes on labour. Yet most of the political appeal of markets is that they hide the true costs to consumers. That is why carbon markets exist in the first place. For this reason it is unlikely that governments would offset the invisible burden of markets by changing visible taxes.

Smart market design could overcome most problems with tradeable permits: price caps could prevent undue harm to the economy; and intelligent regulatory regimes could prevent other forms of gamesmanship. Yet markets are bound to be more complicated than taxes. When in doubt, keep it simple. Markets for carbon are potentially good. But taxes would be better.