Question

McKibbin and Wilcoxen (2002) provide a detailed analysis of the policy design challenges that attend choosing between a carbon tax and an emission trading scheme (ETS). The textbook answer suggest that both will be efficient. However, the tax effectively sets price and the policy maker might need to iteratively adjust the tax to impact on the quantity of pollution. In contrast, an ETS sets the quantity of pollution and allows the market for permits to establish a price. Read the article by McKibbin and Wilcoxen carefully, especially pages 116-122. Explain the benefits of a tax versus an ETS and vice versa and the role of uncertainty. Why do the authors settle on a hybrid policy choice? (Maximum word limit 350 words)

Answer 1

The key issue here is the relative slope of the benefit and cost curves associated with abatement. In simple terms, if the benefit curve is steep and the cost curve flat, then an ETS will be favoured. The logic here is that a tax (which you will recall adjusts the price but not directly the quantity) set too low will not impact on emissions at all and if set high will force emissions close to zero, even though the benefits don’t justify it. If the benefit curve is flat and the cost curve steep then a tax is preferable to an ETS.

Recall that an ETS sets the quantity rather than price (the latter determined by the demand for permits). Thus, when the marginal cost of abatement is uncertain the capping of emissions (via an ETS) can give rise to very large prices for permits; much higher than any additional benefits. McKibbin and Wilcoxen (2002) argue that given the evidence on greenhouse gases, a tax is likely to be preferable to an ETS, That said, a carbon tax has significant political liabilities (ask the former Labor government).

The significant transfers from firms to government also give rise to substantial distributional challenges. The notion of a hybrid policy involves long-term tradable permits (as per an ETS) and some shortterm (i.e. annual) permits; the latter effectively acting as a tax. The idea of a hybrid system is that it avoids the disadvantages of the tax and ETS systems under conditions of uncertainty