Policy Court

Opinion of the court, delivered by William Leich, signed by Nicole Adams:
Before recessing for the July 4th celebrations, the U.S. House narrowly passed an energy bill that seeks to tackle climate change through an emissions trading program.  The chief provision of the bill, dubbed the “cap-and-trade” program, is likely to put a cap on economic growth.

Under the plan the federal government releases emission permits—allocating 85% to companies at no cost and auctioning the rest—each of which allow recipients to emit a specified amount of greenhouse gases.  If companies need to emit more than their permits allow or do not need to emit as much as they are permitted to, they can exchange credits to pollute on the open market.

This emissions capping system is a quantity instrument because it guarantees certain emission reductions each year.  And although quantity instruments are often more damaging to economic growth than price instruments like taxes, they can solve environmental problems that are sensitive to changes in pollution concentrations, like waste water or acid rain.

In the context of global warming, however, emitting three billion tons of carbon dioxide one year and seven billion the next, has a similar impact to releasing five billion tons both years.  Thus a price instrument that can flex with the business cycle makes more sense than cap-and-trade; what we need is a carbon tax.

Instead, America could an emissions cap whose impact on the economy will be varied, unpredictable, and easily exploited.

At the top of the business cycle, demand for the consumer goods that drive carbon emissions will be at its highest, and therefore emission credits will be highly sought after and consequently very expensive.  This can drive up inflation, which is already—at least theoretically—at its highest during periods of high growth.

Meanwhile, a manufacturing company that recognizes emissions credits to be overvalued during growth could sell its credits and temporarily shut down its factories.  When companies are paid to produce nothing, items become scarce and price levels rise; this is exactly what Americans saw in the summer of 2008, when corn prices rose in the heyday of ethanol because production didn’t respond to price signals—a consequence of farm subsidies that pay farmers to leave fields unused.

Ultimately, both these phenomena will heighten inflation’s sensitivity to economic growth, which means when the economy expands too quickly inflation will result at a faster pace.  That alone, could trigger a slowdown.

When a recession does develop, the emissions trading program will hurt the economy and fail to deliver on its environmental promises.  Depressed demand for consumer goods during economic contraction will leave many companies with surplus emission credits; high supplies and low demand will make them, effectively, worthless.  Furthermore, companies may be able to cut costs  by reverting to less efficient means of production—thereby producing fewer goods but emitting the same amount of carbon since there will be no incentive not to.  Not only will a temporary movement away from environmental efficiency harm the environment, but it will also enable companies to produce goods at lower costs, heightening the risk of deflation during the part of the cycle when it’s already highest.

The past six months have proven that deflation and recession can feed on each other.

As low-cost emission credits kill the financial incentive for carbon-efficient production methods during recession, the motivation for environmental innovation will disappear.  Company research funding will come and go with economic growth, and any environmental innovation difficult.

But besides problems with inflation sensitivity and fickle environmental benefits, the cap-and-trade system also raises the issues on taxing imports.  The energy bill passed by the House contains provisions that could tax imports from countries whose carbon emission guidelines Congress deems less rigorous than the U.S. system.  Given the volatility in the cost of emission credits and the difficulty in measuring how much the cap-and-trade program actually costs American companies, tariffs on imported goods will probably be larger than the effective tax of the program and thus protectionist.  Traditionally, protectionism at home is fought with protectionism abroad.  The result is usually globally recession.

Congress could avoid the pitfalls of emissions trading by substituting a greenhouse gas emission tax.

Taxing emissions would give consumers and businesses a clearer idea of the cost of polluting.  That way taxes on imports from countries without strict carbon emissions laws can be more fairly priced, preventing protectionist retaliation from big manufacturers like China and India.  Moreover, a tax would guarantee that the drive for efficiency is a constant one, not one that recedes at the bottom of the business cycle; meaning that companies can’t revert to old technologies during recession and innovation can be more easily achieved.

But most importantly, since a tax wouldn’t rise during expansion and fall during contraction the way the cost of the cap-and-trade system would, it won’t increase inflation’s sensitivity to growth.  The tax won’t create recessions and won’t deflate prices during them when they inevitably come.

The only environmental drawback of an emission tax would be the variability of annual greenhouse gas emissions, which would mirror economic activity.  Still, steady tax hikes would reign in long-term emissions as well as any credit trading program could.

Particularly in a time of turmoil, Congress ought to recognize that the economy doesn’t grow at a constant pace; rather it grows in spurts.  Their energy bill ought to reflect that.  It should allow for the ebb and flow of the business cycle without exacerbating its volatility.  And it can’t be an excuse for protectionism; we tried that in 1930.

David Lamb, concurring:
Just how to balance economic growth with environmental protection is a struggle that has faced every president since Lyndon Johnson.  Climate change and greenhouse gas emissions, both because of their global nature and historically distant consequences, have always been particularly thorny issues; after all, why should U.S. workers sacrifice their living standards for the sake of the planet if Chinese workers will get rich off of their comparative advantage that results from an American emissions law?

They shouldn’t.

But American workers also can’t disproportionately discriminate against imported goods.  The majority opinion handles the prospect of protectionism well, saying  that a tax shows the cost of domestic emissions more clearly than a emission trading program and therefore allows for tariffs on goods “from countries without strict carbon emissions laws [to] be more fairly priced.”

As the Senate looks to pass its own energy bill, it ought to implement a carbon tax for that reason, and add a clause that guarantees tariffs are proportional, per good, to the carbon tax.  This means the bill needs to require foreign companies to report their emissions, needs to ensure reported numbers are accurate, and needs to provide a means for foreign companies to appeal the tariff if it costs more than producing goods domestically and paying the carbon tax would.

Fairness in global trade is especially important because the Treasury needs China’s money; without it, low demand for Treasuries would drive yields too high to sustain.  If China, Japan, and other exporters, find Congress’ energy bill to be protectionist, they could raise their own tariffs, cutting off global trade and preventing Americans from reaping the comparative advantages of countries abroad.

I side with the majority, supporting that an emissions tax ought to replace the cap-and-trade system for the reasons outlined in the court’s opinion, emphasizing only that the resulting “carbon tariffs” must ultimately be fair ones.