Cap and Trade in China: Advantages over a Carbon Tax
September 19, 2016
By Thomas Lee, ENG’17, W’17
Despite this apparent procrastination as to the start of the trading system, China is poised to rein in its immense greenhouse emissions, as long as it can effectively design the market mechanisms. While a carbon tax is theoretically equivalent to permit trading in terms of cost-effectiveness for a given level of desired pollution abatement, the latter market-based solution to climate change may provide several advantages for China.
At first glance, a carbon tax seems much easier for China’s government to implement. For example, one Forbes blog claims, “Most economists agree that a carbon tax is far simpler and more efficient [than cap and trade].” While this efficiency claim is false (a cap achieves equivalent social welfare efficiency in equilibrium), there are significant administrative obstacles to enact a cap and trade system. For example, the government must communicate the new complex trading rules to industry participants and manage local corruption – less messy issues under a uniform tax.
Additionally, there are lapses in China’s measurement, reporting, and verification (MRV) infrastructure, crucial to enforcing permits under a cap. However, MRV is a common problem that must be improved in order to effectively levy a carbon
price as well. Moreover, China’s emission measurement accuracy problem is not as severe as sometimes claimed where international agency estimates apparently “can vary by over a gigaton for the same year.The large variations between the World Bank versus the Energy Information Administration (EIA) and International Energy Agency (IEA) estimates are actually due to the WB figures encompassing all sector emissions, while the latter two energy-focused agencies only publish emissions “from the consumption of energy”. Amid these administrative challenges, cap and trade may be preferable.
The most important advantage of an emission trading scheme over a carbon tax is the certainty in total emissions. The socially optimal level of emissions Q* coincides where the aggregate marginal abatement cost equals the marginal damage from a unit of pollution. A carbon tax sets the price at P* where this equilibrium occurs, whereas a cap sets the quantity of emissions allowed. When there is estimation uncertainty or structural changes, there is a tradeoff between the relative welfare effects.
The most realistic scenario for China is when the abatement cost curve actually shifts downward due to overall improved technological efficiency; for example, solar panel module costs have dramatically and consistently decreased to the point where solar power has reached grid parity in certain regions in China even without any current or future subsidies. This trend would likely continue. As illustrated below, the uniform tax would likely over-regulate – setting too high of a carbon price with too much abatement compared to the social optimum (assuming the MD curve is upward-sloping, which is reasonable given the nonlinear damages present in climate change). On the other hand, the cap would tend to under-regulate – the abatement price has collapsed while the total emissions quantity remains unchanging under control. Thus relative elasticities of the MAC and MD curves determine the comparative welfare effects.
Another source of uncertainty is the demand for the underlying negative-externality product. For China, there is reason to expect the reduction of demand for greenhouse emitting products, mainly coal: in 2015 carbon emissions declined by 1.5% due to decreasing coal usage, while GDP still grew 6.9%. This represents a fundamental decoupling between economic demand and emissions; the economic slowdown itself represents a leftward-shifting demand curve. As for the MAC decrease, there would be a tendency for over versus under-regulation, and relative elasticities determine welfare effects.
Irrespective of such a welfare tradeoff, the certitude of maximum emissions may be much more desirable to China. The Chinese government’s fulfillment of its existing international promises, rather than dynamically-adjusted welfare maximization. China’s intended nationally determined contributions (INDC) submitted officially to the UNFCCC states a goal by 2030 of peaking emissions and reducing GDP carbon intensity by 60% from the 2005 level. These goals have been reaffirmed through the recent bilateral agreement with the US and at COP21. From this international relations perspective, the usage of environmental economics via market-based carbon pricing is a way to achieve cost effectiveness for a given politically determined reduction level, rather than a prima facie way of calculating the theoretically optimal emissions level. So in this regard, cap and trade is preferable to a tax.
The most common criticism of the EU emission trading scheme is the over-allocation of permits, leading to historically collapsed prices. This situation arises precisely due to the abovementioned uncertainty in estimating the abatement costs and business-as-usual demand. However, the EU is implementing back-loading of permit auctions and establishing a market stability reserve to resolve the over-allocation problem. So it is true that these additional safeguards would render cap and trade even more complicated administratively than a simple tax, but the administrative control may actually prove desirable.
Specifically, an emissions trading scheme provides the government with built-in tools to manage distributional welfare. Under cap and trade, the Chinese government controls the initial allocation of permits. This jurisdictional flexibility may be important because China plans to utilize many different abatement options to actualize the abatements, including: increasing coal to gas fuel switching, increasing renewable utilization, re-forestation, and building energy efficiency. The abatement costs from these disparate industries are clearly very heterogeneous, pointing to the benefits of a market-based approach (either tax or cap) over a command-and-control scheme applying uniform standards. At the same time, the wide range of covered industries suggests that the Chinese government may have strategic political interests in promoting certain industries in line with economic or other goals. Theoretically, a tax can also be complemented with redistribution through transfer payments, but this would require additional framework whereas the permitting infrastructure in an emission trading system already enjoys this built-in flexibility. In other words, economic efficiency is determined at the margins through pricing, and industry support is achieved in terms of total firm wealth – both are more easily implemented under cap and trade.
Finally, a cap and trade system enables international participation. For example, China NDRC vice chairman Xie Zhenhua indicated that “Hong Kong would be welcome to participate in China’s national emissions trading scheme when it opens next year as the city’s sophisticated financial sector would benefit the market.”Moreover, there are plans for regional integration of emission trading systems in Asia, as well as the possibility of market integration with the EU ETS. There are at least two benefits from expanding cap and trade internationally. First, the fundamental economic advantage of a market-based approach compared to command-and-control arises from the heterogeneity of abatement costs between different firms; so incorporating the participation of more firms in more countries naturally increases the potential for efficiency gains. Second, market cooperation can spur greater trading liquidity, thus facilitating price discovery and reducing transaction costs. While a common tax might have been an option for the EU, a common carbon tax is obviously impossible for the cross-border links currently being considered for China’s upcoming cap and trade system.
In conclusion, understanding the Chinese central government as an international and political actor with strategic objectives helps to shed light on its choice of cap and trade over a carbon tax. Compared to command-and-control mandates, cap and trade offers cost effectiveness; compared to a simple tax, cap and trade maintains greater jurisdictional oversight, perhaps precisely due to the administrative complications often viewed as disadvantages.
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