Carbonomics: The Price vs. Quantity Debate

Carbonomics: The Price vs. Quantity Debate
By Kate Galbraith

If the nation’s goal is to reduce greenhouse gas emissions and promote the development of clean energy, is it easier to do this by managing the price of emissions and renewables, or by fixing the amount by which they are to be reduced (emissions) and produced (renewables)?

This may sound like an obscure policy distinction, but it is an old debate among environmental economists — and one that has gained new import in the debate over the climate bill passed by the House of Representatives last week.

“The issue of prices vs. quantities resurfaced with a vengeance in the climate change debate about which control mechanism should be favored,” said Martin Weitzman, a Harvard economics professor, in an e-mail message.

Mr. Weitzman is considered by many economists to have written the seminal paper on this subject in 1974 — a time when, according to Mr. Weitzman, most economists supported a tax on pollution.

“There was almost no discussion about the quantity side, such as cap-and-trade,” he said.

Cap-and-trade sets a quantity target: the House bill requires an 83 percent reduction in greenhouse gas emissions (compared with 2005 levels) by 2050.

A carbon tax, in contrast, puts a price on emissions as a way to spur reductions.

A similar debate arises in the promotion of renewable energy, noted Jurgen Weiss, a managing director of Watermark Economics, a Boston-based consulting group. Here again, the House climate bill goes with a quantity target: It would mandate that the nation get 15 percent of its electricity from renewable sources by 2020 (with another 5 percent savings coming from efficiency).

Many individual states already have similar requirements, called “renewable portfolio standards” — California requires its big utilities to get 20 percent of their electricity by 2010 from renewable sources, for example.

By contrast, Europe has typically opted for “price” signals to aid the development of renewable energy. Utilities in Germany and other European countries, for example, encourage the development of expensive solar power by guaranteeing high payments to producers of renewable energy.

“If we knew that, O.K., we need to stabilize greenhouse gas concentrations in the atmosphere at 550 parts per million,” Mr. Weiss explained, “and if we end up with 552 parts per million then we’re going to have Armageddon — in that case setting a quantity target is probably preferable to setting a price.”

Of course, scientists do not have that level of certainty about exactly what level of pollution will trigger climate disaster. Price targets, by contrast, can provide certainty about how much money will be spent. They can also make a system easier to administer.

“A surprisingly large (to me) number of prominent economists in this area supported a carbon tax, but to no avail,” noted Mr. Weitzman of Harvard, who is also in the carbon tax camp.

But setting a price target carries the risk that the price will be wrong — too high or too low to achieve the objective — although it can in theory be adjusted over time.

Speaking of feed-in tariffs, Mr. Weiss said, “In Europe, these things get oversubscribed, which is kind of an indicator that you’re overpaying.” A quantity system, in theory, prevents overpaying (or underpaying), although it can also lead to big price swings (as evidenced in Europe).

Perhaps because Europeans grumble less about taxes, Europe has been more open to direct price management than the United States. To be sure, the European Union as a whole has implemented a quantity-based cap-and-trade policy to reduce greenhouse gas emissions; but a few northern European countries have also tried out a carbon tax. Feed-in tariffs have also become a staple of European policies.

In the United States, by contrast, quantity levers are strongly favored, arguably because American politicians are loath to explicitly lay out the costs of their policies.

(Some Republican opponents of the House climate bill have taken to calling cap-and-trade a “carbon tax.”)

In the real world, of course, the ultimate test of any system is its design, whether it is based on price, quantity or — as often happens — a combination of the two.

There is plenty of room for fudging. California, for example, is virtually certain to miss its 20 percent renewable energy requirement by next year. And a carbon tax can always be ratcheted down under political pressure or, with the aid of loopholes, dodged.