Do U.S. Policy Makers Have Better Alternatives to Cap and Trade? (Conference Paper)

Author(s): Parry, Ian W.H. and Williams, Roberton C. III
Publication Date: May 2011

16 pages; Inventory ID CP217-7-13; English

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This paper appears as a chapter in the volume Climate Change and Land Policies. Use of this paper should include the following citation: Parry, Ian W.H. and Williams, Roberton C. III. 2011. "Do U.S. Policy Makers Have Better Alternatives to Cap and Trade?". Climate Change and Land Policies, eds. Ingram, Gregory K. and Yu-Hung Hong. Cambridge, MA: Lincoln Institute of Land Policy.

Abstract

The authors of this paper, Ian W. H. Parry and Roberton C. Williams III , argue that traditional benefit-cost assessments of different environmental policies often assume that the economy is in a Pareto optimum. Thus, additional welfare costs generated from interactions between the proposed environmental policies and pre-existing distortions created by other taxes are ignored. These interactions can increase the costs of proposed programs such as cap and trade and carbon taxes unless the emissions allowances are auctioned or tax revenues are used to reduce other tax distortions.

Focusing on the energy sector, the authors argue that cap and trade in the United States would increase domestic gasoline prices, which would undermine the global competitiveness of U.S. industries and impose a heavy burden on low-income households. Depending on whether the revenues from auctioning allowances were used to mediate these adverse effects, the result of a cap-and-trade policy could be more costly than regulation or other comparable policies. The estimated additional costs would be about $22–60 billion for a 5–15 percent reduction in CO2 emissions. Carbon taxes would induce labor to substitute work for leisure, thereby increasing the welfare cost by 15–25 percent. One way to avoid the labor loss would be to establish a revenue-neutral principle that mandates the government to use the new collections to offset other tax distortions.

Regulations would have weaker impacts on energy prices and revenue generating power than cap and trade and carbon taxes. Hence, they would have relatively few interactions with the preexisting distortions and create no distributive effect. Combining regulatory policies such as a CO2 emissions standard with energy-efficiency standards for the energy sector may be preferable, because these approaches would avoid large increases in energy prices, which is a major political concern in formulating climate change policy. In this respect, regulatory approaches may be more cost-effective than market-based instruments. Parry and Williams, however, caution against any generalization of their analysis, because the specific design of the market-based and regulatory instruments could make a huge difference in their comparison.

This paper was presented at the Lincoln Institute’s annual Land Policy Conference in 2010, along with numerous other papers on climate change and its impact on land policy. It is included as Chapter 13 in the book Climate Change and Land Policies.

Climate Change and Land Policies