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Do U.S. Policy Makers Have Better Alternatives to Cap and Trade?

Ian W. H. Parry and Roberton C. Williams III

May 2011, English

In 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 Land Policy Conference of 2010 and is Chapter 13 of the book Climate Change and Land Policies.