With the recent passing of the climate legislation in the US Congress it is important to look at two aspects of a cap and trade system. One is the effect of free permits and the second the value of carbon offsets.
Good lesson for the Australian ETS. Both links are the courtesy of Greg Mankiw.
On the free permits:
In simple economic models, a cap-and-trade system can be identical to a carbon tax. If the government sells all of the permits to firms at auction, it raises the same revenue as if it had imposed a tax on carbon. Like a carbon tax, a cap-and-trade system is a market-based regulatory mechanism to reduce carbon emissions. These mechanisms impose a cost on carbon emissions by requiring emitters to either pay a tax or obtain a permit. Ideally, this cost should be equal to the environmental damage caused by emissions. Market-based solutions tend to be the most efficient regulatory approach for correcting environmental externalities because producers and consumers are left free to choose the most cost-effective way to reduce emissions. This efficiency can be lost under regulatory systems that dictate particular ways to reduce emissions.
Therefore, under a system of free permit allocation, the stockholders of companies that receive free permits would receive windfall gains. A cap-and-trade system with freely allocated permits is equivalent to a carbon tax in which the tax revenue is given to stockholders. This gift does not provide the economic benefits of a reduction in taxes on business investment, because the gift is not linked to firms’ current investments.
On Carbon offsets:
So what is the problem with offsets? In a nutshell, it is a problem of measurement. One of the nice features of a cap-and-trade program is that it is fairly easy to measure emissions. The existing acid rain cap-and-trade program requires power plants to install sulfur dioxide monitors in their smoke stacks, which provide precise information to the Environmental Protection Agency at low administrative cost. (The acid rain program does not allow sulfur dioxide offsets.) For a carbon cap-and-trade program, emissions would be measured based on the carbon content of different fossil fuels, which is also a relatively straightforward procedure. But offsets require the measurement of emission reductions, rather than emissions. This simple difference introduces a host of problems, because it is awfully difficult to know what would have happened to emissions absent a given offset project. For example, planting a tree will only lead to a net reduction in carbon emissions if 1) the tree would not have been planted without the offset provision, and 2) the tree will not be subsequently destroyed after the offset purchase takes place. If these two conditions, known as additionality and permanence, are not met, then offsets will not amount to real reductions, and allowing them will loosen the pre-established emissions cap.
The House learned this lesson the hard way. Shortly after purchasing carbon offsets from the Chicago Climate Exchange, the Washington Post reported that the emissions reductions were rather illusory. To take just one important example, the House spent $14,500 to pay farmers for carbon-reducing “no-till” farming, even though the practice was started prior to the purchase of the offsets. Farmers might have been motivated to practice no-till farming to reduce fuel use or to qualify for federal soil-conservation funds. By failing to meet the additionality requirement for offsets, the money spent by the House on no-till farming did not result in the intended amount of carbon reductions.