Cap and Trade Policy Paper

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Introduction:
The issue of carbon emissions is an important one not only from an environmental perspective but also an economic one. While reducing carbon emissions is an important one for the health of human beings as well as that of the environment, the larger question is what type of policy strategy is best for both reducing such emissions which might have an impact on efforts to mitigate the effects of pollution on climate change. While ther are options to consider which does not rely on economics-- technological or output standards achieved by command and control regulations--they are often fraught with political resistance by industry because they do not allow industry to make any choices or play a role in solving the problem of excessive emissions and the burden that these emissions place on others. Instead of such draconian measures based on fiat, the preferred options rely on economic tools instead to provide incentives to industry to police itself by either incenting investment in emission-reducing and/or energy saving technologies or to reduce production in line with the total/social-costs rather than just the private/ producer-costs of production. Two such economic policies to consider in this regard are emission taxes and cap-and-trade policies.

Overview of Policy Problem: Carbon emissions reduction
Consider a company that faces an increasing marginal pollution abatement cost curve as in the Figure 1. Left unregulated it will choose not to reduce its carbon emissions (a.k.a abate carbon emissions) and avert facing the costs of abatement represented by the area underneath the marginal abatement cost curve represented by area (B + C + D) in the diagram below. Figure 1: Marginal Costs and Marginal Benefits of Reducing Carbon Emissions [pic]

Source: Econ 101: Carbon Tax vs. Cap-and-Trade, 2012, n.pag. Suppose that policy analysts have determined that the economically efficient level of pollution abatement occurs at the point where marginal benefits of abatement equal the marginal cost costs of abatement as is suggested in economic theory. The resulting level of carbon emissions is e* (reduction in emissions is measured from the far right in the diagram above to the point e*). The question is what policy to follow to achieve e*: either some type of fiat policy involving either some type of output restriction or requiring use of a particular pollution-control technology or some type of policy that involves financial incentives to reduce emissions. This paper hypothesizes that policy options involving economic incentives are preferable to those options that involve regulatory fiat.

Specification of Economic Policy Models:
1) A Carbon Emissions Tax:
One policy instrument that can be used to achieve this level of abatement is to set a tax where marginal benefit equals marginal cost -- represented by the horizontal "tax" line in the Figure 2 below. Under such a scheme, the polluter will find that it is cheaper to reduce carbon emissions so long as the marginal cost is lower than the tax. Since the tax bill (A + B) is great than the marginal abatement cost bill (B) to the left of the point e*, the firm will choose to reduce emissions up to the level of C with the remaining emissions level indicated in figure 2 measured from the right in the diagram. To the right of e*, the marginal abatement costs, represented by areas C + D, are greater than the tax bill (area D) so the firm will choose to pay the tax and continue to emit pollutants beyond e*. Figure 2: The Carbon Emissions Tax

[pic]
Source: Econ 101: Carbon Tax vs. Cap-and-Trade, 2012, n.pag. So long as the marginal costs and benefits of abatement can be known with certainty, an emissions tax can be set at the point of intersection of these two measures resulting in an efficient level of pollution emissions at e* with total abatement costs (including taxes paid) to the polluter of area B+D and...
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