The crucial contribution of the new pricing approach is the realization that cooperation matters most, not policy details and not special numbers. Since prohibiting cap-and-trade would be a huge barrier to cooperation, allowing cap-and-trade is essential. This requires a little flexibility, but not too much since cap-and-trade does price carbon.
We explain here how a cap could satisfy a price commitment. But perhaps more convincing is the list of climate policy experts that say it can work.
Joseph Stiglitz (Nobel Prize, 2005):
“raise the price of emissions (whether through a carbon tax or emissions caps)”
William Nordhaus (President, American Economics Association):
“the agreed-upon minimum price. … Some countries might simply use carbon taxes. Others might implement their commitment using a cap-and-trade mechanism…”
Martin Weitzman (Renowned Harvard environmental economist)
Nations or regions could meet the obligation of a minimum price on carbon emissions … a tax, a cap-and-trade system, a hybrid system, or ….”
Stéphane Dion (Chair of the UN’s COP 11 in Montreal):
“countries would each make a commitment to … a carbon price, … pricing carbon emissions through a tax or a cap and trade.”
Under cap-and-trade, permit prices fluctuate somewhat unpredictably, so a cap cannot guarantee a certain price. But the tighter the cap, the higher the permit price, so the cap designer has essential control over the carbon price.
Controlling Average Price. In the long run, the cap designer can control the average permit price. So the global price commitment should be to an average price. If this requirement is specified correctly it will interfere little with the cap, and the requirement will assure others that on average the global price is achieved.
A Sample Price-Compliance Rule. First note that average price in any time period is (carbon revenue)/(carbon emissions). Next note that carbon revenue under a cap is defined as the value of permits at the time they are retired. Now define:
Actual “long-run carbon price” (LRCP): A country’s average carbon price, counting all revenues and emissions from day 1 of the treaty.
Floor LRCP: The LRCP that would have been achieved with perfect day-by-day compliance except for a first-year grace period, in which a total failure to comply is assumed for calculation of the Floor LRCP.
Rule: A country’s actual LRCP, must be as high as its Floor LRCP at the end of each year.
Cap Compliance under the Sample Rule. Suppose for simplicity that the global price commitment was a constant $20/t, and a country set a cap that it estimated would result in a $20/t permit price the first year. If the actual prices was $30, then it would have accumulated a “compliance cushion” of $30/t because the grace period’s Floor LRCP is $0/t.
If the actual price was $10/t in the first year, then in the second year it would have to set a floor price on permits of $10/t to avoid the possibility of non-compliance in the second year. It should also tighten its cap slightly to try to raise permit prices to $20/t or more. In the worst case, it would again have a permit price of $10/t and would have used up its entire grace-period cushion. In this case it would need to set a floor price of $20 in the following year.
So a price commitment does interfere with a dreadfully weak cap by bolstering its permit prices. But this is what we want in order to assure other countries that there will be no free-riding. This assurance is necessary if we are to change countries self-interests for the better. No country should be allowed to adopt a weak policy either intentionally or by accident.
But if a country sets a reasonable or somewhat cautious cap from the start, or corrects it quickly when it sees it is too weak, its may never need to set a floor price above zero. And if it does need to set one above zero, that floor price may never bind. So this sample compliance rule will interfere not at all, or very little, with a cap-and-trade policy that is designed to comply with the global commitment.
Other Possibilities. It would also be possible to design a carbon-revenue-credit trading system that allows one country to pay another country for setting a higher price than required. This would protect the global average carbon price—the essential goal, while allowing national flexibility.
And, of course, most countries will (as the EU does now) mix cap-and-trade with fossil-fuel taxes. Fossil taxes can then be adjusted to make sure the cap retains (on average) its initial grace-period cushion without any reliance on a floor price.
Flexibility. It should be remembered that the current situation is extremely flexible to the point of being chaotic. So minor controlled flexibility is not a significant problem. Even in the EU, which has the most organized climate policy, cap-and-trade prices have been under €2/ton while fossil-fuel taxes (on gasoline) have simultaneously been above €200/ton. Obviously we should tolerate considerable flexibility in the global carbon price, especially at the beginning.