It is nice to see that Willem Buiter shares my skepticism about Cap and Trade Carbon schemes relative to Carbon Taxes. It is nice because his London School of Economics credentials eclipse mine, and those are just the beginning of why he is held in high esteem in both financial and economics circles. After showing why Cap & Trade and Carbon Taxes are equivalent in theory under restrictive assumptions regarding uncertainty and/or market efficiency. Buiter explains in Today's Financial Times why he favors a simple Carbon Tax over Cap & Trade. Go read it! Here's a snip:
Cap & Trade is a tax on carbon emissions - fortunately! Willem Buiter, Ft.com, June 12, 2008: … An argument in favour of carbon taxes over cap & trade is that cap & trade requires an efficient secondary market. As we know from recent experience, financial market efficiency cannot be taken for granted. While the instrument that is traded in the secondary market under cap & trade is relatively simple, compared to Residential Mortgage-Backed Securities based on US subprime mortgages, cap & trade does have this additional link in the chain, and is therefore vulnerable to all the familiar financial market pathologies, from market manipulation to illiquidity.
The economic equivalence of carbon taxes and cap & trade is exact only in a world without uncertainty, or in a world with uncertainty but with complete contingent claims markets for risk trading. In the real world, where there is uncertainty and markets are incomplete ….
Why then do politicians and outfits like BP prefer cap & trade to a carbon tax? The politicians prefer it because the cap & trade scheme, while economically equivalent to a tax, will not count as a tax in the traditional record-keeping manuals. It does not add to the official 'tax burden' the opposition likes to bash you around the head with. You can present cap & trade in a way that hides/obscures the fact that for it to work, that is, for it to reduce emissions, it must be equivalent to a tax by increasing the marginal cost of emitting CO2E; however, it does not look like a tax and will not show up in conventional tax burden calculations. Lack of transparency means absence of accountability. That is why non-transparent arrangements are universally valued by politicians.
A second reason is that with cap & trade, you can distribute the shadow tax revenue associated with the cap & trade scheme (that is the amount of revenue you would be able to obtain for the permits in a transparent, competitive auction) in a non-transparent manner. Give-aways through explicit grants or subsidies are not as easy. There are parliamentary committees scrutinizing revenues and outlays; there may be institutions like the UK National Audit Office that can ask bothersome questions.
Life is easier with the initial allocation of permits. You can, for instance, hand out the permits free of charge to your friends (including the heavy historical polluters). This is also the reason, I believe, that the heavy emitters, including BP, favour cap & trade over taxes. They believe that the initial allocation of free permits will favour them. There is this crazy notion that past heavy polluters should not be hit too hard by schemes to reduce CO2E emissions, and that they should therefore be given gratis allowances of permits that are related to their recent past emissions record. I can see no efficiency reason in favour of this, and many a fairness argument against it, but the argument carries weight in the unreal real world.
When the problems associated with running an efficient secondary market for CO2E emissions permits and the political economy of the non-transparent initial allocation of the CO2E emissions permits are taken into account, I believe that, on balance, explicit carbon taxes are better than cap & trade.