The practicalities of emissions trading

• Joshua S. Gans, John Quiggin
• Risk and Sustainable Management Group

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20 November 2007With both major parties proposing to develop an emissions trading regime, this paper discusses some important practical issues and trade-offs.

In the past year, climate change has moved from political controversy to political consensus; at least, in relation for price-based policies the need to limit emissions. Uncertainties remain but with both major parties proposing to develop an emissions trading regime, it is timely to highlight some important practical issues that will face them on that path.

In writing this, we take the case for action as given. There is a scientific consensus that global warming is taking place and that it is, in large part, due to the actions of humans on the planet. The policy prescription is to limit net emissions although the precise technologies that will likely carry the load have yet to be developed. Consequently, in the short-term, behavioural responses are required and to engage in that appropriately a price must be set.

Economists disagree as to the way in which a carbon price might be generated. One set of economists (including the Pigou Club led by Greg Mankiw) support a carbon tax. This would fix the price for emissions, leaving the quantity to be determined by the market. Concern has been expressed that reliance on national carbon taxes may forgo opportunities for international cooperation. Other economists favour emissions trading, which involves the quantity being set by governments and the price by markets.

The issue with emissions trading is that it is largely unknown how it will operate on national and international scales covering a broad range of activity. As with the design of market mechanisms, some caution needs to be applied. It is that need and the trade-offs inherent in it that we address here.