Now that nearly everyone is agreed on the need for a market-based policy instrument to reduce CO2 emissions, the biggest unresolved question is whether to implement carbon taxes, tradeable emissions permits or some hybrid of the two.

I support tradeable permits, but I’ve never really spelt out my reasons for doing so. It’s important before doing this to observe that the differences between the two approaches are more limited than most of the discussion suggests. Both ensure the existence of a price for CO2 emissions and both can be set up to distribute the costs of emissions in a lot of different ways.

That said, tradeable permits have some significant advantages in my view. I have three main reasons for preferring permits, which I will list in order of significance.

First, while the natural starting point for both systems is one in which the government collects the entire implied value of emissions, either as tax revenue or as the proceeds from auctioning permits, the emissions trading system allows for (but doesn’t require) free allocation of some permits. Particularly in transitional stages when not all sources are covered, this can be used to offset unanticipated distributional consequences of the scheme, and thereby increase its political feasibility.* It’s important not to issue too many free permits, as was done with the first round in the European Union, but some limited issue might be beneficial. I don’t want to over-stress this point as much the same outcome can be achieved by paying cash compensation out of tax revenue.

Second, since we are uncertain about the elasticity of demand for emissions we are faced with a choice between allowing this uncertainty to be reflected in uncertainty about reaching the targeted level of reductions in emissions, uncertainty about the price, or some mixture of the two. Given the risk that we will fail altogether if individual countries fall short of their targets, I’d prefer some uncertainty about the price.

Third, and most importantly, the ultimate solution has to be an international agreement to reduce emissions in the most cost-effective way possible. The obvious way to do this is through the creation of international markets for emissions permits. Although a full-scale global market might be some way off, regional or multi-regional markets linked through something like the existing Clean Development Mechanism could be set up reasonably easily. By contrast, I can’t see how, in a world of sharply varying exchange rates, it would be possible to set up a coordinated global system of carbon taxes. I should say, though, that Warwick McKibbin had a piece arguing for something like this in the 7 July edition of the Australian Financial Review.

Whether or not these arguments are conclusive, it seems pretty certain that emissions trading (perhaps with some modest hybrid elements) is the way we are going to go. At this point, it’s more important to push for urgent action than to get hung up in disputes about the details.

* Obviously, if you’re strongly opposed to any compensation of existing emitters and are prepared to risk total failure rather than concede on point, this is a disadvantage rather than an advantage.