7 - Taxes and Caps as Climate Policy Instruments with Domestic and Imported Fuels

Summary

Introduction

Most economists and policy makers today seem to find few fundamental differences between setting an emissions tax and setting a cap on total emissions with free trade of emissions rights among emitters, as an effective policy tool for reducing global carbon emissions. This chapter demonstrates that such a view is generally incorrect. The two climate policy instruments are not (and are often far from) equivalent when different groups of countries have antagonistic interests in fuel markets. I will make the assumption, considered realistic, that these markets and policies are dominated by two groups of countries, with clashing interests: one group that consumes most fossil fuels, and that defines and implements climate policy; and another group that produces fossil fuels. Importantly, both producer and consumer countries tend, as groups, when their within-group policies are coordinated, to behave noncompetitively in the fossil fuels markets. I then show that tax solutions typically dominate cap-and-trade solutions, as the most efficient and effective climate policy instruments from the point of view of fuel-consuming countries.

I consider a highly stylized set-up in which the world economy is divided into two blocs. The first bloc, called region A, consumes all fossil fuels and defines and implements a climate policy. I assume that region A consumes two fuels: fuel 1, imported entirely from the other region (think of oil), and fuel 2, produced in its entirety within region A itself (interpreted alternatively as coal, natural gas, or renewables).