EMISSIONS TRADING VERSUS POLLUTION TAXES: PLAYING "NICE" WITH OTHER INSTRUMENTS.

• Author: Driesen, David M.

1. INTRODUCTION 31 II. EMISSIONS TRADING, TAXATION, AND THE CONTINUING ROLE OF OTHER POLICIES 35 A. EMISSIONS TRADING. 36 B. POLLUTION TAXES. 41 C. THE CONVENTIONAL WISDOM 44 ON WHICH IS BETTER. D. THE USE OF SUPPLEMENTAL 51 POLICIES ALONGSIDE TRADING OR TAXES III. PLAYING NICE: A 55 COMPARISON BETWEEN TAX'S AND TRADING'S EFFECTS ON THE ADOPTION AND SUCCESSFUL IMPLEMENTATION OF SUPPLEMENTARY POLICIES A. TAXES AND THE 55 EVOLUTION OF ADDITIONAL PROGRAMS B. TRADING AND THE 56 EVOLUTION OF ADDITIONAL PROGRAMS C. THE STRENGTH OF 59 TRADING'S DISCOURAGEMENT OF NEW POLICIES IV. SHOULD WE WANT 62 MARKET-BASED INSTRUMENTS TO PLAY NICE WITH OTHERS? A. COST EFFECTIVENESS AND 62 THE CASE FOR SINGLE MARKET-BASED INSTRUMENTS B. IMPERFECT INFORMATION, BOUNDED 65 RATIONALITY, AND THE THEORY OF THE SECOND BEST C. ALLOCATIVE EFFICIENCY AND 67 ADDRESSING ANCILLARY RISKS D. ALLOCATIVE EFFICIENCY AND SUBOPTIMAL 69 MARKET MECHANISMS E. AVOIDING DANGEROUS CLIMATE 70 DISRUPTION AND SUPPLEMENTAL MEASURES F. Why Not Strengthen the Market Mechanisms? AN EVOLUTIONARY AND 71 DYNAMIC PERSPECTIVE. 1. TECHNOLOGICAL INNOVATION 71 2. POLICY EVOLUTION AND 74 ADDITIONAL MEASURES. G. IMPLICATIONS, ADDITIONAL RESEARCH, 77 AND A CAVEAT. V. CONCLUSION 80 I. INTRODUCTION

   In 2013, Dutch electricity producers and environmentalists reached an agreement to phase-out the Netherlands' 1980s vintage coal-fired power plants by 2017. (1) Coal-fired power plants around the world emit more carbon dioxide than any other pollution source. (2) And carbon dioxide constitutes the most important greenhouse gas unleashing global climate disruption, which threatens the planet with higher average temperatures causing sea level rise, inundation of populous coastal areas, drought, more violent weather events, and widespread ecosystem destruction. (3) Because of the importance of fossil fuel use generally and coal-fired power in particular to global climate disruption, climate experts recommend replacing coal-fired power with clean energy as quickly as possible. (4) But governments have considered wholesale replacement of coal-fired power impossible, at least in the near term. So, no country has phased out coal-fired power to address global climate disruption. (5)

   The Dutch phase-out agreement offered the potential to establish a model with important implications for governments around the world. (6) Because the Netherlands is an advanced industrial society with substantial greenhouse gas emissions, the successful implementation of this agreement might constitute an important step toward demonstrating the plausibility of phasing out coal entirely. (7) In order to implement this agreement, the Netherlands would have to confront the challenge of powering a modern industrial economy with cleaner energy, including how to develop more renewable energy and integrate that intermittent energy into an electricity grid. (8) Doing this successfully would likely create demand for more advanced technologies, lower their costs, and show how all of this could be done. If successful, other countries might well follow suit, creating a new sense of what level of ambition is possible for climate policy. This enhancement of ambition matters because, in spite of significant progress at the recent Paris Conference on global climate policy, fulfillment of existing national pledges of greenhouse gas emission reductions will not suffice to prevent dangerous climate disruption. (9)

   The Dutch government's competition authority, however, derailed this agreement between electric utilities and environmental groups because of how it would interact with the European Union's Emissions Trading Scheme (ETS), the first multinational emissions trading program aimed at reducing greenhouse gas emissions. (10) Absent an emissions trading program, phasing out the most important source of greenhouse gas emissions in a major industrial country would directly add emission reductions to the global effort to avoid dangerous climate disruption. Reductions matter a lot to the low-lying Netherlands, which faces an existential threat from rising seas. (11) But under a trading program, phasing out coal-fired power in the Netherlands might not reduce net greenhouse gas emissions. (12) Instead, the pollution reductions could generate credits for greenhouse gas emission reductions, which Dutch utilities could sell to other polluters in Europe. These other polluters would then use these credits to justify not lowering their own emissions, as they would otherwise have to do (absent a credit purchase) to meet their obligations under the ETS. (14) Thus, the phase-out of coal-fired power in the Netherlands might simply redistribute the reductions already required by the ETS. Furthermore, this coal phase out would likely raise the cost of reducing greenhouse gas emissions in the Netherlands, as Dutch utilities (and ultimately Dutch citizens) would likely bear the cost of this ambitious transformation. (16)

   Traditionally, scholars debating the relative merits of emissions trading and pollution taxes as instruments of environmental policy have not considered these market mechanisms' interactions with other policies, like the Dutch phase-out proposal. Instead they have considered these marketbased environmental protection instruments in isolation. (16) But governments almost never rely on taxes or trading exclusively to address significant environmental problems. (17) Instead, these instruments almost always operate in conjunction with other policies. (18)

   The existence of multiple policies raises the question of which of these two market-based instruments works best with other environmental policy instruments. This Article focuses on this question. It compares trading's interaction with supplementary policies to tax's interaction with supplementary policies, primarily in the context of global climate disruption. But in the end, it considers the question of whether the lessons drawn from the climate context apply to other contexts.

   Consideration of the ability to "play nice" with other instruments as a factor in the debate about whether taxes or emissions trading is preferable constitutes a new contribution to the instrument choice literature. But recently, literature has appeared discussing the desirability of supplementing market-based mechanisms with other programs or simply describing how interactions between market-based mechanisms and other programs work. (19) This Article will draw on this literature to address the questions of which instrument plays most nicely with other instruments and of what role playing nice should perform in the taxing/trading debate.

   This Article's second Part provides basic background, explaining how pollution taxes and emissions trading work and what the literature has to say about their comparative value. It discusses standard arguments about the relative efficiency and simplicity of the two approaches and shows that these arguments have limited value. It also discusses an approach to evaluating instruments addressing global climate disruption based on their capacity to induce developing country participation, finding that this "participation efficiency" approach yields uncertain guidance even in this important but limited context. It closes by demonstrating the prevalence of multiple policies addressing global climate disruption and other environmental problems, and discusses some of the values motivating reliance on supplemental programs even when a trading program or a pollution tax applies to the same pollution.

   The third Part explains why programs supplementing pollution taxes add environmental benefits while lowering tax bills. Because of these attributes, pollution taxes may encourage adoption of successful supplemental programs. By contrast, trading tends to lower the environmental benefits of supplemental programs while raising cost. This loss of environmental benefits may discourage enactment of supplemental programs, as it did in the Dutch case, or even spark opposition to existing policies. (21) When a government perseveres and enacts or continues a policy supplementing trading, it may not deliver substantial environmental benefits. (22) Thus, taxes work better with other instruments than trading.

   The fourth Part examines the question of whether a pollution tax's propensity to play more nicely with other instruments than emissions trading should count as a substantial argument for pollution taxes. Many economists and other policy experts who attach great value to economic efficiency might argue that trading's tendency to discourage additional policies would constitute an advantage. (23) Since pollution taxes and trading are cost effective, many economists argue against supplementing them with less cost-effective policies. (24) This Part, however, explains that additional policies may have value in addressing risk/risk problems, correcting market failures that persist under taxing or trading, reaching pollution or sources that neither trading nor taxes can effectively address because of monitoring difficulties, making up for inadequacies in the design of market-based instruments, catalyzing innovation, and stimulating government learning and experimentation to foster progressive policy evolution over time. It argues that these factors, especially additional programs' value in fostering policy evolution over time, matter a lot in the context most often considered these days, that of international efforts to address global climate disruption. At the same time, it acknowledges that for some narrow problems, complete reliance on market mechanisms has merit. Furthermore, whether or not governments should enact additional measures, they almost always do. Hence, the ability to play nice with other instruments matters in practice, regardless of whether it should matter in theory.

2. EMISSIONS TRADING, TAXATION, AND THE CONTINUING ROLE OF OTHER POLICIES

   This Part provides basic...