There’s a new idea circulating—proposed by Washington Congressman Jim McDermott, among others—that’s being called a “managed-price” approach to cap and trade. As it turns out, however, managed-price is very similar to an adjustable carbon tax — and it has many of the same virtues and vices.

Let’s take a closer look.

  • Here’s how a managed-price approach would work, according to recent testimony from Douglas Elmendorf, director of the Congressional Budget Office:

    Under [the managed-price] approach, legislators would set a cap on cumulative emissions over a period of several decades but would not set annual caps. Regulators, in turn, would be charged with setting allowance prices for each year of the policy—with the objective of choosing prices that would minimize the cost of achieving the multidecade cumulative cap.

    Regulators would establish a path of rising prices for allowances, with the goal of complying with the cumulative cap that legislators set. That path would be adjusted periodically if new information indicated that future compliance costs were going to be higher or lower than anticipated or if progress in meeting the cumulative cap was less than expected.

    It sounds simple enough. Legislators set a long-term carbon reduction target and the regulators would publish a fixed carbon price schedule that they believe will meet the legal carbon targets. If the price for carbon turns out to be too high or too low, the regulators adjust the price periodically to try to achieve the targets. (You can see Congressman McDermott’s price schedule in his bill, here.)

    There are some nice advantages to managed-price. For one thing, there’s no price volatility because the price is fixed in advance by government regulators, so polluters have a clear sense of the prices they will pay in the future. In other words, firms can decide how much they carbon they want to emit based on the price schedule.

    On the downside, there is no genuine carbon cap in managed-price system, just as there is no cap in a carbon tax. In any year, the government is willing to sell as many carbon allowances as firms are willing to purchase at the fixed price. The only sense in which managed-price has a carbon cap is that policymakers set aggregate carbon emissions targets for the program to be achieve over some period of time. It’s up to regulators to adjust the carbon price up or down in order to achieve the targets—and these price adjustments serve in lieu of a cap.

    The practical difficulties, however, are enormous. More from CBO:

    In order to forecast the price path that would minimize the cost of achieving the desired limit on cumulative emissions, regulators would rely on information about trends in future emissions, firms’ and households’ responses to higher energy prices, and the availability of technologies in the future. However, the initial price path that regulators set might lead to more or less cumulative emissions than they had anticipated. They would need to make periodic adjustments to the price path to ensure that adequate progress was being made toward the cap and to reflect significant changes in trends in future emissions and new information about future technologies. For example, an increase in underlying emission trends would mean that allowance prices had to be higher than regulators originally foresaw to keep emissions from exceeding the cap; in contrast, the development of an unexpectedly cheap technology for reducing emissions would mean that the target could be met with lower prices and less economic cost. Those adjustments would entail one-time increases or decreases in the current and future prices—that is, upward or downward shifts in the price path.

    In other words, to achieve the carbon targets and also provide price certainty, regulators will need to accurately forecast energy prices, response to energy prices, global and local economic conditions, technological change, and probably some other things to boot. But any one of these subjects is mind-bogglingly complex! In fact, the world’s most skilled energy forecasters are frequently wrong—and they often don’t agree with one another. There are whole bookshelves full of dueling economics literature on the demand-response to energy prices. And predictions about technological development, not to mention popular uptake of technology, are likely to be little better than wild guesses.

    The chance of regulators getting the price schedule right is just about zero. In reality, regulators would almost certainly have to make significant and frequent adjustments to the price schedule if they want to achieve the legal carbon reduction targets. There’s nothing inherently wrong with that—prices fluctuate in ordinary cap and trade too—but it obviates a major point of the managed-price policy because the regulators’ adjustments will make future prices inherently unpredictable.

    What’s more, revising the price schedule likely to become a political hot potato. A climate-unfriendly administration might influence the revisions, keeping them low to benefit polluters. And over the long term, regulatory agencies can become captive to the industries they seek to regulate.

    Still, to the extent that managed-price is really just an adjustable carbon tax, there may be a fine idea in there. An adjustable carbon tax has some shortcomings—including some of those I’ve mentioned above—but it’s not nuts either. Done correctly, an adjustable carbon tax just might be able to use carbon prices to achieve specific carbon reductions.

    But if managed-price cap and trade is basically just a carbon tax, why go to all the trouble of developing the apparatus of a cap-and-trade system? Why not just have a plain vanilla carbon tax instead? Can managed-price marry the advantages of cap and trade to the advantages of carbon taxes? Or is it the worst of both worlds?

    I take a closer look in a follow-up post: Is Managed-Price Cap and Trade Different From A Carbon Tax?