New York City mayor Michael Bloomberg just gave a bombshell speech here in Seattle calling for a federal carbon tax. (Full text of the speech is here, scroll down.)

First off, way to go Bloomberg! In fact, Sightline’s Anna Fahey has written about Bloomberg’s awesome framing. But now, with my researcher’s hat on, I think it’s worth clarifying a few things.

While many of Bloomberg’s arguments in favor of a carbon tax were spot-on, he made some very selective criticisms of cap & trade programs—criticisms that seem targeted at only the worst way of doing it. As far as I can tell, Bloomberg completely ignored the right way to do cap & trade, which starts with auctioning the credits, not giving them away for free.

So as a service for wonky readers, here’s a little primer that I whipped up this morning:

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  • CARBON TAXES—A good first step that could be implemented soon. Taxes have two big advantages: 1) they raise revenue to invest in greenhouse gas reductions, or cushion consumer impacts, or both; and 2) they provide price certainty. But they have a couple of big disadvantages: 1) They can’t guarantee specific levels of reduction. So to reduce ghgs by the appropriate amount, policymakers would need to continually tinker with the tax rate; and 2) tax increases are thought to be radioactive.

    GRANDFATHERED CAP & TRADE—This is what Europe has done and what Bloomberg seems to be objecting to. It’s also the worst system for dealing with global warming. Grandfathering hands out free carbon credits to polluters based on their historic emissions. And because the credits are fungible—they have a cash value—they end up conferring a windfall profit based on past pollution.

    Worse, grandfathering does nothing to cushion consumers from price increases. Just as giving Exxon free tickets to the World Series wouldn’t mean that Exxon would pass out free tickets to consumers. In the very same way, giving Exxon free carbon credits doesn’t mean that Exxon would pass out free carbon to consumers. Instead, Exxon would either sell the credits for their cash value, or raise the consumer price of energy to cover the price of the credit they could have sold. (Hat tip for example to Peter Barnes.) The result? Consumers pay more while energy companies chalk up another windfall.

    AUCTIONED CAP & TRADE—This is the best system, but Bloomberg’s remarks seemed to ignore this possibility entirely.

    In this system, instead of passing out credits for free, the government would hold regularly scheduled auctions. The big advantages are: 1) The cap puts a firm limit on pollution and drives emissions down over time; 2) It raises revenue that can be used to invest in ghg reductions, or cushion consumer impacts, or both; 3) It activates the power of the market to seek out the cheapest and most efficient reductions first, and to prioritize; and 4) It tips the playing field away from big historic polluters and toward leaner and cleaner competitors.

    One of the potential drawbacks of this system is that it has emissions certainty, but price uncertainty. (It’s the inverse problem of the carbon tax.) So there is some risk of price volatility. There are, however, a number of good ways to reduce volatility (such as banking, borrowing, trading system linkages, and so on). These tend to be treated as technical details of the auction system, but they’re actually pretty fascinating. And, yes, I’ll be writing about them at a later date.

    Then, there’s a whole separate issue about upstream and downstream regulation. Bloomberg made hash out of this too, but I’ll ignore it for now. (My short version: upstream is better and simpler.)

    Look, I hate to criticize Bloomberg just at the moment when he’s stepped up with astonishing political courage and vision. He deserves big applause. But it’s also important to get things right—and “straw man” objections to cap & trade won’t help solve our climate problems.