Additional Considerations
This section discusses two other factors that are relevant to the choice among emissions
control instruments: the ability of the instrument to address uncertainty, and the nature of
its distributional impacts.
The Role of Uncertainty
Uncertainties are unavoidable: policymakers can never perfectly predict the outcome of
environmental policies. This is relevant to instrument choice, since the choice of instrument
affects both the type of uncertainty that emerges as well as the expected efficiency gains
generated. Instruments also differ in their abilities to adjust to new information.
The Nature of Uncertainty under Different Instruments
Under emissions taxes, the price of emissions (the tax rate) is established at the outset. What
is uncertain is the aggregate emissions quantity that will result after firms respond to the
tax. In contrast, under pure emissions allowance systems, the aggregate emissions quantity is
established at the outset by the number of allowances introduced into the market, while the
emissions price is uncertain because it is determined by the market ex ante.
To reduce the price uncertainty under emissions allowance systems, some have proposed
augmenting such systems with provisions for an allowance price ceiling or price floor. The
idea of establishing a price ceiling has gained considerable attention in discussions of climate
change policy. Here a cap-and-trade program is combined with a “safety valve” to enforce
a pre-established ceiling price (Burtraw and Palmer 2006; Jacoby and Ellerman 2004; Pizer
2002). Under this policy, if the allowance price reaches the ceiling price, the regulator is
authorized to sell whatever additional allowances must be introduced into the market to
prevent allowance prices from rising further. Note that while the safety valve reduces price
uncertainty, it introduces uncertainty about aggregate emissions. Similarly, it is possible to
enforce a price floor by authorizing the regulator to purchase (withdraw from the market)
allowances once the allowance price falls to the pre-established floor price.
Potential price volatility of allowance systems can also be reduced by allowing firms to
bank permits for future compliance periods when current allowance prices are considered
unusually low, and to run down previously banked permits or borrow permits when current
allowance prices are considered unusually high.
Other instruments involve uncertainties about emissions prices, quantities, or both. Like
an emissions tax, a tax on a goods associated with emissions (for example, a gasoline tax)
leaves the quantity of emissions uncertain. Direct regulatory policies leave uncertain the
amount to which aggregate emissions will be reduced, although they may indicate limits on
emissions at the facility or firm level. Direct regulatory policies also involve uncertainties as
to the effective price of emissions; that is, the shadow price of emissions or the marginal cost
of abatement implied by the regulations