Is carbon trading a market mechanism?

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There appears to be a misconception among many 'lay economists' that carbon trading is a 'market mechanism' while carbon taxes are not. However, government control of the quantity of an item being sold is no more of a market based mechanism than government control of the price. Carbon trading involves selling or giving away a fixed number of rights while carbon taxes involve renting them out at a fixed price. Where it counts, carbon taxes make far better use of market forces than carbon trading schemes.

First though, a little speculation on why people might see carbon trading as more of a market based approach. The economic problems caused by taxes are well known and familiar. People still make this connection, even when the tax is applied to something which we actually want to cost more. On the other hand, government control over the quantity of an item for sale is far rarer and the associated problems far less familiar.

Carbon trading does result in a market where something is actually exchanged. However, while most items for sale have an intrinsic value independent of government action, the goods exchanged in a carbon market exist only as a result of government intervention. While the exchange may have the superficial appearance of a free market, the market itself is an unnecessary extra cost. Private ownership of resources is usually good for the economy, but where strict government monitoring of the ownership or use is still necessary, private ownership loses its advantages over government or communal ownership. The 'stock exchange' itself is seen by some as beneficial as it employs people. However, while stock exchanges typically reduce transaction costs for most privately held items, they actually increase it for CO2 emissions rights. The infrastructure and bureaucracy for a tax based system is still necessary and the cost of seeking out a buyer or seller is an extra and unnecessary burden. Many people hope that Australia will become a centre for international exchange, however this is unlikely given our stalling tactics in current international negotiations. Any local benefit, if achievable would be in the form of a cost charged to the rest of the world for an unnecessary service. This local benefit would be insignificant compared to the local costs of choosing an inferior mechanism for putting a price on CO2 emissions.

The price of an item on the free market is the result of interactions between the forces of supply and demand. The price is the result which we are all familiar with and one we don't like seeing directly affected by the government. However, while we are not usually aware of the quantity of an item being traded, it is actually the more important outcome from an economic perspective. When governments seek to minimise the economic impact of a tax, they do this by choosing goods and services that are insensitive to price. That is, the government can increase the price while having as little impact on the quantity being traded as possible.

Carbon trading and carbon taxes both make some use of market forces. It is misleading to say that one makes more use than the other. However, there is a huge difference in where the power of market forces is directed. Carbon trading schemes direct market forces at reducing the price of emissions as quickly as possible while holding the total emissions (the amount being 'supplied') constant. It is up to a political or bureaucratic process to reduce the total emissions. As you would expect, the market operates much faster, which is why Kyoto and the new trading scheme based in NSW face emissions prices low enough to cripple the trading schemes, while the total emissions have barely been reduced. On the other hand, carbon taxes direct the power of market forces towards reducing the amount of emissions as quickly as the economy can tolerate. Adjustments to the price may be necessary at some stage, but the process is nowhere near as dependent on continual government interference as trading schemes are.

While taxes make better use of market forces to actually reduce emissions, rather than just the price of emissions, by far the biggest advantage of taxes is that they allow for the reduction of other taxes, thereby mitigating almost all of the economic impact. They also result in a far more steady price on emissions, which is critical for industries seeking to invest in various efficiency improvements and emissions reduction technologies.