Smart CAP

We introduce a “smart” cap and trade system that eliminates the welfare costs of asymmetric information (“uncertainty”). This cap increases or decreases in response to technology or macroeconomic shocks. It relies on the market price of certificates to aggregate the relevant information. In the static setting, Weitzman (1974) shows that a tax is more efficient than a (standard) cap if marginal damages are flatter than marginal benefits. In a dynamic setting, the shadow value of the polluting stock measures marginal damage. In the climate change context, it is the social cost of carbon, which is relatively flat in current emissions. The widely used analog of the static argument therefore suggests that taxes are more efficient than (standard) cap and trade systems for addressing climate change. In practice, cap and trade is the dominant market-based climate policy. The smart cap allows policy makers to use these institutions to employ an efficient climate policy. The analysis also shows why the static criterion for ranking taxes versus quantities fails in the dynamic setting and that even a standard cap can be first best under an almost flat marginal damage curve. JEL Codes: Q00, Q50, H20, D80