Response to "Obama’s chance to lead the green recovery" by Joseph Stiglitz and Nicholas Stern (Financial Times, 2 March 2009) in the Financial Time's Economists' Forum.

Joe Stiglitz and Nick Stern are exactly right to emphasize the role President Barack Obama can play in leading the green recovery. They are also right to calling for a “stable, strong carbon price.” But it matters how that price is set. In the United States in particular, the right environmental, political and economic answer is a cap-and-trade system.

A cap guarantees the environmental outcome; a tax does not. A cap has hope for passage in US Congress; a tax does not. A cap would not only provide the basis for the necessary long-term restructuring of the US economy, it would also act as a short-term stimulus, much more than would a tax.

A cap delivers far more innovation than a tax. The cap – even one that goes into effect in, say, 2013 – would help put assets on companies’ balance sheets now, which would immediately change the financing equation in favour of increased spending and investment. This holds true regardless of whether allowances are given away for free or sold in an auction. The cost of auctioned allowances would affect company balance sheets at the beginning of the program, while every incremental investment in low-carbon technology increases the value of carbon assets on the books now.

Innovation is where the true potential of a cap becomes apparent. If we think of research and development as creating options, a future cap signed into law this year would make the “call option” on clean energy research and development significantly more valuable. This would help unleash much-needed energy investments that have been placed on hold while companies have been waiting for clear rules.

Options theory also provides direction for market design. A price ceiling for carbon allowances, like a tax, would be poisonous to the innovation process and the atmosphere alike. An initial price floor would help both. It would also counteract the dampening effects of an uncertain price on green energy investments: downside risk looms large for investments in alternative energy sources. Similarly, a well-designed cap calls for banking and limited future borrowing of allowances to smooth prices and create investment certainty and continued asset values.

Of course, the carbon market also requires utmost transparency as well as patently enforceable – and rigorously enforced – oversight rules. Any regulatory framework must start from the premise that a carbon allowance is not simply just another physical commodity and must not be regulated as such. Rather, the overarching goal of market oversight must be aligned with the fundamental goal of reducing emissions.

Finally, a US cap is the key step toward a truly global solution to our shared climate problem. The United States must lead, but it – and Europe – cannot solve the problem alone. At the very least, the largest emerging economy emitters and tropical forest nations need to limit their pollution as well. A global cap-and-trade market would encourage all nations to seek the lowest-cost solutions and provide incentives for others to join.