Global warming is fast becoming a reality. Unless significant action is taken to reduce greenhouse gas emissions, we can expect irreversible environmental and economic damage. While there is little serious debate on the need to reduce emissions–especially of carbon dioxide–there is a substantial debate on how to reduce these emissions. In theory, either a direct quantity restriction (cap-and-trade) or a price mechanism (tax) could be used to reduce production of carbon dioxide. But there is a policy stalemate on which is better.

Many environmental advocates–such as the Natural Resources Defense Council and the Nature Conservancy–lean toward a cap-and-trade regime simply because of what it is not. It is not a tax; and since politicians don’t like taxes in general, cap-and-trade seems politically more viable. Cap-and-trade programs would limit the total carbon emissions by mandating a “cap” and issuing permits to polluters. These permits could then be traded on an open market so as to help minimize aggregate compliance costs. However, cap-and-trade programs have at least two potential problems. Since carbon permits are an asset with value, they are subject to political whims and lobbying pressure. And, as a cap-and-trade system is implemented, there would likely be significant uncertainty in the future price of permits. This would make it more difficult for businesses to make investment and production decisions or to justify abatement projects.

These considerations and others–including integration with a global reduction efforts–have led many, including Al Gore, to favor a carbon tax. It would be more predictable and transparent, so that businesses could plan emissions reductions as well as adjust to known future cost increases. On the other hand, there is a fundamental problem: It is unknown in advance how much carbon reduction will result from a given level of taxation. In theory, the tax could be adjusted periodically to ensure sufficient reductions, but that might be politically difficult, especially as certain industries start feeling the pain of cost increases. Further, the potential need for adjustments would reduce the predictability of a tax; by the time we realize it’s not working, it might be too late.

What is needed, then, is an alternative mechanism that ensures some level of predictability in the cost increases, ensures that we reach target levels of emissions, and reduces the initial value of permits. All this can be achieved through a cap-and-lease program.

Under such a program, the total number of carbon permits would be set in advance and allocated by auction, just as in a cap-and-trade program (perhaps with some permits given away to reduce the impact on business). However, unlike the permits in a cap-and-trade regime, these permits would also require per-emission payments by polluters, analogous in some ways to a carbon tax. These carbon leases would be tradable, as in a cap-and-trade program, to ensure that abatement is efficient across companies and industries. The resulting hybrid mixes the benefits of both and avoids their disadvantages. The leases require payments that are set in advance and that depend on emission rates, and so they give businesses a predictable cost incentive to reduce pollution. But because there is a pre-set cap, policymakers can avoid the unpredictability of total emissions that comes with a straight tax.

For example, a lease for 10 tons of carbon dioxide could be sold at auction to an electricity producer. The lease would entitle the purchaser to release 10 tons of carbon over the life of the lease (say five years), but it would also require, for these emissions, a fixed per-ton payment, which would be set in advance by the terms of the lease. Businesses would thus have an upfront cost to obtain the permit at auction (though less than in a cap-and-trade regime), and then they would be responsible for the annual payment for polluting. This payment would act like a carbon tax, increasing incentives to reduce emissions while adding predictability to the market and costs. Thus, businesses would be better able to plan for and invest in emissions reductions. The value of the permits would also be lower relative to cap-and-trade, since businesses would be responsible for the annual payments–and hence lawmakers would have less temptation to reward special interests.

Without a broad-based program that changes the economic incentives to pollute, there is little chance that we will bring about the economy-wide transformation required to meet our twenty-first-century energy challenge. A cap-and-lease program would bridge the gap between a carbon tax and a cap-and-trade program, taking the best features from each to provide a politically viable solution.