Issue Report: Cap-and-trade versus carbon tax

Is a cap-and-trade system preferable to a carbon tax in reducing carbon emissions?

The debate between cap-and-trade and carbon taxes is very prominent. As concerns have arisen about global climate change and human greenhouse gas emissions, the question has arisen, what should be done? Many say that the most important avenue for cutting carbon emissions is market systems and incentives. Cap-and-trade and carbon taxes are two of the most prominent approaches to creating such market incentives to cut emissions. Both place a price on carbon emissions from businesses, giving them an incentive to emit less. A carbon tax places a straightforward tax on all carbon emissions. All emitted carbon is treated the same, under such a system, carrying the same price for a business. Under a cap-and-trade system, caps are set for businesses, requiring that they emit less than their caps. If they succeed, they receive carbon credits in proportion to how far below their cap they have reduced emissions. These credits can then be sold for a profit to companies that have failed to reduce emissions below their cap and whom are subsequently required to buy credits to make of the difference. In the United States, the debate has been particularly contentious over the years. The Obama administration planned on implementing a cap-and-trade system. Yet, the debate continues.

Economics: Are cap-and-trade markets more economical than a carbon tax?

A cap-and-trade system incentivizes reductions in carbon emissions where it can be done most efficiently (Conde Nast), "Why a Cap-And-Trade System Beats a Carbon Tax", 4/19/07

“The efficiency [of a cap-and-trade system] comes with the “trade” part. Let’s say you have two power plants, each emitting 100 tons of carbon per hour. The first can reduce its emissions by 20 tons at a cost of $5 per ton, and the second can reduce its emissions by only 10 tons, at a cost of $30 per ton. Clearly the efficient thing to do is to make the former reduction rather than the latter, with the owner of the second plant paying the owner of the first plant to offset the first owner’s extra costs [by buying carbon credits and the “right” to pollute from the first plant].” This allows effective emissions reductions to occur at the lowest cost.

An effective cap-and-trade system helps reduce economic costs caused by carbon emissions

One of the strongest pieces of evidence supporting this argument is the United States sulfur dioxide cap-and-trade system, in which the economic costs of acid rain damage was dramatically reduced.

Cap-and-trade is more flexible in the interconnected global economy

A cap-and-trade system is more flexible in the global economy. Nations that adopt a cap-and-trade system can later link that system into other cap-and-trade systems around the world. It would not be as easy for a carbon tax to achieve this. This is important in today’s global economy, where multinational companies exist across borders.

This is also important because it would make it easier to combat the problem of “carbon leakage”, which probably requires and international solution.

A carbon tax would damage an economy

The consensus among economists is that a carbon tax is the better approach

A cap-and-trade system is complicated and entails substantial administrative costs.

The costs of establishing and administering a cap-and-trade system could be substantial. It demands that a cap be set, monitored, and enforced. This is a highly complicated process, given the size of the energy market, and would demand substantial administrative oversight.

A carbon tax is more predictable and less volatile than a cap-and-trade system

A carbon tax is predictable, as are most simple tax systems. A cap-and-trade system, on the other hand, is subject to market fluctuations, speculation, and volatility. This could have a bad effect on energy prices.

The negative economic effects of a cap-and-trade system would be larger than its environmental benefits

Financial Times, "Carbon Markets Create a Muddle", 4/26/07

“Getting the amount of emissions a little bit wrong in any year [through a carbon tax] would hardly upset the global climate. But excessive volatility or unduly high prices of quotas on carbon emissions [as a result of a cap-and-trade system] might disrupt the economy severely.”

A carbon tax would not damage an economy

A carbon tax would be more efficient

A carbon tax would better distribute the costs of carbon emissions

Cap-and-trade would cause job loss

A cap-and-trade system would be harder on government budgets

Reducing emissions: Is cap-and-trade better at reducing emissions?

A cap-and-trade system better encourages companies to cut their carbon emissions

A cap-and-trade system provides companies with credits if they are able to reduce their emissions below an established level. They can then sell these credits for a profit. So, if a company takes action to reduce its carbon emissions below the designated level, than it can make a profit. This is a powerful market incentive that is more likely to cause companies to invest money in finding ways to reduce their carbon emissions. A carbon tax, conversely, only provides the incentive of cutting costs, and does not offer this important profit motive.

A cap-and-trade system is certain to reduce emissions, which is important in context of the global warming crisis

"Carbon tax vs. carbon market: who would win in a fight?", 9/15/06

“In a cap-and-trade carbon market, total emissions are guaranteed to go down. The cap is the cap, and assuming some reasonably effective enforcement mechanism, not a pound more carbon can be emitted. A carbon tax, on the other hand, merely encourages people to emit less by making it more expensive to do so. And in the case of fossil fuels, people seem perversely resistant to financial incentives.”

A post made on economist Greg Mankiw’s Blog 4/11/07 – “With the cap-and-trade system, there will be a definite decrease in emissions, while with the tax, the decrease depends on whether the cost of cutting emissions is lower than the potential tax. If it is, emissions decrease, if not, there is no effect.”

The market does a better job of directing investments in the best green technologies

**Bill Chameides, Chief Scientist at Environmental Defense, "Cap-and-trade: more effective than a carbon tax",, February 12, 2007

“Subsidizing one or two targeted technologies with a carbon tax would discourage investment in others that may turn out to be more effective. Which technologies should receive these tax dollars? No one has a crystal ball that can determine for sure which will turn out to be most useful. History has shown that the marketplace does a better job of developing new technologies, and a tax takes money out of the marketplace. The solution is cap-and-trade. A cap-and-trade strategy provides the incentive for all segments of the economy to compete to discover the best ways to cut emissions.”

Carbon trading schemes rely on bureaucratic processes to actually reduce emissions.

Tax schemes direct the power of market forces towards reducing emissions, rather than merely reducing the price of emissions. Market mechanisms will work far faster.

A carbon tax would add a clear cost to polluting and create a market incentive to pollute less

A carbon tax sends a serious and important message about the will to fight global warming

A carbon tax would shock consumers into needed behavioral changes

A carbon tax addresses carbon emissions in all industries

Carbon Tax Center, "Carbon Taxes vs. Cap and Trade"

“Carbon taxes address emissions of carbon from every sector, whereas cap-and-trade systems have only targeted the electricity industry, which accounts for less than 40% of emissions.”

A carbon tax would create funds to support environmentally-friendly policies

A carbon tax provides better incentives for green innovation

A carbon tax can be implemented immediately

While a cap-and-trade system may take a long time to take effect, a carbon tax can be implemented immediately. Due to the urgency of the Global Warming problem, the rapid results of a carbon tax are very important

A cap-and-trade system is vulnerable to companies tricking the system by polluting heavily before the system begins

The main problem is that baseline emission allowances for companies are based on their past emissions. For this reason, a company has the incentive to emit as much as possible when these baselines are being set so that the baseline is above or at what the company is already emitting. If a company successfully tricks the system in this way, they will be able to emit carbon as they had before, with no reductions being achieved.

A carbon tax obligates participation, whereas participating in a cap-and-trade system is largely optional

Cap-and-trade system don't ensure local area carbon emissions are reduced

The necessity of a cap-and-trade system depends on the case being made that the environment is seriously, catastrophically threatened

Feasibility: Is a market-based cap-and-trade system more feasible than a carbon tax?

A carbon tax is less popular and harder to achieve politically

The basic problem is that a carbon tax would be a new tax on the public. New taxes are typically unpopular. This makes it hard for politicians to support a carbon tax, as they are beholden to their constituents, and their likely desires to avoid such a tax.

A carbon tax would also require complicated monitoring and enforcement mechanisms

In a carbon tax, emitters would pay a tax for every ton of carbon emitted. This requires that the government know precisely how much carbon is being emitted by energy producers. This is not easy to determine, and requires that a government put in place monitoring mechanisms. Deploying these mechanisms universally would be very complicated, expensive, and require much administration. Then, ensuring that all these monitoring devices operate properly and that all energy producers comply with the tax would also involve a substantial administrative burden. This would be equally as complicated as a cap-and-trade system. However part of the monitoring cost could be absorbed privately by companies who wish to sell their credits, as high price is in their interest.

The transparency and clarity of a carbon tax is attractive politically

The slow implementation of a cap-and-trade system may make it unpopular over time

A cap-and-trade system demands the creation of a large and highly complicated administrative bureaucracy.

A cap-and-trade system demands that the government determine the emissions baselines for companies, the allocation of carbon credits, and the monitoring and enforcement of this all. This is a major administrative burden. A carbon tax would be simpler and require less oversight.

A cap-and-trade system is more susceptible to corruption than a carbon tax

The complexity of a cap-and-trade system would make it easier for companies to cheat. This is largely because the enforcement of this system would be difficult.

Governments within a cap-and-trade system have the incentive to "cheat"

Governments have the incentive to establish conditions favorable to the performance of their own national companies. They can do so by, for example, offering more carbon credits than they should to the companies of their country. The EU’s emissions trading system is the primary example of this occurring.

A cap-and-trade system is susceptible to distortion by lobby groups

"Progressive"?: Is cap-and-trade more "progressive" than carbon tax?

A carbon tax is "regressive"

A “regressive” tax is one that disproportionately burdens poorer groups. Energy consumption generally makes up a larger portion of the personal budgets of poorer groups. Because energy consumption would be taxed equally across social groups with a carbon tax (it’s a “flat tax”), the costs of the tax would disproportionately affect poor groups.

A cap-and-trade system is "progressive".

TerraPass, "Carbon tax vs. carbon market: who would win in a fight?", 9/15/06

“Tradeable carbon credits, on the other hand, could conceivably result in a net transfer of wealth to the poor. Although the poor spend a bigger proportion of their income on energy, the wealthy consume a far greater amount of carbon in absolute terms. So under a cap-and-trade regime, we would expect the poor (and the energy thrifty) to have excess credits to sell to their more profligate neighbors.”

A carbon tax is not really that "regressive", since the wealthy consume more energy and would be taxed more

A progressive tax is one that places a heavier burden on the wealthy. While the carbon tax would be “flat”, some point out that wealthier people consumer more energy and emit more carbon — they drive and fly more, have bigger (and sometimes multiple) houses, and buy more products that require energy to manufacture and use. Most carbon tax revenues will, therefore, come from families of above-average means, as well as corporations and government.

Carbon tax revenues create a basis for progressive "tax shifting"

The revenue generated from a carbon tax, which will largely be from wealthier groups, could allow a government to then cut certain “regressive” taxes – such as the payroll tax (at the federal level) and the sales tax (at the state level) – in a way that benefits poorer groups. This is called “progressive tax-shifting”.

A progressive approach could involve a carbon tax rebate

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