Cap-and-Trade vs. Emission Tax: An Introduction

August 9th, 2007 <-- by Joseph Aldy -->

As interest mounts for a federal policy to mitigate greenhouse gas emissions, two policy options have received substantial attention: a cap-and-trade system and an emission tax.

A cap-and-trade system would limit greenhouse gas emissions by setting an aggregate quantitative cap (e.g., over the entire economy or a specific sector, such as electric utilities). This cap is then allocated to regulated firms – either through an auction or for free – in the form of emission allowances. An allowance would give a firm the right to emit a given amount of greenhouse gases (e.g., one metric ton). Firms are allowed to buy and sell allowances among themselves, in effect creating an allowance market. Firms with high costs of abating their emissions may prefer to buy allowances from firms with low abatement costs. At the end of every regulatory period, firms would submit allowances the government to cover their greenhouse emissions during that period.

An emission tax would limit greenhouse gas emissions by setting a price on those emissions. A firm covered by this program would pay the government a tax on every ton of greenhouse gases that it emits. Just as firms in the allowance market under cap-and-trade respond to the market price for allowances to determine the balance between in-firm emissions mitigation and allowance purchases from other firms, under a tax firms would respond to the incentive of the explicit price on greenhouse gas emissions. Firms with low abatement costs will reduce their emissions extensively and pay lower taxes, while high abatement cost firms will reduce their emissions less and pay greater taxes.

There has been a variety of experiences with cap-and-trade programs. Among the more successful include the U.S. Acid Rain program that caps sulfur dioxide emissions, the U.S. phase-down of lead in gasoline in the 1980s, and the nitrogen oxides trading program for the eastern United States. There have also been some less successful cap-and-trade programs, such as southern California’s RECLAIM market for local air pollutants that experienced dramatic allowance price shocks and non-compliance during the 2000 California electricity crisis, the Chicago volatile organic compounds market that effectively collapsed due to over-allocation of allowances and low demand, and the EU Emission Trading Scheme for carbon dioxide emissions that witnessed a sharp decline in market prices resulting in a fall in market capitalization of nearly two-thirds over one week.

Emission taxes have been employed to address a variety of environmental problems. More than 4,000 communities in the United States employ pay-as-you-throw waste fees – households have to pay per pound or per bag for their residential solid waste collection. Ireland imposed a litter tax on the use of plastic bags by retailers. Several countries have employed carbon taxes in their initial efforts to address climate change, including the United Kingdom, Denmark, and Norway. Sweden levies energy, carbon dioxide, and sulfur dioxide taxes on natural gas and coal. A number of European countries have implemented tax shifts – reducing taxes on labor and capital while imposing new taxes on environmental pollution.

In the U.S. Congress, a number of cap-and-trade and emission tax proposals have been introduced in this session. For an updated description of these bills, please check out this summary. A number of organizations have advocated for cap-and-trade policies, such as a coalition of businesses and environmental NGOs comprising U.S. Climate Action Partnership, the bi-partisan National Commission on Energy Policy, and several Presidential candidates who have co-sponsored cap-and-trade bills in the U.S. Senate (including Clinton on Sanders-Boxer and Lieberman-McCain, McCain, and Obama on Sanders-Boxer and Lieberman-McCain). Former Vice President Al Gore has advocated for both cap-and-trade and emission taxes. Prof. Greg Mankiw, former Chair of the Council of Economic Advisers in the George W. Bush Administration, has called for increasing the tax on gasoline to achieve many goals: first on his list is to address global warming. The recently launched Carbon Tax Center calls for a carbon tax. Congressman John Dingell has called for a carbon tax as has Congressman Christopher Dodd.

With the substantial track record in implementing both cap-and-trade and emission taxes and the significant interest from advocates on both sides of the political aisle for one or the other instrument, I will post commentaries that elaborate on these two policy options over the next few weeks. These include a discussion of the similarities between cap-and-trade and tax (Monday August 13); the differences between the two options (Wednesday August 15); and design questions, such as point of regulation, the use of revenues, and integrating cap-and-trade and taxes in a hybrid system (Monday August 20).

2 Responses to “Cap-and-Trade vs. Emission Tax: An Introduction”

  1. Nick Says:

    I am looking forward to the forthcoming articles, and it is nice to see ClimatePolicy starting to really dig into current policy debates, which I hope will increasse blog readership and comments.

    And, I hope is willing to dig deepeer still in the future. I would be thrilled to see this blog’s contributors occasionally showing more of their fine research skills. Educating people about climate policy isn’t always best served by simplified executive summary style posts; let’s soon see some of the real meat and bones of this beast.

    Thanks for listening.

  2. Methane Mike Says:

    There are solutions that are electrical that do not require economic sacrafices.

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