Cap-and-Trade vs. Emission Tax – Similarities

Cap-and-trade programs and emission taxes share several important similarities, including incentives for cost-effective mitigation, increasing energy prices, and raising revenues (assuming an auction in the cap-and-trade program).

Cost-Effective Mitigation. Cap-and-trade programs and emission taxes promote cost-effective emission mitigation by ensuring that every source of emissions faces the same marginal cost of abatement. Under an emission tax, firms should abate emissions until the last ton of abatement is equal to the tax. If they abate less than this amount, then they would make tax payments on some tons of emissions in excess of what it would have cost to abate those tons. If they abate more than this amount, then it would have cost more to abate some of those tons than it would by paying taxes on them. In a similar fashion under cap-and-trade, covered firms would make abatement decisions based on the clearing price of allowances in the market. If they can abate more tons for less than the current market price, then they would do so and sell any excess allowances. If they cannot, then they would buy additional allowances from the market at a lower cost than the emissions abatement would have cost.

Why is it important that all sources face the same marginal cost of abatement? If some firms face a higher cost than others, then the total costs will be higher. Consider a simple example of two firms that each have the same cost structure for mitigating emissions: abating one ton of CO2 costs $1, abating a second ton costs $2, and so on until abating the tenth ton costs $10. Suppose we want to abate 10 tons of CO2 from the economy. If we ask each firm to abate 5 tons each, then the marginal cost of the last ton abated will be $5 for each firm, and the total cost of abatement will be $30: 2*(1+2+3+4+5). If we ask one firm to abate all 10 tons, then that firm will face a marginal cost of $10 for the last ton abated and the total cost will be $55: (1+2+…+10). The other firm faces a marginal cost of $0. In this stylized example, exempting a firm causes a large disparity in marginal costs and significantly increases the total costs to the economy to meet the mitigation goal. This is a key reason why cap-and-trade programs and emission taxes are superior to standards, such as fuel economy standards, appliance standards, building codes, and renewables mandates. These standards result in significant heterogeneity in abatement costs – some firms can comply with a standard at low costs and others at much higher costs – so these standards cost consumers much more than more cost-effective cap-and-trade and emission tax approaches.

Higher Energy Prices. Both cap-and-trade and emission taxes will increase energy prices. An emission tax will be passed on to consumers in the form of higher energy prices just like energy excise taxes. The price of an emission allowance under a cap-and-trade program will be passed down to consumers just like a tax – the last ton emitted by a firm requires the firm to either buy an allowance at the going market price or forego the opportunity to sell an allowance it already owns into the market. Even if the regulated firms receive their allowances for free from the government, energy prices will increase just like under an auction cap-and-trade or emission tax. The recent experience with the EU ETS, in which almost all allowances were given away for free, shows that electricity prices in several deregulated markets – including Germany, the United Kingdom, and the Nordic market – moved with the EU ETS allowance price (refer to Figure 5 on page 25 of this IEA report). The primary difference between cap-and-trade with gratis allowance allocation and a tax then is not the effect on consumers – you and I will pay more for carbon-based energy and goods in either case – but whether large, CO2-emitting corporations will receive a windfall in the form of free allowances (more on this in my next post).

Revenue Generation. An emission tax and a cap-and-trade program in which allowances are auctioned can raise substantial revenues. For example, a tax on the carbon content of all fossil fuels set at $15 per metric ton of carbon dioxide (which corresponds to an increase in gasoline prices of about 13-14 cents per gallon) would generate about $95 billion in revenue in 2015. Increasing the tax over time would also increase the revenue generation: a $20/ton tax in 2020 would generate nearly $130 billion and a tax of $50/ton in 2030 would generate almost $300 billion. A cap-and-trade program with 100% auctions and auction clearing prices at these values would generate the same amount of revenues. These revenues could then be returned to the economy by reducing distorting taxes on labor and capital. Recent research by my colleague Ian Parry has shown that a modest emission tax of about $15 per metric ton CO2 could actually make the economy better off – without even accounting for the climate benefits – because the economic gains from reducing existing distorting taxes on valuable factors of production exceed the costs associated with mitigating emissions. Returning revenues to the economy can also offset some of the regressive nature of raising energy prices through cap-and-trade and emission taxes, and I will revisit this issue in my post on design issues.