The cost and environmental efficacy of either a cap-and-trade program or an emission tax will depend on several important design issues: the point of regulation; the coverage of emission sources; “complementary” programs; and possible hybrid policies that integrate elements of both approaches.
Point of regulation. It would be infeasible to regulate all greenhouse gas emissions at the very point where they enter the atmosphere – monitors will not be placed on every car and truck tailpipe, every home that heats with natural gas or heating oil, as well as every smokestack in the industrial and electricity sectors. One approach – often referred to as upstream regulation – would impose the emission tax or the requirement to hold permits on energy suppliers, such as at coal mines, natural gas wellheads, petroleum product refineries and importers. The carbon content of all fossil fuels that enter the U.S. energy system would be covered by this approach. This approach would be administratively simple and straightforward because it accounts for almost all U.S. CO2 emissions (more than 98 percent) by focusing on a relatively small number of firms; incorporates existing monitoring and measurement of fuel supplies; and takes advantage of the fundamental molecular properties of fossil fuels that allow for precise measurement of emissions based on the physical amounts of these fuels.
A midstream approach could focus instead on major sources of emissions, such as electric utilities and facilities with large industrial boilers, in a similar fashion as the SO2 trading program. The question then becomes how to integrate other emission sources. In a cap-and-trade program, emissions targets are met at least cost when all sources face the same marginal cost for their abatement. It may be difficult to cover other sources, such as in the transportation sector, in a similar midstream or downstream manner. The point of regulation can influence the extent of coverage of the domestic policy, which raises the costs and lowers the environmental benefits of an emission tax or cap-and-trade program.
Coverage. The broader the coverage of a domestic policy, the lower the costs and the greater the environmental benefits. Some proposals would exclude some sources of greenhouse gas emissions by focusing on just one sector, such as power generation. This raises the costs of the program – with utilities facing a cost for emitting carbon while other sources in the economy facing no cost, the economy foregoes low-cost abatement opportunities. It can also reduce the environmental benefits, as consumers and firms respond to the effect of the program on the utility sector – households install natural gas water heaters (uncovered) in place of electric water heaters (effectively covered), and manufacturing facilities decide to generate their own power instead of buying power from covered utilities. All of these actions would cause emissions leakage – emissions abatement in the covered sector is partially offset by increases in emissions outside of this sector.
The coverage of a tax or cap-and-trade program can also be influenced by “carve-outs.” A domestic policy could exempt some firms based on their size (e.g., those emitting less than a specific threshold) or if they are intensive users of energy. Such exemptions, in either cap-and-trade or a tax, reduce the cost-effectiveness of the policy.
“Complementary” programs. Some have advocated for performance standards – such as on appliances, buildings, fuel economy, and even power plants – to “complement” a cap-and-trade program. These standards do not complement cap-and-trade or emission tax approaches – they increase the total costs to the U.S. economy of a domestic climate change policy. These standards increase costs because they cause marginal costs to differ across sources. There is no environmental need to implement such standards with a cap-and-trade program – the cap limits the emissions, so the only effect of standards is to raise costs. Standards with an emission tax may lower tax payments but increase regulatory compliance costs, and thus increase the costs of goods and services to consumers. Well-designed complementary programs should instead target climate-friendly R&D through support for more basic research and incentives for the private sector to increase their investment in R&D.
Hybrid policies. Some proposals would integrate elements of both cap-and-trade and an emission tax. For example, a cap-and-trade program with a safety valve would allocate emission allowances to covered firms just like a traditional cap-and-trade system. Firms could trade allowances among themselves, or tap the safety valve – the government would sell an unlimited number of allowances at a predetermined price. This effectively acts as a price ceiling in the allowance market – at low allowance prices, the system is more like a normal cap-and-trade, but if costs are unexpectedly high and the safety valve is triggered, then it is more like an emission tax.