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Carbon Tax vs. Cap-and-Trade: What’s a Better Policy to Cut Emissions?

Experts often debate the pros and cons of a carbon tax versus a cap-and-trade system in the United States, and they will do so again at an event in Washington DC tomorrow.  A carbon tax directly establishes a price on greenhouse gas emissions—so companies are charged a dollar amount for every ton of emissions they produce—whereas a cap-and-trade program issues a set number of emissions “allowances” each year. These allowances can be auctioned to the highest bidder as well as traded on secondary markets, creating a carbon price.

So what’s the best policy to rein in U.S. emissions?

WRI researchers recently analyzed this question in our issue brief, Putting a Price on Carbon: Reducing Emissions. We found that while there are legitimate reasons to favor one form of pricing carbon over the other, if well designed, either a carbon tax or a cap-and-trade program can be the centerpiece of U.S. efforts to reduce greenhouse gas emissions.

What Are the Key Similarities Between a Carbon Tax and Cap-and-Trade?

Carbon taxes and cap-and-trade programs share several major advantages over alternative policies. Both reduce emissions by encouraging the lowest-cost emissions reductions, and they do so without anyone needing to know beforehand when and where these emissions reductions will occur. Both policies encourage investors and entrepreneurs to develop new low-carbon technologies. And both policies generate government revenue (assuming emissions allowances are auctioned under cap-and-trade) that can be used in productive ways. 

What Are Some Important Advantages of Each?

Real differences exist among carbon taxes and cap-and-trade policies, and each has distinct advantages. The United States has made commitments to the international community that it will reduce its annual greenhouse gas emissions 26-28 percent below 2005 levels by 2025. By setting an emissions cap that declines over time, a cap-and-trade policy can increase certainty that emissions will fall below the predetermined emissions targets.

A carbon tax offers stable carbon prices, so energy producers and entrepreneurs can make investment decisions without fear of fluctuating regulatory costs. In addition, if emissions reductions are cheaper than expected—which might occur if, for example, an economic downturn causes emissions to fall—then a tax provides a continuing price signal whereas cap-and-trade does not encourage reductions beyond the emissions target. 

What Are the Key Disadvantages?

Critics focus on certain disadvantages of carbon taxes or cap-and-trade, but their arguments are unpersuasive if policies are well-designed. While a carbon tax does not offer the same degree of emissions certainty as cap-and-trade, sufficient stringency can be achieved with a tax through design elements like a “ratcheting mechanism” that would adjust the tax upward if the initial emissions reductions are too low. In any case, as we show in the issue brief, if technological progress continues to reduce the costs and availability of clean energy, a carbon tax is likely to cause emissions to fall more than predicted by the simulation models that shape our policy expectations. 

Critics of cap-and-trade point to problems that actual cap-and-trade programs like the European Union Emissions Trading Schedule and the Regional Greenhouse Gas Initiative have confronted, such as weak emissions caps, volatility in emissions allowance prices, and overly generous allocations of emissions allowances to regulated entities. But these are problems with the design of a cap-and-trade program, and each has a straightforward solution. Emissions caps can be set more stringently, price floors and ceilings can avoid volatility, and emissions allowances can be auctioned instead of given away. Indeed, California’s cap-and-trade program has made important strides in addressing these concerns, for example by establishing a price floor in its auction of allowances. 

So What’s the Bottom Line?

For sure, there are additional advantages and drawbacks to carbon taxes and cap-and-trade that we have not addressed. Still, in the words of Jean Tirole, the 2014 winner of the Nobel Prize in economics, these details are “of second order importance” compared to addressing the risks of climate change.

A large and growing group of economists, scientists, policy makers and businesses support using a price on carbon to achieve the greater climate policy ambition we need. But getting the U.S. Congress to pass a carbon pricing policy will be extraordinarily difficult due to the powerful corporate and ideological opposition. Uncompromising stances on policy preferences are unhelpful and divisive. The benefits of carbon pricing are not worth sacrificing for the goal of achieving any specific policy.

Comments

What about eliminating fossil fuel subsidies?

Citizens' Climate Lobby propose a revenue neutral Carbon Fee and Dividend (CO2 Tax) which prices carbon at source, the well, the mine, the port, i.e, the point at which carbon enters the economy. The 'Fee' rises annually from a starting point of $10 or $15 per tonne and rises by $10p/a tonne. This upstream model is simpler to apply and monitor than downstream emissions, and also covers all products and services which have a carbon footprint.
100% of the revenue raised is distributed evenly to the citizens in monthly 'Dividends'. This has built in equity as the 60% lower income earners receive more back in dividends than they will incur in extra costs as products become more expensive.
This also stimulate the switch to low carbon products or alternatives while giving business and industry a known timeline and cost projection to restructure their business models.
Modelling by REMI, shows rapid lowering of emissions, 52% over 20 years; added job, stimulated GDP and massive health saving as pollution drops.
The point is getting rid of CO2 emissions asap as we are already witnessing major effects from ~ 1º so we need an effective policy to drive out fossil fuels before too much damage is locked in the atmospheric system.
Full modelling details can be found in the REMI report on www.citizensclimatelobby.org

I am glad you are considering this question and look forward to reading how you deal with a way to arrive at the "well designed' path? It has become a political football in Australia and so no discussion occurs politically on best way forward for either direction.
Just all negatives!

Other disadvantages of a carbon tax are 1) nobody knows what the tax rate would have to be to keep emissions within any mitigation target, 2) some legislative body would have to keep raising the tax rate decade after decade, 3) concessions to threatened industries would have to be through tax concessions, weakening mitigation (while under cap & trade valuable free permits would not weaken the cap), and 4) new taxes are impossible to get through the Republican House or Senate.

Thanks for reading the post and for the thoughtful comments. Here are some responses, and I'd love to get your thoughts on them:
(1) It's true that the "correct price" isn't known, but neither is the correct quantity of emissions. If there were a safe level of emissions to shoot for, I'd agree this would be a big drawback of a tax. But the uncertainties in climate science are too large to allow for this (i.e. if there are "tipping points", we don't know where they are with any precision). And of course, the US cannot control global emissions in any case. For all these reasons, while it's important to design a tax so that ensures large emissions reductions, it's not clear there is much added benefit to knowing exactly what emissions levels will be (and the tax provides upside as well as downside).
(2) In theory, such tax increases could be established up front. But for both a cap or tax, adjustments over time would likely be preferable (and difficult in both cases also).
(3) This may be the "default" approach of policy makers for compensating industries, but I see no reason why they would *have to* be compensated through tax concessions, as you say. Tax revenue could be given to them in ways that do not distort incentives.
(4) In the current political climate, it is difficult to envision any national carbon pricing policy passing Congress (and conventional wisdom--which could be wrong--is that cap and trade may be even more of a non-starter than a carbon tax at the moment. Fortunately, I don't think anyone can predict how the political situation will evolve, especially over many years.

So while I agree these are all important issues associated with carbon taxes, I hope we can agree that none are insurmountable. Thanks again.

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