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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.

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