Geoscience Reference
In-Depth Information
CARBON TAXES AND CAP AND TRADE:
THE IMPORTANT DIFFERENCES
Once we move from an idealized analysis to a realistic situation,
signifi cant differences emerge. Generally, economists lean toward car-
bon taxation as preferable, while negotiators and environmental spe-
cialists lean toward the cap-and-trade approach. The following are some
of the major considerations.
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Carbon tax advocates point out that tax systems are mature and uni-
versal institutions of policy. Every country uses taxes. Countries have
administrative tax systems, tax collectors, tax lawyers, and tax courts.
Countries need revenues, and indeed many countries face large fi scal
defi cits today. By contrast, there is limited experience with cap-and-
trade systems in most countries and virtually no international experi-
ence.
A related point is that quantitative limits produce severe volatility
in the market price of carbon under an emissions-targeting approach,
which can be seen in Figure 35 for the European system. Note how
wildly prices fl uctuated in 2008, declining by almost 75 percent in a
few months. The volatility arises because both supply and demand for
permits are insensitive to the permit price. The high level of volatility is
economically costly and sends inconsistent signals to private sector deci-
sion makers. Clearly, a carbon tax would provide consistent price signals
and would not vary so widely from year to year, or even day to day.
One important difference between standard cap-and-trade systems
and taxes concerns who pays and who gets the revenues. Historically,
the permits or allowances under cap-and-trade plans were allocated
free of charge to fi rms who were regulated. For example, under the U.S.
SO
2
program of 1990, virtually all the emissions permits were allo-
cated for free to electric utilities and fi rms who were historically large
emitters and were to be regulated. Allowances were valuable assets,
and the free allocation helped reduce the political opposition to the
plan by the regulated fi rms. Similarly, in the early stages of the Euro-
pean CO
2
trading plan, permits were allocated to fi rms. Economists
fi nd the free allocation of emissions allowances objectionable because it
