EME 803
Applied Energy Policy

Comparison of Carbon Tax and Cap & Trade

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Comparison of Carbon Tax and Cap & Trade

Now that we've explored both the option of implementing a carbon tax for emissions or regulating them under a cap and trade scheme, let's take a closer look at what the differences are.

Table 5.1: Comparison of Carbon Tax and Cap & Trade
Carbon Tax Cap & Trade Scheme
Emissions

Unknown

how willing firms will be to pay the tax to continue with levels of emissions; difficult to predict what future emissions scenarios will look like

Known

the cap for allowable emissions is set and serves as the basis for the program; making it easier to predict future emissions scenarios

Cost of one ton of CO2

Known

the price of a ton of emissions is established, but the total revenue generated from the program remains unclear because of the difficulty in predicting willingness to pay the tax vs. emission abatement

Unknown

the cost of a ton of CO2e emissions is variable, depending on the scarcity of tradable permits and firms' abilities/desire to pursue emission abatement measures to not only avoid buying permits to cover their emissions but also to be able to sell surplus permits to other firms

In summary, when thinking about which program works the best, it's really a question of which variables we want to have more control over and which variables we're willing to leave to the market to sort out. There are considerable advantages to each. So, do you want to set the price, or do you want to set the limit on emissions?

The Center for Climate and Energy Solutions offers a concise summary of cap and trade vs. carbon tax which I encourage you to read (it was previously an assigned reading with this lesson). This is part of a Congressional Policy Brief Series the Pew Center has assembled to address questions from policymakers and their staffers on a variety of topics related to climate and energy policy. You may find this to be a useful resource.

Another alternative for regulating greenhouse gas emissions that we're not going to dig too deeply into is traditional command and control regulation. Under a command and control scenario, the government establishes a limit (for example - every source must reduce their emissions by 40%), and there's no real consideration built-in for the fact that achieving those reductions will be easier (less expensive) for some sources than others, and perhaps even more important, there's no financial incentive to achieve reductions in emissions above and beyond what is prescribed. This isn't to say there aren't useful applications of a command and control policy for environmental regulation, but, rather, that we are instead going to focus our discussions on market-based opportunities to achieve emissions reductions.

Take a look at the graphic below from California Nonpartisan Fiscal and Policy Advisor, Legislative Analyst's Office. It illustrates the cost differences between command and control, carbon tax, and cap and trade. What you'll notice is that in all three scenarios, here, it is possible to cut these (theoretical) emissions in half. The differences come in the costs to achieve this level of compliance, and the flexibility afforded by the mechanism. The options are presented from least to most flexible in terms of achieving compliance. In a command and control scenario, emitters are forced to reduce their own emissions by the prescribed amount or face penalty. In a carbon tax scenario, emitters must pay for every ton of GHG they emit - thereby creating an incentive to reduce emissions in the house as much as possible to avoid the tax burden. With a cap and trade scenario, emitters have the flexibility to reduce emissions in the house or purchase allowances from other emitters who have achieved surplus reductions of their own. One could argue that buying allowances is somewhat similar in structure to paying a carbon tax per ton of emissions, and that's true. However, in the cap and trade design, the value created by generating surplus allowances beyond what you need for your own compliance is thought to incent innovation in emission reduction technologies more so than the design of either other system.

Graphic showing three ways to cut emissions in half. Text version available in caption
Figure 5.1: The Theoretical Potential of Market-Based Mechanisms: Three Ways to Cut Emissions in Half.
Click here to expand for a text description of figure 5.1

The Theoretical Potential of Market-Based Mechanisms: Three Ways to Cut Emissions in Half A Command and Control Policy

  • Government requires each firm to cut emissions in half.
  • Firm A: High Cost ($4 per ton to reduce emissions).
  • Firm B: Low Cost ($2 per ton to reduce emissions).
  • Each firm has 4 tons of emissions.
  • Both firms reduce emissions by 2 tons.
  • Firm A has an $8 cost of reduction and pays $0 to the government.
  • Firm B has a $4 cost of reduction and pays $0 to the government.
  • Total cost of reduction is $12 and the total remaining emissions equals 4 tons.
Market-Based Mechanism #1: A Carbon Tax
  • Government sets a tax of $3 per ton of emissions.
  • For firm A, the $3 tax is less than the $4 cost to reduce, so A pays the tax and does not reduce emissions.
  • For firm B, the $3 tax is more than the $2 cost to reduce, so B pays no tax and eliminates emissions.
  • Firm A remains with 4 tons of emissions and a $12 payment to the government.
  • Firm B remains with 0 emissions and an $8 cost to reduce.
  • Total cost of reduction is $8, the total remaining emissions is 4 tons, and the total payment to the government is $12.
Market-Based Mechanism #2: A Cap-and-Trade Program
  • Government introduces a fixed quantity of allowances.
  • The market allows for the buying and selling of allowances.
  • Price of $3 per allowance results from buying and selling.
  • For firm A, the allowance price is less than the $4 cost of reduction, so A buys 4 allowances and does not reduce emissions.
  • For firm B, the allowance price is greater than the $2 cost of reduction, so B buys no allowances and eliminates emissions.
  • Firm A is left with 4 tons of emissions and a $12 payment for allowances.
  • Firm B is left with 0 emissions and an $8 cost of reduction.
  • Total cost of reduction is $8, the total remaining emissions is 4 tons, and the total payment to the government varies. (Depends on whether the allowances were initially auctioned or given away for free. The auction would result in payments to the government.)
Credit: California Nonpartisan Fiscal and Policy Advisor, Legislative Analyst's Office