Tax or trade?

On the first day of the 21st meeting of the Conference of Parties (COP21) of the United Nations Framework Convention on Climate Change (UNFCCC), held in Paris at the end of November 2015, an international coalition of governments and strategic partners was formed with the aim of coordinating action on reducing emissions of greenhouse gases by setting a price on carbon.

Called the Carbon Pricing Leadership Coalition, one of its first actions was to establish a High-Level Commission with the aim of exploring and evaluating the carbon-pricing options that would induce the change in behaviours needed to keep global average temperatures to below 2°C above pre-industrial  levels.[1]

The High-Level Commission issued its report in May 2017 [2]. It summarized its findings as follows:

  1. Tackling climate change is an urgent and fundamental challenge;
  2. A well-designed carbon price is an indispensable part of a strategy for reducing emissions;
  3. Achieving the Paris objective will require all countries to implement climate policy packages;
  4. Explicit carbon-pricing instruments can raise revenue efficiently because they help overcome a key market failure: the climate externality;
  5. Carbon pricing by itself may not be sufficient to induce change at the pace and on the scale required for the Paris target to be met and may need to be complemented by other well-designed policies tackling various market and government failures as well as other imperfections.

Complementary policies

The most important point in these findings is that a well-designed carbon price is considered to be indispensable if the Paris targets are to be achieved.  At the same time, the report clearly recognizes that other complementary policies may be required. It states:

“These policies could include investing in public transportation infrastructure and urban planning; laying the groundwork for renewable-based power generation; introducing or raising energy efficiency standards, adapting city design, and land and forest management; investing in relevant R&D initiatives; and developing financial devices to reduce the risk-weighted capital costs of low-carbon technologies and projects.”  [3]

What these observations by some of the world’s best economists underscore is that although carbon pricing is regarded as indispensable, complementary policies that focus more directly on reducing emissions of greenhouse gases may also play an important role in meeting the Paris Agreement targets.

Although several countries and sub-national jurisdictions introduced carbon pricing schemes decades ago, the concept has increasingly gained traction over the last few years. At the One Planet Summit in December 2017, on the second anniversary of the adoption of the Paris Agreement, leaders of governments, businesses and international organizations reaffirmed their commitment to accelerate global efforts to fight climate change and to strongly support carbon pricing at regional and national levels.[4]

Two main policy options are available for introducing and maintaining a price on carbon. One option involves setting a price through a tax or levy on greenhouse gas emissions or the carbon content of fossil fuels. The second major option, known as cap-and-trade, limits the total allowable volume of emissions over a specific period of time (the cap) from a specified set of sources, and allows emitting industries  to trade their emission rights.

If a cap-and-trade system functions well and emissions decline, greenhouse gas (GHG) pollution will be reduced each year by a predictable amount—but the price at which the emission rights trade will be uncertain. This means that the price of carbon in a cap-and-trade scheme can be hard to predict, and the level of government revenues from such a scheme are uncertain. 

On the other hand, a carbon tax requires industry to pay for every ton of GHG released into the atmosphere, usually at a fixed price.  Carbon taxes are generally easier to administer than cap-and-trade because they involve neither a market-based trading system (which has to be set up and managed), nor require the enforcement of rules to prevent market manipulation. Moreover, a carbon tax can be added to existing taxes, and industries producing emissions can predict their liabilities reasonably well.  However, although a carbon tax provides certainty about the price (and therefore government revenue), there is less certainty about the level of reductions that will be achieved.   

The question of which carbon pricing mechanism is optimal continues to be debated by economists, policy analysts and political scientists.  Some argue for a direct carbon tax, while other advocate cap-and-trade, while a third group has argued that the two policies are functionally equivalent—meaning that a cap-and-trade system can be designed to essentially mimic a carbon tax and vice versa.[5]

Carbon tax

The diagram below illustrates schematically how a carbon tax works.

How a carbon tax reduces emissions

There are two industries emitting the same amount of carbon pollution. When a carbon tax is imposed, each industry has a strong financial  incentive to reduce its emissions.  The cost of reducing carbon emissions is higher for industry A than for Industry B, so Industry A reduces emissions only to the point where it makes more sense to pay the tax on its remaining emissions. For industry B, it is less expensive to reduce emissions—so it cuts back further, but still pays tax on the lower level of emissions which would cost more to reduce than paying the tax. [6]

Each industry can decide what is its best option. This flexibility of when and how to reduce emissions, and to what level, means that the total costs to the economy are lower than they would be under a regulatory system that simply required both industries to use specific technologies or achieve a specified level of emissions performance.[7]

Cap-and-trade

A cap and trade system is more complicated. The next diagram shows schematically how a cap and trade system operates.

How a cap-and-trade system reduces emissions

Government policy establishes a maximum allowable level of greenhouse gas emissions which is less than present emission levels—this is the cap on emissions. Allowances or permits are issued to industries and they are allowed to emit carbon only up to the level of those permits. Industries and businesses can either reduce their emissions in line with the cap or buy additional permits if they decide not to reduce their emissions—but they have to purchase those permits at the market price.  Industries that reduce their emissions below their allowance are permitted to sell their allowances at the market rate, and the supply and demand for allowances determines the market price of carbon.

A cap and trade system is therefore more flexible than a carbon tax scheme—but more complicated to set up and to administer. Over time, governments rachet down the cap, and the number of allowances available on the market is reduced. The price of purchasing an allowance therefore rises—providing an additional financial incentive for industries to take steps to reduce their emissions.   


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For more information:

[1] See: Carbon Pricing Leadership Coalition: Official launch event and work plan.  At: //www.worldbank.org/en/topic/climatefinance/brief/carbon-pricing-leadership-coalition-release-of-official-workplan/
[2] Report of the High-Level Commission on Carbon Prices. Carbon Pricing Leadership Coalition. Available at: //www.connect4climate.org/sites/default/files/files/publications/CarbonPricingReportFinal.pdf
[3] Ibid. Page 3.
4] See: State and Trends of Carbon Pricing 2018. World Bank Group. Available at //hdl.handle.net/10986/29687/
[5] See: Carl J. and Fedor D. Tracking global carbon revenues: A survey of carbon taxes versus cap-and-trade in the real world. Energy Policy 96 (2016) 50-77.
[6] See: Clearing the air: How carbon pricing helps Canada fight climate change. //ecofiscal.ca/reports/clearing-air-carbon-pricing-helps-canada-fight-climate-change/
[7] Ibid