Carbon Tax or Cap and Trade, which is a better policy to cut emissions?

By Puja Meiyammai

The imposition of tax on each unit of greenhouse gas emissions giving firms (and households) an incentive to reduce pollution is called a Carbon tax. Naturally, lower carbon emission would mean a lower or no tax. The tax is set by assessing the cost or damage associated with each unit of pollution and the costs associated with controlling the corresponding level of pollution. When the tax level is too low, firms and households would prefer paying the tax and pollute, which would ultimately negatively affect the society. Too high a tax would mean that the costs would rise beyond optimum, lowering compliance, increasing evasion, and impact profits, employments, and consumers.

A cap-and-trade system sets a maximum level of pollution, a cap, and distributes emissions permits among firms that produce emissions. Companies must have a permit to cover each unit of pollution they produce; they can obtain these permits either through an initial allocation or auction or through trading with other firms. Since some firms inevitably find it easier or cheaper to reduce pollution than others, an alternative trading platform is borne. Whilst the maximum pollution quantity is set in advance, the trading price of permits fluctuates, becoming more expensive when demand is high relative to supply (for example when the economy is growing) and cheaper when demand is lower (for example in a recession). A price on pollution is therefore created as a result of setting a ceiling on the overall quantity of emissions.

But the 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 the certainty that emissions will fall below the predetermined emissions targets.

Critics reveal the disadvantages of such carbon-based systems 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. As shown 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.

Like the two sides of a coin, there are various advantages and disadvantages one could think of. However, 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, policymakers, and businesses support using a price on carbon to achieve the greater climate policy ambition we need. Even then, the powerful corporate structure, lobbying, corruption, ideological opposition, and evils of the market structure makes the adoption of a carbon-pricing policy very difficult. Uncompromising stances on policy preferences are unhelpful and divisive. Thus, the benefits of carbon pricing are not worth sacrificing for the goal of achieving any other policy.

School of Policy and Governance, Azim Premji University