Clearing the Air: Cap-and-Trade vs. Carbon Tax

Lori Smith Schell, Ph.D.

President, Empowered Energy

Phone:(970) 247-8181

Fax:(970) 246-3761

Overview

In an effort to maintain the significant effort already invested in reducing global carbon dioxide (“CO2”) emissions, countries around the globe are scrambling to negotiate a replacement for the Kyoto Protocol, which expires in 2012. Terminology related to various types of programs to control CO2 is widely used in news reports found in all types of media, leaving many consumers of such news reports with the feeling that they should–by now–understand the terminology being used. However, it is clear that many people remain confused by the concepts and terminology associated with the various public policy options available for reducing CO2 emissions.

The purpose of this paper is to provide a primer that lays out the fundamental differences between a cap-and-trade program and a carbon tax, including a brief historical overview of events leading up to the Kyoto Protocol. The paper provides a qualitative comparison of how a cap-and-trade program works versus the operation of a carbon tax. The paper includes a discussion of the similarities and differences between a cap-and-trade program and a carbon tax, including a comparison of where each may be applied and to which type of entities, and how each is viewed by policy makers and politicians. Understanding the basic differences between a cap-and-trade program and a carbon tax is important to enablingcitizens to make better informed decisions in the debate over climate change.

Methods

This paper starts withan historical overview of the climate change debate, with definitions of commonly used terminology such as global warming potential and carbon dioxide-equivalents. After comparing past command-and-control regulations related primarily to criteria pollutants, the paper introduces cap-and-trade and a carbon tax as two means of achieving a similar end for the control of greenhouse gases. The paper then expands on the similarities and differences between the two programmatic means for pricing CO2, in an even-handed manner that attempts to not give away the biases of the author. Continued emphasis is made throughout the paper on the QUANTITY control of CO2 emissions in a cap-and-trade program versus the PRICE control of CO2 emissions under a carbon tax. Historical pricing trends from EuropeanCO2 tradingexperience are presented and compared to pricing trends associated with tradable criteria pollutant emissions in the Northeastern United States. Simple examples of how CO2 prices might be derived are provided, and the regional impact in the United Statesof putting a price on CO2 pricing is explored. Examples of leakage related to any CO2 compliance program are explored, along with potential means to minimize such leakage. The issue of revenue recycling is also addressed, in the event of either a carbon tax or a cap-and-trade program that auctions CO2 emissions allowances.

Results

Due to the expository nature of the paper, there are few quantitative results presented, other than the simple examples of how CO2 prices might be derived. The purpose of the paper is to clarify the similarities and differences between a cap-and-trade program and a carbon tax, with the intent of dispelling some of the reader’s misconceptions about each of the two methodologies most often proposed in the climate change debate.

Conclusions

A cap-and-trade program and a carbon tax are fundamentally two sides of the same coin. In an ideal world, the results of both would result in a similar CO2 emissions reductions. However, given that we live in a world of vested interests, politics, nationalism, and regional economic differences, each option for reducing CO2 emissions has its own pros and cons with respect to ease of applicability, transparency, and political acceptability.

References

Intergovernmental Panel on Climate Change, 2007, “Fourth Assessment Report: Climate Change 2007, Synthesis Report,”