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Climate Change Economics and Trade Short Form

Carbon Taxes vs. Cap and Trade: Economic Theory and Outcomes

What is Carbon Pricing and Why Do We Need It?

Time is running out to prevent a 2°C rise in global temperature. The world has 29 years to make annual carbon emissions 40 – 70 percent lower than they are today[1]; otherwise, 190 million people will be exposed to extreme droughts, and more than 70 percent of Earth’s coastlines will be flooded[2]. While there are several avenues to reduce emissions, carbon pricing is a uniquely powerful mitigation solution. One analysis found that on its own, carbon pricing could deliver almost a third of the emission reductions necessary to avoid a rise of 2°C – more than any other mitigation option available.[3]

Carbon pricing is an economic tool that discourages pollution by imposing monetary costs on CO2 emissions. When faced with a price tag on carbon, industries will pursue emission reduction opportunities that are cheaper rather than paying the price. The price of carbon can be set through two vehicles: a carbon tax or a carbon cap.

A carbon tax directly prices carbon through a fixed, per-unit charge for each ton of CO2 emitted. While the level of emissions may fluctuate, the tax is set according to a projected amount of emissions at that price.[4]

A carbon cap indirectly prices carbon through a quantity-based approach. It sets a quota of carbon allowances, or permits, for emitters which represents their emission target. A carbon cap is often called “cap-and-trade” or an “emissions trading system” because the cap limits the number of allowances that businesses can have, but there is a market which enables the emitters to buy and sell their permits, effectively setting a price for emitting CO2

The primary advantages of carbon pricing are that its effects radiate across all sectors of the economy, it’s technology neutral, it provides a transparent price/quantity, and it generates revenue that can be used by governments to support an equitable clean energy transition.

Here, we argue that carbon taxes are preferable to cap-and-trade schemes due to offering price certainty, a simpler implementation and administrative cost, and a comparatively lower chance of corruption and rent-seeking behavior.

What are the Economic Assumptions Behind Carbon Pricing?

At its core, carbon pricing seeks to address the market failure of pollution control. In a market economy, firms have no incentive to restrict the negative externalities from greenhouse gas emissions like sulfur dioxide and particulate matter or dumping toxic waste.

The burning of coal is responsible for 800,000 premature deaths in the U.S. every year [5] while the byproducts of fracking have known links to asthma, childhood leukemia, cardiac problems, and birth defects in surrounding communities[6]. Yet companies rarely pay for these harmful impacts unless through successful litigation or penalties imposed by government authorities like the EPA. Carbon pricing attempts to impose a cost on these firms for their polluting activities by determining a socially efficient level of pollution.

The socially efficient level of pollution is determined through a cost-benefit analysis that balances the marginal social benefits (MSB) from pollution control with the marginal social costs (MSC). While striving for zero pollution would be ideal in the context of combatting climate change, the costs of achieving this would be astronomical and may not even be possible. At the same time, cleaning up the last few units of pollution would likely not provide that much additional marginal benefit.

As indicated in Figure 14-3[7], where the MSB and MSC curves intersect at Point E is considered the socially efficient level of pollution because the emissions rate maximizes the net social value of production.[8] The marginal private benefit (MPB) curve represents the benefits to the firm of cleaning up its pollution. As is evident from the graph, the firm does not achieve that much benefit compared to what the community receives and if left to its own devices would abate emissions at point I, far below Point E. Thus, to abate emissions at a socially efficient level an external intervention is needed.

Carbon pricing analyzes this market dynamic and attempts to compel firms to abate emissions at a socially efficient level. At Point E, the carbon tax would be set at the price on the Y axis, while cap-and-trade would set the emission cap based on the quantity on the X axis. Both schemes rely on foundational ceteris paribus, or all-else-unchanged, economic assumptions about the MSC and MSB of abatement. If these assumptions change, then the economic rationale for these policies also changes.

The first assumption is that the marginal social benefits curve is downward sloping. This implies that the first few units of abatement provide a lot of social benefit, but this benefit decreases over time as more emissions are cut. The logic is that as more emissions are cut the end products those emissions are created for – be it electricity, consumer goods, or transportation – get further reduced which diminishes your quality of life. But what if the MSB curve was upward sloping? In this case as more emissions are reduced, then the positive environmental externalities of cleaner air and water and preserved forests improve your quality of life more than carbon-intensive goods becoming more expensive. In that scenario, the tax price would be a lot higher, and the emissions cap a lot lower since the marginal social benefits are increasing the more pollution is reduced and everyone is better off if emissions can be abated more aggressively.

The second assumption is that the marginal social costs curve is upward sloping. This implies that the more emissions are abated, the more expensive it gets for the firm and society to do so.  While some emission reductions could be easier and cheap to achieve early on, after the low hanging fruit are addressed then more expensive technology and product substitutes are needed to achieve additional reductions.

A carbon cap uses a quantity based approach by allocating a fixed amount of carbon allowances tied to an emissions target. A carbon cap is often called “cap-and-trade” or an “emissions trading system” because while the cap limits the number of pollution allowances that businesses can have, there is a market where emitters can buy and sell their allowances, effectively setting a price for emitting CO2.

However, this relationship is likely not linear. As firms begin reducing emissions, there will be improvements in energy efficiency and technology along the way which will decrease the cost of abatement over time. As a result, the marginal social cost curve can be thought of as an initially upward sloping curved line that then begins to flatten and move downward. Consequently, the price of a carbon tax would likely be lower and the emission cap higher. This is because as the abatement cost decreases, then the socially efficient pollution point is further down the marginal social benefits curve so a higher amount of emissions can be curtailed (cap) at a lower price (tax).

The third assumption is that the carbon price or emission quantity at the socially efficient pollution level is sufficient to avoid the impacts of climate change. There is no guarantee that the point where the MSC and MSB curves intersect is the exact quantity which prevents a rise of 2°C. Indeed, there is still considerable uncertainty as to the exact amount of emission reductions that are needed to avoid this fate. If a tax or a cap is placed at the socially efficient pollution level and the planet continues to warm beyond the target 2°C benchmark, then carbon pricing schemes can no longer be set at socially efficient pollution levels and instead need to be set at a higher amount, economically inefficient level in the hopes of achieving the reductions necessary.

Which Carbon Pricing Scheme is Preferable?

There are several advantages and disadvantages when choosing between a carbon tax or cap-and-trade system, but in theory both will create incentives for cost effective emission reductions in the short run and cost reducing innovation in the long run.[9]

Based on years of real-world results, a carbon tax is preferable to cap-and-trade for three reasons[10]: more effective revenue collection, lower risk of corruption, and carbon price stability.  

First, carbon taxes can capture revenues more easily than cap-and-trade with lower administrative cost. Cap-and-trade systems are more complicated to implement due to the need to determine the pricing of permit allocations as well as developing trading infrastructure so firms who reduce more emissions than required can sell their additional reductions to firms that are behind. This complexity is compounded by the need for some degree of free permits needed to be given to energy-intensive industries where fossil fuel substitutes don’t exist, like in the creation of cement or steel. Carbon taxes are a comparatively easier and more straightforward way to collect revenue since they are evenly applied across all industries and at a flat rate based on the quantity of emissions released.

The ease of revenue collection under a carbon tax connects to our first assumption – what if the marginal social benefits curve is actually upward sloping, not downward? In that scenario every unit of emissions reductions gets converted into revenue that the government can use to accelerate mitigation and adaptation efforts. This improves your quality of life more than the negative effect of certain products being more difficult or expensive to consume, especially if you’re living in a coastal community affected by sea-level rise, or in the American West that’s been ravaged by wildfires. Thus, choosing a carbon tax which can more effectively collect revenue is preferrable to increase the marginal social benefits of abatement.

Second, carbon taxes provide less opportunity for corruption which can occur through rent-seeking behavior with cap-and-trade permits. Cap-and-trade systems create a new valuable asset in the form of pollution permits. It also creates a scarcity where one previously did not exist. As a result, scarce permits can be exploited by politicians and corrupt administrators who can sell off permits to certain favored industries and pocket the fees. A carbon tax provides less opportunity for corruption because it doesn’t create artificial scarcities, monopolies, or rents.[11] The tax cannot be sold to other entities and there are no new rent-seeking opportunities.

This benefit of carbon taxes connects to our second assumption – that the marginal social costs of abatement is assumed to increase over time but may actually be decreasing. Carbon taxes help drive a decrease in social costs because the fees are not being diverted by corrupt economic agents like could potentially happen in a cap-and-trade system. Rather these funds can be re-invested to bring down the cost of expensive technology that’s needed to achieve additional reductions after easy decarbonization steps are taken.

Third, a carbon tax offers price certainty as opposed to quantity certainty which limits volatility in the market price for carbon. Under a cap-and-trade system only the quantity of emissions is fixed, thus allowing the price to fluctuate as economic agents shoulder their own individual costs in order to meet that emission limit. For example, in 2006 the carbon prices the European cap-and-trade system ranged from $44.47 to $143.06 per ton of CO2.[12]  While cap-and-trade provides greater emission reduction certainty and is more environmentally effective, the price uncertainty of this approach may make the gains short lived. Uncertainty in the price of carbon will slow investments in clean energy, disrupt energy markets, and may become extremely unpopular with the public if the price fluctuates frequently causing instability in the price of everyday consumer goods.

This drawback of cap-and-trade connects to our third assumption – even if we have quantity certainty about the emissions we’ll reduce, how do we know that’s sufficient? If the assumption changes that the quantity of emissions at the socially efficient pollution point is not enough to mitigate against climate change, then carbon taxes provide a preferrable alternative since they drive market behavior through prices not quantity and can achieve progressively higher emission reductions through higher prices.

The Way Forward

Ultimately, carbon pricing is a crucial tool for reducing CO2 emissions as the environment continues to deteriorate. Currently, four-fifths of global emissions are unpriced, and the global average emissions price is only $3 per ton[13] – far too low to induce substantial emission cuts. As policymakers continue to explore avenues to decarbonize their economies, pricing carbon at the socially efficient pollution level presents a market-driven opportunity to act on this existential crisis.

Introducing carbon taxes as part of international climate negotiations at COP26 is one viable path forward to increase their uptake. For example, negotiations are continuing on how much money developed countries will donate to developing countries to help with adaptation and mitigation costs. These transfer payments could be conditioned on developing countries instituting carbon taxes with more aid going to countries with higher carbon taxes. This approach would incentivize more ambitious carbon pricing globally and increase trust in the system that climate aid is tangibly going towards higher amounts of abatement.


Works Cited

[1] Hal Harvey, Robbie Orvis, and Jeffery Rissman, “Designing Climate Solutions: A Policy Guide for Low-Carbon Energy,” pg.2, November 2018, https://islandpress.org/books/designing-climate-solutions.

[2] Alan Buis, “A Degree of Concern: Why Global Temperatures Matter”, NASA, June 19th, 2019,  https://climate.nasa.gov/news/2865/a-degree-of-concern-why-global-temperatures-matter/.

[3] Hal Harvey, Robbie Orvis, and Jeffery Rissman, “Designing Climate Solutions: A Policy Guide for Low-Carbon Energy,” pg. 253, November 2018, https://islandpress.org/books/designing-climate-solutions.

[4] Sanjay Patnaik and Kelly Kennedy, “Why the US should establish a carbon price either through reconciliation or other legislation,” The Brookings Institution, October 7th, 2021, https://www.brookings.edu/research/why-the-us-should-establish-a-carbon-price-either-through-reconciliation-or-other-legislation/

[5] EndCoal, “Health,” https://endcoal.org/health/.

[6] NRDC, “Reduce Fracking Health Hazards,” https://www.nrdc.org/issues/reduce-fracking-health-hazards

[7] Paul Samuelson and William Nordhaus, “Economics: 19th Edition,” pg 275, https://www.mheducation.com/highered/product/economics-samuelson-nordhaus/M9780073511290.html.

[8] Paul Samuelson and William Nordhaus, “Economics: 19th Edition,” pg 273, https://www.mheducation.com/highered/product/economics-samuelson-nordhaus/M9780073511290.html.

[9]James Boyce, “Carbon Pricing: Effectiveness and Equity,” 2018, Ecological Economics, https://www.sciencedirect.com/science/article/abs/pii/S092180091731580X.

[10] William Nordhaus, “To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming,” Review of Environmental Economics and Policy, Volume 1, Number 1, Winter 2007, https://www.journals.uchicago.edu/doi/abs/10.1093/reep/rem008.

[11] William Nordhaus, “To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming,” Review of Environmental Economics and Policy, Volume 1, Number 1, Winter 2007, https://www.journals.uchicago.edu/doi/abs/10.1093/reep/rem008.

[12] William Nordhaus, “To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming,” Review of Environmental Economics and Policy, Volume 1, Number 1, Winter 2007, https://www.journals.uchicago.edu/doi/abs/10.1093/reep/rem008.

[13] Kristalina Georgieva, “Launch of IMF Staff Climate Note: A Proposal for an International Carbon Price Floor Among Large Emitters,” The International Monetary Fund, June 18th, 2021, https://www.imf.org/en/News/Articles/2021/06/18/sp061821-launch-of-imf-staff-climate-note.

About The Author

Chetan Hebbale is currently a graduate student at the Johns Hopkins School of Advanced International Studies (SAIS) in Washington, D.C. focused on international economics, climate change, and sustainability.

Prior to this, he spent over 4 years at Deloitte Consulting working on technology and strategy projects at the CDC and U.S. Treasury Department.

He is a native of Atlanta, GA and attended the University of Georgia.

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