Fiscal incentives to reduce carbon emissions have generally fallen into two categories: a carbon tax and a cap-and-trade system. A carbon tax discourages carbon emissions by making them more costly, charging the emitters a tax for every ton of pollution they emit. In a cap-and-trade system the government sets a cap on overall emissions and issues tradable permits that grant businesses the right to emit a certain amount. These permits are marketable – businesses that can reduce their emissions can sell their unused allowances to other businesses that cannot reduce their emissions in a cost efficient manner. Both the carbon tax and the cap-and-trade systems are economic, market-based incentives that put a price on carbon emissions.
How a carbon tax works
Since the burning of fossil fuels generates the carbon dioxide emissions that contribute to global warming, the carbon tax is intended as an economic measure to reduce these emissions. It is a pollution tax that is levied on the production, distribution or use of fossil fuels. The amount of the tax is based on how much carbon the fuels produce when they are burned. The government sets an overall price per ton of carbon emissions, and then makes the calculations to apply the tax on the industries that generate these emissions, based on the type of fuel, such as coal, petroleum or natural gas.
By making the dirtiest fuels more expensive, the carbon tax is intended to encourage industries to improve their technology to clean up their processes, become more efficient and consume less fossil fuel, or shift to cleaner sources of energy. Since the tax could be passed on to consumers, it encourages individuals to reduce their consumption and increase their energy efficiency.
A carbon tax is also intended to make alternative energy sources, such as solar and wind, more cost competitive and shift consumption to these cleaner ways of generating energy. As explained by Sarah Dowdey in How Carbon Tax Works, by taxing inexpensive fuels like coal, the price per Btu is increased, making it more comparable with cleaner forms of energy, which historically have been more expensive.
A carbon tax could be levied at different points in the supply chain. For example, it could be charged on producers like coal mines and oil wellheads, on suppliers such as coal shippers and oil refiners, and on distributors such as utility companies. The carbon tax could also be charged directly to consumers through gasoline taxes and taxes on their electric bills.
The fiscal revenue generated by a carbon tax could be used to subsidize environmental programs, fund other priorities, or to shift the tax burden. One tax-neutral position that has been proposed is to offset the carbon tax with corresponding reductions in payroll taxes. The idea is that this would avoid the regressive effect on low and medium income individuals who could be hit the hardest by a tax on fuels.
In his article Cap-and-Trade vs. Carbon Tax: Formulating an Effective Carbon Accounting System Ryan Hottle makes reference to a proposal by Dr. James Hansen of Columbia University to return the money generated from a carbon tax directly back to the people, depositing the money into their bank accounts each month. Dr. Hansen suggests that this would be a way to show voters that the system is transparent, fair, and non-regressive.
How carbon cap-and-trade works
The basis of the cap-and-trade system is a nationwide limit on total carbon emissions. As explained by Mark MacLeod in How does cap and trade work?, the cap would probably be measured as billions of tons of carbon dioxide emitted into the atmosphere each year. This cap would be progressively lowered to continue cutting emissions. The overall limit would then be divided up into allowances, or permits for a certain amount of emissions. The total of all the allowances would be equal to the overall cap.
Each year, the businesses subject to the cap, such as power plants, manufacturers, and others that have carbon emissions, have to turn in allowances that are equal to their emissions. When a business can reduce its emissions so that it has more allowances than it needs, it can sell the excess allowances. Businesses that find it is too costly to make the necessary adjustments to reduce their emissions would have to buy allowances from other businesses with lower emissions and excess allowances. This creates a marketplace for the ‘carbon credits’ and provides a strong incentive for businesses to reduce emissions since they can profit by selling excess allowances.
The initial credits under a cap-and-trade system could be given away by the government to the companies that have historically produced carbon emissions. Or the credits could be distributed based on an auction each year – each company would have to purchase the credits they need. As in the case of a carbon tax, the revenue from a carbon credit auction could either be used to fund government programs, or could be returned to the people as a ‘dividend’, to help offset the additional cost of energy and goods that are passed on to consumers.
Pros and cons
There are differing opinions on the relative merits of each method of controlling carbon emissions. In terms of the objective of reducing carbon emissions, proponents of the cap-and-trade system argue that it sets an overall limit. Total emissions can be controlled and accounted for. The best scientific data available can be used to set the limits. A carbon tax discourages emissions but does not directly set a limit on the total amount of emissions.
A carbon tax would provide certainty regarding the cost of emissions, while a cap-and-trade system provides certainty as to total emissions. The carbon tax sets a definite price on emissions that businesses could take into account in determining their return on investments in cleaning up their processes or investing in alternative sources of energy. This predictability is an argument in favor of the carbon tax. New York Mayor Michael Bloomberg, as quoted by Matthew Hennessey in Cap and Trade vs. Carbon Tax supports the carbon tax for this predictability, among other reasons. With cap-and-trade there is predictability as to the total emissions, but not necessarily the cost, since the value of carbon credits can fluctuate according to market conditions.
Proponents of cap-and-trade argue that the chance to make a profit by selling unused allowances would stimulate innovation in cleaner technology and alternative energy sources. This view is shared by Vincent DeVito, former acting U.S. Assistant Secretary of Energy who helped launch the U.S. Climate Change Technology Program in 2002. Proponents of the carbon tax would counter that a tax also encourages innovation by making carbon emitting more costly and leveling the playing field for alternative energy sources.
As quoted in an article on the Triplepundit website, Rex Tillerson, Exxon Mobil Corp’s chief executive came out in favor of a carbon tax, describing it as a more direct and transparent approach. Opponents of cap-and-trade argue that it would be complex to administer and subject to abuse. But Eileen Claussen and Judith Greenwald, in an op-ed for The Pew Center on Global Climate Change, point out that neither system is inherently more complex. Both systems require monitoring and enforcement.
Proponents of a cap-and-trade system in the U.S. argue that it could be more easily integrated with other international systems, such as the Emission Trading Scheme implemented by the European Union in 2005 in response to commitments taken on under the Kyoto Protocol. Other countries including Finland, The Netherlands, Norway and Sweden have enacted a carbon tax. In their article We Need a Global Carbon Tax in the Wall Street Journal, Ralph Nader and Toby Heaps point out that “China emphatically opposes a hard emissions cap on its economy”. Both sides in the carbon tax vs. cap-and-trade debate would agree that any international effort to reduce global emissions must include China and the U.S. and that action is urgently needed. It may turn out that some combination of the two methods may be the most effective, hopefully taking the best aspects of each to develop an integrated solution. As Ryan Hottle indicates in an article on the Global Climate Solutions website, we have precious little time.
Cap and Trade vs. Carbon Tax, by Matthew Hennessey – Policy Innovations
Cap-and-Trade vs. Carbon Tax: Formulating an Effective Carbon Accounting System, by Ryan Hottle – Global Climate Solutions
Carbon Cap – GreenTerraFirma
Carbon Tax Versus Cap-And-Trade – Triplepundit
Carbon Taxes vs. Cap-and-Trade, By Steve Coll – The New Yorker
Emission Trading Scheme (EU ETS) – European Commission on the Environment
The European Union’s Emissions Trading System in perspective, by A. Denney Ellerman and Paul L. Joskow, Massachusetts Institute of Technology – Pew Center on Global Climate Change
How Carbon Tax Works, by Sarah Dowdey – HowStuffWorks
How does cap and trade work?, by Mark MacLeod – Environmental Defense Fund Climate 411
Op-Ed: Cap & Trade vs. Tax, by Eileen Claussen and Judith Greenwald – The Pew Center on Global Climate Change
We Need a Global Carbon Tax, by Ralph Nader and Toby Heaps – The Wall Street Journal