Policy commentary

Which is Best: Emissions Taxes or Emissions Trading?

Dec 24, 2007 | Ian W.H. Parry, William A. Pizer

Welcome to the RFF Weekly Policy Commentary, which is meant to provide an easy way to learn about important policy issues related to environmental, natural resource, energy, urban, and public health problems.

There is near universal consensus among economists and other analysts that the United States should implement a national program to reduce greenhouse gas emissions, particularly carbon dioxide. However, there has been an intense, and often polarized, debate over what form regulation should take, mostly focusing on the issue of emissions taxes versus a cap-and-trade system. This week's commentary, by Ian Parry and William Pizer, suggests that the choice between these two instruments is not black and white. Either instrument may have considerable merit, but this depends critically on the details of the policy specified in accompanying legislation.

Congress is considering a dozen bills that would require action to slow climate change, most of which would impose a limit on the country's emissions of carbon dioxide (CO2) through a domestic cap-and-trade system. However, just as the momentum for emissions trading seemed unstoppable, a vocal minority has begun arguing in favor of a CO2 tax, and two tax bills have recently been introduced. Whether the tax or permit approach is best isn't a simple matter, however. Much depends on the details of the specific programs - particularly the breadth of coverage, the use of revenues, and the choice of emissions or price certainty.

For example, carbon tax proposals typically focus on fuel producers and importers, levying the tax in proportion to the carbon content of fuels and adjusting for exports and sequestration. This would effectively regulate all CO2 throughout the economy and achieve the cheapest possible emissions reductions. In contrast, most emissions-trading policies, such as the EU Emissions Trading Scheme, deal only on large, stationary emissions sources and bypass cheap opportunities from smaller and mobile sources. However, an upstream emissions-trading system (now contained in several Congressional proposals) - in which fossil fuel producers and importers are required to have permits to cover the carbon content of their fuels - would work in a similar way to the typical carbon tax scheme and achieve the cheapest possible emissions reductions. 

Another clear difference is that CO2 taxes raise large amounts of revenue for the government; for example, a $10 per ton CO2 tax would raise about $60 billion in revenue per year. Probably the best use for most of this revenue would be to reduce personal income taxes, particularly in a way that provides some compensation to low-income households for higher energy prices. Cutting income taxes also benefits the economy by helping to slightly offset the distorting effect on incentives to work and save. If revenues were recycled in this way, research suggests the overall costs to the economy from a $10 CO2 tax would be very small. In contrast, under traditional permit systems, where all allowances are given away free to firms, the revenue-recycling benefit is forgone, implying that the overall costs of the permit system are much larger. We estimate the extra costs under this permit system to be around $20 billion per year for a $10 per-ton price on CO2 emissions.

However, the question of whether a strong fiscal argument exists for CO2 taxes over cap-and trade lies in the details. If legislation accompanying the tax does not specify that revenues offset other taxes, then the new revenue sources might end up being wasted in special-interest spending. Moreover, auctioning off the allowances in a cap-and-trade system, rather than giving them away for free, would generate the same amount of government revenue as an emissions tax for a given CO2 price. So what matters is not so much the choice of emissions-control instrument, but rather whether that instrument raises revenue (as both auctioned allowances and emissions taxes do) and uses that revenue productively.

A final and perhaps apparent argument for a CO2 tax is that it fixes the price of emissions. In contrast, under a pure cap-and-trade system, emissions reductions are certain, but the CO2 permit prices would vary over time with changes in energy demand, fuel prices, and so on. Volatility in permit prices may deter large investments in carbon-saving technologies (for example, carbon capture and storage) or major R&D programs (like hydrogen or plug-in hybrid vehicles), as it makes the long-term payoffs from these investments uncertain. Moreover, it makes economic sense to allow firms to produce more emissions in years when the costs of meeting a given emissions cap would otherwise be very high (a year of particularly high energy demand, for example), while encouraging extra abatement effort in years when the costs of meeting the cap are lower. An emissions tax provides this flexibility, and studies show that over time the expected environmental benefits, minus emissions-mitigation costs, may be much greater than those under a fixed emissions cap.

But again, the distinction between taxes and permits may be more apparent than real, as cap-and-trade systems can be designed to limit the price volatility. For example, "safety valves" eliminate disruptive price spikes as the government steps in to sell extra allowances if permit prices reach a certain trigger point. Alternatively, allowing firms to borrow permits from the government during periods of high permit prices and bank permits when there is downward price pressure would help to smooth out sharp price fluctuations. In fact, some price flexibility might be desirable as it allows new information to be instantly reflected in market prices and abatement decisions. For example, if global warming occurs faster than expected, speculators would expect a tightening of the future cap, forcing permit prices both in the future and in the present higher; in contrast, it could take years to get a change in emissions-tax rates enacted in response to new scientific information.

The key distinction is not really between CO2 taxes and a cap-and-trade program. Rather, it is between policies that are designed wisely, raise and use revenues carefully, and can cope with the unexpected, versus those that fall short. 



Views expressed are those of the authors. RFF does not take institutional positions on legislative or policy questions.

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Further Readings: 

Goulder, Lawrence H. and Ian W.H. Parry, 2007. "Instrument Choice in Environmental Policy." Review of Environmental Economics and Policy, forthcoming.

Hepburn, Cameron, 2006. "Regulating by Prices, Quantities or Both: An Update and An Overview." Oxford Review of Economic Policy 22: 226-247.

Nordhaus, William D., 2007. "To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming." Review of Environmental Economics and Policy 1: 26-44.

Parry, Ian W.H. and Pizer, William A., 2007. "Combating Global Warming: Is Taxation or Cap-and-Trade a Better Strategy for Reducing Greenhouse Emissions." Regulation 30: 18-22.