CPF_AssessingUSClimatePolicyOptions

Emissions Trading versus CO2 Taxes versus Standards
Ian W.H. Parry and William A. Pizer

Summary

Much attention has focused on the design of a trading program for carbon dioxide (CO2) emissions, but a more fundamental question is whether emissions trading is really the best regulatory model. In particular, are there potential advantages or disadvantages to a CO2 tax versus a cap-and-trade program? What about more traditional forms of regulation? This issue brief compares and contrasts these policy approaches, and offers the following observations:

Emissions Trading versus CO2 Taxes versus Standards

There are many similarities between CO2 taxes and tradable allowances or permits. Both reduce emissions by associating a uniform price with emitting activities at any point in time, leading to efficient, low-cost emission reductions. Both can be administered on upstream fossil-fuel producers (based on the carbon content of fuels) to capture economy-wide emissions, or on downstream emitters to capture emissions from large sources. And both can incorporate incentives for carbon sequestration and other offset activities.
Taxes generally fix the price of emissions, and leave the annual level of emissions uncertain; in contrast, tradable permits generally fix the level of emissions, and leave the price uncertain. Because climate change hinges on the long-term accumulation of global emissions, a predictable price tends to have advantages - for both the environment and the economy - over fixing the level of U.S. emissions for a short time horizon of several years. Over longer horizons, as nations converge on a common target for stabilizing atmospheric greenhouse gas (GHG) concentrations and as international participation in global emission-reduction efforts grows, fixed emissions targets become increasingly advantageous.
Taxes generally raise government revenue, while tradable permits - at least traditionally - have not. New government revenue, if used to cut other taxes or provide valuable public goods, generates additional economic benefits that are not achieved under a traditional system of tradable permits in which the majority of permits or allowances is allocated for free to regulated entities. On the other hand, the allocation of free permits or allowances under an emissions-trading regime can be tailored to address concerns about an otherwise unequal distribution of regulatory cost burdens across firms and regions.
These traditional differences between a tax and trading policy are easily blurred in a hybrid emissions trading system where some allowances are auctioned to raise government revenue and where banking and a safety valve (or perhaps borrowing) stabilize prices. Recent proposals for a Federal Reserve-like body to monitor allowance markets address this same issue.
A few differences between these two types of policies are more immutable. For example, emissions trading does require additional institutions, though experience suggests that these institutions are likely to arise quickly and for the most part inexpensively. Another difference is that a CO2 tax tends to reframe the debate in terms of revenue and fiscal policy.
Traditional forms of regulation - technology and performance standards - represent an alternative to emissions trading or CO2 taxes, but can be much more costly because they do not allow the flexibility to shift efforts toward the cheapest mitigation opportunities. As a complement to emissions trading or CO2 taxes, however, flexible standards can address possible additional market failures and potentially lower costs.