Gauging the appropriate price for carbon dioxide (CO2) and other greenhouse gases is a high priority for legislators and administration officials seeking to address global warming. In this RFF Issue Brief, Senior Fellow Ian W.H. Parry looks at two distinct ways of viewing this problem. The first is a "cost-effectiveness approach" that sets limits on greenhouse gas accumulation in the atmosphere and seeks to meet those goals at minimum cost, which also over time fixes a market price for emissions. The second is a "welfare maximizing approach" that tries to balance potential damages from global warming against economic mitigation efforts. He concludes that a price of at least $5–20 per ton of CO2 is warranted on economic grounds, and possibly much higher.
Parry also examines the tradeoffs between levying a tax on CO2 and creating a cap-and-trade system. On balance, he suggests that a revenue-neutral carbon tax is "the ideal domestic emissions mitigation policy on economic efficiency grounds." However, the case for a CO2 tax is nuanced, because in large part a cap-and-trade system can be designed to mimic the potential advantages of a tax.
Whichever instrument is chosen, the critical issue is to design it in a way that contains the cost of the policy, for a given overall reduction in emissions. Most important in this regard is judicious use of the revenues from a CO2 tax or auctioned allowance system, which might amount to around $100 billion a year. Parry suggests that if this revenue was used to reduce income taxes that distort employment, investment, and savings decisions, the overall costs of the climate policy are dramatically lower than if the revenue is not used productively, or if CO2 allowances are given away for free. Other important design issues include maximizing coverage of greenhouse gases and limiting emissions price volatility.