Corrective Tax Vs Cap And Trade: Pollution Reduction Strategies

The world is facing an urgent need to reduce pollution and curb the impacts of climate change. Economists argue that a free market will not be able to achieve this goal as there is insufficient incentive for firms and households to reduce emissions. Two main policy options are available to address this market failure: a corrective tax or a cap-and-trade scheme. A corrective tax, also known as a carbon tax, imposes a tax on each unit of greenhouse gas emissions, giving entities an incentive to reduce pollution. On the other hand, a cap-and-trade scheme sets a maximum level of pollution and distributes emissions permits among emitting firms, which can be obtained through auctions or trading. Both policies aim to reduce pollution and generate government revenue, but they differ in their implementation and outcomes. This article will explore the advantages and disadvantages of each approach and discuss which policy is more effective in reducing pollution.

Carbon tax vs cap-and-trade: which is a better policy to reduce emissions?

The world is facing an urgent need to reduce greenhouse gas emissions and mitigate the accelerating impacts of climate change. Two prominent policy approaches to achieve this goal are carbon taxation and cap-and-trade systems. Economists argue that a free market will result in excessive emissions due to insufficient incentives for firms and households to reduce pollution. Therefore, implementing the "polluter pays principle" by placing a price on carbon dioxide and other greenhouse gases is recommended. This can be achieved through either a carbon tax or a cap-and-trade scheme.

Carbon Tax

A carbon tax directly imposes a tax on each unit of greenhouse gas emissions, providing an incentive for firms and households to reduce pollution when it is more cost-effective to do so than to pay the tax. The key challenge is setting the tax at the right level: too low, and entities may opt to pay the tax and continue polluting; too high, and the costs may outweigh the benefits of reduced emissions. Carbon taxes offer stable and predictable prices, enabling energy producers and entrepreneurs to make investment decisions with confidence. Additionally, carbon taxes are generally quicker to implement, easier to understand, and harder to manipulate compared to cap-and-trade systems.

Cap-and-Trade

A cap-and-trade system sets a maximum level of pollution (a cap) and distributes emissions permits among emitting companies. These permits can be obtained through initial allocation, auction, or trading with other firms. The trading price of permits fluctuates based on supply and demand, creating a price on pollution. One advantage of cap-and-trade is that it provides certainty about the quantity of emissions, which will not exceed the predetermined cap. However, there is uncertainty about the cost of achieving these reductions. Cap-and-trade systems can also be complex and time-consuming to develop and implement, and they may suffer from issues like price volatility and excessive allowances.

Similarities and Conclusion

Both carbon taxes and cap-and-trade programs share several advantages over alternative policies. They reduce emissions by encouraging low-cost emissions reductions and stimulating the development of new low-carbon technologies. Additionally, they generate government revenue that can be used productively. While each approach has its unique advantages and disadvantages, well-designed implementations of either policy can be effective in reducing U.S. greenhouse gas emissions. Some economists even recommend a hybrid model that combines elements of both approaches to achieve the best outcomes.

The pros and cons of a carbon tax

A carbon tax is a fee imposed by a government on any company that burns fossil fuels, such as coal, oil, gasoline, and natural gas. The aim is to reduce carbon emissions and encourage investment in sustainable energy sources. It is based on the "polluter pays principle", which was established at the 1992 Rio Summit, and states that those who cause environmental damage should bear the full cost of their actions.

Pros

• A carbon tax can reduce pollution and encourage the development of more environmentally friendly alternatives.
• It can raise revenue for governments, which can be used to subsidise green alternatives, repair environmental damage, or reduce other taxes.
• It leads to a socially efficient outcome, as it makes people pay the full social cost of their carbon emissions.
• It improves the environment by incentivising companies to reduce pollution and seek out alternatives with a lower environmental impact.
• It has been successful in some countries, such as Sweden, the UK, British Columbia, and Canada, resulting in lower carbon emissions and, in some cases, substantial falls in CO2 emissions.

Cons

• A carbon tax may increase costs for businesses and reduce investment and economic growth.
• It may be difficult to evaluate the level of external cost and, therefore, how much the tax should be.
• There is a risk of tax evasion, as higher taxes may encourage firms to hide carbon emissions.
• It may be regressive, hitting lower-income families the hardest.
• It may be politically unpopular, as consumers often dislike new taxes and do not believe they will be revenue-neutral.
• It may encourage businesses to relocate to countries without carbon taxes, a phenomenon known as "leakage".

The pros and cons of a cap-and-trade system

A cap-and-trade system is a market-based tool used by governments to reduce pollution. It sets a maximum level of pollution and distributes emissions permits to companies, which they must have to cover each unit of pollution they produce.

Pros

• It creates a new economic resource for industries, as companies are incentivised to lower emissions and sell any extra credits for a profit.
• There is a predetermined maximum level of emissions, which helps to track atmospheric influences and work on reducing maximum levels over time.
• It can supplement taxpayer resources, as governments can purchase emissions credits and sell them to businesses, using the income to supplement taxpayer resources.
• It could help to fund alternative energy resources, as income from credits can be used to fund research into alternative energy resources.
• The average person can create change, as consumers can choose whether to purchase from businesses that are out of compliance or cheating the system.

Cons

• Many emissions credits are just given away, so it costs businesses nothing to expand their emissions, which can harm local economies.
• The government can retire emissions credits, meaning taxpayer money is used to purchase something that isn't used and could potentially stagnate industry development.
• Some credits are artificially high in price as environmental agencies can purchase them and choose not to use them.
• The emissions credits are almost always cheaper than converting to friendlier resources, so there is no real incentive for industries to change their practices.
• It is relatively easy to cheat the system, as most industries don't have monitoring devices installed.
• It would create higher prices for goods and services, as renewable energy resources are relatively new and expensive.
• Different nations may have different standards as to what a maximum cap should be, with some being very lenient and others very strict.

How do carbon tax and cap-and-trade distribute the cost of reducing pollution?

A carbon tax and a cap-and-trade system are two methods of reducing pollution. Both approaches have their own unique mechanisms for distributing the costs associated with pollution reduction.

A carbon tax is a price instrument that imposes a tax on each unit of greenhouse gas emissions. The incentive for firms and households is to reduce pollution whenever the cost of doing so is less than paying the tax. The quantity of pollution reduced is dependent on the chosen level of tax. The tax is set by assessing the cost or damage associated with each unit of pollution and the costs associated with controlling that pollution. The key challenge is setting the tax at the right level. If the tax is too low, firms and households may opt to pay the tax and continue polluting. Conversely, if the tax is too high, the costs of reducing emissions will be higher than necessary, impacting profits, jobs, and consumers.

In contrast, a cap-and-trade system is a quantity instrument that sets a maximum level of pollution, known as a cap, and distributes emissions permits to firms that produce emissions. Companies must hold a permit for each unit of pollution they produce, which they can obtain through an initial allocation, auction, or trading with other firms. The maximum pollution quantity is set in advance, but the trading price of permits fluctuates based on demand and supply conditions. This creates a price on pollution as a result of setting a ceiling on overall emissions.

One key difference between the two policies is the way they distribute the cost of reducing pollution. In a cap-and-trade system, permits are often initially given out for free, a practice known as "grandfathering." This results in cheaper compliance for industries in the early stages of the scheme, as they only pay for additional permits purchased from other firms. In contrast, a carbon tax imposes an immediate cost on businesses for every unit of greenhouse gas produced, resulting in a more significant initial impact on their finances. While grandfathering is favourable for near-term business profitability, it may not be the best outcome for society as it deprives the government of potential revenues from auctioning the permits.

In summary, both a carbon tax and a cap-and-trade system aim to reduce pollution by providing incentives for firms to lower their emissions. The key distinction lies in their approach to cost distribution, with a carbon tax imposing immediate costs on polluters, while a cap-and-trade system may offer initial cost savings to industries.

The effectiveness of cap-and-trade

Cap-and-trade is an approach that uses market forces to reduce emissions in a cost-effective manner. It is a regulatory program that limits or caps the total level of certain emissions resulting from industrial activity. The government issues a set amount of permits to companies that comprise a cap on allowed emissions, typically carbon dioxide.

Distribution of Permits

Cap-and-trade programs can distribute permits through an initial allocation or auction, or through trading with other firms. In some cases, permits are given out for free initially, which is known as "grandfathering". This approach is popular with industries as it provides cheaper compliance in the early stages of the program. However, it may not be the best outcome for society as it deprives the government of valuable revenues that could be used to reduce other taxes.

Uncertainty in Cost and Benefits of Reducing Emissions

Cap-and-trade provides certainty about the quantity of emissions (it cannot exceed the cap) but creates uncertainty about the cost of achieving these reductions. In contrast, a carbon tax ensures that the price of emitting a unit of pollution is set, but there is uncertainty about the total quantity of emissions. The preferred approach depends on the sensitivity of environmental damage and the cost of reducing pollution to changes in emissions.

Hybrid Models

Some economists recommend a hybrid model that combines a cap on emissions with adjustment mechanisms such as a carbon price floor or ceiling to keep the price of permits within acceptable bounds. However, hybrid schemes can be more complex and require more intervention by the regulator in the permit market.

Monitoring and Enforcement

Global Consistency

Another challenge for cap-and-trade programs is the lack of global consistency in standards and maximum caps for emissions. Without a global cap-and-trade system, the impact on reducing emissions may be limited.

Well-Designed Initiatives

Well-designed cap-and-trade initiatives have proven to be environmentally and cost-effective. For example, companies that have effective emissions monitoring systems and comply with regulations can benefit economically by banking excess allowances, which can significantly reduce their costs.

Frequently asked questions