Exxon is right: Let us re-examine our choice for a cap-and-trade system over a carbon tax

doi:10.1016/j.enpol.2009.01.029

Energy Policy

Volume 37, Issue 6, June 2009, Pages 2462-2464

https://doi.org/10.1016/j.enpol.2009.01.029 Get rights and content

Abstract

This commentary examines the impact of the recently launched European Union Emission Trading System (EU ETS) in terms of emission reductions and cost to the public. The study points out that a cap-and-trade system may not be the most cost-efficient mechanism to reduce greenhouse gas emissions. It also lists seven main differences between such a system and a carbon tax along the following issues: amount of emissions reduced; flow of revenue to the public purse; cost of the system to the public; marginal cost of carbon emission reductions to the firm; generating excess rent; price setting mechanism and stability of system; as well as duration and commitment. When looking at emission reductions along these dimensions, it becomes clear that an internationally coordinated carbon tax may be a quicker and cheaper way to reduce greenhouse gas emissions worldwide.

Section snippets

Difference 1: amount of emissions reduced

A carbon tax is usually negotiated at the national level. The level of the tax therefore depends on the national political climate. Emissions will be reduced as long as tax savings are higher than the cost of reduction. There is no upper limit to possible emission reductions. On the other hand, a cap on emissions means a cap on emission reductions. There will not be more emissions reduced than the cap indicates across the system. Since the cap is set through political bargaining across

Difference 2: flow of revenue to the public purse

Both a carbon tax and a cap-and-trade system that auctions off certificates generate revenue for the government. This revenue can be used to sponsor green projects, such as renewable energy, that require high up-front investments. A carbon tax generates continuous revenue flows, but it is uncertain how much will accrue over time as industry adjusts to the tax and lowers emissions. The revenue stream can be expected to increase in boom times and decrease in a recession as industrial activity

Difference 3: cost of the system to the public

Governments have been collecting taxes for centuries. Adding another type of tax is not that difficult to do administratively. Measuring emissions could be done in a standard, verifiable way. There could be some time and effort spent on political wrangling to come up with the tax rate at the start of the system, but this is also within common political practice. A cap-and-trade system requires the government or another central player to take on the function of a bank. Accounts must be set up

Difference 4: marginal cost of carbon emission reductions to the firm

The cost of carbon emission reductions in an economy is low at first, as ‘low-hanging fruit’ are addressed, and then increases as carbon reductions become more difficult to obtain. Eventual structural change may be quite costly. Having said that, as technology matures, it may actually become cheaper to reduce emissions over the long term. A carbon tax rewards emission reductions at an equal rate no matter how much the reduction cost. Firms will reduce emissions as long as the cost of reduction

Difference 5: generating excess rent

A cap-and-trade system inherently bears potential excess rent for the participants and ‘helping agents’. Firms that reduce emissions more cheaply can benefit from selling units strategically. As the price fluctuates, there is much room for speculation, especially since there is always the gamble towards the end of the commitment period to see whether the participants have arrived at the emission reductions and publically available calculations were accurate. There is also room for arbitrage

Difference 6: price-setting mechanism and stability of system

A carbon tax provides a clear price signal. The price of carbon emissions is stable until there is a change in national policy or governing political party. This price can be adjusted over time but it will not fluctuate as greatly as it would in a cap-and-trade system. The latter is due not only to supply and demand adjusting constantly to new information, but also to political bargaining. As parties are allowed to join or leave the system, the volume of units may change over time, even within

Difference 7: duration and commitment

A tax is usually set for a particular timeframe and then potentially renewed, adjusted or dismissed. It is therefore dependent on the political climate in the country. The actors affected by the tax will have to measure and report their emissions and pay the appropriate tax to the government. Having said that, carbon taxes can also be synchronized across countries, but there has been less of a track record of doing that historically. A cap-and-trade system can be set up locally but has been in

What is it that we want?

When we look at the intricacies of the systems, we can see that there are indeed subtle but potentially far-reaching differences between a cap-and-trade model and a carbon tax. When we ask the question of which system to choose as a society, we have to be clear on what we want as a deliverable. This should not be a difficult question to answer because, clearly, we want a system that lowers emissions at the lowest cost to society and provides environmental integrity. The above assessment

Acknowledgments

The author would like to thank Jonathan Koehler, Eamonn Molloy, Chukwumerije Okereke and David King for their encouragement and helpful comments.

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CommunicationExxon is right: Let us re-examine our choice for a cap-and-trade system over a carbon tax