Wednesday, May 1, 2013

Pricing Carbon: Cap and Trade or a Carbon Tax?


Greenhouse gas emissions (GHGs) are one of the most commonly cited examples of a negative externality: when prices in a competitive market do not reflect the full cost of producing a product or service. The days of freely emitting greenhouse gas emissions are numbered and government institutions are in the process of determining the best way to price carbon emissions. Among the plethora of options, carbon taxation, a pricing instrument, and emissions trading, a fixed quantity model, remain the two economically efficient policies.

Putting a price on carbon dioxide is an attractive alternative to providing expensive subsidies to the renewable energy sector. Since carbon pricing increases the price of fossil-fuel based energy sources, the price of renewable energy becomes more competitive in comparison. What’s more, carbon taxation provides organizations with an incentive to invest in greener technologies. In fact, executives of oilsands’ companies have expressed their support for carbon pricing.

The leading proposal in the United States and globally is to create an emissions trading system, also known as cap-and-trade.  Cap and trade systems place a limit on the amount of pollution that can be emitted. Therefore, firms must pay for each unit of pollution in the form of a permit. The price of these permits varies depending on supply and demand. Firms that can reduce greenhouse gas emission inexpensively can sell their permits to other organizations. The widespread acceptance of cap and trade is no surprise as the system benefits almost all stakeholders. For governments, cap and trade offers the opportunity to take action to combat climate without the negative perception of an added tax. For environmentalists, emissions trading systems ensure governments commit to a fixed reduction in greenhouse gas emissions. Cap and trade systems can work effectively as evidenced by the sulphur dioxide allowance-trading program that was established under the 1990 Clean Air Act Amendments (CAAA). The goal of the program was to reduce S02 emissions by ten million tons relative to 1980. The program was immensely successful; sulphur dioxide emissions declined by 43%, despite electricity generation from coal-fired power plants increasing by over 26% between 1990 and 2007.

Despite being positioned as a market-based approach to curb greenhouse gas emissions, cap and trade systems are not the best tool to combat climate change. First, cap and trade systems can take years to implement because of delays associated with policy implementation. Given the uncertainty over the price of carbon dioxide emissions, in the event that the price of carbon rises, there will be pressure on the government to relax the carbon cap, thereby reducing the overall efficacy of the policy.

A carbon tax levies a tax on each unit of greenhouse gas emissions and provides incentives for organizations to reduce pollution. Carbon taxes are easier to implement than cap and trade systems and can be adjusted if the resulting changes are too strong or too weak. Carbon taxes are supported by economists on the left and right because they are a market instrument that does not require substantial government involvement: change the price and let the market work its magic.

Carbon taxes carry limitations as well. Perhaps the biggest obstacle is the challenge of instituting an additional tax. There are many psychological reasons why people oppose things like carbon taxes. For one, the endowment effect—when peoples' willingness to accept compensation for a good is greater than their willingness to pay once their property right is established—is one reason why taxes are hard to accept.  While both pricing systems increase energy prices, cap and trade is often more viable politically because it is not labelled as a tax. Finally, there is a temptation that politicians will use carbon taxes as a revenue source rather than a neutral tax. Remember that carbon taxes are intended drive down consumption of fossil-fuel based energy source (see British Columbia's revenue neutral carbon tax as a case in point: http://www.fin.gov.bc.ca/tbs/tp/climate/carbon_tax.htm).

Both pricing models achieve the outcome of increasing energy costs and reducing greenhouse gas emissions.  The challenge is that while carbon taxation is a more holistic solution, it is less appealing to voters due to the negative perception associated with an added tax. In short, carbon taxation is a remarkably system that allows governments to reduce spending (particularly on supporting renewable energy), lower our dependence on foreign oil, reduce pollution, and correct a market failure.

By Trevor S.